Municipal Bankruptcy

A federal judge today accepted the bankruptcy application from Stockton, California. The city had filed for Chapter 9 bankruptcy last summer, but had continued to pay in full the pensions of municipal workers and retirees. This was challenged in court by municipal bond holders, targeted for cuts by the city, who cited the principle that in bankruptcy, similar classes of creditors must be treated the same way. In his ruling, Judge Christopher Klein agreed, noting further that bankruptcy was necessary for the city to continue providing essential services: "It's apparent to me the city would not be able to perform its obligations to its citizens on fundamental public safety as well as other basic government services without the ability to have the muscle of the contract-impairing power of federal bankruptcy law".

The ruling is surely being scrutinized by other governments, notably those of the City of Detroit and the State of Michigan. After more than a year of will-he, won't-he, Michigan Governor Snyder sent in a team to review Detroit's finances which, in February, reported that, yes, a financial emergency existed in the City. The Governor then appointed an emergency manager, a move initially contested by City Council members - though not by the Mayor, Dave Bing, who had clearly recognized by this point the inevitability of such a move.  

The new emergency manager, Kevyn Orr - a bankruptcy lawyer and graduate of the University of Michigan Law School, who worked on the Chrysler re-organization in 2009 - joins several other such managers of Michigan entities, including the Detroit Public Schools. He started just this past week, and though he has the authority to remove local elected officials from financial decision-making, change labor contracts, and close or privatize departments, his first step was to restore the salaries of the Mayor and Council members. He's ready to proceed quickly, though, noting when introduced by the Governor that solutions can come “as quickly as anybody is ready to make a deal".
 

Mr. Orr must have sensed that things are urgent, and that he will need the co-operation of Detroit's politicians, and that of many other civic and public-sector union leaders, if he expects over his 18-month term to stop, then reverse, the financial rot in Detroit. This has been decades in the making. Council President pro tem Gary Brown described, simply and bluntly, the final stage of such rot, saying: "This was bad decisions piled on top of each other. It has all been a strategy of hope. You keep borrowing where every piece of collateral is already  leveraged. You have no bonding capacity - you're at junk status. You're overestimating revenues and not managing the resources. Now the chickens have come home to roost".

None of the decisions will be simple. Already, even Mr. Orr's appointment is being challenged, in U.S. District Court, where a lawsuit by various civic groups, unions and religious leaders contends that the state’s new emergency manager law is unconstitutional, violates the Voting Rights Act, and disproportionately affects the state’s black population. One wonders if Detroit - where some 700,000 residents live in a 139-square-mile city that held nearly 2 million people just a few decades ago - can be financially restored. It can't borrow (anymore) or print money (as its federal counterpart does), its tax base is eroded, it accumulated cash deficit is projected to be $100 million by June 2013, and its long-term financial obligations alone exceed $14 billion.

Good luck to Mr. Orr. If he succeeds in turning around  Detroit, rather than it ending up like Stockton in Chapter 9, it will rank as the financial rescue of at least this decade. Government officials everywhere - especially in Europe - should watch intently.

The Brotherhood

​The Muslim Brotherhood (founded in the Egyptian city of Ismailia in 1928 as a Pan-Islamic religious, political, and social movement) formed, in effect, the principal political opposition in Egypt (and elsewhere in the Arab world) for decades, even though the party was officially illegal, and even though - particularly under Hosni Mubarak - its members were persecuted and banned from participation in political life. All that changed with Egypt's Arab Spring revolution - Mubarak was ousted and the Brotherhood was legalized. Launching a new political arm in 2011, the Freedom and Justice Party, it won 51.7% of the vote in the 2012 national elections, and its leader, Mohamed Morsi, became President.

Finally in power, after so many decades out of it, it's so-far, so-bad, for the Brotherhood. Politically, Morsi's popularity, as high as 79% in September 2012, has dropped precipitously in only a few months. Promising at the time of his electoral victory to be inclusive and tolerant, Morsi has been anything but - forcing an Islamist-inspired new Constitution onto an increasingly secular Egyptian society, granting himself unlimited powers to “protect” the nation, along with the power to legislate without judicial oversight or review, and just this week ordering prosecutors to arrest more political activists, including the Egyptian satirist, Bassem Youssef. This is hardly what the Arab Spring had in mind - Egyptian society has, if anything, become more polarized, politics is harsher and nastier, and violence erupts in the streets more loudly and ever more frequently. The police and army are at best inconsistent in carrying out government directives; security is, even, at times, non-existent. Morsi is on the brink of losing legitimacy and control, and the Egyptian experiment with Islamist rule appears close to failing.

