Portuguese Judiciary Deals a Blow to Austerity

Portugal is in the news because its constitutional court tossed out part of its austerity package. This from a story today by Raphael Minder, "Portuguese Debt Crisis Brings New Trouble for Euro":

In an address to his beleaguered nation on Sunday, Prime Minister Pedro Passos Coelho warned that his government would be forced to cut spending more and that lives “will become more difficult” after a court on Friday struck down some of the austerity measures put in place after a bailout package two years ago. 

The renewed tension in Portugal raised the threat of further trouble elsewhere in the euro zone, where ailing members have struggled to rebuild economic growth after enduring wrenching spending cuts. 

“The risks in the euro zone have increased markedly over the past six weeks or so,” wrote Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London-based consultancy that assesses risk on sovereign debt. 

A critical moment for the latest trouble took place on Friday, when Portugal’s Constitutional Court struck down four of nine contested austerity measures that the government introduced as part of a 2013 budget that included about 5 billion euros, or $6.5 billion, of tax increases and spending cuts. The ruling left the government short about 1.4 billion euros of expected revenue, or more than one-fifth of the 2013 austerity package. 

Specifically, the court, which began reviewing the legality of the government’s austerity measures in January, ruled as unconstitutional and discriminatory the government’s plans to cut holiday bonuses for civil servants and pensioners, as well as to reduce sick leave and unemployment benefits.

Minder also quotes Jens Weidmann, the head of Bundesbank, saying Cyprus may need an additional bailout:

Cyprus received a bailout of 10 billion euros from international creditors last month. It may need even more to save its banks, a top German policy maker said on Sunday. 

“The situation in Cyprus has stabilized in the last few days,” Jens Weidmann, president of the Bundesbank, the German central bank, told Deutschlandfunk radio. “However, I wouldn’t rule out that the need for liquidity in Cyprus could increase.” 

The crisis in Cyprus reflects how urgent it is for the euro zone to establish a means to shut down failed banks without burdening taxpayers or endangering the financial system, Mr. Weidmann said. 

“There continues to be a problem with banks that may be too connected and too big to wind down without creating a danger for the financial system,” he said.

Last Friday Landon Thomas Jr. had a story, "Ex-Bank Officials Named in Cyprus Inquiry," about the findings of an investigative report commissioned by the central bank of Cyprus. Known as the Alvarez report after the financial consulting firm Alvarez & Marsal that the central bank hired to look into why the Bank of Cyprus doubled down on risky Greek bonds, it establishes what has already been widely reported. According to Thomas,

The Bank of Cyprus, long considered the better run of the two large banks that have been at the center of the Cypriot bailout debacle, decided to speculate in high-yielding Greek bonds by accumulating a 2.4 billion euro position from late December 2009 until June 2010, just as the Greece government was running out of money. 

That decision resulted in a loss of 1.9 billion euros, or about $2.4 billion, when bond investors were eventually forced to take a 75 percent haircut under the final terms of the Greek bailout, worked out last year. 

That loss and a larger one at the other big Cypriot bank, Laiki Bank, on a similarly misguided investment foray, totaled 4.5 billion euros. That was more than Cyprus, with a gross domestic product of 18 billion euros, was able to sustain. And the losses resulted in a near-collapse of the Cypriot banking sector, leading the country’s government to seek a 10 billion euro bailout from the troika of international lenders: the International Monetary Fund, the European Commission and the European Central Bank.

The Alvarez report provides new details on the extent to which Bank of Cyprus officials were hoping that the high yields generated by the Greek bonds would cover the bank’s imploding loan book. 

Alvarez investigators said that, according to the records they were able to secure from the bank, the decision to buy the bonds was based on a last gasp effort by the bank to generate profits as their loan book began to sour in late 2009 and through the spring of 2010. 

Investigators also said that the bank, like others in Europe at the time, made use of cheap financing from the European Central Bank to make these bets. As a result, executives in the bank’s treasury department bought the riskiest high-yielding bonds available and found willing sellers in banks eager to reduce their exposure to Greece. 

When it became clear not long after the Greek bailout in May 2010 that some form of debt restructuring would have to take place, the Bank of Cyprus found itself stuck with a 2.4 billion euro portfolio of Greek bonds.

