Financial Review

Broken PROMESA

Sinclair Noe — May 3, 2017

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DOW + 8 = 20,957
SPX – 3 = 2388
NAS – 22 = 6072
RUT – 8 = 1390
10 Y + .02 = 2.31%
OIL – .22 = 47.60
GOLD – 19.20 = 1238.70

The Federal Reserve left interest rates unchanged as they wrapped up their two-day FOMC policy meeting. In a hawkish statement, the central bank also said consumer spending continued to be solid, business investment had firmed and inflation has been “running close” to the Fed’s target. “The committee views the slowing in growth during the first quarter as likely to be transitory,” the Fed said in a unanimous statement.

That sounds like the Fed is sticking to its guns and plans on 2 more rate hikes this year. The Fed raised its benchmark rate by a quarter percentage point at its last meeting in March to a target range of 0.75 percent to 1 percent. The rate-setting committee is also gearing up to announce sometime this year when and how the Fed will begin shrinking its $4.5 trillion balance sheet. Wednesday’s statement offered no new details.

Payrolls processor ADP said private employers added 177,000 jobs last month. It was the smallest gain since the 62,000-increase last October. ADP said private employers face increasing difficulty finding qualified workers in a tightening labor market.

The ADP figures come ahead of the Labor Department’s more comprehensive non-farm payrolls report on Friday, which is expected to show about 185,000 net new jobs in April, following an anemic 89,000 new jobs reported in March.

The Institute for Supply Management (ISM) said its index of non-manufacturing activity rose to 57.5 in April from March’s 55.2. A reading above 50 indicates expansion in the services sector.

Puerto Rico announced a historic restructuring of its public debt, touching off what may be the biggest bankruptcy ever in the $3.8 trillion municipal bond market. While it was not immediately clear just how much of Puerto Rico’s $70 billion of debt would be included in the bankruptcy filing, the case is sure to dwarf Detroit’s insolvency in 2013.

The move comes a day after several major creditors sued Puerto Rico over defaults on its bonds. Bankruptcy may not immediately change the day-to-day lives of Puerto Rico’s people, 45 percent of whom live in poverty, but it may lead to future cuts in pensions and worker benefits, and possibly a reduction in health and education services.

The island’s economy has been in recession for nearly 10 years, with an unemployment rate of about 12 percent, and the population has fallen by about 10 percent in the past decade. The debt restructuring petition was filed by Puerto Rico’s financial oversight board and was made under Title III of last year’s U.S. Congressional rescue law known as PROMESA.

The Title III provision allows for a court debt restructuring process akin to U.S. bankruptcy protection. Puerto Rico is barred from a traditional municipal bankruptcy protection under Chapter 9 of the U.S. code, but Title III is basically the same thing. The process will give Puerto Rico the legal ability to impose drastic discounts on creditor recoveries.

U.S. Supreme Court Chief Justice John Roberts will appoint a life-tenured judge, likely a U.S. District Court judge, to oversee the case. That’s different than Chapter 9 municipal bankruptcy cases, where a bankruptcy judge controls the process. The person appointed to oversee the case will have significant power over how it unfolds.

This debt-cutting process has never occurred, so the lack of legal precedent could leave the judge with much sway over the future of Puerto Rico. The oversight board will aim to negotiate debt cuts with creditors, after which it will propose a plan of adjustment.

The judge will decide whether to authorize the plan. For investors, bad news. If investors hold secured bonds, they might get paid in full. But unsecured bondholders could suffer significant cuts, depending on which types of debt the judge determines to be vulnerable.

Complicating matters is the various governmental entities included in the bankruptcy filing, each of which has its own investors and creditors wanting to be paid. It really isn’t clear how creditors stack up against each other, but it is widely anticipated that pensioners will have a low spot in the pecking order. That’s exactly what happened in Detroit.

The GOP health bill gains new life as key holdouts vow support. Representative Fred Upton of Michigan says he will back the bill once an amendment he helped devise is added. It would provide an $8 billion boost in funding for people with pre-existing conditions; and while that sounds like a lot of money, it is but a speck of dust in the overall price tag for healthcare.

A White House official said Republicans are still two or three votes away from being able to guarantee passage. Even if it passes in the House, it would likely fail in the Senate.

Fresh data from real-estate website Trulia show that just 34.2% of homes have returned to the peak levels registered before the onset of the recession in 2008. What’s more, Trulia estimates it could take until 2025 for a true national recovery in home prices.

