Sigrún Davíðsdóttir's Icelog

Icelog has earlier dealt extensively dealt with the saga of the Landsbanki Luxembourg equity release loans. As pointed out there seem to be good reasons to question both how Landsbanki dealt with its customers before its demise in October 2008 and then later how the administrator has allegedly dealt with these loans, as well as ignoring questions regarding the Landsbanki Luxembourg operations.

The clients, mostly elderly people, have shown great resilience in drawing attention to questions seeking answers but the authorities in Luxembourg have not been too keen in taking up the issues raised by the group. One of many remarkable events was when the Luxembourg Prosecutor went out of his way to issue a press release defending the administrator, i.a. by throwing doubt on the victims’ motives, though he did not publish any tangible proof for these allegations.

As reported earlier, the group has now sought legal assistance and is seeking ways how best to proceed with their claims. The group has now open a website with all relevant information, contact details etc.

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At a press conference today, a group of almost 200 clients of Landsbanki Luxembourg in Spain and France raised complaints against the bank, because of its equity release lons and its administrator, Yvette Hamilius, for not investigating what went on in the bank prior to its default. A Brussel-based lawyer, Bernard Maingain, discussed the complaints, most of which Icelog has already written about earlier.

The action taken by the group is both aimed at the Landsbanki Luxembourg operations and the administrator. As Maingain pointed out today, the Landsbanki operations raise many questions – such as if the equity release loans were put together in such a way that they would never make the money promised, if they were mis-sold, if Landsbanki really had the license to operate in Spain and France. It is part of an administrator’s duty to investigate any possible irregularities prior to the failure of the company administrated.

Tomorrow, these claims will be presented in Luxembourg. This is just the beginning of a case, which no doubt will run for a while. The interesting thing is that here Luxembourg is being challenged on its supervision of its gigantic banking sector – the lifeblood of this tiny Duchy. But as representatives of the group said today, they are seeking nothing but justice from Luxembourg.

It will be interesting to see how easy it is to seek justice in a bank-related case in a country utterly and completely at the mercy of its banking sector.

*Here is a video link, in English but mostly in French, on the Landsbanki Luxembourg action, made last week during the press conference in Brussels, with interviews with some Landsbanki clients. 

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Icelog has earlier told stories of Landsbanki Luxembourg and equity release loans sold by the bank in France and Spain.

The remarkable thing is that although those who bought the product have good reasons to feel that that Landsbanki Luxembourg missold the loans, mismanaged the accompanying investments and miscalculated the loan cover ratio (in early Sept. 2008, a month before the bank collapse), the administrator has not been willing to discuss these matters with the clients. Since no reports regarding the administrator’s work can be found on-line (contrary to ia the operations of winding-up boards of the collapsed banks in Iceland), it’s not clear how and in what way the administrator has fulfilled normal duties to investigate if the bank took any actions before the collapse that might be either illegal or should be repealed.

In addition, the equity release clients have been frustrated by the wholly opaque and, what has at time, seemed arbitrary operations of the administrator. The clients have ia had varying and inconsistent information as to the status of their loans. Yet, no authority in Luxembourg – such as the Luxembourg financial services, CSSF or the Luxembourg Central Bank – seems to have paid any attention of a) what went on in Landsbanki Luxembourg before its demise b) the operations of the administrator. In this tiny country that lives of banking, the authorities don’t show any interest in knowing what really is going on in Luxembourg banks.

As to the assets, the Landsbanki Winding-up Board has now taken them over. The WuB has not been willing to answer questions regarding what they know about the Landsbanki Luxembourg operations before or after the collapse. The unusual position of the Landsbanki Luxembourg estate is that there are essentially only two creditors: the Landsbanki Iceland estate, now run by the Winding-up board and the Luxembourg Central Bank.

As mentioned earlier on Icelog there are two important events concerning Landsbanki Luxembourg: a court case in Spain and actions taken in France by a French judge.

A court in Spain has ruled in one case that the Landsbanki Luxembourg was illegal, awarded the borrow compensation – but because the case is being appealed these borrowers are still kept in agony.

In France, Judge Van Ruymbeke* is investigating the Landsbanki Luxembourg operations and has seized some properties belonging to Landsbanki Luxembourg clients – in order to prevent the Landsbanki Luxembourg administrator from confiscating the properties against loans she claims are in default.

In spring, the Luxembourg State prosecutor took the extraordinary step to issue a press release in support of the said administrator – although a) the prosecutor had not, judging from the press release, investigated the matter b) had not been asked to investigate it and c) had, as far as could be judged from the press release, nothing to rely on but information from the said administrator. Quite extraordinarily, the prosecutor makes the claim that a small number clients, complaining about the operations of the administrator, are only people who are trying to evade repaying their loans.

The fact that a State prosecutor steps forward to defend in this way an administrator of a private company, is I believe unheard of in any country claiming to be run by the rule of law.

What makes this case particularly poignant is that many of these clients, who now have lived with the threats of being evicted from their homes, are elderly people who thought they were securing their later years in a sensible way by taking out these loans. There are many and various European and domestic schemes to protect consumers and bank clients. So far, none of these seem to have worked for the clients of Landsbanki Luxembourg in Spain and France.

*Judge Renaud van Ruymbeke has a formidable track record in investigating huge and high-profile corruption cases. He worked with Eva Joly – who advised the Icelandic Special Prosecutor when the office was set up – on the Elf case where ministers and politicians were convicted to prison sentences and has run big investigations such as the Clearstream 2 case and French investigations into the Madoff fraud. 

Update to clarify the legal standing of an administrator in Luxembourg: a judge appoints an administrator and all actions have to be accepted by this judge. In the case of the Landsbanki Luxembourg administration the presiding judge is Karin Guillaume. As far as I understand, the judge is therefor also responsible for the actions taken by an administrator appointed by the judge.

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A recent ruling in a French court spells out that while a case against Landsbanki Luxembourg for wrongful selling of its products is ongoing in France, Landsbanki Luxembourg cannot pursue its recovery of these loans. Over 80 clients in France of Landsbanki Luxembourg brought a civil case in France against Landsbanki, represented by Yvette Hamilius, for wrongful presentation of its loans. In a ruling July 13, Judge Renaud van Ruymbeke ruled that the recovery could not continue as long as this case is ongoing.

As Icelog has pointed out earlier, so many of the Landsbanki Luxembourg clients with equity release loans and often some investments found that incomprehensibly their assets fell just below the value, which demanded they added assets so as to cover 110% of the value. This put many of them in arrears, meaning that the Landsbanki Luxembourg administrator started threatening to sell their houses and has indeed sent the bailiffs out.

This French ruling gives them some hope that the selling of the loans, events at Landsbanki before its demise and the consequent actions of the administrator will be clarified.

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Readers of Icelog already know some of the answer to this question. Luxembourg is a gateway to the offshore world. The offshore world is a hide-away heaven for money that needs to be visible only to the owners and not to others. It’s a popular place for big corporations and wealthy individuals in search of good tax schemes and by shadowy elements who need to move money, quickly and efficiently, out of sight. It’s no coincidence that the Icelandic banks, allegedly, ran all their most dubious loan deals through Luxembourg. It’s also worth keeping in mind that all European – and many international – banks, which want to be something more than a little local bank, operate in Luxembourg.

An interesting view on Luxembourg – and Icelandic – operations can be gauged through the operations of Landsbanki Luxembourg. The bank’s equity release scheme leaves some questions to be answered, as pointed out earlier on Icelog. Also, how the bank bought Landsbanki and Kaupthing bonds as investment for clients in mid and late 2008, in some cases directly against written agreement with clients. (At this time, there were literally no buyers for bonds of these two banks. Landsbanki did at this time set up a company in the Netherlands, Avens BV, stuffed it with all sorts of Icelandic bonds and used it to repo with the European Central Bank, an interesting story in itself, with the aid of Crédit Suisse.)

In addition to the bank’s own operations, before the collapse, the actions of the administrator, Yvette Hamilius, have been brought into question.

The administrators of the Icelandic banks, in Iceland, have all scrutinised the banks’ operations prior to the collapse. This is always done in a bankrupt company. A bankruptcy is the outcome of a long process and an administrator always looks at all dealings some months prior to the bankruptcy to make sure that managers, owners or others haven’t made anything that could be seen as unfavourable to creditors.

All the administrators in Iceland have brought cases against managers – and in some cases against the large shareholders – for causing the creditors of the bank in question damages. Apart from that, there are the ongoing investigations of the Office of the Special Prosecutor in Iceland.

If the Landsbanki Luxembourg administrator has questioned any of the dealings in Landsbanki prior to its fall or brought any cases against the managers such moves have not been communicated. – Instead, the Luxembourg Prosecutor has issued a statement where he declares his support for the administrator’s actions. Just his statement makes one wonder what sort of a country Luxembourg is. Why isn’t the Luxembourg Prosecutor doing what is Icelandic colleague is doing, investigating banks, which have shown ample reasons for suspicion? Is that because Luxembourg bases its wealth on the flow-through of international funds and doesn’t want to do anything to disturb the smooth flow?

