The Cyprus Debacle: Is Taking Money From Depositors Logical?

by: David Schneider

The recent news has certainly been a huge surprise to investors and the citizens of Cyprus. However, is taking from depositors that much worse than Cyprus printing their own money and devaluing their currency dramatically? The decision is yet to be finalized and may change at any minute.

The current proposal is to take 6.75 percent of depositors money who hold under 100,000 euros ($129,490) and 9.9 percent of depositors greater than 100,000 euros ($129,490). The wealthy depositors are much worse off than the small depositor, which is similar to the progressive tax system. This will narrow the wealth gap further. Theoretically, the poor to middle class should be thrilled about this solution since they are now catching up to their fellow wealthier citizens. This ironically has not been discussed.

Surprisingly, there is not much of a difference to the underlying purchasing power for the Cyprus citizen. If Cyrpus were to print their own money and devalue the currency, it would easily lose 10 percent of its value, as its percentage of debt to GDP was over 70 percent in 2011.

Cyprus: Debt evolution

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Cyprus: Debt evolution as percent of GDP

This proposed solution is a direct way of handling the debt crisis of Cyprus by digging their hands right into their citizen's bank accounts. The indirect way of printing money is viewed as more acceptable, most likely because the citizens do not actually understand or see their hard earned money being taken away from them in front of their eyes.

It is understandable that investors fear a contagion will occur and this will become the norm solution for governments to repay debt. In theory, investors fear that all depositors will flee their current banks and hide their money under a mattress to "insure" it does not get taken away (at least they will have a fighting chance against a potential robber).

From an objective stand point, it certainly seems outlandish that money would be directly "stolen" or taken away. However, the outcomes are very similar as the purchasing power of inflation greatly becomes eroded. Ultimately, debt cannot be simply ignored. It will hinder future trade amongst nations and thus must be paid for in some way or another. Credit quality is extremely vital in future trade and global economic growth.

Ben Bernake's quantitative easing efforts will in essence result in a similar outcome. It boils down to perception, and currently investors seem to not understand that the outcomes will not be much different to the underlying value of money. The United States stock market is reacting favorably to quantitative easing mainly because interest rates in fixed income are well below inflation numbers. This means that investors are actually losing and falling behind as they keep their hard earned money in these low fixed income vehicles. Hence, there are not many other alternatives. Most investors have been transferring that money into riskier assets such as equities and have been pushing stock prices much higher. As rates on fixed income rise eventually, there will most likely be more demand for bonds and a rotation back from the equity to bond market.

On a broader macroeconomic scale, quantitative easing by the federal reserve affects the whole United States economy. How about on a smaller scale when we analyze specific stocks? A similar chain of events occurs through the pricing of secondary offerings. Management increases its outstanding shares, or temporarily dilutes shareholder value for the future prospect of building and strengthening its company. Hence, the underlying concept of inflating or diluting value prove to follow the same ideology. In both cases, the Federal Reserve and the management of companies utilize similar tools to build a solid foundation for fundamental growth.

Microeconomic Comparison

On a microeconomic scale, let us compare this concept with particular stocks. For example, prospect capital (NASDAQ:PSEC), Teekay LNG Partners LP (NYSE:TGP) and Beazer Homes (NYSE:BZH) have had a history of announcing secondary offerings.

The master limited partnership had announced in September of 2012 that it would offer 4.6 million shares to the public, or an increase of 6.6 percent. Teekay's share price dropped 4 percent in the aftermarket without hesitation, eventually dropping to a low of under $38 within a week. Teekay has consistently raised funds with this strategy in order grow its fleet of carriers, which remain in heavy demand to accommodate rising global LNG traffic. Teekay currently is trading at over $40 per share as of late day trading on Tuesday, March 19, 2013.

Companies offer more equity in their company for various reasons. Strong companies will sell more of their shares for future acquisitions and further expansion. This of course means there will be more shares outstanding for the stock (similar to inflation). However, the money raised from this offering will be invested in productivity that yields a return (similar to governments paying down debt to increase future trade and economic growth). This return usually results in higher revenue, cash flow and dividends. As a result, the future stock price increases.

Most investors are short sighted and do not analyze these secondary offerings correctly. They immediately jump to the conclusion that their value will be decreased and should get out as soon as possible. The smart investor will understand the potential future gains and buy more shares or enter a strong stock on the irrational sell off, after analyzing the secondary offering of a strong company.

Perception and understanding outcomes are vital when analyzing investments. A short sighted investor will be scared out of the market, while the smart money will take this as an opportunity to prey upon the fearful investor and jump in on the "weakness."

Disclosure: I am long PSEC, BZH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.