Much of Arizona is such an idiosyncrasy. Tucson is second only to Las Vegas in the ranking of cities where the smallest numbers of homes have recovered their value. In Tucson, only 2.4% of homes have recovered their peak prices. In Phoenix, 5% of homes have climbed back to or above their earlier peak price.

After the closing bell, Facebook reported added 80 million monthly users in the first few months of the year, as ad revenue popped 51 percent from a year ago. Net income rose to $3.06 billion, or $1.04 per share, from $1.73 billion, or 60 cents per share, a year earlier, beating estimates of 87 cents. Revenue was $8 billion vs. $7.8 billion consensus estimate. Shares moved lower in after-hours trade.

Facebook plans to hire 3,000 more people to review videos and other posts after getting criticized for not responding quickly enough to murders shown on its service. The hires over the next year will be on top of the 4,500 people Facebook already has to identify crime and other questionable content for removal.

Tesla posted a wider than expected first-quarter loss but said it had just over $4 billion in cash to handle the future. Tesla is betting on the launch of its $35,000 Model 3 midsize sedan to help meet its goal of producing 500,000 cars annually in 2018. The Model 3 is expected to go on sale later this year in the United States.

Tesla delivered 25,000 vehicles in the first quarter ended March 31, its highest since the carmaker went public in 2010, and a 69 percent increase from a year earlier. Tesla’s results reflect the first full quarter that includes solar panel installer SolarCity, which it bought last year.

Twilio makes cloud-based software that brands can use to reach out to customers: think in-app messaging services. While it has major brands on its books as clients, including Nordstrom, Airbnb and Amazon, Uber and Facebook’s WhatsApp are its two largest clients by far.

Uber accounted for 12% of the company’s revenue during the quarter, but Uber will be moving some of the technology it uses to communicate with customers in-house. The Uber news effectively torpedoed an otherwise horrible earnings report. Twilio down 25% today.

A day after the American Petroleum Institute injected a bit of optimism among traders by reporting a crude oil inventory draw of 4.2 million barrels, the EIA once again poured cold water on the oil bulls by reporting a much smaller decline, of 900,000 barrels. This is only the sixth inventory draw reported by the authority for the last 18 weeks.

In gasoline, the situation was pretty much the same. API estimated inventories in the week to April 28 had fallen by 1.9 million barrels, and the EIA refuted the estimate: according to it, gasoline inventories were up by 200,000 barrels in the seven-day period.

Copper prices dropped 3.5% today, the biggest one-day drop in 19 months after a jump in inventories increased worries about an economic slowdown in China, the world’s largest consumer of the metal.

On-warrant inventories available for delivery at LME-registered warehouses increased by 38,950 tons, or 32 percent. Earlier in the week, copper prices leaped to their highest in nearly a month. Traders expected prices to rise given a planned month-long strike at Freeport-McMoran’s Grasberg mine in Indonesia.

The Writers Guild of America has reached a tentative agreement for a new film and TV contract, averting a potentially devastating strike that would have impacted the fall season. The finale even came with a plot twist – an intervention from studio executives, who normally take a less hands-on approach to union talks.

The Securities and Exchange Commission has approved a request to trade quadruple-leveraged exchange-traded funds, because triple leveraged ETFs were just too boring. ForceShares Daily 4X US Market Futures Long Fund will trade under the ticker UP, and ForceShares Daily 4X US Market Futures Short Fund, under the ticker DOWN.

If you receive an email with an unexpected invitation to open and view a Google Doc, don’t do it. In what appears to be a large-scale phishing attack, people are reporting that they’re receiving these invitations from people they know. If you click on “Open in Docs,” it will spam everyone in your Google contacts, and it may also try to steal your information.

Tuesday, April 29, 2014 - Lowering the Bar

Financial Review with Sinclair Noe

DOW + 86 = 16,535
SPX + 8 = 1878
NAS + 29 = 4103
10 YR YLD + .02 = 2.69%
OIL - .12 = 100.72
GOLD - .40 = 1296.90
SILV - .13 = 19.54

The S&P/Case-Shiller home price index for February showed prices up 12.9% from February a year ago, that’s down from the 12-month advance of 13.2% reported in January. The index tracks existing home sales in 20 major metropolitan areas, and this economic report tends to lag, plus it is a 3-month moving average of prices; so maybe we could be seeing one of the last reports to reflect bad winter weather.