I have had the opportunity to look at, in detail, documents related to certain clients of Landsbanki Luxembourg. A perfectly normal part of the equity release contract is that if the value of the assets underlying the contract – in Landbanki case normally a property in France or Spain – falls below a certain limit, here 90%, the bank can call for cash or further valuables to cover itself.

A closer look at the realities in portfolios related to some clients Icelog has seen, indicates some rather remarkable movements. According to overviews, not only from one but several clients, the bank re-evaluated the portfolios just before its collapse – and miraculously the valuation turns out to be 89.9%. A tiny fall, allowing the bank to call in further payment.

At least in one case, an Icelog source who is familiar with the property in question is pretty sure the house is under-valued. One French real-estate agent who operates in the South of France, where some of these properties are, has commented on Icelog that she is unaware of any changes at the time the bank was claiming there was a falling value. – A banker, familiar with type of deals, says that the bank might have envisaged an imminent decline in its re-evaluation but there should have been some documentation to prove it. Otherwise, a bank can forecast whatever it wishes.

There are clients who are now just about to lose their houses to bailiffs because of this tiny fall. The administrator has offered them a deal, which means that they either pay – in cases that Icelog has seen they are supposed to pay much more than they took out of the scheme because they are deemed to be in default. The remarkable thing is that the administrator doesn’t seem to be paying any notice to these weird movements in valuation: if the valuation hadn’t fallen down below the 90% many of these borrowers wouldn’t have the bailiff at the door.

In the UK, equity release scheme don’t create havoc to lenders and make them lose their homes anymore – as was common some 20-30 years ago – because banks in the UK are bound by strict rules in this field. This doesn’t seem to be the case in France and Spain.

Now back to the original question: what sort of a country is Luxembourg? It seems to be ia a country where the State Prosecutor comes to the aid of an administrator who hasn’t provided lenders with numbers that make sense when their houses, the roof over the head, is being taken away from them. It’s not a country where banks are questioned. It’s also a country where bank clients are completely unprotected when a bank loses clients’ money by investing directly against written agreements. Why the Luxembourg regulator, the CSSF, hasn’t investigated the serious allegations of mismanagement of clients’ funds and breach of MiFID rules in Landsbanki indicates that the reputation of Luxembourg as a good country for banks means more than Luxembourg being a good country for bank clients.

These are not just theoretical issues. These issues mean that in France and Spain some real people of flesh and blood, mostly elderly people, are losing their houses after a harrowing fight against forces in Luxembourg that seem to protect banks and bankers, not ordinary people.

*Earlier logs on Landsbanki Luxembourg are here and here, where I go more in detail through some of the topics related to Landsbanki Luxembourg and the equity release scheme.

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There has been a lively discussion on Icelog regarding Landsbanki, Luxembourg. For all of you interested in that matter, I strongly advise you to read it. I will take a better look at it myself in the coming days but here are a few issues touched upon:

Regarding Landsbanki operations:

The valuation that Landsbanki made of the properties – and then sudden drop in value just before the bank failed, is commented on by Sharon, a real estate agent in this area in France where many of the houses are.

Money was taken from accounts to buy Landsbanki bonds, even though the clients had it in writing that no investments were to be made without their approval.

Information of risk sent to clients after the loan was issued.

Serious lack of information and documentation, in addition to the questionable valuation, when the bank claimed the “security ratio” (the ratio between the loan and the collateral) had fallen and the clients was obliged to pay in order to address the shortfall.

Promises were made to make money available to clients but it seems that no money was forthcoming from Landsbanki – at least for some clients – already from July.

After the administrator took over:

In spite of investigations by the failed banks’ Icelandic resolution committees, ia Landsbanki’s ResCom, into the banks, the administrator in Luxembourg seems not to have undertaken any investigation, or at least that hasn’t been made known to clients.

Information from administrator to former clients on what they supposedly owe the bank does in many cases differ greatly from what the clients themselves see as possible but they don’t seem to be getting any explanation as to why there is this great difference.

—

These comments show that both regarding Landsbanki’s own operations and then the operation of the administrator there are serious issues to be addressed. There seems good reasons to question some legal aspects of the loans themselves – and then the administrator seems to have done a questionable job of dealing with the equity release loans. All this has been to a great distress for the clients involved.

For further information, here is an earlier Icelog on the nature of the equity release loans and Luxembourg.

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Landsbanki promised “the most comprehensive protection possible” according to the bank’s documentation. That has proved to be very far from the truth. – As reported earlier on Icelog, a group of Landsbanki Luxembourg clients claim they are wrongfully being targeted by the bank’s administrator Mme Yvette Hamilius to pay back dubious “equity release” loans – and in some cases investments, which the bank made without the clients’ knowledge and/or acceptance.

The Icelandic resolution committees for the three Icelandic banks have used time and resources to investigate alleged fraud in the Icelandic banks. The same doesn’t seem to be done in Luxembourg. Icelog has heard evidence from Landsbanki Luxembourg clients, which give good ground to suspect that Landsbanki:

1 Bought the bank’s own bonds, on behalf of clients, without clients’ acceptance, shortly before the bank failed (and at a time when it was most likely already insolvent)

2 Money was taken from clients’ accounts without proper consent for trading

3 MiFID rules were neither applied correctly nor were the clients made aware of these rules and their implications for the clients.

As far as is known, the Landsbanki Luxembourg administrator hasn’t done anything to investigate – or have the proper Luxembourg authorities investigate – if this was the case or not. If it is indeed the case that Landsbanki Luxembourg accessed and used clients funds in an inappropriate way it would be most interesting to know who ordered it. Was this a concerted action? And who ordered this allegedly inappropriate use.

In spite of these alleged irregularities, Mme Hamilius seems to treat the clients as if nothing was wrong with the loans and is trying to recover them, going after people’s homes when everything else fails. Most of the clients are elderly and the administrator’s actions and her insufficient communication have put these clients under severe stress and duress by the administrator. An administrator’s business if of course recovery – but an administrator also has the duty to report eventual irregularities and to maintain a reasonable level of communications with those hit by the administrator’s actions.

There are already some legal cases related to Landsbanki clients in France and Spain traversing through court systems there. One couple in Spain have already won their case: their home is now debt free and Landsbanki has to pay them €23.000 in compensation. In spite of this, the Luxembourg administrator carries on as if nothing was happening.

Lately, the Landsbanki Luxembourg clients have organised themselves as “Landsbanki Victims Action Group” to put some pressure on Mme Hamilius. They now seem to be making some headway. After issuing a press release on May 7, where they questioned the buisness morale in Luxembourg the local media reported on the Action Group, its plights and a case in France, involving Mme Hamilius. She was interviewed in Paper Jam, a Luxembourg newspaper. Some of her answers there don’t quite fit the reality, seen from the perspective of the clients. The interview was no doubt a reaction to a media action by the clients’ pressure group, reported on in Luxembourg.

But the absolutely most remarkable part of this saga is that on May 8, Robert Biever Procureur Général d’Etat – nothing less than the Luxembourg State Prosecutor – issued a press release, as an answer to the Action Group. It is jaw-droppingly remarkable that a State Prosecutor sees it as a part of his remit to answer a press release that’s pointed against the administrator of a private company. One might think that a State Prosecutor would be unable to comment on a case, which he has neither investigated nor indeed been involved with in any way.

In this surprising move, the Prosecutor puts forth the following claim (in my rough translation; my underlining):

“Following a criminal proceeding in France against Landsbanki Luxembourg November 24 2011 for fraud by the Parisian Justice Van Ruymbeke and without the liquidator accepting the merits of the claims, she offered the borrowers an extremely favourable settlement whereby the borrowers will only reimburse that part of the loans which they received for their personal use, excluding funds used for investments. A considerable number of debtors have now accepted the settlement and the repayment is now being finalised. However, a small number of borrowers are trying with all means to escape their obligations. These are the same people who sent out a press releases on May 7 2012.”*

Apparently, Biever takes such an extreme interest in the case that this civil servant can, the day after the Action Group’s press release (and on the same day it appeared in the Luxembourg media) answer with authority and full certainty. The Prosecutor’s statements raise some questions. How can the State Prosecutor say this is an “extremely favourable settlement”? What makes it favourable? According to my information, it’s indeed not the case that most have paid. How does the Prosecutor know how many have accepted the administrator’s offer? Where did the Prosecutor get that information? If that information came from the administrator, did the Prosecutor verify the numbers?

Since the high office of the Luxembourg State Prosecutor takes such an interest in this case there is perhaps hope that Biever’s curiosity is now sufficiently aroused for him to take a further look at what really happened in Landsbanki Luxembourg in terms of unsound business practice and improper use of funds. I can’t think of any European country where a State Prosecutor would wade into a case of this kind to make a comment. If his comment is made to come to the rescue of the administrator, the functioning of the Luxembourg justice system is light years from the justice system in its neighbouring countries.

Luxembourg makes a good living by being a financial centre. No doubt, its authorities want to emphasis, just like Mme Hamilius does in her interview, that in the little country investment is safe. International creditors should rest assured that no matter what, they will get their money back. This credo seems so important that the State Prosecutor sees it as his role to back up a bank administrator under pressure.

There is indeed a lot to defend in Luxembourg. Monday night (May 14) the BBC programme, Panorama, will “reveal how major UK-based firms cut secret tax deals with authorities in Luxembourg to avoid paying corporation tax in Britain.”  – Possibly another worthy case for the Luxembourg State Prosecutor.

