Cyprus: The World’s Biggest "Poker Game" + News Russia May Reconsider Cyprus Bailout Role, Bailout Vote Delay Crushes Overnight Ramp Attempt

Submitted by Tyler Durden: While this kind of 'wealth tax' has been predicted, as we noted yesterday, this stunning move in Cyprus is likely only the beginning of this process (which seems only stoppable by social unrest now). To get a sense of both what just happened and what its implications are, RBS has put toegther an excellent summary of everything you need to know about what the Europeans did, why they did it, what the short- and medium-term market reaction is likely to be, and the big picture of this "toxic policy error." As RBS summarizes, "the deal to effectively haircut Cypriot deposits is an unprecedented move in the Euro crisis and highlights the limits of solidarity and the raw economics that somebody has to pay. It is also the most dangerous gambit that EMU leaders have made to date." And so we await Europe's open and what to expect as the rest of the PIIGSy Banks get plundered.

Authored by Harvinder Sian and Michael Michaelides of RBS,
Cyprus: the world’s biggest “poker game”
The deal to effectively haircut Cypriot deposits is an unprecedented move in the Euro crisis and highlights the limits of solidarity and the raw economics that somebody has to pay. It is also the most dangerous gambit that EMU leaders have made to date.

• What did they do? Hit depositors.
• Why did they do it? Politics, economics, and because they think they can get away with it.
• Cyprus needs to vote on this and any delay of opening the banks on Tuesday is more risk-off.
• Short term market reaction: Risk-off. The situation is fluid but watch politics, Cyprus bank runs risk, weak periphery banks impact and rating agencies. Worst case scenario? EMU exit talk. The Best case scenario? Germany is correct and the ECB bridges the time to when this is clear.
• Big picture: This is toxic and a policy error.
• Long bunds, sell the euro, sell periphery, Spain could underperform Italy, but nobody in the periphery wins.

1. What did they do?
In the early hours of this weekend, the Troika decided to impose an effective haircut to both uninsured and even more interestingly insured (<€100k) Cypriot bank deposits. More precisely, the €10bn bank rescue in Cyprus will end up with a bail-in on junior bondholders and a one-time tax on depositors. Deposits below €100k will be taxed 6.75%, and those above at 9.9%, for a total contribution of €5.8bn. Depositors will receive bank equity as compensation and the Cypriot President has offered Gas-linked notes if deposits are kept in the country for two years.
In addition, the Eurogroup expects the Russian government to come to an agreement with Cyprus soon to make a contribution to the rescue.
The Eurogroup head, Dutchman Jeroen Dijsselbloem, has refused to rule out that Cyprus will be the last instance where deposit holders get hit. Olli Rehn however has ruled this out by saying Cyprus is unique. The difference is that Mr Dijsselbloem represents the views of national finance ministers and leaders.
2. Why did they do it?
There is an excess debt problem and somebody has to pay. The division of costs is a policy choice.
The typical choices beyond growth and inflation, are via (a) getting friendly foreigners to pay such as Germany/EFSF/ESM etc; (b) getting wealthy domestics to pay (c) forcing the debtor nation to make good the loans over time through austerity; and (d) force losses on creditors such as the expropriation of SNS Reaal subordinated bonds, losses on Anglo Irish senior bonds, OSI, and of course PSI.
The signal is on the limits of core solidarity
The haircut on the deposit base in Cyprus is unique in hitting the most secure ladder in bank capital, when Cypriot government bonds and senior bank paper are still planned to be made whole. That policy choice was unexpected. One key message is that the decision represents visible evidence of the limits of core EMU solidarity. In truth, this was already evident via the ESM’s seniority and the CACs in 1y+ new government bonds.
...and the limits of the economics
According to media reports (FT) the Cypriot leaders were felt to be left with little choice. We discuss this below but why should Germany, other core countries and even the ECB threaten to take down the Cyprus’ largest banks or threaten full bail-in of depositors? The answer is that resources are limited. Core EMU is not large enough to bailout the periphery risk and so default has to be part of the solution.
Politicians are taking on the prospect that Cyprus is not systemic
Behind this political and economic backdrop is also another crucial factor: The implicit gambit here from the Troika is that the actions in Cyprus will not have systemic consequences. For instance, UK Sky television sources reported that this was indeed the message to the Cypriots over the weekend.
Is that true? Yes, on a myopic level this is correct. Cyprus has special features which include the size of the banking sector with assets of €126.4bn, or over 7-times GDP. The deposit base is €68bn, of with over €20bn is by non residents, mostly Russian. Moreover, there was little else in the banking sector to haircut with around €2bn in senior and sub, and PSI in Cypriot government bonds is was always problematic given that a large share of the debt is under English law where the CACs mean 25% holdings can provide a block while 55% domestic debt ownership implies PSI would necessitate further bank recapitalisation.

