Bonds at the heart of Cypriot disaster

The genesis of the Cypriot banking disaster lies in Greece’s government bonds. In 2008, when Cyprus joined the eurozone, this island nation’s banks had to meet the requirements of what typically was an 8% reserve requirement within a flexible time frame. The reserves had to be in sovereign bonds; so, in 2010, Cyprus’s banks duly bought the cheapest sovereigns they could find – Greece’s state bonds, which then were selling at a 50% discount on average.

Greece was not yet in default. So, these bonds could be – and were – carried at 100% of face value on the books of Cyprus’s banks. These banks had, in effect, cut their reserves to 4%. It was legal, utterly dishonest and it set the stage for the inside job – the theft of clients’ money and the dishonour of senior and junior bonds in the current insolvency.

After protests frightened Cyprus’s government into honouring deposit insurance for sums of less than 100,000 euros, deposits above that threshold will take a 60% hit. Customers will have 37.5% of their deposits that are above the threshold converted to voting shares in the reconstructed Bank of Cyprus, the bank designated to survive.

Another 22.5% will be put into escrow for future use as bank capital for an indeterminate time to ensure that the bank meets the terms of its recapitalization, as Bloomberg LP reported on March 28. Both senior and junior bondholders appear to be among those to be given stock; in other words, bondholders now will participate in a crapshoot rather than being paid bond interest on time.

This solution has grave consequences for all fiscally squeezed European countries. As Mario Draghi, president of the European Central Bank puts it: “Cyprus’s economy is small, but the systemic risks may not be small.”

Bond investors and their advisors should take note: this sets a precedent, says Fergus McCormick, senior vice president and head of sovereign ratings with Toronto-based DBRS Ltd. in New York, as it has never been done before in the European Union.

In previous bailouts, such as Ireland’s government rescue of Anglo Irish Bank in 2009, which saw subordinated bondholders take a writedown, senior bondholders and depositors were spared. Their bonds were treated as solemn promises and paid on time. In a Spain-based bank restructuring last year, haircuts were imposed only on shareholders and holders of subordinated debt and preferred shares. Cyprus’s conversion of depositors to unsecured creditors is without precedent in post-Second World War European banking.

Theft of bank clients’ money and the dishonouring of senior bonds had its genesis in account insurance by national authorities. Insurance created moral hazard, for it meant that banks could lend money without having to face the wrath of mobs demanding their money back. Free from the risk of runs on their banks, bankers could – and did – issue loans more freely and produced higher rates of growth in assets under administration (AUA).

Due to the compensation process, these bankers often got bigger bonuses for raising total AUA, even if the underlying business was shaky. It all worked until the tower of debt, bad loans and unsupportable reserves collapsed. In the collapse, bondholders’ rank in the windups has been pushed aside. After all, crowds in front of banks demanding their money are more morally compelling.

Worse is still to come. Capital controls will be imposed to keep money from fleeing. So, no one is going to invest in Cyprus’s bank or the country’s other corporate bonds – or even make direct investments in Cypriot businesses, suggests Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. In fact, Cyprus’s government bonds will be suspect and will be salable only with wide spreads over German bunds, the baseline for European sovereign debt.

It is too early to tell how the new business model of Cyprus banking will sell in global bond markets. Bond investors are risk-averse, and the solution adopted (which dishonours senior bonds and large deposits) is likely to raise red flags around the world. Moreover, in a world in which second-tier bonds of questionable issuers are not hard to find, fresh issues of Cyprus bank or government bonds will not be easy to sell.

In fact, Cypriot government and corporate bonds will trade as global junk. It is an ignominious end to the compromises the banks and the Cypriot government made. The cost will be borne by the local companies that will be unable to get capital and the government that will be unable to borrow money for infrastructure, trade or anything else.

As a result, Cyprus is effectively out of the global bond market for the foreseeable future.

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