*“Suite à l’introduction d’une procédure pénale en France contre Landsbanki Luxembourg et à sa mise en examen le 24 novembre 2011 pour escroquerie par le juge d’instruction parisien Van Ruymbeke, le liquidateur sans pour autant reconnaître le bien fondé des poursuites, a proposé aux emprunteurs des transactions extrêmement favorables aux termes desquelles ceux-ci ne remboursent plus que le capital à eux remis pour leur usage personnel, à l’exclusion des fonds destinés aux investissements. Bon nombre de débiteurs ont d’ailleurs déjà accepté cette proposition et les transactions sont en cours de formalisation. Toutefois un nombre infime d’emprunteurs s’oppose à tout remboursement des fonds reçus et essaye de se soustraire à ses obligations par tous moyens. Ce sont ces mêmes personnes qui sont à l’origine du communiqué de presse du 7 mai 2012.”

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These days, the administrators of Landsbanki Luxembourg, led by Madame Yvette Hamelius, are sending bailiffs around in Spain and France to take over properties against which Landsbanki made equity release loans. These loans have already been reported on by English media in the UK expat community since many of those hit by the Landsbanki loans are English.

Typically, the bank would lend against the value of the property. The borrowers, often pensioners living in valuable property without much cash at hand, would get 20% of the loan in cash whereas Landsbanki invested 80%. The bank promised that the investment was good enough to pay off the loan. In theory, this could perhaps work. In practice it didn’t, the investments were unsound and resulted in losses and the small print hid the horrors of fees and interest rates. About 400 people took out these loans. Plenty of them, also hit by falling real estate prices, can’t pay, which is why Madame Hamelius is now making use of bailiffs to recover the outstanding loans.

The three main Icelandic banks are now being investigated for fraud by the Office of the Special Prosecutor in Iceland. Equity release loans were not prevalent in Iceland and cases, identical to the Spanish and the French stories, haven’t surfaced there. But if the Landsbanki equity release loans are partly an example of faulty advise there are similar cases. The Icelandic High Court has recently ruled in several cases where people had borrowed money from Glitnir to increase their stake in Byr, a saving society.* The Court ruled that those borrowers did not need to repay their loans because the bank hadn’t fully informed them of the risk and also because the bank had put pressure on these people to take out the loans.

It is interesting to keep in mind that administrators in the Icelandic banks have all spent a considerable amount of money to investigate the respective banks. It’s a fact, ia clear from the SIC report, that much of the dodgy loans and deals going on in Landsbanki did indeed go through Landsbanki Luxembourg. The question is if the Landsbanki Luxembourg administrator is doing anything to investigate eventually fraudulent activities in the bank. It should be in the interest of the creditors of the bank to make sure that these issues are investigated.

It should also be of interest for the Luxembourg authorities that the bank is investigated. A failure to do so won’t do much good for the reputation of this secrecy jurisdiction at the heart of Europe. As it is now, the borrowers of Landsbanki Luxembourg now driven to despair because of these loans will certainly not be recommending anyone to do business with banks in Luxembourg because they feel badly let down by the Luxembourg authorities.

The administrators make use of EU regulation on collaterals from 2005. However, the recovery of collaterals rests on the assumption that everything in the bank’s operation complied with rules and regulation. When this case came up in the Icelandic media in March 2009 the Landsbanki Luxembourg manager Gunnar Thoroddsen claimed the loans had been no different from similar loans offered by other banks.

The question is if this well and truly was the case and if the bank’s operations were sound. Was Landsbanki solvent in 2008? Did it have the full credential to issue these loans in these two countries? Did the investments Landsbanki supplied against these loans meet the investment framework of the loan agreements and the standards that this type of investments should meet? – These are some of the questions that the Luxembourg authorities, the lawyers of the borrowers and the administrators should be looking at.

The SIC report sows doubt as to the solvency of Landsbanki, as well as Glitnir and Kaupthing, from late 2007 until its collapse in early October 2008. Landsbanki had grave funding problems during 2008 and focused heavily on the equity release loans in France and Spain during that time.

The loans issued to borrowers in France and Spain were issued through Landsbanki Luxembourg. Questions have been raised if Landsbanki Luxembourg had the proper credentials to issue the loans in these two countries. Icelog sources have pointed out that questions have been raised if those acting on behalf of Landsbanki in Spain had the full credentials to operate in finance.

The nature of the investments also raised serious questions. I have heard from Landsbanki borrowers in Spain, who have investigated the matter, that the set-up of the investment – part investment, part insurance and fees to two companies – was such that it could indeed never have provided the cover promised to the borrowers.

It also seems that the invested funds were, at least to some extent, used to buy shares in the bank itself and possibly in other Icelandic banks. Shares in Kaupthing have been mentioned. The question is if this was in compliance with the information given to the borrowers. In the SIC report there are examples where ia the banks’ money market funds were used to invest in shares of the banks though that seems to go against the investment schemes for these funds.

Landsbanki wasn’t the only bank issuing equity release loans and not only Landsbanki customers are now feeling the pain. But due to the above – questions of solvency, legality of the operations and the set-up of the investments – the Landsbanki case raises different questions.

A famous French singer, known as Enrico Macias, has brought his case to a French court, saying he borrowed €8m but is being pursued by the Landsbanki administrator with a claim of €43m. Recently, the court demanded that Landsbanki place €50m as a guarantee, a record sum at a French court according to French media. The ruling in this case is being followed closely by other borrowers of Landsbanki Luxembourg.

It’s been pointed out that some clients of Landsbanki might have used these loans for tax purposes. That is another story and shouldn’t detract attention and focus on the legality of the Landsbanki operations in Spain and France.

*Why would Glitnir be interested in lending to Byr stake-holders? Because at the time the same group – Baugur and others related to Jon Asgeir Johannesson and Palmi Haraldsson – were in control of these two financial institutions. The Byr story has been told earlier on Icelog.

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Austria was one of the eleven founding members of the Eurozone in January 1999 but the Austrians never quite put their money where their mouth was: Austria is the only euro country where households flocked to take out foreign currency loans. About three quarters of these loans are coupled with repayment vehicles. Unfortunately, the Austrian authorities have known for more than a decade that the repayment vehicles add risk to the already risky FX loans: the crunch time for domestic foreign currency loans will be in 2019 and later when 80% of these loans mature. – This is the saga of authorities that knew full well of the risks and yet allowed the banks to turn households into carry traders.

Foreign currency loans are “… not suitable as a mass market product” – This was the lesson that the Austrian Finance Market Authority, FMA, had already in 2008 drawn from the extensive foreign currency, FX, lending to Austrian households; only in 2013 did the FMA state it so clearly. Long before these risky loans shot up by 10-15%, following the dramatic Swiss decap from the euro in January 2015, the risks were clear to the authorities.

From 1995, Austrian banks had turned a finance product, intended only for specialised investments, into an everyman mass-market product. Contrary to other founding euro countries, the euro did not dampen the popularity of the FX loans, mostly in Swiss francs, CHF. Austrian banks expanded into the neighbouring emerging markets, offering the same product there. Consequently, Austrian banks have turned households at home and abroad into carry traders.

From the beginning, the FMA and later also the Austrian Central Bank, ÖNB had been warning the fast-growing financial sector, with kind words and kid-gloves, against FX loans to unhedged households. The warnings were ignored: the banks raked in fees, FX lending kept rising until it topped (on unadjusted basis) in 2010, not in 2008 when the FMA claimed it banned FX lending.

FX loans in Austria are declining: in 2008 270.000 households had FX loans, 150.000 in March 2015. In February 2015 the FX loans to households amounted to €26bn, ca 18% of household loans. With maturity period of ten to 25 years serious legacy issues remain.

Further, three quarters of these loans, ca. €19.5bn, are coupled with repayment vehicle, sold as a safety guarantee to pay up the loans at maturity. Ironically, they now risk doing just the opposite: according to FMA the shortfall by the end of 2012 (the latest available figure) stood at €5.3bn. An FMA 2013 regulation to diminish this risk will only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019.

Added to the double risk of the domestic FX loans and the repayment vehicles are FX loans issued by small and medium-sized Austrian banks in the Central European and South-Eastern European, CESEE (the topic of the next article in this series). All this risk is susceptible to multiple shocks, as the IMF underlined as late as January 2014: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”

Consequently, as stated by the ÖNB in April this year, seven years after the 2008 crisis FX loans “continue to constitute a risk for households and for the stability of the Austrian financial system” – a risk well and clear in sight since Austria became one of the founding euro countries in 1999. There are still significant challenges ahead for Austrian Banks. Nonperforming loans are rising – Austrian banks are above the European average, very much due to Austrian banks’ operations in CESEE.

Add to all of this the Hypo Alpe Adria scandals and the Corinthia guarantees and the Austrian hills not alive with the sound of music but groaning with well-founded worries, to a great extent because Austrian authorities did not react on their early fears but allowed banks to continue the risky project of turning households into carry traders – yet another lesson that soft-touch regulation does work well for banks but not for society.

