27 August 2014 Why non-passage of foreclosure bill could be catastrophic for Cyprus

This article appeared in Greek in Politis newspaper on Sunday 31 August 2014 under the title << Ένας λαός στον σκουπιδοτενεκέ;>>

If the foreclosure bill does not pass before the EU-wide stress test deadline, this could be a catastrophe for Cyprus that will be even worse than the one we narrowly missed last year.

Those who look at a modest debt repayment schedule in the next few months are missing the point. It is not a default on debt payments that we need to fear; it is the collapse of three banks.

Here are the reasons why.

Let us start with the size of non-performing loans (NPLs). At the end of March, according to Central Bank of Cyprus statistics, these had reached EUR 27.8 billion: EUR 7 billion in the cooperatives and almost EUR 21 billion for the banks.

If we analyze the financial statements of the cooperatives for December 2013 and Bank of Cyprus for the first quarter of 2014, we can infer that the coverage ratio (total loan loss provisions as a proportion of NPLs) is around 40% for the banking system. It was 42.1% for the cooperatives at the end of December and 39% for Bank of Cyprus at the end of March.

This means that, out of the total EUR 28 billion in NPLs, 60%, or EUR 16.7 billion is uncovered. This is just over 100% of GDP.


No foreclosure law would mean massive capital shortfall

During a discussion in parliament in mid-August, the Central Bank Governor, Chrystalla Georghadji, was reported as saying that the value of loans would be counted as zero in the upcoming EU-wide stress tests if the foreclosure bill was not passed.

I have not been able to get confirmation from the Central Bank of Cyprus that this is exactly what was said. Other sources say that this was not what was said and instead cite her saying that property collateral would be discounted 40% (this is approximately the fall in the value of property since the 2008 peak).

Either way, it is true that the Asset Quality Review (AQR) conducted as part of the EU-wide stress tests will take into account the period it takes for a bank to foreclose on bad loans. The longer the period, the bigger the discount applied to the value of the loans (assets).

If these assets are worth zero, then the bank must increase its loan loss provisions by EUR 16.7 billion to meet the NPL risk in full. Provisions have a negative impact on profits, which have a negative impact on capital. So the banks must find EUR 16.7 billion in capital to get back to their capital ratios before the stress tests.

Let us be generous and assume that all loans are collateralized with property (probably some loans are not collateralized at all) and we apply only a 40% discount.

So we take 40% off the EUR 16.7 billion in uncovered loans. The result is that the banks must find EUR 10 billion in capital (see table).

Bank of Cyprus’ capital in March 2014 was EUR 2.5 billion, so even if the amount is just EUR 10 billion it would mean yet another massive dilution for current shareholders.


Finding the capital will not be easy

The banks have six months to find this amount in capital but it will not be easy.

Bank of Cyprus has found it difficult to persuade current shareholders to increase capital by only EUR 1 billion. We also know from last year that EU taxpayers were unwilling to fund EUR 7.8 billion in capital for Bank of Cyprus. There is no reason to believe that it will be willing to fund EUR 10 billion today.

We also know that the government, with annual revenue of just EUR 6 billion and a debt stock of more than EUR 18 billion, does not have these funds. Comparisons with Portugal, which had to find half the amount, EUR 5 billion, for Banco Espirito Santo, but has annual government revenues seven times that of Cyprus, at EUR 44 billion, are misleading.

If the banks have to find EUR 10 billion they will then face two options: be declared insolvent, with 100% losses on all depositors and shareholders or use the same option as last time, namely a haircut on deposits.

How much will that haircut be? Total deposits are around EUR 46 billion. So a haircut of EUR 10 billion could mean a haircut of around 22% on all deposits or another big haircut on deposits over EUR 100,000 (if there are any left) at the three largest banks.


Don’t expect the stress tests to give us the benefit of the doubt

Some people hope that maybe the EU will be kind to us and run the stress tests on the basis of a law that has not yet been passed.

Since the troika has played hard ball on the contents of the bill, we can take that as a sign that the European Banking Authority will do the same. Just like in 2013, there will be no “benefit of the doubt” for Cyprus.

Nor would it be clever to allow ourselves to fail the stress tests and hope to pass them next year after the bill is passed. The rest of the world, including potential investors, would only see the headlines: “Bailed out Cyprus fails stress tests”. They would ignore the finer details.

If we fail the stress tests, we shall not only lose the new investors in Bank of Cyprus but those interested in oil and gas as well.

So this article ends with a plea to the political parties.

Yes, there has bene lack of clarity about personal insolvency and what happens to primary residences.

Yes, the government should have prepared the foreclosure and insolvency bills at the same time.

Yes, it could have done more to bring the parties into drafting the legislation.

But that is no reason to send the whole nation into the dustbin.



Postscript 31 August 2014

Since writing this article we have received confirmation that that the assumed period of foreclosure will be a key component in discounting the value of the collateral of NPLs. This, in turn, will have an impact on provisions, which negatively affect profits, which affect capital. If it takes 12 years to foreclose on a bad loan, which is often the case at present, the value of collateral will be discounted over 12 years at the rate of interest of the loan, instead of what is likely to be 4 years if the law is passed.

According to our calculations, and based on an assumed 6% interest rate, the value of collateral at 4 years will be 20% less than in Year zero. But after 12 years it will be close to 50% less. If this additional 30% is translated directly into additional provision requirements on the €24bn NPLs of the three banks undergoing the stress tests, this could mean that the banks will have six months to find €7bn in additional capital. Moreover, this is before taking into account the fall in the value of properties, which has been around 48% in nominal terms since the mid-2008 peak according to our calculations.