Annie Lowrey has a story today, "Lew to Press for Growth in Europe," about Treasury secretary Jacob Lew's trip this week to Europe to ostensibly jawbone leaders there to dial back on austerity. What's interesting about the story is that the normally excellent Lowrey undercuts her lead halfway through the article:

But countries like Germany have shown little willingness to ease the constraints of austerity for peripheral European countries, or to engage in stimulus spending themselves. And for years, European officials have bridled at being lectured by officials from Washington — particularly because many feel that their financial crisis was largely caused by American financial products exported around the world by American banks. 

Though Mr. Lew will travel to Europe with a familiar message from Washington, it may not be delivered as urgently as in the past. The European crisis continues to weigh on American growth, cutting into exports, but many economists believe that the United States has entered a cycle of self-sustaining economic growth driven by a turnaround in housing and improving household budgets. 

Moreover, American companies have over the last few years steeled themselves against Europe’s financial woes, and the risk of contagion is perceived to be relatively low. 

Europe was the primary international concern for Timothy F. Geithner, Mr. Lew’s predecessor as Treasury secretary and a familiar face on the Continent. But perhaps as a sign of Europe’s diminishing threat to United States economic stability, Mr. Lew’s first overseas trip as Treasury secretary, last month, was not to Paris or Berlin or Brussels, but to Beijing.

Apparently what Lew is really in Europe to do is continue negotiations on a free trade agreement between the United States and the European Union. In other words, it is neoliberalism full speed ahead. Talk up stimulus, continue with austerity, and finalize the free trade agreement.

Destruction of the Economy in Cyprus

One small Cyprus story this morning by Landon Thomas Jr., "Some Savers in Cyprus May Lose 60 Percent," buried on page B7 of the New York Times Busines section belies its importance. Deposits above 100,000 euros at the nation's largest bank, the Bank of Cyprus, will be confiscated to the tune of 60% to 77.5%. According to Thomas,

Over the past week, government officials have been saying that depositor losses would not exceed 40 percent — even though bankers and lawyers involved in the negotiations have been warning for some time that the final figure would need to be higher if the bank was to re emerge as a viable entity. 

Under the terms of the transaction, large depositors would have 77.5 percent of their savings turned into different forms of equity. 37.5 percent would be direct equity, in the bank with the rest coming in the form of securities that may convert into shares at a certain period. The remaining 22.5 percent would be a frozen, non-interest-bearing deposit that they would be able to access in the future. 

As a result of this arrangement, the bank’s largest depositors will initially become its major shareholders. 

If the bank does well, depositors would be able to sell their stock. But even in the best case, in which the bank thrives on the back of a quickly recovering economy — a long shot most economists believe — the loss is likely to exceed 60 percent and could well be much more than that. 

Lawyers and bankers who have analyzed the transaction believe the ultimate loss to the depositor could be anywhere between 60 and 77.5 percent.

To get a sense of the implications of this latest development check out today's must-read post by Yves Smith on naked capitalism, "Destruction of Cyprus Economy Proceeding Ahead of Schedule,"  which concludes as follows:

Now remember, Laiki and Bank of Cyprus were the core of the payments system in Cyprus. And it would be very difficult for a business of meaningful size not to have over €100,000 in deposits. If you freeze a significant majority of the commercial balances, how can you operate? How can these businesses even survive and pay each other? By e-mail, Antonis Polemitis of Ledra Capital teased out the implications:

If the Reuters story is correct, for the purposes of liquidity on Tuesday morning, that is a 100% haircut. 

If that is what they do, I am not sure how Cyprus can engage in economic activity on Tuesday without going to barter or scrips. 

I mean, that basically will mean 100% of the large deposits (all the business accounts) at Laiki and BoC are lost or not available as of next week. The Laiki wipe out may have been survivable. If you wipe (for liquidity purposes at least), both Laiki and BoC, then we are not talking about whether or not GDP drops X%, we are talking about ‘how do you actually engage in commerce?’ 

If they do this, there is little chance it can last more than a month — the economy will simply fail at even basic functions…

And if the plan has been accurately reported and plays out as Polemitis fears, it will undermine the “Cyprus is a special case” narrative. This Eurozone fiasco is making Geithner look good. The former Treasury secretary used the need to keep the confidence fairy alive as the excuse for any and every sop to the banks, from coddling miscreant executives to foaming the runway with mortgage borrowers to stealth bailouts. But the Eurocrats have completely ignored the impact of undermining confidence in the banking system. The fact that Cyprus has a decent-sized population of English retirees means that the British media will report on the Cyprus meltdown, which will be a stark contrast with Greece, where the economic devastation has not gotten the coverage it warrants. Grim accounts of the destruction wrought by the tender ministrations of the Troika should strengthen the position of the growing Euroskeptic sentiment in Italy, borne out by the success of Berlusconi and Grillo in the recent elections. Playing into the hands of Italian refuseniks should be the last thing Brussels and Berlin want. The cost of getting tough with Cyprus is likely to be far greater than they anticipate.