Kid-gloves against a mighty and powerful banking (and insurance) sector

There are over 800 banks in Austria, but the three largest, Erste, Raiffeisen and UniCredit Bank Austria, “account for almost half of total bank assets” according to the IMF, which in 2013 pointed out that the financial system, “dominated by a large banking sector,” faces “significant structural challenges, especially the smaller banks.”

Six Austrian banks, three of which are Raiffeisenbanks in different parts of Austria, were included in the ECB Asset Quality Review in October 2014. As expected, the Österreichische Volksbank, partially nationalised, did not pass but the others did. However, the Austrian banks require an additional loan provisioning of €3bn.

The size of the banking sector as a ratio of GDP has been rising, at 350% by mid 2014. The expansion of small Austrian banks in CESEE, where non-covered non-performing loans in these banks’ operations are high, is a serious worry. As is the sector’s low profitability, seen as a long-term structural risk, as is a domestic market dominated by a few big banks and large CESEE exposures.

Theoretically, unhedged borrowers alone bear the risk of FX loans but in reality the risk can eventually burden the banks if the loans turn into non-performing loans en masse, which make these loans significant in terms of financial stability as the IMF has been warning about for years.

Intriguingly, already in 2013 the IMF pointed out that Austria needed to put in place a special bank resolution scheme and should not await the formal adoption of the EU Directive on bank recovery and resolution. It should also pre-empt the coming EU Deposit Guarantee Scheme Directive and the Basel Committee on Banking Supervision (BCBS) Core Principles for Effective Deposit Insurance Schemes as minimum standards. However, the progress in this direction has been slow.

Austrian FX loans: from a specialised product to everyman mortgage

In the mid 1990s Austrian households cultivated an appetite for FX loans, unknowing that they were indeed turning into carry traders without the necessary sophistication and knowledge. The trend started in the 1980s in Vorarlberg, the Bundesland in Western Austria where many commute for work to neighbouring Switzerland and Liechtenstein.

At the end of the 1980s 5% of household loans in Vorarlberg were in FX, compared to the Austrian average of 0.2%. From 1995 there was a veritable Austrian boom in FX lending, with borrowers preferring the CHF, and to a lesser degree, the Japanese yen, to the Austrian Schilling. This trend only got stronger as the interest rate differential between these currencies and the Schilling widened.

Quite remarkably, the introduction of the euro January 1 1999 did not dampen the surge: the Austrians kept their faith to the currency of their Swiss neighbours. At the end of 1995 FX loans to individuals amounted to 1.5% of total lending; in 2000 this had risen to 20%. The popularity of the FX loans was clear: in December 2000 82% of household loans issued that month were in FX. Even though the CHF appreciated by over 6% in 2000 it did not affect the popularity of the FX loans. The FX selling machine was well-oiled.

Since household debt in Austria was fairly low, Austria being among the lower middle group of countries as to the debt-to-equity ratio, the ÖNB was relatively relaxed about these changes – but not quite: already in its first Financial Stability report, published in 2001, it underlined the risk of FX lending and borrowing.

FX loans issuance to Austrian households continued to increase. In 2004, 12% of households reported a mortgage in FX. The trend topped in 2006, after which the demand fell. By the end of 2007 the FX loans, measured in euro, amounted to €32bn, i.e. almost 30% of the volume of loans issued. Here it is interesting to keep in mind that with the exception of few months annual growth rates of FX loans to households have always exceeded the growth of household loans in the domestic currency, until late 2006.

FX loans in Austria are declining: 2008 270.000 households had FX loans, 150.000 in March 2015 but the size of the problem is by no means trivial: in December 2014 “18.9% of the total volume of loans extended to Austrian households was still denominated in foreign currency;” in February 2015 the FX loans to households amounted to €26bn.

There are also indications that because the FX loans seemed cheaper than the euro loans households tended to borrow more. The ÖBN has pointed out that the growth in household borrowing in 2003 to 2004 “can to a large part be attributed to foreign currency loans.” As I have mentioned earlier, the fact that FX loans seem cheaper than loans in the domestic currency, lends them the characteristics of sub-prime lending, i.e. leads to households borrowing more than sensible, thus yet fuelling the FX risk.

This FX lending boom did not only signify borrowers’ taste for carry trade but also that financial products, earlier only on offer for large-scale investments had now become an everyman product, as was ominously pointed out in the first ÖBN Financial Stability report 2001.

Why did (only) Austrians turn into a nation of carry traders?

Nowhere in Europe were FX loans to households as popular as in Austria, as the ÖBN noted in its first Financial Stability report in 2001. At the introduction of the euro, FX loans had been popular in various European countries. Around 2000 Austria stood out but so did Germany where FX loans were being issued at the same rate as in Austria. But only in Austria did the trend continue.

The question is why Austrian households favoured FX over euro loans.

A study in the December 2008 Financial Stability report sketched a profile of Austrian household borrowers, based on an Austrian 2004 wealth survey of 2556 households. The outcome suggested “that risk-loving, high-income, and married households are more likely to take out a housing loan in a foreign currency than other households. Housing loans as such are, moreover, most likely taken out by high-income households. These findings may partially assuage policy concerns about household default risk on foreign currency housing loans.” – This profile only tells who was most likely to choose FX loans over domestic loans, not why this group in Austria differed from the same social groups in the other euro countries.

As I have explained earlier, FX loans often characterise emerging markets, as in the CESEE, where Austrian banks have indeed promoted them, or in Asia in the 1980s and the 1990s. FX tend to gain ground in newly liberalised markets, as in Australia in the 1980s. Then there is Iceland where the banks, fully privatised in 2003, expanding and borrowing abroad, hedged themselves by issuing FX loans, also to households.

FX loans are often an indication of instability where people try to bypass a fickle domestic currency, the apparition of bad policies and feeble politicians. In addition, there are interest rate margin, which may look tempting, if one ignores the fact that currencies rarely have a stable period of more than a few years, making them risky as an index for mortgages, normally runnig for ten to twenty years or more.

None of this is particularly fitting for Austria or any more fitting for Austria than the other mature European economies.

As always when FX loans turn into a problem, the banks blame the borrowers for demanding these highly risky products. If this were the case it could only happen because banks do not fulfil their duty of care, of fully informing the clients of the risks involved. As an Australian banker summed up the lessons of the Australian FX lending spree in the 1980s: “…nobody in their right mind, if they had done a proper analysis of what could happen, would have gone ahead with it (i.e. FX loans).”

According the ÖNB’s December 2008 Financial Stability report banks did claim there was so much demand for these loans that in order to be competitive they had to issue FX loans. But Peter Kolba from the Austrian Consumers Association, Verein für Konsumentinformation, VKI, disagrees that the demand came from the customers: in an information video he claims the loans were very much peddled by the banks, which reaped high fees from these loans.

It is indeed interesting that from 1995 to 2000 Austrian banks experienced a veritable fee surge of 75%, part of which the ÖNB attributed to the increase in FX lending. For the banks there was an extra sugar coating on the increased FX lending profits: “the interest rate and exchange rate risks are borne largely by the borrowers. However, the risk of default by debtors has increased the risk potential of such operations” – the possibility of a default did of course expose the banks to a growing FX risk.

There is one aspect of the Austrian FX lending, which seems to have greatly underpinned their popularity: the loans were widely sold by agents, paid directly for each loan, thus with no incentive to inform clients faithfully about the risk. In addition, the same agents often sold the repayment vehicles, thus reaping profits twice from the same customer.

As summed up by ÖNB’s spokesman Christian Gutlederer (in an e-mail to me) there were specific Austrian structural weaknesses: “Presumably, the interplay of the role of financial service providers, extensive media coverage and rational herding behaviour would offer the most plausible explanation for the popularity of such products in Austria. Tax incentives provided one additional layer: payments of life insurance premiums (the most important kind of repayment vehicle loans) and, in some cases, interest payments for mortgages can be deducted from the tax base.”

The above caused an Austrian FX loans surge, contrary to other euro countries. In addition, the fact that the authorities were so timid in clamping down on the risky behaviour of the banks is worth keeping in mind: the lesson for policy makers is to act decisively on their fears.

Lessons of domestic FX loans: “not suitable as mass product”

Being so aware of the risk the ÖNB and the FMA, have over the years taken various measures to mitigate the risk stemming from the FX lending, though timidly for the first many years.

Already in 2003 the FMA issued a set of so-called “Minimum Standards” in FX lending to households but this did little to dampen rise in FX loans to Austrian households. In 2006, the FMA and the ÖNB jointly published a brochure for those considering FX loans, warning of the risk involved. At the time, businesses were less inclined to take out FX loans: whether the brochure or something else, there was a decline in FX loans 2006 but only temporary.

Andreas Ittner, ÖBN’s Director of Financial Institutions and Markets worried at the time that “private borrowers in particular are unaware of all of the risks and consequences.” FMA Executive Director Kurt Pribil found it particularly worrying that “people seem to be unaware of the cumulative risks involved and of the implications this might have, especially if you consider the length of the financing.”

Though contradicted by the rise in FX lending to households, the two officials emphasised that restrictions put in place in 2003 were working. There was though a clear unease at the state of affairs: “At the end of the day, any foreign currency loan is nothing more than currency speculation.”