• In other words, breaking the taboo on hitting depositors, was a deliberate policy on politics, economics and a ‘bet’ from the Trokia that Cyprus’ problems will not radiate into more widespread Euro risk concerns.
• Very clearly, the OMT announcement effect coupled with the moderate reaction to SNS Reaal, Anglo Irish, and Italian elections have helped to embolden political ‘poker-like’ tactics with the markets.

3. Cyprus needs to vote on this and any delay of opening the banks on Tuesday is even more risk-off
The decision to hit depositors is a surprise to the markets but also Cypriot leaders, some of which had very recently described the idea of hitting depositors as ‘stupid’. So what happened? According to the FT and other media, a creditor group led by Germany & Finland and supported by the IMF, had been pushing for depositor haircuts to limit the overall size of the rescue loan. There was seemingly no appetite to recreate the fudges in the Greek debt sustainability analysis. The Cypriot leadership were stunned by this move but were cornered by news the ECB would otherwise pull the plug on Cyprus’ Laiki bank, which rather fortuitously, apparently no longer qualified for ELA. This in turn would have meant the sovereign would be on the hook for all insured deposits, which according to the FT would be some €30bn or 175% of GDP, as well as ushering in social upheaval.
This explains the fact that Cyprus – which had planned to vote for deal on Sunday 17th March – has had to delay the vote to Monday 18th March.

• The reason is that Cypriot President Anastasiades did not have a mandate a move to haircut deposits.

Moreover, Anastasiades’ calls for all political parties to support the Eurogroup decision in parliament, to avoid an uncontrolled collapse of financial system; job losses and Euro exit, is a signal that a Yes vote is not assured.
As for the vote count in Parliament, the main governing party will likely say Yes but the junior coalition partner has set three conditions for support, (i) written confirmation this is a one-off, (ii) the ECB must provide unlimited liquidity to make up for any deposit run and (iii) no new austerity measures beyond those already agreed. We do not know whether these conditions can be met. Note all opposition parties are against. It is possible that the vote could be with abstentions. In addition, note the initial read of popular opinion is overwhelming against the deal with 71% of respondents to an early survey saying Parliament should reject the deal.
Bank runs and bank holidays
The local Cypriot media report that bank ATM machines have run dry and that there is general anger about a freeze in electronic transfers
The move by the Eurogroup is unprecedented but the fear is rather obviously that a bank run may be in the offing. This is behind the rationale of President Anastasiades’ statement that depositors keeping their money in Cyprus for 2-years will receive securities linked to future profits from natural gas revenues. It remains to be seen whether the confidence trick of paying Cypriot taxpayers with their own resources works.

• The situation is rather fluid and there is enough concern on the political backlash in Cyprus that it has been mooted that Cypriot banks will stay closed beyond the Monday bank holiday. If this is the outcome (probably from political paralysis) then risk markets are likely to take even greater fright.

4. Short term market reaction

a) This is risk-off but how far it goes is too fluid to pin down with markets initially focused on bank risk, and related political risk, but also be watchful for ratings risk.
b) Worst case scenario: EMU exit debate.
c) Best case scenario: Cyprus swallows the medicine and this looks like a policy error at the next crisis... But even here we have a period of darkness to get through first.