Home prices fell in 13 of the 20 cities in February compared with the previous month, and it wasn't just cold weather cities; prices in Las Vegas dipped 0.1% in February from the previous month, the city's first monthly decline in nearly two years; home prices fell 1.6% in Cleveland and 0.7% in Tampa, Florida. Las Vegas still posted the biggest 12-month gain, with an increase of 23.1%.

The Conference Board said its index of consumer attitudes dipped to 82.3 from an upwardly revised 83.9 in March; still, very near a 6-year high.

A new report today from the National Employment Law Project finds that as the economy has inched toward recovery, low-wage jobs have returned far more quickly than middle- or high-income work. The report’s finding shows how the housing sector in particular is a key middle-income employer that has failed to rebound.

Employment among specialty trade contractors, who earn a median wage of $20.03 an hour, is still down 22%. The number of workers who manufacture wood products, with a median pay of $14.94 an hour, is down 27%. Jobs working in rental and leasing services, with a median wage of $14.17 an hour, are down 16.3%. Employment in “credit inter-mediation and related activities,” which includes mortgage lending, is down 7.1%. Those jobs pay a median wage of $18.51 an hour.

Home-builders have been slow to pick up the pace of construction, which in turn is squeezing the housing market. Without good job growth among younger and middle class workers who would be first time home buyers, builders are focusing on higher-end projects, which is a smaller market. It’s the old idea that workers need to be paid enough to buy the products they make, otherwise, the market falters, and it becomes harder and harder to break out of the downward cycle.

The Federal Reserve FOMC is meeting today and tomorrow. The outcome is expected to be rather boring; more of the same; reduce the amount of money it is pumping into the economy by another $10 billion per month. The Fed’s purchases of long-term bonds, known as quantitative easing, are widely expected to end in the fourth quarter of this year. The steady phase-out has become routine and predictable. It will only become interesting if the Fed goes off script.

The US treasury reports the biggest debt pay-down in 7 years. The drop in net marketable debt will be $78 billion in the April-June period, $38 billion more than the pay-down projected three months ago, with an end-of-June cash balance of $130 billion. That trend may be temporary. A faster pace of hiring and soaring corporate profits are lifting tax receipts while spending increases at a slower pace. That’s helping shrink a budget deficit projected this year to be the smallest as a share of the economy since 2007. (Considering what followed, maybe we shouldn't rush to pay-down.)

The majority of S&P 500 companies are reporting better than expected earnings, albeit on lowered expectations; that’s the plan, lower the bar and step right over it.  Easy, right? Not always.

Twitter stumbled today, posting a first quarter loss of $132 million or 23 cents per share, compared to a loss of $27 million or 21 cents per share a year earlier. Revenue more than doubled to $250 million but it wasn’t enough. Shares were hit by 9% in after-hours trade.

EBay posted a loss of $2.3 billion compared to profit of $677 million a year ago. Revenue rose 14%, but shares dropped nearly 4% in after-hours trading.

A number of health-care related companies reported earnings today. Here’s a quick summary. Merck beat estimates by 9 cents; share price was up about 3%. Bristol Meyers Squibb beat earnings estimates but revenue missed expectations; shares down 3%. Cubist Pharmaceuticals posted a 30 cent per share profit, while analysts had expected a loss; shares up 4%. HCA Holdings’ earnings came in one penny short and then they lowered guidance; shares down 4%.

Pfizer has bid $100 billion for AstraZeneca, the biggest and latest in a series of proposed big pharma mergers. Traders and investors love big mergers because it represents a possible liquidity event, mainly for the party being acquired. Earlier this month, Valeant Pharmaceuticals offered to buy Allergan in a deal valued at more than $45 billion, while Novartis sold and exchanged business units with Eli Lilly and GlaxoSmithKline. And Mallinckrodt bought Questcor Pharmaceuticals for $5.6 billion. On Monday, Forest Laboratories, which has been offered $25 billion by Ireland's Actavis PLC, said it would offer up to $1.5 billion for Furiex Pharmaceuticals.

What does this mean for the industry and consumers? Not much good. The Pfizer-AstraZeneca deal is mainly about taxes. Pfizer would become a British company by combining with AstraZeneca, lowering the new company's tax rate dramatically. There's even a euphemism for this kind of move. It's called a tax inversion in the trade. Pfizer's tax rate was about 27% last year. In the UK the corporate tax rate stands at 21% and will fall to 20% in 2015. The tax code provides an incentive for US-based companies to move overseas, often times taking good jobs with them. That also means there might be political opposition to the Pfizer-AstraZeneca deal from Washington.