On October 10 2008, during turbulent times on the financial markets, the FMA “strongly recommended” that banks to stop issuing FX loans to households. The FMA has since repeatedly claimed FX loans were “banned” in 2008 but that was not the wording used at the time. Funnily enough there is no press release in the ÖBN web archive from this date related to the October restrictions. In its 2014 Annual Report it talks of the autumn 2008 measures “de facto ban” on issuance of new FX loans to households.

According to the IMF, in 2013, the measures “introduced in late 2008 to better monitor and contain FC liquidity risks, by encouraging banks to diversify FC funding sources across counterparties and instruments, and lengthen FC funding tenors.”– There was no ban, not even a “de facto ban.”

FMA’s 2003 “Minimum Standards” for FX lending were revised in 2010. By then, the FMA and the ÖNB had been warning about the FX loans for a decade or longer. In spite of the “non-ban” 2008 measures, it was only in 2010 that Austrian banks “made a commitment to stop extending foreign currency loans associated with high levels of risk, in line with supervisory guidance provided to this effect (“guiding principles”).” In January 2013 the FMA revised the “Minimum Standards,” also taking into account recommendations by the European Systemic Risk Board, ESRB.

All of these warnings are in tip-toeing and kid-glove central bank and regulator speak: there is no doubt that behind these Delphic utterances there were real concern. All along, Austrian authorities have underlined that these standards were not rules and regulations, more a kind advice to the banks to act more sensibly.

The IMF has over the years voiced concern in a much stronger tone and language than the Austrian authorities. As late as January 2014 the IMF underlined the possibility of multiple shock: “Exchange rate volatility (e.g., CHF) or asset price declines associated to repayment vehicles loans (RPVs) could increase credit risk due to the legacy of banks’ FCLs to Austrian households.”

It was not until 2013, five years after the crisis hit and, counting from 2000 when the FX lending had soared, numerous currency fluctuations later that the FMA finally had a clearly worded lesson for the banks and their household FX borrowers: “foreign currency loans to private consumers are not suitable as a mass product…”

Another dimension of FX lending risks: other shocks accompany exchange volatility

In the FMA’s latest regular FX lending overview, from December 2014 it points out that following initiatives to limit the risk on outstanding FX loans, as well as what it there (as elsewhere) calls ban in 2008 on new loans, the volume of borrowings has been falling: outstanding FX loans to private individuals, as a share of all outstanding loans end of September 20014 is now at 19.1%; 95% of these loans are denominated in CHF, the rest mostly in Japanese yen.

Correctly stated, the FX lending is declining but the devilish nature of FX loans is that the principal is affected by chancing rates of the currency the loans are linked to. The number of loans issued may have been declining – the ÖNB points out FX loans to Austrian borrowers have indeed been declining since autumn 2008 but the real decline in the FX lending has been “offset by the appreciation of the Swiss franc.” As seen from ÖNB data the loans did indeed not top until 2010 (see Table A11).

The ceiling set by the Swiss National Bank, SNB, in late summer 2011 helped stabilise the exchange rate – but this stability ended spectacularly in January this year.

What further adds to the risk of FX lending is that it is easy to envisage a situation where banks and borrowers are not hit only by a single shock wave stemming from currency fluctuations but by other simultaneous shocks, such as a slump in asset prices; again something that the ÖNB has underlined, i.a. as early as in the bank’s Financial Stability report April 2003.

If several private borrowers would become insolvent due to rising exchange rates, “the simultaneous and complete realization of the above-mentioned collateral would considerably dampen the price to be achieved.” Thus, banks with a high percentage of foreign currency loans incur a concentration risk, which would endanger financial stability in the region, if the collaterals needed to be sold. It is an extra risk that the banks with the highest share of FX lending were small and medium-sized regional banks in Western Austria; in some cases up to 50% of total assets were FX loans.

Repayment vehicles = no guarantee but an even greater risk

The fact that the majority of Austrian domestic FX loans comes with a repayment vehicle has often been cited as a safety net for FX borrowers and consequently for the banks. This is however a false safety and both the ÖNB and the FMA, as well as foreign observers such as the IMF have, again for a long time, understood this risk.

In order to gauge the risk it is necessary to understand the structure of the FX loans: almost 80% of the FX loans are balloon loans, i.e. the full principal is repaid on maturity: interest rates, according to the LIBOR of the currency and repriced every three months, are paid monthly. The FX loans can normally be switched to euro (or any other currency) but at a fee; another aspect in favour of the bank is a forced conversion clause, allowing the bank to convert the loan into a euro loan without the borrower’s consent.

The repayment vehicle is usually a life insurance contract or an investment in mutual fund, paid into the scheme in monthly instalments. The majority of those who have taken out the FX loans coupled with repayment vehicle have done so via an agent, clearly an added risk as mentioned above.

Consequently, for borrowers there is a twofold risk attached to FX loans with repayment vehicle: firstly, there is the currency risk related to the loans themselves; second there is the real risk of a shortfall in the repayment vehicle, clearly born out by the volatility in 2008. As pointed out in the ÖNB’s Financial Stability October 2008 report the repayment vehicles “in addition to other risks, are exposed to exchange rate risk.”

The ÖNB had however been aware of the repayment vehicle risk much earlier than 2008. Already in its Financial Stability October 2002 report, the risk was spelled out very clearly: the repayment vehicles “usually do not serve to hedge against exchange rate or interest rate risk; rather, they add risk to the entire borrowing scheme.”

If the repayment vehicle does not perform well enough to cover the principal of the FX loan one may try to switch to other investments but at a cost. “If the performance of these repayment vehicles cannot keep up with the assumptions used in the provider’s model calculations, the borrower, who is already exposed to high exchange rate and interest rate risk, becomes exposed to even greater risk.”

In short: on maturity, there is high risk that the repayment investment will not cover the loan, i.e. the alleged safety net has a hole in it. In the present environment of low interest rates it is a struggle to avoid this gap.

Following a 2011 survey there was already a growing shortfall in sight, according to an FMA statement in March 2012. At the time, FX loans with repayment vehicle amounted to €28.6bn. By the end of 2008 the shortfall had been €4.5bn, or 14% of the loan volume. End of 2011 the shortfall in cover amounted to ca. €5.3bn, at the time 18% of the outstanding loans; the increase between 2011 and 2012 had been €800m, an increase in the shortfall by 22%.

In 2013 the FMA put in place regulation, which obliges the insurance companies to create provisions from their own profits should these repayment vehicles fail. This will however only be tested when the attached FX loans mature: 80% of them are set to mature in or after 2019; a “significant redemption risks to Austrian banks” according to the ÖNB in December 2014.

The ÖNB and the FMA are indeed paying extra attention to the interplay between FX loans and the repayment vehicles: the two authorities are conducting a survey in the first quarter of 2015 to uncover the risks posed by these two risk factors, the FX loans and the repayment vehicles. Somewhat wearily, the ÖNB points out that the two authorities have been warning against these loans for more than ten years. Though reined in and declining FX loans still “continue to constitute a risk for households and for the stability of the Austrian financial system.”

Austrian consumer action in sight

Following the Swiss decap in January the Austrian Consumer Association, VKI, has taken action to inform FX borrowers on their options.

The Austrian FX loan agreements normally have a “stop-loss” clause, seemingly a protection for the borrower to limit sudden losses because of currency appreciation. Sadly, following the Swiss decap in January many FX borrowers have discovered that this clause did not limit their losses. These clauses have been the cause of many queries made at the VKI. The FMA, claiming it can not act on this, has advised borrowers to bring the matter to the attention of the banks, but gave the end of February 2015 as a deadline; a remarkably short time.

VKI is also advising FX borrowers to try to negotiate with the banks regarding coast of converting CHF into euro loans or loss incurred from the FX loans compared to euro loan, arguing that these costs should not be carried by the borrowers alone but shared with the bank.

As elsewhere, the Austrian banks have taken fees for administering the FX loans, typically 1 to 2%, as if they had incurred costs by going into the market to buy CHF in connection to the FX loans. However, as elsewhere, the Austrian loans are CHF indexed, not actual lending in FX. In the Árpad Kásler case the European Court of Justice, ECJ, ruled that this cost was illegal since there were no actual services carried out. Consequently, this might be of help to Austrian FX borrowers; also that part of the ruling, which obliges banks to inform clients properly.

If these actions take off this could mean a considerable hit for the banks. After all, 150.000 households have FX loans of €25bn in total, not a trivial sum.

Given the fact that so many of these loans and the repayment vehicles were sold through agents their responsibility for informing clients has to be tested at some point: it is inconceivable that important intermediaries between banks and their clients bear no responsibility at all for the products they arrange to be sold.

As in other countries, Austrian FX borrowers have already been heading for the courts. So far, the cases are few but have at least in some cases been positive for the borrowers.

The question is whether Austrian politicians will be firmly on the side of the banks or if they will come to the aid of FX borrowers. But there really is good reason for political attention, given that the problem certainly is still lingering. It should also be of political concern that the ÖNB and the FMA chose to treat banks with kid-gloves lightly – though full well knowing that the products being sold to consumers were highly explosive and hugely risky both to the borrowers and the country.

* This is the second article in a series on FX lending in Europe: the unobserved threat to FX unhedged borrowers – and European banks.The next article will be on Austrian banks and FX lending abroad. The series is cross-posted on Fistful of euros.

