Cyprus Is Not A 0.2% Problem

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 |  Includes: EU, FXE, SPY
by: All American Investor

I am tired of listening to the endless stream of pundits that CNBC parades before us, telling us that Cyprus' GDP is a mere 0.2% of total eurozone GDP, and therefore, its demise is meaningless in the scheme of things.

Before taking issue with this premise, I will stipulate that:

(1) Cyprus' GDP is about 0.2% of total eurozone GDP and that if it fell in ocean today, no one would notice, save those left on the island.

(2) The so-called Cyprus template (i.e. risk takers - shareholders, creditors, uninsured depositors - must bear bank losses, not taxpayers) is, in my opinion, a great solution because it follows the rule of law instead of the rule of political expediency which has been the eurocrats' solution of choice to other restructurings to date. Indeed, I will go out on a limb here and say that if our group of ruling class geniuses had followed the same template, our banking system and our economy would be in better shape today than it is.

(3) Anything that causes heartburn in the European banks makes our own financial system look relatively better and attracts money not only to our banks but to our markets.

Gee, says you, if this guy is feeling that warm and fuzzy, why should I worry about Cyprus?

In answering that, let me first give two underlying assumptions. If you don't agree with them, then you don't need to read further because you will likely not agree with the conclusions that I draw. They are: (1) there is no way the EU, packed as it is with sovereigns that are far too indebted and banks that are far too leveraged, can escape the economic pain associated with either (A) fiscal austerity - reducing sovereign debt - and deleveraging---bank balance sheets or (B) going belly up; and furthermore, there is no way that some of that pain doesn't find its way to the US. (2) the Cyprus template rules.

The 0.2% statement quoted at the beginning of this piece seems to imply that, Cyprus notwithstanding, the EU will "muddle through" - which is the counter argument to # (1) above and with little to no pain being transmitted outside the EU.

So let's think about what these optimists could be missing:

(1) Irrespective of the fact that the eurocrats didn't go through with it, the hubris associated with disregarding the near sacrosanct concept of guaranteed deposit insurance has to make very citizen in every one of the PIIGS or any PIIGS wannabe nervous as a cat on a hot tin roof. Think about it - if you lived or ran a business in one of those countries and it looked like your government or banking system or both were going to need a bail out, would you leave money in the bank? I know that I wouldn't.

(2) Even assuming that the citizens of a country believe that deposit insurance is cast in stone, what about the citizens and businesses with over E100.000 on deposit (the uninsured deposits). Would you even wait for a hint of a crisis? I would be on the phone with my lawyer and my accountant today figuring out how to do business without keeping deposits of substance in-country. No waiting for me.

(3) And with the introduction of capital controls would any of the above even leave their money in the EU banking system, if they have the means to place it elsewhere?

So what are the implications of the above?

(1) For one, if deposits of any magnitude start leaving a bank, what happens? Answer: to obtain the money to fund the withdrawals, they have to raise funds somewhere or sell assets. The former is easy if investors are dying to give them money. But who wants to put money in a shaky bank when the EU has basically reinstated the rule of law meaning risk takers get punished first?

OK. So they just sell assets. But you know that most of those assets are the sovereign debt of the host country. Remember, the banks bought those bonds in the first place because they couldn't be sold elsewhere at the price paid. Now the banks need someone to buy them but under strained economic conditions; and that means they have the age old "to who" problem. To who are they going to sell those bonds? Who wants to buy the bonds of an overly indebted country that is in the midst of a recession and, even if they do, what is the bid price? Oooops.

OK, so the bank takes a loss on the sale of the bonds. But remember, the banks are overleveraged. So it won't take many losses to wipe out their capital. Now they got trouble with a capital T, right here in River City. Oops.

To be sure, the ECB could step in and supply all those funds to the banks, and maybe it will preserve the euro. But that will increase the euro money supply by the amount of the deposits withdrawn from the eurobanks, converted to other currencies and deposited in foreign banks - which likely means all those extra euros out there sloshing around will aggravate the potential global inflation problem caused by far too easy central banks and do nothing to address the lousy loans on the eurobank balance sheets.

You see how this can become an extremely negative feedback loop: money leaves, banks need restructuring, depositors fear losses, so more money leaves ... and so on.

(2) If you really want a horror case, consider the exposure of these banks to the derivatives market. Of course, we can't consider that because the banking class won't tell us their exposure, and if JPMorgan (our banking fortress) is any guide, they can't tell us because they don't even know. So what happens when, as and if one or two of big banks get in trouble and start calling counterparties to pony up? The answer is we don't know that either - but it is probably not good.

(3) Please also remember that southern Europe is in a recession if not a depression. None of the above is going to improve those economies, nor will they be particularly beneficial to the northern EU economies. Also remember that roughly forty percent of US corporate profits are derived internationally and Europe is one of our main trading partners.

So what is the point? The point is that the decisions made by the eurocrats on resolving the Cyprus bail out if applied to the rest of Europe when, as and if there is ever another bail out required could cause banking and economic problems that would extend beyond the EU, impacting not only US corporate profits but also our banking system via counterparty risks the magnitude of which no one including our bank managements has a clue.

Having said all of that, the pain that will come from the rationalizing of EU fiscal policies and the deleveraging of their banking systems through the implementation of the Cyprus template will be less than if the eurocrats kept slapping band aids on every problem until the system collapses under the weight of even more sovereign debt and an even more leveraged financial system.

The Cyprus template of the "muddle through" scenario may mean less pain but certainly not no pain. Further, given its potential impact on corporate profits and our own financial system's health, I believe that argues for a larger cash position than would otherwise be appropriate if we only had the US economic situation to consider.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.