The OMT announcement effect has been very powerful in reducing investor sensitivity to event risks in the European periphery. The fact the ECB can stand conditionally behind a sovereign is important in helping markets to differentiate between tail risks and this reduces contagion. This is part of the explanation behind the muted reaction to Anglo Irish Seniors, SNS Reaal subs and the Italian election. Nonetheless, wiping out depositors is at another level of concern.
What we are watching near term

• Cypriot politics will dictate the most immediate reaction and obviously the local bank runs. A delay to the vote for the deal (which means extending the bank holiday) or a ‘No’, will heighten market concerns. Conversely, a ‘Yes’ vote could materially reduce near term risk as the ECB can stand behind the Cypriot financial system with ELA to compensate for lost deposits. The hope here will be that confidence and deposits eventually return as they have done in other countries such as Greece.
• Cross border bank contagion - most likely to weaker periphery banks. The Cypriot banking system is sufficiently unique to mean that we are not looking at wholesale cross border contagion.
• Ratings agencies: The sheer guile in taking haircuts to deposits means there is less EMU solidarity than initially thought and one could also make the argument that Loss-Given-Default is materially higher now. This combination means in our view that there is downside rating risk to the periphery.

How bad could it get? If Cyprus rejects the deal, there is a political vacuum, and uncertain funding vacuum in who will fill the gap when the Cypriot banks eventually do open, and net this means speculation on EMU exit.
The best scenario? The Parliament swallows the medicine fearing financial collapse and/or EMU exit, and in time the one-off promise of the deposit tax is seen as more credible, meaning that deposits flow back into Cyprus. In the meantime, the ECB ELA keeps the banks alive.
5. Big picture, this is toxic and policy error
Our view has been that debt restructuring is a necessary albeit painful component of the crisis resolution. This stems from the fact that creditor nations are simply too small to absorb debtor risk and because sovereign EMU states will still exist for many years. That means a line has to be drawn under the available cross-border assistance and in practical terms this means (a) sovereign debt restructuring risk is higher than the consensus believes and (b) private sector and intra-country wealth transfers would have to be forced.
The decision to hit depositors was however much bolder than we expected – and we think this has two major influences.
Firstly, game theory the future where a country such as Italy is reaching the limits of debt sustainability. The analogue here is to get wealthy Italians to finally pay tax via perhaps a one-time solidarity tax on sovereign bond coupons/principal, given that domestic residents and the ECB own 71% of the market. Alternatively, getting the locals to make a sacrifice by extending the debt maturity is also feasible under the concept of ‘you broke it – you pay for it’.

• In a sense, the more domestic financial architecture, including ownership of government bonds, makes such local burden-sharing solutions more politically viable. One could even say that the ownership moves in markets aids some type of Paris Club and London Club workout.

Secondly, even if the Eurogroup wins on the idea that Cyprus wants the Euro so much that it takes the medicine, and Cyprus’ banks are unique enough to mean limited contagion effects, then that would only be phase one of the impact.

• We think the very fact that deposit haircuts have been put on the table means the cost of future bailouts will be higher as banks (at a minimum the weak banks) will be destabilised.

6. Markets
This is risk-off, and we think that the most likely scenarios involve more political wrangling where Cyprus tries to fight for a better deal – and waits to see if there is contagion to force the hands of core EMU. That means, the odds are on the banks remaining closed for a few more days and more local political wrangling. We are also attentive to any deal with Russia. Moreover, once the banks do open, markets will be attentive to the scale of deposit flight. As we mentioned above, we are also alert to ratings risks and that even in a best case scenario, there is a period of turmoil to pass through.
This is a recipe for long bunds, sell the Euro FX, selling periphery risk in general. The focus on banks and deposits could see Spain underperform Italy.
(h/t Steve)

