Purchasing distressed financial assets in Cyprus is the latest potential investment opportunity that demonstrates both the globalisation of distressed investing and the complexity of the political and regulatory dimensions of the international arena. The passport of many a hedge fund analyst has been stamped in Iceland, Spain, Italy, Greece and Portugal.
We can now add Cyprus to the list.
Background
Cypriot banks were heavily exposed to Greek debt and suffered major losses as a result of the Greek bailout and the 70% “haircut” forced on holders of Greek debt. In June 2012, Cyprus applied for financial assistance after its two largest banks – Bank of Cyprus and Cyprus Popular Bank (Laiki Bank) – sought state aid following approximately €4.5bn (i.e. 25% of Cyprus’ GDP!) in writedowns of their Greek debt holdings.
In March 2013, the European Central Bank, the European Commission, the International Monetary Fund and the government of Cyprus finalised the terms of a €10bn rescue package to avert a collapse of the Cypriot banking system and to cover both the government’s financial needs and the shortfalls faced by BoC and Laiki.
As part of the rescue, Cyprus has agreed to significantly restructure its banking sector, install capital controls restricting movement of funds, and implement other austerity measures. These measures are designed to raise billions towards the bailout, while protecting bank customers with deposits of €100,000 or less. Unlike other bailouts, this rescue is described as a bail-in because portions of each bank customer deposits above €100,000 at both Laiki and BoC will be contributed by the government towards the rescue, in effect raiding personal bank accounts to strengthen the country’s financial system. This is the first time that the eurozone has imposed losses directly on bank depositors as part of a rescue package.
Laiki
Laiki has been placed into resolution and is being wound down. Deposits at Laiki of €100,000 or less (along with certain other “good” assets) have been transferred to BoC. Deposits above €100,000 (totalling approximately €6.4bn), along with “bad” assets and related liabilities, remain at Laiki and are currently frozen. Holders of deposits that remain at Laiki will have a claim against the bank, but recoveries are expected to be small since all “good” assets have been transferred to BoC.
Bank of Cyprus
Any deposits at BoC of €100,000 or less (including the deposits recently transferred from Laiki) are protected and should not be directly impacted by the bail-in. With respect to deposit amounts in excess of €100,000 at BoC (totalling approximately €8bn), some of this amount will be subject to a haircut, with any remaining amounts eventually returned to depositors. Specifically:
- 37.5% of deposit amounts in excess of €100,000 has been converted into class A shares of the restructured BoC, although no shares have yet been issued by BoC;
- 22.5% is frozen and being held as a buffer for possible conversion into class A shares in the future, depending on the conclusion of the independent valuation of BoC’s assets;
- 30.0% is frozen and being held as deposits in order to support the liquidity needs of BoC and as part of the country’s capital controls, with the expectation that this amount will be unfrozen at some future time; and
- 10.0% is available to deposit holders, subject to temporary withdrawal and transfer restrictions. Although the original equity holders of BoC will receive new subordinated shares in the restructured BoC, they will effectively be wiped out as part of BoC’s restructuring.
All other Cypriot Banks
Depositors at all other Cypriot banks (including domestic deposit holders of certain foreign banks with branches in Cyprus) are subject to temporary restrictions on cash withdrawals and money transfers that are expected to remain in place for six months. There are daily, monthly and other limits on cash withdrawals and money transfers, with the limits being renewed or revised on a weekly basis. Cyprus has lifted these limits for international clients of foreign banks doing business in Cyprus, although domestic clients of such foreign banks are still subject to the temporary restrictions.
Investment strategy
The new and unprecedented banking reality in Cyprus has generated considerable interest within the distressed investment community. Deposit holders need liquidity, and potential buyers of a bank deposit (or its related claim against the underlying bank) are formulating plans to purchase the frozen deposits, step into the shoes of the current Cypriot bank deposit holder, and acquire the bundle of rights that deposit holder would have against the banks.
There are, however, several roadblocks that would need to be overcome to enable the efficient purchase of Cypriot bank deposits therein. New deposit accounts cannot be opened in Cypriot banks, and existing accounts cannot be transferred to new holders. Current deposit holders cannot transfer funds in one account to different account held in another name. If a large deposit is the sole asset held by a business entity, it may be possible to transfer the underlying ownership of the business entity to the buyer from the seller through the sale of the equity in the business entity. However, this solution is applicable to only a limited number of business entities.
An extension of this solution involves the creation of an investment vehicle to purchase the equity of entities whose sole assets are deposits in Cypriot banks. The investment vehicle would then issue equity or beneficial interests to potential investors, thereby providing exposure to the underlying deposits. Purchasing a business entity solely for its Cypriot deposit account assumes that the account is the only asset or liability of the business. Buyers will therefore need to perform extensive due diligence in order to get comfortable with this approach and such due diligence will undoubtedly lead to settlement delays and increased transaction costs.
Alternatively, one could consider indirect transfers but these create problems of their own. For example, purchasing a depositor’s claim with the expectation of receiving a payment stream from the depositor would lead to increased counterparty credit risk.
Current discussion has therefore been focused on the sources of possible collateral support, including obtaining a charge over (or lien on) the deposit account, a pledge over the BoC shares of issued to the deposit holder, or requiring the deposit holder to post additional (unrelated) collateral as security for future payment obligations.
Conclusion
While Cyprus is clearly of great interest to distressed investors, given the difficulties of transferring deposits, mitigating counterparty credit risk, and predicting political outcomes, it is currently unclear whether it will ultimately generate the same level of claims trading activity that has recently been seen in Lehman, Iceland and MF Global.
That said, given the creativity of the claims trading market and its ability to adapt, as soon as a way to transfer depositor claims has been determined that can be replicated in a cost-effective and consistent manner, then market participants will flock to Cyprus to take advantage of this new investment opportunity.
(Carl Winkworth is a partner, and Matthew Hughes counsel, at Richards Kibbe & Orbe in London; Andrew Martin and Joon Hong are both partners of the firm in New York)