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Why do the inhabitants of an EU country prefer to keep cash amounting to ca. 6% of GDP hidden at home? Badly burnt after the banking collapse in March 2013 Cypriots neither trust their government nor banks to keep their money safe. After following from afar the events in Cyprus I recently visited the island. Many Cypriots feel that the banking collapse is now only history and no point thinking about it. But that is far from the truth: as long as neither Cypriots nor the other EU countries know the whole Cypriot saga it can neither provide lessons nor a warning; and the mistrust lingers on. In addition to a public investigation of what really happened and why, write-downs of household debt and a functioning insolvency framework Cypriots desperately need one thing: hope for the future.

Crisis-stories are a plenty in Cyprus and the islanders are more than willing to tell them. During the traumatic days in March 2013 when the banks were closed for ten long days people called the Central Bank of Cyprus, CBC, crying. “The bail-in wasn’t fair because it hit depending on with which bank you were banking,” one Cypriot said. “And look at what it’s done to us, all the empty space in the centre,” said the owner of a small business. “One of my clients,” said a man working in finance, “had a loan of €5m and €7m in deposits. Next day, he still had a loan of €5m but only €100,000 in deposits.” The client, of course, banked with Laiki Bank, also known as Cyprus Popular Bank and Marfin Popular Bank. Then there was the man on the beach in Paphos, selling boat trips. He now owns 500,000 shares in Bank of Cyprus worth quite a bit less than the €500,000 on his account until his funds, together with all other deposits above €100,000, were converted into shares.

In March 2013 Cyprus stared into the abyss of financial collapse. In order to qualify for a €10bn Troika loan, the absolute maximum the Troika – i.e. the European Union, EU, the European Central Bank, ECB and the International Monetary Fund, IMF – was willing to lend, Cyprus had to raise €5.8bn. After the Eurogroup threw out its first rescue plan, which included a levy on guaranteed deposits, i.e. less than €100.000, the Cypriot government grabbed deposits above €100,000 in Laiki to merge it with Bank of Cyprus where non-guaranteed deposits were turned into shares. This bail-in came as a surprise but had indeed been worked on since summer of 2012 by a small group of Cypriot officials.

From the Cypriot point of view it seems unfair that whereas Cyprus had to find own funds other hard-hit European countries – Ireland, Greece, Portugal and Spain – got Troika loans to bail out banks. The overwhelming feeling in Cyprus is that the island’s 1.1m inhabitants and an economy contributing 0.2% of the euro zone economic output was too small and insignificant to matter to the Troika. Abroad lingers the suspicion that Russian money in Cyprus were unpalatable to the Troika.

However, the reason for the misery seems more complicated and closer to home: the government of Demetris Christofias was adamant not to enter a Troika programme; a noble aim in itself but the government’s manoeuvres to avoid it seem less noble. CBC officials fed incomplete if not misleading information to the ECB. Fragments of this story have emerged only recently, not from the two attempted public enquiries but from a secret report done at the behest of president Nicos Anastasiades, later leaked to the New York Times.

“People want answers,” one Cypriot said but so far, there are few answers but plenty of questions, the most pressing being why there is no wish for  a proper investigation on the events leading to the drama in March 2013. The Special Investigative Committee, SIC, set up in Iceland after the Icelandic collapse in 2008 would be an ideal inspiration.

The story of the Cypriot collapse has many intriguing aspects. One of them is the sale of Greek branches of Cypriot banks, i.a. Bank of Cyprus’ Greek operations; another is the purchase of Greek sovereign bonds (mainly from German banks, which had a high exposure on Greece) by Cypriot banks, possibly seeking high-risk high yield investment to cover earlier disastrous lending.

Below, two further aspects are scrutinised: why the bail-in happened and why the Troika accepted, though only for some hours, a crisis levy on guaranteed deposits.

The rumours before the collapse and the hope that this time, it would be different

As in Iceland, the Cypriot banking sector was far too large – seven times the island’s GDP – for Cyprus to support it on its own. Its destabilising core was Laiki Bank,. The bank had for a long time offered higher interest rates than other banks; only ever attractive to risk-takers and naïve investors who do not recognise it as a warning sign. In the summer of 2012 the Cypriot government attempted to solve the Laiki problem by nationalising the bank.

With Ireland, Portugal, Greece and Spain struggling there had been little focus on tiny Cyprus but its problems were evident to anyone who bothered to look. After the nationalisation of Laiki there were talks with the Troika in late summer and autumn 2012 as to what should be done. No one, least of all the Cypriots, expected any drama. My Cypriot contacts kept telling me that the talks would no doubt end quietly in a negotiated bail-out of some sort. After all, Cyprus was a small economy, the Troika had by now some practice in dealing with failing banks threatening an entire economy; and there was also a growing awareness that private debt should not be shifted on to the state. Compared to the on-going Greek drama his would go well, I heard.

There were however rumours that this time it would indeed be different. In January 2013 Landon Thomas wrote in the New York Times of “Questions of Whether Depositors Should Shoulder the Bill:” officials in Brussels and Berlin were said to be working on “a controversial plan that could require depositors in Cypriot banks to accept losses on their savings. Russians, holding about one-fifth of bank deposits in Cyprus, would take a big hit.” Truly a radical departure from bailouts in Portugal and Ireland and a haircut, albeit only after an earlier bailout, in Greece – so far, bank deposits had been held sacrosanct.

Considering the delicate situation CBC governor Panicos Demetriades gave a rather remarkable interview to Wall Street Journal on March 5 2013 where he rejected the idea of haircut on depositors. Instead, he aired the idea of a “special solidarity levy” on interest income, which could give the state an annual income of as much as €150m – a risible sum compared to what was needed – but hoped that privatisation would gather €4.5bn. Alex Apostalides lecturer at the European University Cyprus has recently written about an encounter with Demetriades on the fateful 15 March 2013: when asked, Demetriades said that any haircut on deposits would be a catastrophe for the banking sector.

At the beginning of 2013 all the Cypriot political energy was in the presidential election campaign. But some were more aware than others that something might happen; there are still rumours of people who emptied their bank accounts just before the bail-in. ECB data shows that deposits were seeping out. In June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

Capital controls, i.e. limits on amounts taken out from deposits or moved between deposits, were part of the package in March 2013. Yet, money did allegedly seep or even flow from certain deposits in spite of the controls. In Cyprus stories are told of private jets clouding the skies over Nicosia on and after 18 March, carrying neck-less black-clad men accompanying their angry-looking masters to the banks; all returned smiling with bursting hold-alls. List with names of people said to have taken out money in spite of the controls circulated in the media. – All of this is part of the still unwritten report of what really happened.

What seemed like good idea at the time: ‘un-guaranteeing’ the €100,000 deposit guarantee

On Friday March 15 2013 the Eurogroup met in Brussels at 5pm after markets closed. In the wee hours of March 16 the Group published a statement and its representatives held a press conference. The statement itself was short but not sweet, at least not for the Cypriots who had hoped and believed that their island would be assisted like other troubled euro-countries.

The press release stated (emphasis mine in all quotes):

The Eurogroup further welcomes the Cypriot authorities’ commitment to take further measures mobilising internal resources, in order to limit the size of the financial assistance linked to the adjustment programme. These measures include the introduction of an upfront one-off stability levy applicable to resident and non-resident depositors. Further measures concern the increase of the withholding tax on capital income, a restructuring and recapitalisation of banks, an increase of the statutory corporate income tax rate and a bail-in of junior bondholders. The Eurogroup looks forward to an agreement between Cyprus and the Russian Federation on a financial contribution.

The Russian loan never materialised any more than a Russian loan promised to the governor of the Central Bank of Iceland, CBI as the Icelandic banks collapsed in October 2008. (Cyprus’ relationship with Russia was long-standing Iceland was not known to have any particular relationship with Russia, which meant that this promise seemed very much out of the blue.) However, just as the Christofias government was against a Troika programme the governor of the CBI and a few others were equally against seeking assistance, in Iceland’s case from the IMF.

Interestingly, neither the March 16 press release nor the statement specified what ‘an upfront one-off stability levy’ implied. Those who gave the 4AM press meeting seemed  ill at ease and unwilling to spell out the action. Christine Lagarde director of the IMF only talked of “burden sharing.”

According to Reuters, citing an unnamed source, Cyprus “agreed a one-off levy of 9.9 percent to apply to deposits in Cypriot banks above 100,000 euros and of 6.7 percent for deposits below 100,000 euros…”

With this fundamental diversion from earlier policies the Eurogroup agreed that an EU country could touch deposits below the guaranteed €100,000. In other words: depositors in EU now knew that in a financial crisis their guaranteed deposits were no longer untouchable.

Whether a momentary mental black-out or a wish to try something unorthodox this solution evaporated over the weekend. The statement released following a Eurogroup phone conference on Monday March 18 carried a very different message:

The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000. The Cypriot authorities will introduce more progressivity in the one-off levy compared to what was agreed on 16 March, provided that it continues yielding the targeted reduction of the financing envelope and, hence, not impact the overall amount of financial assistance up to EUR 10bn.

