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What's The Deal With Cyprus?

Daily State of the Markets
Tuesday, March 19, 2013

Good Morning. Let's see a show of hands for everyone who uttered the words, "Here we go again" on Monday morning. For if you were taken by surprise with the early algo onslaught related to the latest edition of the European debt crisis, you couldn't be blamed for assuming that the day wasn't going to be pretty. And although the bears really didn't do all that much with what appeared to be a golden opportunity yesterday, I'm sure there are more than a few folks wondering what the deal is with Cyprus right now.

Let's start with some fun facts to know and tell. First, can you locate Cyprus on a map? Did you know there was an Eastern Mediterranean Sea? Did you realize that a teeny-tiny island south of Turkey and north of Egypt was part of the Eurozone? Did you know that at 1.1 million people, the country's population is smaller than South Dakota? Did you know that the GDP of the country represents just 0.2% of the Eurozone's economy? Did you know that the EU bailout of Cyprus's banks is a mere 10 billion euros? And based on all of the above, did you EVER think Cyprus would matter? I certainly didn't.

But apparently Cyprus does matter - well, at least a little anyway. So here's the story. This tiny island nation has been yammering on for a while now that its banks are in need of restructuring. So last week, the EU formally approved a bailout. If Cyprus could come up with 5.8 billion euros, then the EU and friends (aka the troika) would pony up 10 billion to shore up the banks. This, of course, led to the question of where the 5.8 billion that Cyprus needed to bring to the deal would come from. And THIS is where the problem started.

Over the weekend, the Cyprus government announced that it was planning to impose a one-time "levy" (a nice word for tax) on bank deposits. For accounts under 100,000 euros, the government would abscond with 6.75% of the account value. And for accounts over 100K, they'd grab 9.9% of the balance.

What? Are you kidding? Isn't that just stealing from the citizens of Cyprus to pay for the sins of fat-cat bankers who mismanaged their businesses? This is an outrage! This is a blatant betrayal of public trust! And it sets a precedent in the Eurozone for future bailouts. The public will pull their money out of the banks. Heck, if this stands, all Europeans will lose faith in the banks and a national "run" on the banks will ensue. Have they lost their minds? They can't do this, right?

Well, apparently they can. Or at least they're going to try anyway. But before you run out and start buying gold (NYSEARCA:GLD), dollars (NYSEARCA:UUP) and leveraged inverse ETFs (NYSEARCA:SPXU) there is a pretty large "catch" to the story here.

To their credit, EU officials have expressed concerns about hijacking cash from "the poor" (the Cypriots with less than 100,000 euros in their bank accounts). It seems the term "moral hazard" might have come up a couple times lately. But, what was strange (at first) is that EU officials didn't seem to mind Cyprus doing a cash grab on "the rich" (those with over 100k in the bank).

I know what you're thinking. This is just the typical European/socialistic view. Wealth should be distributed fairly and governments know best how to accomplish this, right? Although you deserve an "A" for effort for coming up with such a response, you also have missed the point entirely.

Here's the deal. Cyprus has a large banking system - a VERY large banking system. And if you immediately jump to the conclusion that this situation is thus all about the health of the global banking system, you've probably got your hand extended for another gold star. You "get" that Asia plunged 2% on contagion fears in the banking system. You likely understand that other banks were likely invested heavily in Cyprus banks and as such, dominos could begin to fall. But once again, you're going to be disappointed. You see, there's more to the story.

First let's try to put the size of Cyprus's banking system into perspective. According to some math wonks from CNBC, on a scale relative to the country's GDP, the U.S. would need to build 40 more banks the size of JPMorgan (NYSE:JPM) to compete with Cyprus. Wow. Ok, so the banking system in Cyprus is big. But again, there's more.