It's hard to find fault with this analysis, unless some sort of exception is made for business accounts, which is probably illegal (but capital controls in the eurozone were supposed to be illegal too). Bersani can't form a government in Italy. The next month should be a momentous one for Europe. Get those sell orders in.

Cyprus: "The Money is Going to Stay There for a Very Long Time"

Banks are scheduled to open tomorrow in Cyprus and rules outlining how people can access their money are still being promulgated. This is from today's story, "In Cyprus, Big Losses Expected on Deposits," by Landon Thomas Jr.:

The government is also struggling to come up with some form of capital controls in a bid to prevent too much money from draining from the banks and leaving the country. Given that more than 30 percent of the Bank of Cyprus’s 14 billion euros in long-term deposits belongs to foreigners — mostly Russians and Greeks — who would not hesitate to take their money out of the country, the restrictions on those funds are likely to be onerous, bankers say. 

“That money is going to stay there for a very long time,” said one person who has been involved in the discussions, but who requested anonymity because he was not authorized to speak publicly.

Beyond the challenge of dealing with the large depositors is the question of what to do with about 27 billion euros in deposits in accounts under 100,000 euros that now carry the Cypriot government’s full backing, following last weekend’s reversal of the decision to tax those deposits, too. That figure alone exceeds Cyprus’s annual gross domestic product of 18 billion euros. 

If the banks reopen on Thursday, as planned, Cyprus’s shellshocked citizens will have access to their insured deposits for the first time in more than a week. With their bills and fears mounting, it is widely expected that many will immediately seek to remove these funds from the banks. 

For now, officials say, it is likely that uninsured depositors will face stiff restrictions when it comes to withdrawing money from an automated teller machine or sending money abroad. But if a depositor at Bank of Cyprus wanted to transfer funds to, say, Hellenic Bank, a smaller institution that is in better shape, the controls would be less severe because that money would remain within the Cypriot banking system. Such arcane mechanisms are now being thrashed out in Brussels and Frankfurt.

With more time to consider the bailout an assessment has gone from bad to worse. The low end of the haircut, 30%, for uninsured depositors at the Bank of Cyprus has given way to the high end, 40%, because the bailout estimate of a 3% contraction of Cyprus' economy is being reassessed as too modest; now, according to Thomas' story, economists are predicting a shrinkage of 5%-10% within a year.

Andrew Higgins and Liz Alderman have a good "how we got here" story today, "Europeans Planted Seeds of Crisis in Cyprus." The Eurogroup's decision in October 2011 to make private-sector investors take a 50% write-down on Greek government bonds doomed Laiki Bank. Higgins and Alderman conclude their story with seven paragraphs that pretty much sum up the whole story heretofore. And the gist of it is that the eurozone is finished:

After the Greek write-down, Cyprus compounded its problems by dithering on whether to seek a bailout from the European Union. At first, it appealed to Russia, which provided a 2.5 billion-euro loan in December 2011. But this money quickly ran out, and when Cyprus did finally go cap-in-hand to its European partners for a lifeline, it received a rude shock: Germany, already gearing up for an election this year, wanted not just budget cuts and other conventional austerity measures but a complete overhaul of Cyprus’s economic model, built around financial services for foreigners seeking ways to dodge taxes and, Berlin suspected, launder dirty money. 

“They did not want the Cypriot model to exist as it did — they wanted Cyprus to stop being a financial center,” said Pambos Papageorgiou, a former central bank board member who is now a member of parliament and on its finance committee. “It was very brutal, like warfare.” 

Mr. Papageorgiou complained that the European Union had shown “the opposite of solidarity” in its dealings with one of its weakest and most vulnerable members. 

In the three years since Europe’s rolling debt crisis first exploded in Greece, governments and citizens in the hardest-hit nations have fumed that decisions made in Brussels pay little heed to their interests and are dictated instead by the economic concerns and election cycles of Germany. Whether in Athens, Dublin, Rome, Madrid or Nicosia, people increasingly ask whether the European Union serves their own aspirations or those of remote institutions dominated by others, particularly Germans. 

