Kass: Cyprus Blight Could Spread

Is this the real life?
Is this just fantasy?
Caught in a landslide,
No escape from reality....
Because I'm easy come, easy go,
Little high, little low,
Any way the wind blows
Doesn't really matter to me
To me....
Didn't mean to make you cry
If I'm not back again this time tomorrow
Carry on, carry on as if nothing really matters.

-- Queen, " Bohemian Rhapsody"

Over the weekend the EU imposed a tax on bank deposits in Cyprus as part of a bailout of that country. In its essence, the Cyprus government, in conjunction with the EU authorities, is confiscating bank deposits (although depositors get bank equity in return for the confiscated funds).

In trying to understand the motivation of this surprising move, we will probably hear that the northern countries in the EU grew increasingly uncomfortable with the rapid reduction in sovereign debt yields and the tightening in spreads that eased the pressure on the weaker southern countries to institute reforms. The intention might also have been to reduce moral hazard in Europe.

Investors were not expecting this at all. And consider the ill-timed nature of the decision, which was announced ahead of a European bank holiday on Monday, March 18.

Bottom line: This is a poorly thought-out move by a group of northern Europeans, who seem to have tired of taking the role of the go-to honey pot to the indigent southern Europeans.

The madness of this decision is unfathomable.... The leadership used a counter factual argument to justify it. "If we hadn't done this, it would have been worse...." Europe has found a new way to shoot itself in the foot.

-- David Kotok, Cumberland Advisors

Though Cyprus is a small country, the potential implications of a bank deposit haircut seem significant. The news is a wake-up call to investors that the European sovereign debt issue is far from being resolved and that there remains additional downside risk to the already muted and modest economic projections for the EU.

Again, it is important to emphasize that not in any discussions or readings about the Cyprus situation that had I seen over the past few weeks was there a notion that insured deposits in Cyprus were at risk -- only uninsured creditors. Notwithstanding the likely ECB statements that this is a special one-off case, a European-wide bank run is likely to begin quietly now (see unintended consequences below), and a concomitant flight to safety seems the order of the day over the near term.

Whether a bank run and deposit flight accelerates will depend upon a number of factors, including the degree to which the market believes in the soothing assurances by the ECB that are certain to be announced by the opening of the NYSE on Monday.

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