Cyprus Today and America Tomorrow

22 Mar

I’d suggest everyone follow what’s going on in Cyprus very closely, because it’s very likely going to be playing out across the globe including in America in the next couple of years.  Timing is difficult to ever say, but I’d be surprised if Obama isn’t still the president when we get to this stage.  This post makes use of several parts from Karl’s Denninger’s Ticker Now It’s Getting Real in Cyprus.

Banks in America

Let’s think about how banks work to start with.  The banks get money in a few ways.  Everyone thinks about people depositing money, but that’s not the only place money comes from.  They also have people who buy stock from them.  Those people gain an ownership stake in the company and possibly part of the profits in exchange for their money.  The bank also has bondholders.  Bondholders for companies, like for the government, are basically giving loans of their own.  They loan out money and at the end of the term, they are paid back more than they started with.

Once a bank has money, it can loan it out.  The way they make money is they get paid back with interest. They know there is a certain amounts of risk in loans and that’s supposed to be reflected in the interest rates.

What happens if they make a lot of bad loans though?  By law in America, once the banks assets are less than what it owes (its liabilities) it is supposed to be taken over by the FDIC (government program).  By assets, it’s meant the value of what it owns.  Say for instance the bank is realistically going to get paid back only 50% on one set of bad loans.  Well, then the asset is only worth 50% of what the bank was supposed to be paid back.  It legally can’t claim its worth more than that if no one else would be willing to buy those loans from them at that rate.

This law was enacted during the 1930s Great Depression for very good reasons.  As long as the bank is taken over as soon as liabilities are greater than its assets, then the size of the problem is small.  Someone still has to lose money then though.  The order of loss goes like this:

  1. Equity (stock) holders
  2. Unsecured bondholders
  3. Senior bondholders
  4. ——————————-(FDIC protection)
  5. Depositors

So if there is a loss, the stockholders are the first to lose out.  They know this going in.  If a bank fails they probably aren’t getting their money back.  As a consequence, they also have the highest possible rewards when things go right.  If the stock going to zero isn’t enough to cover the banks shortcomings, then the unsecured bondholders, the ones who were getting higher returns in return for less security lose first.  If all of their value still isn’t enough, then the senior bondholders lose out.  If all of the money from those 3 groups still doesn’t cover the losses then the only group left that has money there are the depositors.  The government through the FDIC though is supposed to protect accounts up to $250,000 and will cover the loss on those accounts.

Those latter stages are all academic if the law is followed and banks are taken over as soon as their assets are less than their liabilities.  As long as they are, you rarely have to go very far down the list and certainly not all the way to depositors.

The law hasn’t been followed, not here, not in most the world (with their own versions).  The result was that we had big banks making short term huge profits on very risky investments.  As soon as the risk made it evident the banks owed more than they were worth, they should have been taken over and sold off (with smaller better run banks rising up to take their place).  They weren’t.  The short term profits continued which just pushed more to do the same thing.

This has led us to a point where banks have massively larger liabilities than assets.  In the US, rather than accept this finally a few years ago and put many into receivership, the federal government did a number of direct and indirect bailouts of the banks.  There was TARP which was the most direct.  There was taking over AIG.  AIG sold an extremely large number of credit default swaps to banks. The banks treated these as insurance and used them as a way to lend out a lot more than they would otherwise be allowed to.  Both AIG and most the banks had to know they could never get repaid for these though as there was no actual money kept to pay back.  Rather than let the current big banks fail though, the government took over AIG and the taxpayers paid out those credit default swaps.  The government also simply ignores the fact that what many banks have claimed loans/properties/etc are worth are not what they’d actually get on the free market.

Cyprus Today

The problem isn’t over though and Cyprus is showing what likely coming.  Their banks are currently closed.  They are so far under that they do not have the money to cover depositors and its gotten bad enough to make even normal day to day operating impossible.  Now that info is out as well, which just makes things worse as depositors want their money out before their lose money.

So the Cyprus government closed the banks and proposed a “one time tax” of 9.9% on all deposits over €100,000 and 6.75% for the rest.  They said, it was impossible to exclude  the smaller ones as they were too much of the total.

Let’s think about this proposal.  That money is in saving accounts and checking accounts, it’s retirement money, college fund money, bussiness accounts which are needed for payroll, etc.  The money was already taxed when it was earned.  At what point do we stop calling it a tax and simply call it theft?

Regardless of what you call it though, the situation is desperate and the only choices left are terribly bad ones.  The Cyprus Parliament rejected the tax and the new move is to push for much higher “tax” rates on the Russian accounts in exchange for a lot of concessions to the Russian government.

That happened because the Cyprus people and government let the banks violate the law and amass huge amounts of debt.

It will happen here because the American people let many big banks and government break the law.  Maybe the bailouts have been enough to plug the holes (doubtful, but let’s pretend).  It’s still coming because that trillion plus a year in debt the federal government issues is never going to be paid back.  When that happens, we will be facing the same tough choices at the same time that our economy is collapsing.  Best thing to do is to demand strict following the law now and that the federal government balance its budget regardless of the cuts.  That won’t happen though.

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