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additional:
News Russia May Reconsider Cyprus Bailout Role, Bailout Vote Delay Crushes Overnight Ramp Attempt
Submitted by Tyler Durden: As expected, it is all about Cyprus this morning, and overnight, and just as naturally it wouldn't be a centrally-planned market without the generic BTFD overnight ramp attempt, which we got from the EURUSD, as the pair rose from sub 1.29 to 1.2973, which also pushed the US futures up to nearly fill half the overnight gap lower. Citi explained this, observing the "EUR/USD squeezed higher on reports Cyprus bailout terms may be eased, CitiFX Wire says", but it did add that "selling was likely to materialize; flow has 60% bias in favor of downside, Seeing heavy net selling, mainly from leveraged funds." Naturally, the market does what it does best - clutches at straws, although not even this centrally-planned market could ignore news that today's Cyprus parliament vote has been cancelled, that banks will likely remain closed tomorrow, and that a vote may not happen until Friday, which likely means the bank holiday is about to stretch to one week, and possibly much longer as Cyprus is terrified to open its banks to the fury of scrambling "bank-runners."
As for Cyprus, the absolute confusion deepens following comments from the ECB's Asmussen that the ECB did not insit on a Cyprus bank levy structure. This is confusing, and comes on the heels of last night's comments from German FinMin Schauble in which he blamed the ECB, Commission and Cypriot government for the wide bail in. So if the ECB, Germany, and the Cypriot government all did not want a deposit confiscation, who did? Russia?
And speaking of the Russian wildcard, things are starting to get interesting: first the country reported, via RIA, that it sees no impact on capital movement from Cyprus tax, which is interesting considering all bank transfers in and out of the island have been frozen.
But then things started to get interesting following another RIA report citing finance minister Siluanov, that Russia may reconsider its role in the Cyprus rescue following the bank tax. Siluanov added that bank tax breaks the plan for joint steps on Cyprus and that the decision was made without Russia (which is expected since Russia is not part of the Eurozone).
Russia concluded the overnight headlines after deputy economy minister Sergei Belyakov told reporters in Moscow that the Cyprus decision casts doubts on the EU banking system. Here is why all of Europe can kiss Russian oligarch savings goodbye: risks to safety of retail and corporate bank deposits “cast doubt on the principles of the banking system not just in Cyprus, but in the countries of the EU,” Belaykov says. Cyprus deposit losses won’t influence Russia’s attempts at "de-offshoreization" of economy, Belyakov added.
Forget trade and currency wars - is this the weekend we just launched the second part of the Cold war? Because if memory servers, the last time Russia and Germany were openly at each other's throats, things in Europe did not end too well...
Finally, for those who missed the news frenzy of the weekend, here is DB's Jim Reid summarizing it:
I had a strange dream that night that a European country had seized a portion of insured depositors money to fund a bail-out while senior bondholders of the banks and the Sovereign survived unscathed. I think it took until yesterday and the effects of the medicines to wear off to realise that this was what actually happened. Although EU leaders have made it clear that the shock resolution in Cyprus is a one-off it has surely changed the landscape in Europe and now provides a template that will be at least on the table, even as a bargaining chip only, in the years ahead.
The real damage here is going back on the Government's pledge to honour all deposits up to Euro 100k - one that now exists EU wide. It’s clear that the Cypriot Government was given the alternative of a chaotic default where arguably much more would have been lost for many. But could the authorities not have taxed the uninsured depositors more than the 9.9% and kept those with under 100k whole as opposed to a 6.75% levy? Overnight reports have suggested that this is one area that might be up for internal negotiations within Cyprus before the banks reopen tomorrow after today's holiday. Indeed, The FT is reporting that deposits over 100k could see an increased rate of 12.5% while smaller deposits would be levied at 3.5% in an effort by President Anastasiades to scrape together a parliamentary majority to approve the bailout. Martin Schulz, head of the European parliament, while agreeing that savers should bear some of the bailout costs, called for changes to exempt those with savings under €25,000 (The Guardian).
If the smaller depositors are hit at all, one can't help thinking that this move has crossed a sacred line and that any depositors in any bank domiciled in a country reliant on the largesse of the EU should in theory now think very carefully about alternative places to store money whatever the size of their holdings. For now one would suspect that markets are calm enough that the contagion will be limited but such a move could easily amplify any future crisis in Europe as the spectre of deposit losses will now be on the table whatever politicians say in advance or whatever insurance scheme is on the table. So this is perhaps more of a slow burning issue than the start of the immediate resumption of stress. It is however worrying that little consistency has been used relative to previous bail-outs and that smaller seemingly insured savers have been brought into the solution.
