The letter which forms the main body of this post was first written on 28th July 2011 – two weeks after the Mari disaster – in the form of a private letter to a key person in the unfolding Cypriot banking and economic catastrophe.

The letter called for the urgent separation of the Greek banking activities of the Cypriot banks with a view to shutting down the contagion channel which eventually engulfed Cyprus. Despite the ceaseless efforts of the recipient of this letter to do exactly that, our political and economic elite never took this warning seriously: even as late as this week, Cypriot bankers and officials are procrastinating with respect to the Troika’s request to spin off the Greek-based banking activities of Cypriot banks.

Today, and as predicted in this letter almost two years ago, Cyprus is staring at the destruction of its banking system as we have known it. As for the Eurozone, by now it has probably passed within the “event horizon” which leads to it being split asunder, most likely with an eventual German departure but not excluding departures from the periphery as Eurosceptic political parties rise in the polls everywhere.

28 July 2011

Attn: Mr …………

Dear …………..,

On current trends, and given our structural weaknesses in public finances, I am concerned that if we also add the recapitalization liabilities for our banks onto the public debt we will be looking at a lost decade for the economy, as by necessity the public sector must proceed to strangle the private sector on an ongoing basis in order to service the debt.

What is worse, this huge sacrifice of the recapitalization burden might fail to save our banks if the participation of Cyprus in the Eurozone is questioned even slightly leading to deposit flight.

If Italy and Spain lose access to the bond markets, as it appears they might, the pressure for countries to leave the Euro will increase still further. If or when that taboo is broken by the first disorderly default and departure, and if by then Cyprus is an EFSF ward, then the question of our future Eurozone participation will be asked about Cyprus also.

Hence, protecting the standalone credit worthiness of the Cypriot sovereign at all costs offers, in my opinion, the best hope of survival for our banking system in the event that the Eurozone begins to unravel.

To protect the creditworthiness of our sovereign, I believe that the public finance reforms are necessary but not sufficient. Preventing the banks’ Greek liabilities from landing onto the balance sheet of the Cypriot sovereign is also necessary, and I hope that the two together will be sufficient.

Our secondary market bond yields were already above the unsustainable level before the explosion at Vasiliko, before the political crisis, and before the key 8th July meeting on the economy. Thus, even if we magically repaired Vasiliko tomorrow at zero cost and also passed the perfect package of public finances measures tomorrow, bond markets should still be closed to us. If they are, I suspect it would be due to the following contagion pathway:

– The Euro project in its current incomplete state (monetary union without fiscal union) is fundamentally flawed and unsustainable

– Public opinions of surplus countries do not accept the fiscal union, and the bigger the debts of the profligate periphery that have to be covered by the core, the more reluctant the public opinion of the core must become

– As long as this underlying political situation persists, the flight from debt continues in a self-reinforcing feedback loop, and the Euro project remains on course to collide with a brick wall at some point that is now not too far off

Turning to Greece:

– The latest Greek bailout did not make the Greek public debt sustainable

– The continued focus on austerity in Greece entrenches the deflationary / depressionary economics going forward, inflicting further damage to the credit quality of Greek banks’ private sector loan portfolios

– More and larger European countries are on the same slippery slope of needing “rescue” – and who can blame the bondholders for stampeding towards the exit

– Therefore a huge episode of debt repudiation / Euro exit lies ahead for Greece at some point in the near future (it could be as imminent as weeks or months away if Italy and Spain go into meltdown causing the bailout agreement to unravel amidst much bigger problems, or as much as two years if not)

– The huge exposure of Cypriot banks to Greece (public + private) which exceeds our island’s GDP is known to all market participants. If anyone didn’t know all they had to do was download the recent stress test results

– The same stress test results reveal that the Cypriot banks are on the margin with respect to capital adequacy

– Therefore, the large future haircut from Greece (the amount is large but uncertain, but the event is essentially expected with certainty) will trigger a recapitalization requirement for the Cypriot banks which will be a significant fraction of GDP.

