A Cypriot seniority quirk? | FT Alphaville

A Cypriot seniority quirk?

S&P has downgraded (to B from BB) Cyprus, the little island which is facing a great big bank recapitalisation bill from the fallout in Greece. It could well be the biggest ever such bill in history, relative to GDP.*

The bank bailout – finally under serious negotiation – could also fall afoul of the new resistance to direct ESM recapitalisation of ailing banks. Official (ESM) loans used to finance the recaps instead could very quickly blow up the size of Cyprus’ debt, given the bailout’s high cost to GDP and the fact that quite a bit of the private debt matures in the next two years or so. (In its downgrade to B, S&P moaned about the Cypriot government’s increasing reliance on T-bills). It’s a strange situation given how minuscule a Cypriot bailout would be in absolute terms.

You can complete the picture: Cyprus may be testing the canard that PSI was “unique and exceptional” to Greece sooner rather than later, or it might be a testing ground for official generosity in eurozone bailouts.

Although intriguingly S&P have also thrown up an ESM-related curveball.

From the statement:

In our view, it is highly likely that the burden of recapitalizing the banks will fall on the government’s balance sheet, increasing the risk of a government debt rescheduling. Given the significant constraints on Cyprus’ fiscal flexibility, we view the government’s potential debt burden as difficult to service. It could reach 130% of GDP by the end of 2013, the upper end of our July 2012 estimate.

In our opinion, Cyprus’ commercial banks–or the government itself–could be forced to reschedule their debt in order to meet the terms of an official lending program. Potential loans from the ESM could be senior to holders of Cypriot debt, and we understand it is somewhat uncertain whether this could trigger the acceleration of debt repayment issued under the government’s medium term notes (EMTN) program according to the provisions of the EMTN transaction documents.

This could significantly weaken confidence in Cyprus’ financial system; the banking system currently holds nonresident deposits valued at around 140% of GDP.

These seem to be the EMTN provisions in question…

(Click to enlarge)

As S&P say, the terms are uncertain. But it’s this point that the notes “at all times rank at least equally with all its other present and future unsecured and unsubordinated indebtedness” in particular. In any case, ESM loans leading to an event of default would be quite unusual.

Update – Thinking about it, maybe there is a nuance in ESM seniority that has come up before, over Spain, which could get a Cyprus bailout off the hook in terms of triggering bonds. As Citi pointed out over Spain, the ESM Treaty says that “loans will enjoy preferred creditor status in a similar fashion to those of the IMF”. We all know IMF seniority over bondholders is implicit, and in a sense in legal limbo; it won’t trigger until a government defaults. So would claims brought over the Cypriot notes might not have anything to bite onto, if we read that line as meaning the ESM is implicitly senior in the way the IMF is? Well. Hmm. If it was clear, why waive seniority outright in the Spanish loans.

At the very least, it’s awkward. It’s a reminder of the problems posed by the ESM’s seniority, despite its recent (one-off?) waiver for loans to Spain, and perhaps an argument that it just needs to be waived for good. (Which would be a decision for governments.)

As for the effect on Cypriot bank non-resident deposits, well, we don’t know. These may be somewhat captive given Cyprus’ role as a tax haven for Russian and CIS money.

Although that reminds us – a rescheduling of Cypriot debt (which S&P allude to) would presumably have to incorporate the fact that 19 per cent of it is a loan from the Russian government.

We wouldn’t like to make that phone call to the Kremlin.

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*That’s counting the costs of Greek bond losses and loans to the Greek economy for Cypriot banks alone, which could be some 60 per cent of GDP, according to calculations by Exotix’s Gabriel Sterne. See Sterne’s chart below, from July, for comparisons. This is just the flipside of Cypriot banking assets being some 835 per cent of GDP (according to 2011 IMF data.) Meanwhile, bad loans continue to pile up Greece, while to quote S&P: ‘The banks’ domestic loan books are deteriorating faster than we had originally anticipated’. These costs are not over.

And so this whole story is, in a way, about justice – should a country be made to shoulder so much debt for problems that emerged in another?

Related link:
Let’s not blow this second chance – FT letters