One of the more interesting sideshows from the Cypriot "bail-in" was the cause of the effective insolvency of Laiki (Popular) Bank and the impact that everything had on the Bank of Cyprus.
Although people talk of the "eurozone crisis", that is somewhat misleading. While the fundamental causes of the problems are the same – monetary union without fiscal union, an initial set of exchange rates that woefully undervalued the old Deutschmark and (implicitly) woefully overvalued nearly all of the other currencies that joined the euro, and interest rates set at the levels required by Germany rather than those required by the peripherals – the problems expressed themselves in a number of different ways. They also expressed themselves with different degrees of urgency.
In Ireland and Spain, as we have seen, the problems arose because the low interest rates created an asset bubble. In Greece the problems arose because the Greek government fudged the statistics, concealing how much more they were consuming than they were producing. In Italy the problem was no more a problem under the euro than it had been under the lire – eventually the country would go broke, but it wouldn't go broke straightaway unless there was a crisis of confidence.
But why did the problems arise in Cyprus? There was no massive property asset bubble, and the country was not anywhere near as profligate as Greece. Indeed there was optimism as late as early last year that Cyprus was on track to reduce its deficit to 2.7%.
You can see, therefore, that if you said that it was all one big problem, and if you pointed out that the problems in Italy (and, to a certain degree, Spain) were ones of confidence rather than fundamental insolvency, then you could pretend that the entire problem was one of a crisis of confidence.
But if you saw that in some cases (in particular, Italy), the problem today was really one of confidence, even though the problem in the distant tomorrow was one of forthcoming insolvency, but in other cases (particularly, Greece), it was one of absolute stone cold insolvency, then you could also see that "solutions" in one part would not work in others.
Now, let's fast-forward from the crises of 2008/09, when half the banks in Europe effectively had to be bailed out, to early 2012.
In those three years (a vital three years for banks and insurers) one of the things that nearly all financial institutions did was offload their Greek bonds – frequently at a significant discount to par. They buyers were, in the main, hedge funds and private equity punters who reckoned that, eventually, saving the euro would be more important than anything else, and that Greek bonds would be saved.
Unsurprisingly, some of the banks with the biggest exposure to Greek bonds, as a proportion of their capital, were the Cypriot banks. Cyprus, in fact, had a problem that was closest to that in Iceland. It had a banking system far too large for its GDP. It also had a problem that Iceland did not have – it was in the euro.
But, as we have seen, Cyprus was not guilty of lunatic lending to any wide-boy property dealer. Indeed, Cyprus has fairly strict building laws. There was none of the mass over-development that blighted Spain and Ireland.
Although there were clearly TOO MANY banks in Cyprus, that problem disappeared if you started thinking of Cyprus as a kind of in-house Cayman Islands, or Guernsey, or Bermuda. All of these territories have financial systems that are huge compared to their GDP. But they survive. Indeed, they prosper, with the average GDP per capital approaching $100,000.
In other words, having a financial sector that dwarfs the rest of the country's production isn't necessarily a recipe for disaster. And Cyprus had other products – mainly tourism. Sure, banking was bigger, but not necessarily to the degree that meant inevitable disaster.
It is here that the Greek bond default, for that is what it was, becomes phenomenally significant for Greece. Last March the owners of Greek debt agreed to exchange their bonds for new ones, with a longer term, at a lower interest rate, and with a lower face value. You may recall that the European Central Bank, for reasons of politics rather than economics, actually managed to sidestep a write down on its own Greek bonds, but that is a story for another day. The Cypriot banks were not so lucky, and it was on March 9th that the death sentence for Cyprus was written.
It may seem a little unfair, therefore, that a write-down forced on (some) unwilling bondholders by the EU (and, in particular, Germany) should lead less than a year later to mainly Russian deposit holders having to take a massive haircut on their Cyprus deposits.
But, as is the case with virtually everything in the euro crisis, all is not as it seems.
In late 2009 and early 2010 the Bank of Cyprus spent billions of euros buying Greek bonds. This was when nearly every financial institution that I was writing about was selling them off. The Greek debt was yielding very high interest rates and – and this is a significant point – the ECB (which had its own chunk of Greek bonds) and the regulatory system Basel II meant that sovereign bonds could be counted at 100% of redemption value. It was still maintained that sovereign bonds – when it came to calculating capital – were safe.
Here it gets murky. It would appear, but it has not been proved, that bank executives at bank of Cyprus were buying Greek bonds, but that they were keeping the details of those purchases from Board Directors. Indeed, in December 2009 the Bank of Cyprus claimed that most of the bank's Greek bondholding had been sold. And it appears that the Board of Directors believed that this was the case. Unfortunately, many, if not more, Greek bonds had also been bought.