Given the fact that the Eurogroup had less than 48 hours earlier agreed to a levy on guaranteed funds the words “continues” and “reaffirms” do not quite rhyme with the earlier statement.

The banks remained closed on the following Monday, March 18 2013 as the Cypriot government under president Nicos Anastasiades, only in power since March 1, struggled to get a grip on failing banks – and to find another solution when the original idea lost its sparkle.

In a rare display of tense irritation the ECB issued a statement on March 21 saying that the ECB governing council had “decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks. – As far as is known, this is the only time the ECB has ever issued a statement acknowledging the end of ELA.

The Cypriot banks remained closed for whole ten days, until March 28. When they opened again there were capital controls in place to prevent a run on the banks – and depositors in Laiki and Bank of Cyprus had been singled out to carry the cost.

In hindsight, it is profoundly interesting that the Eurogroup, ECB and the IMF did indeed agree to a levy on guaranteed deposit. Allegedly, the Germans were not happy but agree they did. In the end, things did change in the coming days. Further, a general levy was voted down in the Cypriot parliament. The Cyprus collapse did not happen over a few days in March but over almost two years, from May 2011 when the island lost access to markets. The course of events cannot just be explained by panic.

Indeed the bail-in was no panic solution but had been in the making for more than half a year; only the Cypriots did not know it.

A pact with the offshore devil

Since slamming a levy on guaranteed deposits truly was a novel idea the short struggle to ram this measure through merits attention, also because it can be argued that it was indeed a much fairer financing of the crisis solution than the one used.

According to much of the media coverage the idea of a levy on guaranteed deposits came from the Cypriot government. However, sources close to these events have indicated to me that the EU commission, attempting to merge various and to some degree conflicting points of view, originally suggested a levy on guaranteed as well as non-guaranteed deposits. The preposition was that Cyprus had to fund a big part of the rescue package, banks have heaps of money on deposits – and a small percentage levy is a relatively painless way for a state to spread the burden in a crisis.

The various parties to the talks were advocating various solutions. IMF advocated the full resolution of the two banks, Laiki and Bank of Cyprus and did not seem to be opposed to a bail-out. The Anastasiades government was looking for a traditional bail-out programme apparently unaware that the Christofias government had worked on a bail-in (more on that below). The Commission was looking for a middle way where wealth tax could perhaps fill a gap if needed but sensed that a bailout was out of the question.

The country needed to raise €5.8bn in order for the Troika to lend the €10bn needed. It was a matter of arithmetic how to juggle the percentage so as to land on the right sums; it proved a struggle as Reuters recounted on 18 March. President Anastasiades and his team refused to go above 10% on the uninsured deposits and settled for 9.9%. These deposits amounted to €38bn, insured deposits were €30bn which meant that €2bn had to be taken off the latter if the government held onto 10% being the pain threshold; ergo, the percentage had to be respectively 6.75% and 9.9%.

Non-Cypriot officials wanted the percentage on the guaranteed deposits to be lower, even considerable lower. Already at the meeting the feeling was the Anastasiades was sheltering the island’s offshore status, ignoring the interest of ordinary Cypriots.

The political reaction in Cyprus drew the attention from the fact that after sleeping on it the Eurogroup woke up realising that the levy would ‘un-guarantee’ the guaranteed €100,000. The original plan must have come with some convincing reasoning (from the EU Commission, right?); otherwise, it would not have gone through. For sure, it worked like magic – but struck by daylight the carriage was again a pumpkin.

“The guaranteed deposits turned out to be EU’s sacred cow,” one source said. In a certain sense, for every country crisis is utterly unique, not in the general mechanism, but in the outward detail. If Cyprus had indeed accepted a levy on guaranteed deposits the EU would have been in a difficult position: it would have had to argue that Cyprus was an utterly unique case.

In order to reach the necessary sum of €5.8bn 15% levy on the uninsured deposits would have done the trick. But on an island, which lives – and has lived well – from its off-shore status and the foreign funds it attracts the government baulked at taxing the non-guaranteed deposits too heavily so as not to drive these funds elsewhere. That was the cost of the Cypriot pact with the offshore devil.

Laiki: the core of the Cyprus problem

In the euro-crisis context the bail-in was a remarkable solution but as can be seen from the Anastasiades report it was, quite remarkably, not a new idea. It had been in the making for some time, at least from autumn 2012, and was closely connected to the core problem: Laiki. The report traces the drafting of a new bank resolution framework, which rested on using deposits in an insolvent bank in a bail-in.

The desperate state of the Cypriot economy was exposed when Cyprus lost market access in May 2011, much due to Laiki Bank owned and managed by Andreas Vgenopoulos. Laiki was diligently issuing bullet loans to Vgenopoulos’ companies. Bullet loans are familiar to those who have studied the operations of the Icelandic banks where they were issued to large shareholders and other favoured clients. The Icelandic bullet loans to these clients were either constantly rolled over or refinanced, rarely paid back. The bullet loan magic on a balance sheet is i.a. that in spite of not being paid back they are not non-performing.

One insistent question for Cypriots is why the CBC and other Cypriot authorities allowed Laiki to operate as it did and for so long. By summer 2012 the Cypriot authorities had run out of excuses and justifications for continued assistance to Laiki, to the ECB and others. Instead of investigating Laiki’s operations, the bank was nationalised, hook line and sinker and no questions asked.

It is a pertinent question when the CBC realised that Laiki was a dead bank. There were leaks in Cypriot and Greek media in autumn and winter 2012 on the severe state of Laiki, allegedly known to the CBC. Even sending staff to be questioned by a prosecutor CBC focused on investigating the leaks, not the issues they raised.

Nationalising Laiki increased the state’s liabilities; the EU and the IMF were uneasy, as expressed at a Eurogroup meeting 12 September 2012 in Cyprus. Laiki was in a sorry state and it was dragging down another weak bank, Bank of Cyprus. The government continued its delay-tactic, thereby taking the entire banking sector hostage.

The Troika held a meeting 9 November 2012 in Cyprus but could not reach an agreement with Cyprus. By now, Cyprus was, quite literally, living on borrowed money, straight from the ECB: on 15 November 2012 ECB’s Emergency Liquidity Assistance, ELA, to Cypriot banks, i.e. Laiki, amounted to €11.9bn, around 65% of GDP.

The Troika’s patience was evaporating fast: when president Demetris Christofias visited Brussels 22 November he was informed the ECB would stop the ELA immediately. The following day finance minister Vassos Shiarly said the government had now agreed to the terms of the “Memorandum of Understanding on Specific Economic Policy Conditionality.”

The birth of a brutal and unfair solution

The November 2012 MoU was full of good intentions. But the direction taken was not new. During the Troika meeting in Cyprus in June 2012 those present had agreed that the core of the Cypriot problem was an over-extended financial sector, which the feeble island economy could not support. Consequently, an alternative way to recapitalisation had to be found but the question was how.

In a 2 July 2012 letter ECB stated, referring to its opinion on legal support for Laiki, that the best way was to use a fully-fledged bank resolution tool, as outlined in Directive proposal, COM (2012) 280 final adopted in June 2012, for bank resolution where the cost was not being borne by tax payers, adopted in June 2012 and later developed into a Bank Recovery and Resolution Directive.

Hence, amongst those working on the coming Cyprus banking rescue operation it was already clear by the summer of 2012 that Cyprus could not expect anything like the other troubled euro countries. The assessment circulating, i.a. from Fitch, was that Cyprus needed €10bn in financial aid, 60% of GDP.

The three key objectives of the MoU were “to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management; to continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit” by reducing current primary expenditure, maintaining fiscal consolidation i.a. by increasing the efficiency of public spending, enhancing tax collection and improve the functioning of the public sector; structural reforms to support competitiveness.

As the MoU shows Cyprus was not stingy with its promises, i.a. : “With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE)… the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.”

The innocent-looking clause in the November 2012 MoU, which the Cypriot government was arm-twisted into accepting, was a further foreboding of the bail-in to come: The authorities will introduce legislation establishing a comprehensive framework for the recovery and resolution of credit institutions, drawing inter alia on the relevant proposal of the European Union.

The Anastasiades secret report concludes that it was clear from summer 2012 that the legal tools being forged would prevent a bail-out, forcing Cyprus to rescue its financial system with own resources, i.e. a bail-in:

“However, the perception which prevailed was that neither the government nor the CBC adequately understood this context. Moreover, no one admitted to know or have heard about the bail-in before the Eurogroup of 15 March 2013. The fact that the government, the state and its institutions acted as if they could not comprehend what was going on in order to disguise their inadequacy… ultimately proved to be a very effective policy to avoid taking responsibility. The reality is that as early as 6 November 2012, the CBC Governor, Panicos Demetriades, informed the ECB President, Mario Draghi that the resolution law was almost done, three whole weeks before the MoU of 25 November. …

From the moment the two major banks would pass into the hands of the Resolution Authority, the CBC should have to act within the given legislative framework and to provide solutions which would not bear any burden to the taxpayer. The law in itself was prohibiting the bail out and was legalizing the bail-in.“

The law, legalising a bail-in, was supposed to be passed in January 2013 but the Cypriot government and the CBC continued the delay game. After being reassured that short-term financing need was covered, the Eurogroup finally accepted to wait; it seemed clear that the final agreement on a programme would have to wait until after the election in February.