Such questions have grown to a furious pitch in Cyprus, where terms set early Monday for a 10 billion-euro bailout will deepen an already painful recession and send unemployment — now at 15 percent — soaring. They require the dismantling of Laiki Bank, with the loss of around 2,500 jobs, and a significant reduction in the country’s role as an offshore financial center. 

“We are looking at a very grim future for Cyprus,” said Michael Olympios, chairman of the Cyprus Investor Association, a lobbying group. “Even firm believers in European project like myself see now that it was a bad idea and that we should have at least stayed out of the euro.” 

As jobs disappear and the economy contracts, Mr. Olympios said, faith in Europe will wither. “I used to be a believer. Not anymore.”

The eurozone will continue on for some time of course. But this is the beginning of the end. Bigger is not always better. The idea has finally sunk in.

Dijsselbloem's Deal with Anastasiades

A deal is reported to have been struck between the Eurogroup, led by Jeroen Dijsselbloem of the Netherlands, and Cyprus President Nicos Anastasiades. Here's how it breaks down, according to a cross post by Cyprus.com this morning on naked capitalism:

1. Laiki is resolved via good bank / bad bank, with uninsured depositors (4.2B) most likely losing everything (along with shareholders and bond holders). 
2. Bank of Cyprus will have a bail-in of uninsured depositors, with them losing between 30-40% most likely. Shareholders and bond holders will be wiped out. 
3. Troika will lend 10B to the Cyprus government, solely for fiscal purposes and based on a memorandum to be determined. None of the troika funds will be used for the bank bailout.
4. Insured depositors will be protected (sub 100K euros). 
5. The 9B of ELA [Emergency Liquidity Assistance] at Laiki will be transferred to Bank of Cyprus. This is the single most bizarre and unfair part of the agreement. It has not been discussed why the Bank of Cyprus creditors should be paying for the ELA of Laiki and no reporter pressed with a follow-up question. 
6. Note that for the most part the bailout is NOT hitting the Russian depositors that hard but will hit local Cyprus depositors hard. Russian depositors were not largely at Bank of Cyprus.

Gone is the specific demand that Cyprus raise 5.8 billion euros since none of the 10 billion euros the Troika is lending is going to a bank bailout. There is some question whether the deal needs to be approved by Cyprus' Parliament. Dijsselbloem is quoted in today's New York Times saying that it can implemented immediately. But naked capitalism raises the possibility that this is not the case:

I have been operating on the assumption ... that the deal negotiated in the early AM in Brussels was set because it relied on the bailout provisions already passed by the Cypriot parliament and did not require additional approvals. And of course, one of the biggest tricks in deal land is to act like something is done even if the remaining “technical” details aren’t technical but are actually substantive and could be used to stymie consummation of the transaction. 

However, Richard Smith has found a tweet that suggests otherwise:

If this source is right, it’s still possible for the Parliament to reject the deal. Consistent with that being possible, I noticed how the recent rounds of messaging about the pact considerably downplayed how bad the hits to Cypriot borrower would be (as in it seemed to be more in sales mode than I would have expected). The early estimates (not official, just based on a look at the balance sheet and knowledge of what was on it) was that the Laiki depositors >€100,000 would be very lucky to get anything back, and the Bank of Cyprus losses for the over €100,000 depositors had been 22% to 25%, and that may not include the ELA transfer, which would presumably increase the losses considerably. 

Admittedly, at this point, the inertial course would be to approve the agreement. However, the influential Archbishop of Cyprus advocated leaving the Eurozone over the weekend. That plus a show of outrage from the population could undo what seems to be a settled deal. And that would have more immediate, unexpected ramifications.

Krugman in his column this morning welcomes the imposition of capital controls in Cyprus and provides a little historical perspective:

I am, of course, not the first person to notice the correlation between the freeing up of global capital and the proliferation of financial crises; Harvard’s Dani Rodrik began banging this drum back in the 1990s. Until recently, however, it was possible to argue that the crisis problem was restricted to poorer nations, that wealthy economies were somehow immune to being whipsawed by love-’em-and-leave-’em global investors. That was a comforting thought — but Europe’s travails demonstrate that it was wishful thinking. 

And it’s not just Europe. In the last decade America, too, experienced a huge housing bubble fed by foreign money, followed by a nasty hangover after the bubble burst. The damage was mitigated by the fact that we borrowed in our own currency, but it’s still our worst crisis since the 1930s. 