The long-standing ties between Cyprus and Greece are well-known, but the purchase of Greek bonds from 2009 onwards was, let's face it, mental. It was as mental as the actions of the Icelandic financial system (buying up stuff for far too much money in an attempt to pay the interest rates that it had promised foreign subscribers).
Here Reuters takes up the story:
On December 10, 2009, Yiannis Kypri, a general manager at Bank of Cyprus, told a Cypriot website, Stockwatch, that the bank had "minimal exposure to Greek sovereign debt" after reducing its holdings from 1.8 billion euros to 0.1 billion.
The same day, according to the investigators' report, Andreas Eliades, then Bank of Cyprus's group CEO, instructed his treasury department to begin new purchases of such bonds. With these new instructions, that day the bank bought debt worth €150m, and a total of €400m by the end of 2009, according to the consultants Alvarez and Marsal.
Bank of Cyprus later tried to rewrite history by claiming that Kypri's statement referred to only a temporary sell-off. That, clearly, is bollocks. Kypri's statement was clearly interpreted as a permanent reduction in exposure. Did Kypri know this? If so, he said nothing to disabuse the markets of their interpretation. If he didn't, then he can't have been paying much attention.
By April 2010 Bank of Cyprus had €2.4bn worth of Greek bonds – above the Bank's own limit, but that limit was raised a month later. Bank of Cyprus bosses still maintain that "everybody was buying into Greek bonds at the time". Well, yes, there were lots of sellers (mainly banks) and lots of buyers (mainly private equity speculators). There were not many bank buyers. At the end of 2010, only two banks in Europe actually had bigger holdings than BoC (€2.2bn) and Laiki (€3.3bn). Those banks were the vastly larger operations BNP Paribas and Société Générale. And both these banks got hurt hard when the default came.
More interestingly, it appears that the Bank of Cyprus knew that it was in a bit of a mess. Notwithstanding the claim that Kypri was only referring to a short-term sell-off in response to market conditions, in April 2010 BoC moved €1.6bn in Greek bonds out of its trading book and into its "held to maturity" book. That meant that the bank could count the Greek bonds at the price it paid (the value of Greek bonds had been falling for some time). BoC said at the time that the move was made because Greece would redeem the bonds – a triumph of hope over reality, as the events of early 2012 proved.
Andreas Eliades, CEO of the group until April last year, still insists that no-one could have imagined that a European country in the euro could default.
That, of course, is an excuse we have heard from many others in the banking sector – not just in Cyprus. "No-one could have foreseen it; no-one predicted it", was said again and again, despite the fact that from 2000 onwards several people were foreseeing a credit bubble and several people were predicting that it would end in tears.
When the axe fell last March, Bank of Cyprus was €1.8bn in the hole. Cyprus, whose GDP outside of offshore banking was tiny, was never going to be able to bail out BoC and Laiki. I've written before about the farce that led to a short period where all bank deposits at Boc and Laiki were going to suffer a hit. That nightmare scenario, which within 18 months would have led to banking crises in several other countries in the eurozone (starting with Slovenia) was thankfully abandoned a week later. But the larger depositors had to take a hit, and the effect was to destroy the Cypriot financial system. No-one would leave money in the Caymans if they thought their money would be confiscated. For Cyprus, the game is over and the economy is shot.
But things get even murkier. As we've seen, it would appear that the managers of the bank were almost operating on their own, with a Board of Directors who didn't really know what was going on. Was this true?
We shall never know. As Reuters reported, one day last October a memory stick was placed into a desktop computer at the Bank of Cyprus. There was some clever software on that memory stick. It quickly erased a staggering 28,000 files, including internal emails in late 2009 and early 2010 – precisely when many of the Greek bond purchases were taking place.
As such we will never know who knew, and, more importantly, we will never know the motives of the people who decided to do the buying. Did they really
believe, unlike nearly every other bank and life assurer in the western world, that Greek bonds were a good bet? Even if they did, such expenditure as defended by Eliades would have been grossly irresponsible in reality (but not in EU fiction, which still maintained that Greek bonds were rock solid in terms of capital requirements). Banks are not about taking good bets that are risk that, if they go wrong, will bankrupt both the bank and the country. That's just too big a risk, even if it is plus EV. It's the old story of Warren Buffett coming up to you and offering you two-to-one on the toss of a coin, but you have to put up your entire wealth. The marginal value of money comes into play.
Or were the buyers of those bonds less stupid than they pretend they are; were there other, familial, reasons for buying Greek bonds? Was it misplaced loyalty to a country that had supported Cyprus in the past? Were there incentives from the selling counterparties?
We shall never know.