– It is therefore assumed that the public debt of Cyprus including this contingent liability is equal to the present amount plus the future recapitalization requirement

– That level of debt, together with our structural deficit, means that our debt dynamics are unsustainable, hence we cannot access external financing

The political parties are as irresponsible as ever, they are not uniting to take tough decisions in order to confront the coming Armageddon with any chance of success. Instead they are resigning to the inevitability of disaster and positioning themselves for future electoral advantage amid the smoking ruins of our economy. As for the executive branch, Christofias is preoccupied with how to hang on, and AKEL is not throwing him under the bus. The state is paralyzed at the most critical moment when urgent, tough decisions must be taken.

And so I come to my conclusion, that only the top management of the Cypriot banks and the Governor of the Central Bank can change our course, and furthermore that they MUST act to change our course, otherwise we face the likely destruction of the banking system along with our economy if they fail to act decisively.

The clearest leverage point to escape the dynamics described above is that the markets must be caught completely wrongfooted in their belief that a large liability from Greece will strike the Cypriot banks and thus by extension the sovereign. This should bring bond yields down. It must then be followed up by austerity measures which have to be agreed in parallel while the banking reform is going on.

The public finance reform alone is not enough. Once the EFSF is here, and the negotiation starts on austerity, corporation tax reform etc., we are at risk of deposit flight. Confidence is a very flimsy thing.

Somehow, the Cypriot banking elite must find a truly convincing way to stop the contagion from Greece. It must not be a half measure, because we might only have one shot at this.

I am not an expert so I don’t know what tweaks or details would have to be attended to in order to make feasible one of the three generic options that I can see:

– A “bad bank” in Greece owned with limited liability by the three major Cypriot banks, to take over all the Greek balance sheets of the three Cypriot banks. Maybe this could be an existing bank in Greece with a Greek banking license, currently controlled by one of the Cypriot banks?


– Spinning off the Greek parts of the Cypriot banks into standalone Greek bank holding companies by issuing free shares in the Greek units to existing shareholders.


– Restructuring the Cypriot banks in the right way that ALL BANKS around the world should be restructured, with losses for bank bondholders.
o Take all three Banks under custodianship on a Friday afternoon
o protect all depositors,
o write down all bad loans to their fair market value, using conservative estimates if needed for speed purposes,
o wipe out equity holders,
o convert sufficient bondholder debt to equity up to the point that the bank would be truly well capitalized to withstand any foreseeable stress under the current situation
o Reopen the Banks on Monday morning and hand over the keys of the Bank to its new owners (its former creditors) who will presumably install new management

The latter option, which I think is by far the best one from society’s point of view, would presumably be carried out against the wishes of the local banking elites, and possibly against the wishes of the ECB itself which would not want this precedent for Europe’s overleveraged banking system. Does Mr. Orphanides have the power to do this unilaterally?

As for the first and second options, the bad bank and spinoff options, these have been questioned as to whether they would be acceptable by Greece. I am unsure of the philosophically correct answer, however the other side of the coin might be:

– Why should Cypriot taxpayers take on private Greek bad debt losses caused by deflation / depression in Greece? Is that equitable?

– The European banks are minimizing their private exposure to Greece and transferring it to the European tax payer and to the Greek citizens who are being asked to service debts they cannot afford to service. Ethics have long since gone out of the window over this sovereign debt episode, and it is every society for itself. We should give the same primary weight to outcomes that other policy elites had chosen.

– Lifeboat ethics: Greece is apparently going to default anyway in future because what cannot be paid back won’t be paid back, and its economy is already in ruin. As we said above, this is transmitting losses to Cyprus. Should we let Cyprus be ruined too, or should we add another 5 billion to the much larger pile of bad debts that Greece will be defaulting upon anyway in the near future?

…….., if anything can be salvaged at this late hour, only you can do it. Good luck to you and I am available to help if I can.