The reality though is this move is the latest (but by no means the last) manifestation of financial repression -albeit one which is a bit less subtle than say inflation or devaluation but one that has a similar impact. Indeed those of us with money in a UK bank account have seen the international value of these deposits fall notably in 2013 so far and a fair bit more since 2008. In international terms, as it stands, the smaller Cypriot deposits will have lost similar amounts to UK depositors in 2013 but clearly in a manner that will provoke much more anger. It perhaps shows how the options become more limited when you don't have your own currency to use as part of the solution.
For the record, further measures of the deal include a bail-in of junior bondholders and increases of taxes on capital income. Corporate tax rates will also be lifted to 12.5% from 10%.
According to the Eurogroup, these measures, combined with the deposit levies will reduce the size of the Cyprus bailout from around EUR 17bn to EUR 10bn and lead to an improvement in the Cypriot public debt trajectory with debt/GDP falling to 100% by 2020. So what's next? Cypriot finance minister Michalis Sarris has said that his government had already moved to ensure deposit holders could not make large withdrawals electronically before Tuesday’s open. ECB's Jörg Asmussen also said a portion of deposits equivalent to the levies would likely be frozen immediately. In terms of the legislative process, Cyprus' parliament will not be convened until 4pm Cypriot (2pm London) time today with a vote on the levy expected before tomorrow. The current ruling party's lack of majority may just complicate things here. Indeed the parliament is composed of 56 MPs and legislation requires a simple majority of 29 votes. DB’s George Saravelos noted that the opposition already stating that they will vote against so the ratification hinges on all of the ruling party's (DISI, 20 MPs) and the smaller coalition partner's DIKO (9 MPs) votes. That said, George’s baseline scenario is that the levy will pass, not least because there is now little alternative left but he also highlighted that the approval would be a close call and the risk is that decisions are delayed. A delay or failure to approve the bailout may put Cyprus banks' liquidity profile at risk. For instance, the UK Telegraph noted that Cyprus Popular Bank could have its emergency liquidity assistance funding removed by the ECB by 21 March. Interestingly, approval of the levy would also have consequences on the approximately EU2bn of British deposits held in Cyprus but George Osborne on Sunday said that British troops and Government staff's savings that are threatened by the bailout will be compensated with the details to be worked out over the next few days.
Taking a look at the market reaction thus far, the EUR took a dive against the Dollar overnight to 1.2885 (vs 1.3076 close on Friday) but is off the intra-session lows for now. Asian equities are lower across the board with losses seen on the Hang Seng (-2.1%) and ASX200 (-2.05%). Most other Asian indices are down between half to one percent but are off the early lows.
S&P 500 Futures are down -1.7% overnight. Credit spreads gapped wider with the Australia and Asia iTraxx indices 4-5bp wider as we type. European Financials Snr and Sub indices are 24bp and 36bp off their recent wides but we can perhaps expect a weak day ahead given the focus on Cyprus. Reflecting the greater demand for so-called safe haven assets, gold is up 0.3% and 10yr UST yields have rallied 9bp overnight.
Aside from the events in Cyprus, the other news of note over the weekend was the election of presidents (speakers) in the Italian parliament’s two houses. As DB’s Marco Stringa writes, both speakers are newcomers in the Italian parliament. In the senate, Pietro Grasso, an antimafia prosecutor, won in a run-off vote. Grasso obtained 13 votes more than the number of centre-left senators with the additional support more likely coming from a minority of the Five Star Movement senators than Monti’s centre. However, this should not be read as an opening of the 5SM to an alliance with the centre-left. The great majority of the 54 5SM Senators followed the party’s line even in the run-off. Indeed, Marco continues to sees little hope for cooperation among the parties to form a government.
Turning to the day ahead, the immediate focus will be on the parliamentary session in Cyprus beginning this afternoon. There is little data scheduled for today with the US NAHB housing index the main release of note.
Beyond today, the FOMC’s policy announcement and Bernanke's press conference on Thursday will take centre-stage. Our US economists do not expect any imminent changes in Fed policy. Thursday’s flash European PMIs will be the focus data-wise following the mixed readings last month. In China, the HSBC flash manufacturing PMI (also on Thursday) will be watched for any bounce back after February’s fall - which many blamed the timing of new year for. A busy week for the UK is scheduled with the government's 2013 budget (Wednesday) as well as jobless/inflation/retail/government borrowing reports and BoE minutes through the week. In the US we get the latest round of housing data with housing starts and building permits on Tuesday; and existing home sales/house prices on Thursday. Outside of housing, Thursday's Markit PMI and Philly Fed surveys are worth watching.

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