Now what? I don’t expect to see a wholesale, sudden rejection of the idea that money should be free to go wherever it wants, whenever it wants. There may well, however, be a process of erosion, as governments intervene to limit both the pace at which money comes in and the rate at which it goes out. Global capitalism is, arguably, on track to become substantially less global. 

And that’s O.K. Right now, the bad old days when it wasn’t that easy to move lots of money across borders are looking pretty good.

Predictions are that Cyprus' economy, 45% of which is in financial services, will shrink 20% to 30% in the next two years.

Bailout Agreements Getting Worse

The Cyprus bailout deal seems to have changed from when I posted yesterday. Now what's being reported by James Kanter and Liz Alderman is that the uninsured deposits above 100,000 euros to be hit with a levy are at the Bank of Cyprus not Laiki Bank, and the tax will be 20% not 22% to 25%. There will a 4% tax on all uninsured deposits at all banks; also, gone is the nationalization of pension funds from state-run companies. According to Kanter and Alderman,

The revised terms under discussion would assess a one-time tax of 20 percent on deposits above 100,000 euros at the Bank of Cyprus, which has the largest number of savings accounts on the island. Because the Bank of Cyprus suffered huge losses on reckless bets that it took on Greek bonds, the government appears to be taking depositors’ money to help plug the hole. 

A separate tax of 4 percent would be assessed on uninsured deposits at all other banks, including the 26 foreign banks that operate in Cyprus. 

Under the plan, savings under 100,000 euros would not be touched — a significant difference from the original plan, which not only enraged Cypriot citizens but ignited fear that precedent had been set for euro zone governments to tap insured bank savings in times of a national emergency. 

Cypriot officials have also backed off a proposal that would have sought to raise billions of additional euros by nationalizing state-owned pension funds. Germany, whose political and financial clout dominates euro zone policy, had indicated it opposes the move.

Naked capitalism is keeping it real per usual with a cross post from Professor Yanis Varoufakis, who blogs regularly on the euro crisis, "While waiting for Cyprus' Godot....":

Every bailout agreement, beginning with Greece’s in May 2010, seems less logical and more toxic than the previous one. The culmination was of course Cyprus this past week. Think about it: In one short week, Europe has managed:

• To put in jeopardy the hitherto sacrosanct concept of state guaranteed deposit insurance
• The monetary integrity of the Eurozone
• The European Union’s single market principle according to which capital controls are a no-no.

Damage to Cyprus Already Done

Once again the news coming out of Cyprus is not encouraging. Yesterday Cyprus' Parliament came up with a new bailout plan to present to the troika Sunday evening, though it still has to vote on one proposal to confiscate a quarter of all bank deposits above the insured amount of 100,000 euros for Laiki Bank account holders. Parts of the plan that passed, as Liz Alderman and James Kanter report today, include capital controls to prevent withdrawals and account closings as well as the shutting down of Laiki, creating a bad bank for the non-performing accounts and rolling its good accounts into the Bank of Cyprus. Parliament also voted to confiscate the pension funds of state-run companies.

I've seen reports that this might not satisfy the troika. The troika wants the legislation to apply to all Cypriot banks not just Laiki. Cypriot president Anastasiasdes jets to Brussels tomorrow to take his lumps.

The message from all of this -- banks have been closed for over a week now in Cyprus -- is that the damage has already been done. Even if the new bailout plan is accepted by the ECB, the IMF and the European Commission, Cyprus' days as a financial hub are over and capital flight from eurozone countries with vulnerable banks like Spain will likely commence posthaste. As naked capitalism opines in "Cyprus Capitulates to Eurozone (Updated)":

The imposition of capital controls has the potential to alarm depositors in periphery countries even more than deposit seizure. While the Eurocrats can try claiming that the deposit grab is a one-off, the result of Cyprus having a huge financial sector that was heavily deposit funded, it was already troubling that they didn’t go after equity or bondholders. But the imposition of capital controls effectively creates another currency without the benefit of allowing the currency to revalue.

As we’ve indicated, the big risk coming out of the cramdown of Cyprus is a resumption of the flow of deposits out of periphery countries, which had been underway last year but was arrested by the introduction of the OMT. You’d be nuts to keep your money in a Spanish bank after the brutal treatment of Cypriot depositors. Expect Swiss, German, American, and, as Dizard put it, “banco de Mattress” to be the beneficiaries.

So far U.S. markets have dismissed Cyprus as inconsequential. Let's see what the prevailing wisdom is next week. The 17-nation eurozone appears about to shrink.