There is a way out. Morsi needs to drastically alter his focus - now - away from imposing an Islamist regime in Egypt, towards restoring the collapsing economy. Conditions are dire, and, as the Economist magazine noted yesterday, deteriorating: "Virtually every economic indicator points to trouble. The currency has slid by 10% since January. Unemployment may be as high as 20%. The stock exchange this year has slumped by a tenth. Tourism, which used to account for 12% of Egypt’s GDP, has evaporated. Foreign investment has dried up. Foreign reserves have shrunk. Many of Egypt’s most dynamic businessmen have fled, fearing they will be arraigned for complicity with Mr Mubarak. The government is threatening to reverse a number of privatisations. Meanwhile, the price of food is soaring at a time when the average family already spends almost half its income to feed itself. A good quarter of Egypt’s 83 million people live below the poverty line".

An IMF team is returning to Cairo this week, to resume discussions regarding a $4.8 billion loan, now urgently needed, but long delayed given the recurring and often violent demonstrations in Egyptian cities. Morsi's government should do two things immediately: first, restructure the cabinet to include secularists and technocrats, much as neighboring Tunisia, facing its own, post-revolution difficulties with governing, implemented last month. This would signal significant recognition of the broad political spectrum characterizing 21st-century Egypt.  Secondly, it should commit itself to, this time, finalizing the IMF negotiations - even though it will require acceptance of harsh reform measures, such as removal of fuel and food subsidies. With an IMF loan in place, additional, bilateral government aid, and private foreign direct investment, would resume. The economy would then be poised to begin what would nonetheless be a very long road back. 

Still No White Smoke

As serious as ongoing developments in Cyprus are ​(and they are serious, because depositors in over-leveraged European banks are now fair game, as taxpayers have been all along, if a sovereign/bank bail-out becomes necessary, say in Spain), they pale next to the threat from Italy.

Italy, the Euro-Zone's third largest economy, has been without an elected central government for a month since its national elections on February 24-25. Though President Napolitano charged Pier Luigi Bersani (leader of the leftist PD party) last week with the responsibility of forming a new ruling coalition, he cannot. Other parties, like Beppe Grillo's 5-Star Movement, want nothing to do with him (or any other part of the political establishment). Indeed, Mr. Bersani seems not just unable, but unwilling - he was quoted today as saying that only an "insane" person would want to lead Italy now. As a result, Italy's $8.8 billion bond auction Wednesday was weak, and yields on peripheral sovereign debt zipped higher. (Spanish 10-year yields rose above five percent.)

Italy's President is likely to have little choice but to call for new elections later this year, and install another technocrat (non-party) government for the interim. No "white smoke" can be expected. The issue is this - more than ever, Italy very much needs a strong, legitimate central government, to devise and implement policies for long-term fiscal re-balance, and economic structural reform. Without these, a resumption of growth, and a turnaround in the labor market, is impossible. And, in such an uncertain political and economic environment, contagion from economic emergencies in much smaller peripheral countries - like the Republic of Cyprus -  is that much more of a threat.

Watch early tomorrow morning when the Cypriot banks re-open. Bank runs and domestic turmoil in Nicosia could trigger problems in Italy, and elsewhere.

Winners and Losers

In the early Monday morning hours in Brussels, the EU/IMF agreed to bail out Cyprus, thus avoiding an imminent collapse of the Cypriot banking system when the banks re-open later this week. Stock markets throughout the world initially rallied, from relief. But the euphoria has faded through the day, after the Dutch Finance Minister (head of the Eurogroup) said the Cyprus rescue represented a new "template" for resolving euro-zone banking problems, and that other countries may have to restructure their banks. A new European "bail-out", "bail-in" regime has apparently begun.

Given the composition of the Cyprus deal, it is clear that the Germans, with the IMF by their side, prevailed in the negotiations, with their insistence that, as a condition of a bail-out loan being advanced from the EU, there be in addition a "bail-in" of, at least, large depositors in the Cypriot banks. Russians, on the other hand, who hold the bulk of these large deposits (large defined here as over 100,000 euros) are furious -  Russia's prime minister, Dimitry Medvedev, was quoted by news agencies as telling a meeting of government officials that "in my view, the stealing of what has already been stolen continues".

