For more than four years, financial markets have been assuming that bank bailouts on both sides of the Atlantic are a certain thing, as the alternative would be chaos that would hurt both Wall Street and Main Street.
The trouble with this assumption, however, is that the politicians who make bailout decisions are elected by citizens rather than by traders, investors, and bankers. And citizens' interests do not necessarily coincide with the interests of financial markets -- especially when bailouts are followed by a depression (e.g. Greece and Portugal) or by an outright tax on bank deposits, as was the case in Cyprus recently.
We aren't talking about a tax on interest earned on bank deposits, but a one-time tax on the principal -- confiscation could be a better word--depositors will have their deposits reduced by anywhere between 6.75 and 9.9 percent, depending on the amount deposited. That can explain why the Cypriot parliament voted down the proposed bailout package.
Why is this dangerous for financial markets?
For three reasons: First, it threatens to fuel bank runs across Europe.
Second, it pits the countries of the European south against the countries of the north, and most notably against Germany -- which seems to have had its way on this bailout package, having Cypriot depositors rather than German taxpayers shoulder the cost. That could increase the spread between the treasury yields of the southern and northern Eurozone members, re-igniting fears of another round of sovereign debt crises.
Third, and perhaps most important, it threatens to turn Cyprus into the Lehman of Europe, as it isn't certain whether the bailout package will get approval--a scenario that would re-ignite fears of a generalized 2008-9 style crisis.
What should investors do? Buy some insurance, e.g., buying calls on iPath S&P 500 VIX Futures (NYSEARCA:VXX) or puts on major equity index ETFs like SPDR S&P 500 (NYSEARCA:SPY), SPDR DJ (NYSEARCA:DIA), PowerShares (NASDAQ:QQQ), and Financial Select Sector SPDR Fund (NYSEARCA:XLF).
A few words of caution: Cyprus is a tiny economy in the Eurozone; and its sovereign debt is nowhere near that of other south European countries. Besides, large world economies like the US have made great progress in correcting some of the excesses that led to the 2008-9 financial crisis.