When the Anastasiades government came into power March 1 2013 neither the out-going government nor the CBC presented it with the draft for the resolution law. Accordingly, the new government seems to have intended to negotiate a bail-out as in previous Eurozone crisis countries. The old powers and the CBC kept quiet, making it look as if the bail-in was all the work/fault of the new government – or that is at least how the story is told in the Anastasiades report. The Resolution of Credit and Other Institutions Law of 2013 was published 22 March 2013 as part of the crisis measures.

The Anastasiades report shows that though panicky the decisions taken over the fateful days in mid March were no last-minute solutions. The Christofias government had been planning a bail-in, i.e. a self-financed salvation or refinancing of the banking system – and it was vehemently against entering a Troika programme.

The “punishment for the Russian connection” theory and other speculations

In hindsight – always a great vantage point – a one-off levy on deposits, even a tiny sliver on guaranteed deposits, would have been a lot less painful to Cypriots in this time of great crisis. But the political reaction in Cyprus was such that the government stepped back and abandoned any general levy. “The measures chosen did not punish risk-takers but made some people poorer completely by chance,” one source said.

“The solution was to treat deposit holders as investors,” as one Cypriot put it. Indeed, but only deposit holders in two banks took the hit for everyone else; a much more brutal and arguably a less fair measure than a levy.

In the weeks following the Cypriot bail-in there were speculation that the anomalous outcome had been dictated by a lack of trust in Cyprus for allowing Russian funds to flow so freely through the country’s banking system. It is alleged that 20% of Cypriot deposits are Russian; considering the long-standing connections between Russia and Cyprus this does not seem shockingly much.

In addition there are rumours, strenuously denied by Cypriot authorities, that the island’s financial system had been facilitating money laundering. According to persistent rumour the German authorities had commissioned a secret report that showed as much. However, nothing concrete did ever materialise and certainly no German report.

Cypriot officials were very much aware of these rumours and visited some European capitals in January 2013, i.a. Den Haag, to rebut the rumours and explain measures taken in Cyprus against money laundering.

The IMF viewed Cyprus as a unique case because of the size of its banking sector. Germany was in no mood for a bail-out. “Cyprus had irritated the Troika so much,” one source said. The ECB press release on ELA 21 March 2013 proves the point. Christofias had publicly spoken badly of the IMF; his attempts to get loans from China and Russia were not successful.

Essentially, a bail-in had been in the making for a while and seems to be what Christofias and his government had in mind. “It was clear that Cyprus would indeed be different,” on source said. “The obstacles were mostly political.”

Why the Christofias government did aim at a bail-in can only be clarified in a Cypriot SIC report. Perhaps the government saw that as a good way to keep the Laiki story buried, a continuation of the fact that Laiki had been nationalised but neither restructured nor scrutinised. And/or Christofias the communist was content to nationalise it to prove a political point. Fundamental question on the March 2013 events can only be answered in a thorough report. Sadly, it seems that very few Cypriots believe that such a tell-all report is possible on their little island.

No appetite for investigations

The Anastasiades report bears the telling title: Laiki Popular Bank – How a bank’s mismanagement toppled an economy. Laiki was not the only problem in the Cypriot economy but it was the crystallisation of many problems. Some advisers had recommended action on Laiki already when Cyprus lost market access in May 2011 but to no avail. As one source said: “It was a grave mistake not to take Laiki over earlier.”

The Anastasiades report was not intended for publications. It was not the first investigation into the Cypriot banking mess. There was an earlier planned investigation, which as the Anastasiades report stated, “didn’t happen.”

In August 2012 the CBC assigned Alvarez & Marsal, a management and restructuring consultancy, to examine why Laiki and Bank of Cyprus had requested state support, which they got, in total €1.8 bn. The following four points were to be investigated:

1. Bank of Cyprus’ losses from investing in Greek bonds
2. The purchase of shares of the Romanian bank Banca Transilvania
3. The acquisition by the Bank of Cyprus of the Russian bank Uniastrum
4. The merger of Marfin Laiki with Egnatia and in specific the conversion of Egnatia from a subsidiary of Marfin Laiki to a Cypriot bank

In October 2013 this assignment was in the news, not for the firm’s findings but for its fees: on top of €4.5m it turned out that CBC governor Panicos Demetriades had, without the CBC knowledge, agreed to a further fee of €11m. Nothing has been heard of the report and regrettably the four items above remain unexplained.

As the Anastasiades report states: Now we know why: An investigation into the reasons why the Cyprus Popular Bank requested state support of €1.8 bln, would reveal the disastrous decision taken by the Christofias government to nationalize the Cyprus Popular Bank and this was achieved in collaboration with both CBC Governors, initially Orphanides and later on Demetriades.

The Anastasiades report comes to its own conclusions:

The Cyprus Popular Bank, was insolvent before the haircut of the Greek bonds. After the haircut, the Bank had little chance to survive. The only realistic option for a successful recapitalization was through the EFSF. However, it was impossible to receive funding from the EFSF without entering a programme. Christofias’ government followed a policy of avoiding the programme at all costs. By refusing the programme, Christofias’ government led the entire banking sector into captivity.

What the Anastasiades report spells out quite clearly is how Cypriot authorities, from autumn 2011, led by the various ministers of finance and governors of the CBC kept convincing the ECB that all was well and fine with Laiki. When it was no longer possible to dress the bank up as a solvent company the bank was nationalised. In March 2013 it was no longer possible to plaster over the cracks, the bank was restructured and merged with Bank of Cyprus – at the cost of €5.8bn from deposits in the two banks.

According to the New York Times, Benoît Coeuré executive board member of the ECB was also instrumental in coming up with a collateral plan when there were seemingly no collateral left to support further ELA for Laiki. Cypriot authorities, led by the CBC, conspired to thwart suspicious ECB. This whole exercise left the Cypriot state with €10bn of ELA debt, apparently the cost of trying to save a failed bank.

After the events in March 2013 president Anastasiades set up an investigative committee to examine possible civil, criminal and political liabilities regarding the development in the Cypriot economy and financial sector. The six members were all elderly judges with long careers.

Their report was handed over to the cabinet end of September 2013. It has not been made public. The documents leaked by the New York Times indicate that there is plenty of material that the commission did not make use of. Since this report has not been published it is impossible to say how thorough it is but the general feeling is that the 280 pages did not reveal anything much. The attempts to investigate the events leading up to March 2013 and the aftermath have so far been futile exercises.

Based on available material it seems logical to conclude that the bail-in was part of the Christofias government plan to avoid a Troika programme and possibly the scrutiny that might follow. If the latter was the case all fears have been groundless: regrettably, the Troika has never pushed for an investigation to clarify events.

The fact that Cypriot authorities did everything to hide and deny the dire situation from May 2011 had hardly mellowed the Troika in March 2013 when action could no longer be postponed. But it does not explain the attempt to put a levy on insured deposits.

Being a gateway to offshore structures may not have helped Cyprus. That said, EU and IMF officials are hardly squeamish in these matters: Luxembourg and Malta offer similar environment not to mention the tax structures provided by Ireland and the Netherlands.

What Cyprus needs

The ECB is trying to strengthen trust in the European banking sector. In general, an important step towards creating confidence “is to recognize loans that are bad and write them off, ” according to William White, former economic adviser to the Bank for International Settlements. Non-performing loans have been a major problem in the Cypriot financial sector. I heard in December that with a new insolvency or foreclosure framework this would be resolved.

I therefore find it both surprising and worrying that according to Eurogroup remarks 16 February 2015 the foreclosure framework has still not been finalised but is much needed in order to enable banks to clean their balance sheet and start lending again. This is now the main hurdle in the recovery program for Cyprus.

Household debt is a problem – Cyprus could do with some general measures similar to the Icelandic “110% way” where mortgages were written down to 110% of the estimated value of the property to pull households out of the doldrums of negative equity.

“Confidence in the Cypriot banking sector has not been restored,” one source pointed out. That can i.a. be seen from the fact that many prefer to keep cash at home; as much as 6% of GDP could be under pillows and mattresses.

As so often in countries plagued by corruption everyone is aware of it but it is rarely mentioned except when it surfaces in news. But is indeed a huge problem as can be seen from EU Anti-Corruption Report 2013: 78 % of Cypriot Eurobarometer respondents claim corruption is widespread, EU average is 76 %; 92 % say that bribery and good connections is the easiest way to access certain public services, EU average is 73 %. Among Cypriot business people 64% say corruption is a problem compared EU average of 43 %. And most seriously, 85 % of entrepreneurs think that favouritism and corruption hamper business competition in Cyprus when EU average is 73 %.

Cypriots need to know exactly what happened and when – and so does Europe, if any lessons are to be drawn from the crisis. But most of all, Cyprus needs hope. Parents need to believe there is future for their children on the island. Young people have to see a reason for staying after their education or returning there after studying abroad. A country marred by untold stories, unexplained action and corruption is simply not a good country for growth and optimism – the necessary prerequisite for hope.

*My oral sources are all from Cyprus. In agreement with them they are not identified by position since Cyprus is a small country. – This blog is cross-posted on A Fistful of Euros.

 

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