Here's the essence of the final loan package: The EU/IMF will loan 10 billion euros (of the 17 billion needed) to the Cypriot government. Cyprus's commercial banking system is not being bailed out, but rather completely restructured, with one of the two principal banks, Laiki Bank, being liquidated, with its viable assets and insured deposits (under 100,000 euros) going into a new "good" bank. The remainder, including deposits over 100,000 euros, will go into a "bad" bank. The "good" bank will then be blended into Cyprus's other main bank, Bank of Cyprus, which won't be closed, but rather recapitalized by forcing bondholders to take a cut, and imposing a tax on uninsured deposits (over 100,000 euros), reportedly as much as 30-40%. Moreover, what's then left of the "large" deposits must remain in Cyprus, as the government introduces "temporary" capital controls. All this is designed to raise an additional 5.8 billion euros. to total a full rescue package of 17 billion.

With this dramatic shrinking of its banking sector, and with the imposition of capital controls, Cyprus's status as a largely-unregulated, offshore financial centre is suddenly gone. Its economy, already in recession (it declined 2.3% in 2012), will weaken further, especially as austerity measures accompanying the EU/IMF 10 billion loan are implemented. A Greek-style GDP slide (20% drop in 5 years) is not improbable. Cyprus's formidable offshore Aphrodite natural gas field (to which Turkey also claims territorial rights)  doesn't come on-stream until later this decade, and there is nothing else on the island, with financial services gone, that could spark economic growth until then (unless the Turk and Greek Cypriots finally agree to ratify the Annan Plan, reuniting the island into one nation and one economy).

Ironic, then, that Greek Cypriots today are actually celebrating the annual holiday that recognizes Greek independence - from the Ottoman Empire in 1832. The Republic of Cyprus will now be, for some years to come, utterly dependent on new foreign powers - the European Union and other international lenders.

The Brussels/Frankfurt/Washington/Nicosia Axis

Following a week of protests, long lines at the ATM machines of closed banks, a Russian rebuff to Cypriot pleas to help its banks, a no vote by the Cypriot parliament to a joint EU/Cypriot government proposal to tax depositors' bank accounts, and a breakdown last night of negotiations with an EU/IMF team in Nicosia, ​Cypriot President Nicos Anastasiades decided to seek assistance at a higher level. He and his Finance Minister flew to Brussels this morning, on a private jet provided by the European Council, to meet with European Union leaders, including Council President Herman Van Rompuy and Commissioner President Jose-Manuel Barroso, IMF Managing Director Christine Lagarde, and the head of the European Central Bank, Mario Dragy. Meeting on the same issue, also on an emergency basis, was the EU's bloc of 17 Finance Ministers.

This is the latest round in the ongoing Euro Zone debt/political crisis, manifesting itself this time in Cyprus -  an island economy, about one quarter the size of that of Cincinnati, Ohio, and accounting for 0.2% of Euro-Zone GDP, the bloc to which it was admitted in 2008. Size does matter here, though, clearly not of the Cypriot economy, but of the country's commercial banking system, which functions inter alia as an offshore tax haven, and holds deposits roughly three times, and assets about eight times, the size of the domestic economy. Wealthy Russians and other non-residents have maintained large, liquid deposits in the Nicosian banks. The banks have, in turn, made substantial loans to Greek enterprises, and hold Greek debt. Thus, they have borrowed short, and loaned long - as all banks do - but having been caught in Greece's financial meltdown, much of their asset base is now, at best, worth far less than book value, at worst, worthless. Cyprus's two largest banks, in particular, the Bank of Cyprus and Laiki, are bankrupt.

Thus, the Cyprus emergency has arisen.​ Cyprus is bust, and cannot afford to bail out its banks. Early last week, the EU/ECB/IMF (the so-called "Troika"), concerned that a bank run, even in tiny Cyprus, could be systemic within the rest of the Zone, and ultimately affect the viability of the euro, stepped forward with a 10 billion euro bail-out proposal. But, on German/IMF insistence, the loan would be conditional on Cyprus coming up on its own with an additional 5.8 billion, by levying a tax on the deposits in the Cypriot banks, even on those below 100,000 euros that by European law are covered by deposit insurance. The loan proposal, designed to both recapitalize the banks and restructure the country's debt, backfired, angrily rejected outright by the Cypriot parliament, who called it "bank robbery".

New proposals were made just before President Anastasiades left for Brussels. By tomorrow, if no deal has been struck, the ECB has said it will stop its emergency lending, without which Cyprus's banks will be completely illiquid. This would cause a banking collapse and almost certainly push Cyprus out of the euro. Then, with this precedent, what might Greek, or Spanish, or Irish, or Portuguese, or even Italian depositors decide to do?