Yesterday, the Obama administration announced a new round of sanctions to punish Russia, even as it acknowledged that sanctions are unlikely to bring an immediate change in Russian behavior. The new measures froze the assets of 7 Russian individuals and 17 companies associated with them, and prohibited any US dealings with them; all were identified as closely linked to Russian President Vladimir Putin. The administration also announced new restrictions on Russia’s import of US goods deemed to contribute to its military capabilities. The European Union said it would expand its sanctions list to include 15 more individuals.

The Russian stock market moved higher today; call it a relief rally. Putin responded by threatening to reconsider Western participation in energy deals in Russia where several western energy companies have big projects underway or planned. ExxonMobil has a deal with Rosneft to explore and develop shale oil fields in the Artic, with a potential of 9 billion barrels in reserves; that would put the value at as much as $900 billion. The sanctions leave Exxon in business with a group headed by a man who’s not allowed into the US. Drilling was scheduled to start in August; might not happen now.

Meanwhile, a New York based investment firm, Goldentree Asset Management is buying Russian bonds, saying the securities offer value after suffering a 5.4% selloff this year. Russian dollar-denominated corporate bonds are yielding 7.2%, up from 5.8% at the end of last year. Patriotism be damned in the chase for yield.

The Supreme Court has breathed new life into Environmental Protection Agency rules targeting air pollution that drifts across state borders, handing a victory to the Obama administration on one of its major environmental efforts. The agency for years, under two administrations, has struggled to carry out a directive under the federal Clean Air Act to protect downwind states from pollution generated in other states, mostly from coal-fired power plants. The EPA’s rules from 2011 were challenged by a coalition of upwind states and industry, which prevailed in lower courts.

In determining how much individual upwind states should be required to reduce their emission, the EPA’s interpretation of the law allows for several factors to be considered, including what it will cost and how much the state has already done to cut pollution. A lower court ruling disagreed with this approach and said the reductions must be proportional to the state’s share of responsibility for downwind problems. In a 6-2 ruling, the Supremes determined the EPA must have leeway to confront the complex challenge of interstate pollution.

Energy Future Holdings has filed for Chapter 11 bankruptcy protection. Energy Future Holdings owns TXU Energy, which has the largest share of the Texas retail electricity market, and Luminant, the state’s largest power generator; the company also has about $40 to $50 billion in debt; making this one of the biggest corporate bankruptcy cases in US history.

Energy Future’s troubles can be traced back to its bet that natural gas prices would rise, helping it repay the interest and loans it took to acquire TXU Energy in 2007, but a glut of US shale production has instead brought natural gas prices to record lows, hurting the company’s bottom line and its ability to pay its debt. And even while natural gas prices spiked sharply higher last winter as bands of arctic air froze broad swaths of the country, it was simply too little, too late. Recently, it skipped a deadline to pay $109 million in interest.

A crucial part of the restructuring is a $7 billion tax liability hanging over Energy Future’s head. When the company took over TXU in 2007, the new stakeholders were spared having to pay that federal tax bill on the acquisition. However, the terms of the deal stipulated that if the company split up, the massive tax bill would come due.  Stakeholders hope they have reached a restructuring framework that will allow them to shed some of their assets without having to pay that tax, and have asked the IRS to rule on their request.

Friday, April 11, 2014 - Corrupt or Incompetent, Take Your Pick

Financial Review with Sinclair Noe

DOW – 143 = 16,026
SPX – 17 = 1815
NAS – 54 = 3999
10 YR YLD - .01 = 2.62%
OIL - .07 = 103.33
GOLD + .30 = 1319.40
SILV - .07 = 20.06

The S&P 500 closed at its lowest level in two months. The gauge slipped 2.7% this week, the biggest loss since 2012. The Dow Industrial are down 2.4% for the week. The Nasdaq Composite Index dropped 1.3% today, capping its biggest two-day retreat since 2011; and down 3.1% for the week; closing at its lowest level in 4 months. The major US indices are all back in the red year to date. Biotechs fell for the 7th week in a row; the worst run since 1998; and now down 21% from recent highs. About 7.4 billion shares changed hands on US exchanges, 5.8% higher than the three-month average.

We are entering a period that has historically been very poor for stocks. The idea is called “Sell in May” or the worst six months. According to the Ned Davis (NDR) database, had you invested $10,000 in the S&P 500 every May 1st starting in 1950 and sold October 31 of the same year, your initial position would only be worth $10,026. Put another way, by investing only from May through October, a $10,000 stake invested in 1950 would have only made $26.

