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Four Important Messages From the Cyprus Situation


Pay very close attention to the risks outlined here -- particularly as the level of social mood will materially impact the first three risks enormously.

Judging by the tone on Twitter over the weekend, there were a lot of people flabbergasted by Friday's EU proposal to "tax" Cypriot depositors. While I didn't have the specifics precisely forecasted, I wasn't surprised at all. Cyprus fits. What was put forth pulls together and reflects four of the risk-themes I have been writing about for years for my clients and here on Minyanville.

So what were those risk-themes?

Resyndication Risk
Since 2009, I have been beating the drum that it is all about the re-syndication of risk. For overleveraged European nations, it has never been a question of losses being taken, just a matter of who would take the loss and when. (See Resyndicating Risk Is Not Eliminating It.)

Even more, investors needed to appreciate that the resyndication decision would be made by "reactive" public policymakers. (See When Policymakers Become Extreme Reactionists: A Survival Guide for Investors.)

As American investors witnessed firsthand with the bankruptcies of General Motors (NSYE:GM) and Chrysler, re-syndication outcomes are not necessarily consistent with historical precedent or existing legal frameworks. And because re-syndications are reactive in nature, they establish new rules often with unintended and underappreciated consequences. At best, re-syndication is policymaking on the fly.

Co-Investment Risk
An important corollary to re-syndication risk is co-investment risk. For investors it is critical to understand specifically who stands with them as risks are being re-distributed. For example, I'd offer that during the 2008 US banking crisis as the US government considered how to put the Agencies into receivership, the senior debtholders of Fannie Mae and Freddie Mac benefitted enormously from the fact that China was a huge co-investor. In the case of Cyprus, however, the reverse was true, with bank depositors taking a beating because of their fellow "money laundering Russian" depositors.

Public perceptions matter. And as re-syndication paints with a very broad brush, what policymakers think of your fellow investors (both in terms of public reaction and the ability to withstand financial pain) is far more important than most people appreciate today.

For years, I have been writing about the "interplex" of Europe and how that region's large crossholdings of debt among sovereigns, national governments, and central banks make the orderly re-syndication of risk all but impossible. (See Why 2011 Is Much Worse Than 2008.)

Europe has become an oversized game of Whack-A-Mole in which the mitigation of loss in one entity only exacerbates the problem somewhere else.

For policymakers, defusing the Cypriot "interplex" was particularly challenging. Given how and where Cyprus sovereign debt is held today, policymakers had little choice but to focus on bank liabilities -- and more specifically, bank deposits -- instead. And I suspect if interviewed, policymakers would all agree that the solution was viewed to be the least bad alternative. Thanks to the "interplex" there are no good choices left.

Social Mood Risk
Finally, if there is a risk investors have underappreciated in the resolution of the European debt crisis it is the impact of falling social mood and plummeting confidence. At the risk of oversimplification, falling mood brings with it concurrent weak economic growth, high fiscal deficits, deteriorating credit quality, self-interest, a lack of generosity, in-fighting, nationalism, popular unrest, political instability, paranoia, and so forth.

Thanks to falling mood, those most able to help are far less willing, and those being helped feel victimized by the solution. That burden-sharing and open hostility grow as crises unfold naturally follows declining mood. Our level of confidence drives what we believe to be true, and in turn, our preferences, decisions, and actions. As I have written often, if highly confident people exhibit "us, everywhere, forever" choices, for people with very weak confidence it is all about "me, here, now." That Cypriots are driving bulldozers into banks speaks to the acts of "me, here, now" desperation which naturally accompanies very weak mood. And unless mood improves quickly, there will many more.

I'd offer that taken together, the four risks outlined above framed not only what policymakers proposed on Friday, but also the public and investor reactions since then. Cyprus fits.

How things specifically evolve from here is anyone's guess, but I would pay very close attention to the risks outlined above, particularly as the level of social mood will materially impact the first three risks enormously.

See also:

Pre-Market Primer: Cyprus Deposit Tax Shakes Global Trust in Banks; Markets Nosedive

Cyprus: Has the Next Phase of the Global Crisis Arrived?

As the Euro Tragicomedy Continues With Cyprus, What Should Traders Do?

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.

"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world." -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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