Here comes the fun part; the part that explains why the DJIA wasn't down 262 points yesterday. And the part that explains why the situation in Cyprus may indeed be, well, unique to Cyprus. It turns out that the Cyprus banking system has a bit of a "don't ask, don't tell" policy when it comes to where their deposits come from. According to reports I perused yesterday, the island has developed a reputation as a great place for foreigners looking to hide cash. Think money laundering. Think ill-begotten gains. Think Russian mafia.

Ah... suddenly this makes a little more sense. This is why the government has decided it is okay to just go in and take what it needs. This is why the troika isn't squawking about the "tax" (insert giggle here) being imposed on accounts over 100,000 euros. (And by the way, who besides the uber wealthy and/or the gangsters of the world need to keep several hundred thousand euros in a bank account anyway?) And this is why the strategy won't be repeated in other countries.

In short, this is also why the EU isn't too worried about taxing those bigger accounts. After all, this money was likely never taxed to begin with. I mean come on, fair is fair, right?

However, the EU (and the rest of the world, for that matter) does seem to be pretty ticked off at the idea of the "little guy" getting punished here. So as Monday wore on, we heard about new developments, new ideas, and new amendments that may soon be attached to this new law in Cyprus. Oh, did I fail to mention that this new "tax" needs to be approved by the Cyprus Parliament? Yea, so there's that drama still to come - joy.

As of Monday afternoon, the latest proposal was as follows. On accounts under 100,000 euros, the tax would be cut to 3%. For accounts between 100K and 500K, the tax would be 10%. And those "savers" with accounts over 500,000 euros, would see a "tax" of 15%. This puts the bailout onus on those with gains of questionable origin and everybody seems to be happy (relatively happy, that is) with that idea.

Then there is also talk of Russia's Gazprom bucking up the cash to restructure the banks in return for the exploration rights for natural gas in Cyprus. So, the point is that this is not a done deal by any stretch. And until it is, the markets are likely to remain a little jumpy.

Here's the timeline as it stands now... Banks in Cyprus will remain closed until Thursday. However, it is a safe bet that the banks will stay closed until the government makes a decision and passes it into law. And on that note, currently there is a vote in Parliament scheduled for Tuesday at 6:00 pm local time. However, I've heard chatter about that being pushed back as well.

And so, as investors here in the U.S., we wait. While we're waiting, it will be important to watch the action in the markets. Remember, as the saying goes, "It's not the news, but how the market reacts to the news that matters." Thus, in light of the fact that stocks didn't get hit too hard on Monday, it would seem that so far at least, Cyprus doesn't seem to matter too terribly much. But be sure to stay tuned because I'm guessing there will be an algo-driving headline or three still to come this week.

If you are looking for more on Cyprus and how this situation affects the markets, join me for a live discussion Tuesday 3/19 at 6:00pm eastern. Here's a link to register

Publishing Note: I have an early meeting on Wednesday and will publish morning report. Regular "State" reports will return on Thursday.

Let's talk strategy... Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision System Can Help.

Turning to this morning... All eyes remain focused on the situation in Cyprus this morning. The latest update appears to be a push toward no tax on accounts under 20K euros, a 6.75% levy on accounts between 20k and 100k, and then a 9.9% tax on accounts over 100k euros. In addition, politicians in Cyprus indicate that there will be no vote on the current plan as it cannot pass. Stock futures in the U.S. are pointing a bit higher in response.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:

Major Foreign Markets:
- Shanghai: +0.76%
- Hong Kong: -0.19%
- Japan: +2.02%
- France: -0.72%
- Germany: -0.36%
- Italy: -0.25%
- Spain: -0.63%
- London: -0.18%

Crude Oil Futures: +$0.18 to $93.72

Gold: -$1.40 to $1603.20

Dollar: lower against the yen and pound, higher vs euro

10-Year Bond Yield: Currently trading at 1.94%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +3.15
- Dow Jones Industrial Average: +24
- NASDAQ Composite: +4.70

Thought For The Day...

Your attitude, not your aptitude, will determine your altitude. - Zig Ziglar

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

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