The Labor Department reports the producer price index, gained 0.5% for March. Excluding the volatile categories of food and energy, core PPI prices rose 0.6% after falling 0.2% in February. The University of Michigan/ Thomson Reuters consumer sentiment rose to a preliminary April reading of 82.6, the highest reading since July, from a final March level of 80.

You’ve probably heard about the Heartbleed bug.  Heartbleed is a flaw in OpenSSL, a piece of code intended to create a secure connection between a server and Web browser; for example, between an online shop and customer. The bug allows an attacker to make the server surrender bits of information out of its memory that should not be accessible. What's more, the exploit leaves no trace. The fear is that the bug may expose credit card numbers, passwords, and more.

By some estimates the Heartbleed bug puts two-thirds of all websites at risk. Millions of smartphones and tablets running Google’s Android operating system have the Heartbleed bug. The government has issued a warning to businesses and banks to be on alert for hackers possibly stealing data.

The Federal Financial Institutions Examination Council, made up of representatives from the Federal Reserve Board of Governors, the Consumer Financial Protection Bureau and other regulators, said: “The vulnerability could allow an attacker to potentially access a server’s private cryptographic keys compromising the security of the server and its users. Attackers could potentially impersonate bank services or users, steal login credentials, access sensitive e-mail, or gain access to internal networks.”

And there’s not a lot you, as a consumer, can do until the websites fix the problem on their end. It may take some time. The Heartbleed bug has been found in the hardware connecting homes and businesses to the Internet. Cisco Systems and Juniper Networks said some of their networking products are susceptible to the encryption bug. Security experts say it might help to change passwords on sites you visit, but fixing the network equipment and software means the companies will rely on customers applying patches as they become available. Cisco said it would tell customers when software patches for its affected products are available.

Now for the scary part.

Bloomberg News reports the National Security Agency has known about the Heartbleed bug for 2 years, and rather than report it, or take steps to close it down, the NSA instead regularly used the encryption flaw to gather intelligence. Putting the Heartbleed bug in its arsenal, the NSA was able to obtain passwords and other basic data that are the building blocks of sophisticated hacking operations. The agency found the Heartbleed glitch shortly after its introduction, according to one of the people familiar with the matter, and it became a basic part of the agency’s toolkit for stealing account passwords and other common tasks.

The revelations have created a clearer picture of the two roles, sometimes contradictory, played by the US’s largest spy agency. The NSA protects the computers of the government and critical industry from cyberattacks, while gathering troves of intelligence attacking the computers of others, including terrorist organizations, nuclear smugglers and other governments.

Questions remain about whether anyone other than the US government might have exploited the flaw before the public disclosure. Sophisticated intelligence agencies in other countries are one possibility. If criminals found the flaw before a fix was published this week, they could have scooped up millions of passwords for online bank accounts, e-commerce sites, and e-mail accounts across the world.

If the reports are true, they would represent a serious breach of the NSA's mission.  There’s no excuse for leaving Americans and businesses vulnerable to breaches on this scale. They should be helping to shore up vulnerabilities, not exploiting them. The NSA has issued a statement denying prior knowledge of the Heartbleed bug; which is not a reassuring denial. This is one of the biggest breaches in the history of the internet, and the NSA, which is supposed to watch this stuff, claims they know nothing. For now, the NSA is sticking to their story that they are incompetent rather than corrupt.

Earnings reporting season is gearing up, with an epic miss from the biggest US bank. JPMorgan Chase said its first-quarter earnings fell 20%, driven by a decline in investment banking and mortgage lending. The bank reported net income of $4.9 billion for the first quarter, after stripping out payments to preferred stockholders. That was down from $6.1 billion in the same period a year earlier. On a per-share basis, the earnings amounted to $1.28, missing estimates of $1.39. Revenue, after stripping out the effect of an accounting charge for credit losses, was $23.8 billion, down 8 percent from $25.8 billion a year earlier. Revenues at the bank's fixed income trading business, part of its investment banking unit, slumped 21% to $3.8 billion. Mortgage originations plunged 68% to $6.7 billion, compared with the same period last year; the bank doesn't expect the trend to change anytime soon.

Wells Fargo posted a profit of $5.9 billion, up 14% from the same period in 2013. Still, the bank’s revenue for the quarter fell to $20.6 billion from $21.3 billion in the same period a year ago.

A federal judge has approved the city of Detroit’s latest attempt to extricate itself from some long-term derivatives contracts that have been costing it tens of millions of dollars a year, holding up a settlement as an example of “the very spirit of negotiation and compromise” that he hoped other creditors would follow. Judge Steven Rhodes of United States Bankruptcy Court ruled that Detroit could proceed with a plan to pay $85 million to UBS and Bank of America to terminate the financial contracts, known as interest-rate swaps, that were used to help finance pensions.

Under the terms of the settlement, the two banks agreed to back Detroit’s overall plan of adjustment, which is critical for the city’s push to resolve its bankruptcy by early fall. Municipal bankruptcy rules say that if one class of impaired creditors votes to approve the city’s plan of debt adjustment, the judge may be able to impose the terms forcibly on everybody else. The judge’s decision gives Detroit leverage for settlements with other creditors.

Earlier this year, Judge Rhodes had rejected a previous attempt to end the swaps that called for Detroit to pay the banks $165 million. He called that proposal “just too much money” and noted that Detroit would have a reasonable chance of success if it sued the banks outright, calling the swaps invalid and refusing to make any termination payments at all. The message was to re-engage in negotiations, and apparently it worked.

Detroit’s emergency manager, Kevyn Orr, and other officials have been calling for creditors to negotiate settlements quickly out of fear that Detroit’s case will become a hopeless quagmire if creditors keep fighting the city’s proposals for resolving their debts. The state law that put Detroit under emergency management is scheduled to expire in September.

Detroit entered into the swap contracts in 2005, when it tapped the municipal bond market for $1.4 billion to put into its workers’ pension funds. Much of the deal was structured with variable-rate debt, and the swaps were intended to work as a hedge, to protect Detroit if interest rates rose. But rates fell, and under those circumstances, the terms of the swaps called for Detroit to make regular payments to UBS and Bank of America. The swaps cost Detroit about $36 million a year.

The 2005 borrowing also required an unusual structure to avoid violating the city’s legal debt limit. In 2009, the debt was downgraded to junk, putting the city out of compliance with the terms of the swaps. So Detroit restructured the swap obligations, offering the two banks the tax revenue that it received from local casinos as a backstop.

When Detroit declared bankruptcy last summer, it estimated the cost of terminating its swaps at about $345 million. Days before filing its bankruptcy petition, Detroit said Bank of America and UBS had given it a break, so that it would have to pay only about $250 million to cancel the contracts. But other creditors, facing bigger relative losses, complained that the two banks were still getting way too much. They argued, among other things, that the interest-rate swaps were invalid from the beginning because the use of casino taxes for financial hedges is not allowed under state law. So, Detroit either got off cheap at $85 billion or the banks just stole $85 billion.

What Do We Do Now?

Cyprus.com Editors

By Cyprus.com. Cross posted with permission

Yesterday, we discussed why we thought the combination of an across-the-board bank levy (regardless of institution health), in absence of restructuring the capital structure of banks was a bad idea and bad precedent.

Today, we will lay out what we think should happen. We recognize that we are working with more limited information than the teams actually negotiating the bailout, but we will give it our best shot.

Our parameters for a proper solution are the following:

1. Respect the €100K deposit insurance limit

2. Preserve moral hazard / fairness to bank creditors. In other words, hit the creditors of the bad banks more aggressively than the creditors of the good banks.

3. Have a solution that is sustainable for Cyprus over the medium-term.

This is actually a more more complicated question than it seems and at the crux of our analysis and our concerns about the initially proposed plan.

(a) For better or worse, financial services (broadly defined to also capture accountants, lawyers and other corporate services firms involved in managing the financial services clients) accounts for 45% of Cyprus GDP. A large % of this comes from serving Russian clients and is the most important industry in Cyprus.

With a British Law and British accounting heritage, independent courts and a highly educated population, it is the most natural industry for us, regardless of if Germany is confused about why Cyprus is in this sector. It is something that Cyprus has spent decades nurturing and protecting (often at significant cost to it).

(b) If either the deposit levy is seen as too unfair (and investors leave) or if Russia revokes the double-taxation treaty as punishment for the levy (as threatened today by Medvedev), this sector of the economy would take a huge blow.

We are going to use a completely made up estimate that, over a two year period, Russian departure would cost Cyprus a 15% drop in GDP (reduction of the financial sector by 1/3) with another 5% in knock-on effects for a total loss of 20% of GDP. The total could actually be higher, but we can use this as a planning assumption because whether it is 15% or 25%, it does not change the outcome of this exercise.

(c) This means any scenarios below that involve throwing away the Russian business need to be scored with a GDP 20% lower than our current GDP

We also have a few more variables to throw in the mix that have been discussed publicly since yesterday:

1. Nationalization of Cyprus pension funds and forcing them to lend to the government. This apparently can capture up to 4B.

2. Doing special bond issues to the local population against future oil and gas revenue.

3. The vastly land rich Church of Cyprus has offered to mortgage its land on behalf of the government, though we are not exactly sure how the mechanics of that would work, nor does anyone have any real estimate of the value of said land.

4. On the Russian front, nothing substantive has emerged. There are constant leaks and denials that one or more private Russian actors would purchase Laiki before and/or after a full and/or partial recapitalization.

Analysis

Given the above, here is our analysis of several possible Scenarios

Scenario A: Government / Troika Track: The Existing Solution +/- some modifications

This seems the most likely approach at this time and what the Cyprus government is discussing with the troika.

1. The troika will lend 10B as in the original plan.

2. Cyprus will then make up the remaining 5.8B through a combination of:

a. Nationalization of pension funds and forcing them to loan money to the government.

b. possibly loans against future oil and gas revenues from the Church of Cyprus and the local population

c. a reduced deposit levy in the 3%-5% range (possibly exempting small accounts).

Initial reports were that the troika rejected this plan because they were afraid that 2(a) and 2(b) would lead to unsustainable debt for Cyprus but surely that is a failure of imagination. These instruments could easily be made subordinate to official lenders or otherwise termed out into the long future at which point they are acting as pseudo-equity for the government.

So we will assume that they can work out the subordination of the local loans.

Our concern about this plan is the following:

(a) Even though the levy is lower than the initial levy, the damage might still be irreversible to Cyprus as a banking center if we apply an across the board levy (or the damage might have already been done from the events of this week).

(b) In which case, the drop in GDP will be coming anyway through the loss of its financial services sector, but Cyprus is still levered up to 120% of its original GDP (as if it had not fallen).

(c) Which means that, within a year or two, Cyprus will be looking at a debt-to-GDP in the 150-160% range which is clearly unsustainable and will either lead to Greek-style austerity or another depositor tax (if there are any left at that point).

We believe the initial Troika plan suffers from this risk as well and is the key risk that needs to be taken very seriously by Cyprus, namely that we lever up to protect the financial services sector, but then lose it anyway.

For us to be supportive of any measure that limits the hit on large foreign depositors, we need to see real evidence that the offshore sector is not fatally wounded, as per our Scenario B below.

Alternative Scenarios

We now present three alternative Scenarios B-D for consideration.

Scenario B: Return to Rule of Law / Protect Russia

The basis of this scenario is to preserve the principles of our legal system and to maintain our financial sector.

(1) As it relates to banks:

(a) Shareholders in any of the banks to be bailed out need to be completely wiped out. It is small fries at this stage, but it should happen as a matter of principle

(b) Bondholders should be wiped

(c) Senior management should be replaced and salaries cut bank-wide.

(d) Insured depositors are protected

(e) Uninsured depositors *in the failing institutions* make up the difference. That means that in practice, large account holders in Laiki have the largest haircut, followed by Bank of Cyprus and then Hellenic and the Coops. Other banks that are healthy do not have cuts.

(f) Place a Good Bank-Bad Bank structure in place for Laiki and possibly BoC with a Resolution Corp in charge of unwinding the bad assets

(g) Merge the Good parts of Laiki with BoC - there should be significant operation savings in branches, etc.

(2) The messaging to the offshore sector, despite the chaos of this week, would be the following:

(a) "We voted in, the face of the annihilation from Europe, to protect your deposits. Where else do you have that security in the EU?

Malta, Luxembourg, Latvia all have similar EU pressure and risks. Malta has 7x bank assets:GDP and Luxembourg 21x bank assets:GDP and are in the Euro so they are one accident away from also being at the mercy of Germany. Latvia is within the EU, has applied for the Euro and, furthermore, its bank sector controlled by German banks. Ireland is under a package of its own. So, the usual suspects (for an EU entity) face similar risks as Cyprus.

Furthermore, you do not know how they will respond under external pressure. Whereas, we are proven - we took on the ECB, the IMF and the EC to deliver for you."

(b) We protected your deposits (the ones in your own, Russian or English, highly-rated institutions). If any serious investor was still in Laiki as of March 2013 given years of downgrades into junk status by the major agencies, then, honestly, he or she has only himself to blame.

(c) These are the same rules of the road you will find in any serious jurisdiction -- aka there is predictability in creditor precedence and predictability in which banks are risky or not and innocent bystanders are not hurt.

(3) As it relates to the government:

Immediate cuts in spending. We need to do this anyway. It is no 'victory' to preserve salaries and deficits when the deficit funding is coming at such high cost in sovereign autonomy. For the same reasons, the SGOs should be privatized.

(4) To the degree that any additional funding is needed, use the additional sources from Scenario A (pensions, etc)

This is the theoretically best plan in our mind but for us to to support this plan, we would like to see some sense of real official support from Russia that shows they consider it acceptable and will support Cyprus's continued role in financial intermediation. This could include:

(a) Even a nominally small loan of 500M-1B euros on the same terms as the Troiaka (just to show commitment to the plan, in exchange for their depositors not being burned)

(b) Re-affirmation of the tax treaty

(c) Positive statements about deepening ties

If this is not achieveable, proceed to Scenario C

Scenario C: Burn the Russians

This would be our modification of Scenario A.

If one comes to the conclusion that the offshore business is gone in any case (see recently articles in WSJ, Medvedev's statements about cancelling the tax treaty, etc), then you might as well burn them hard and reduce your debt burden to a level sustainable by an 20% smaller economy.

By our rough calculation, we think that is an additional 4-5B euros minimum haircut from the non-EU depositors. They might yell and scream, but, hey, they are gone anyway...

In any case, this Scenario C is much better leverage in bringing the Russians along on Scenario B than offering to sell them Laiki.

In this scenario, you still resolve the banks, cut government spending, privatize the SGOs and so on.

Solution D: Self-Bailout (Burn everyone)

This it the model for the 'patriots' to follow, if they have the stomach for it.

Their patriotic, reflexive approach to date is 'leave the Euro' which is moronic and will leave Cyprus with an immediate drop of national wealth in the range of 50-60% as the NCYP (New Cyprus Pound) would have a hard devaluation immediately and no access to the ECB.

If one is willing to take that type of pain in order to achieve independence from foreigners, there are better solutions within the Eurozone as follows:

1. Cram down the sovereign bond-holders. If they don't accept, hard default on the June refinancing. Even though they are English Law bonds, Cyprus has almost no assets outside Cyprus that we can think of that they can freeze. So let them go to court and play for time. In the meantime, don't pay them (since, anyway, you don't have the money to pay them)

2. Cut government spending dramatically in order to run a surplus (Cyprus won't be borrowing on the international markets any time soon in this model), privatize SGOs, etc.

3. Resolve the insolvent banks as per Scenario B AND burn the offshore depositors as in Scenario C

4. Supplement with nationalization of pensions and Church of Cyprus support as needed.

5. At this point, you have no official creditors, can control your own policy and you hold out until the oil/gas comes online

6. As it relates to the ECB, request ongoing support with the solvent banks, including the Good Bank, as per ECB rules.

We don't recommend this path. But if things start going astray and the alternative is Euro exit, in our opinion, this is better. And theoretically the Northern countries should be pleased that we are not asking for any of their money and glad that we are not setting a 'leave the Euro' precedent.

It is disappointing that these are the options on the table as none of them are ideal. In our opinion, Scenario B was workable and should have been worked out behind closed doors. It would have been a very reasonable and fair solution and would have not damaged Cyprus's reputation the way that this week's events have. If the Troika wasn't so intent on intimidating Cyprus into a solution and (for reasons not known to us) insulting Russia, it could have been done this way.

At this point, it is mostly a judgement call of 'is the offshore business beyond recovery under any model?'

If not, then we should do Scenario B to save it. If it is, we should be hard-minded and do Scenario C and at least leave Cyprus in a fiscally survivable position.

The Editors, Cyprus.com

The End of US Capitalism

History will point back at September 2008, as the beginning of the final economic decent into the first global depression of the 21^st century. If, the natural world’s symbol of the Great Depression was the dust bowl and drought throughout the 1930’s, then, hurricane and flood will become its substitute.

 America’s total world hegemony is indisputably on the wane.  Evidence to support this theory includes the nationalization of Freddie Mac and Fannie Mae, the bankruptcy of Lehman Brothers, and the surrender of Merrill Lynch to Bank of America.  Additional exhibits offered for the record includes the near drowning of the U.S. cities of New Orleans and Houston.  

 Metaphorically, the bull, Merrill Lynch’s signature mascot and Wall Street’s icon of capitalism’s vitality and unparallel economic period of prosperity in America, is corralled under duress, and, which may signify a coming collapse of middle class opulence, which might never be duplicated.