Bank Deposits – The Final Backstop

Put this in perspective. The government of Cyprus borrowed money it had neither means nor intent to repay. Borrowing, for a government, means selling bonds. The Cyprus banks borrowed money, which for a bank means taking in deposits (among other sources of funds). They used that money they borrowed from their depositors to buy Cyprus government bonds.

Now, those bonds are heading to default because the government of Cyprus cannot pay the interest without selling more bonds, and the market does not want to bid on their new bonds. So the government is rapidly heading towards default. They are seeking a bailout from the IMF, ECB, and EC (“the Troika”). The Troika said sure, but bank depositors must take a haircut too.

In this context, what is the meaning of a bank depositt, or the government’s guarantee of bank deposits which are defaulting because the bank has bad assets which are the bonds of that very same government?

6 replies
  1. Keith Weiner says:

    As JR correctly notes, the US government is in exactly the same position as the government of Cyprus or Greece. It must sell new bonds to pay the interest on the old ones. I discussed this in this video:

    This is a process of capital destruction, though while it is ongoing it is not recognized. At the end of the road, the losses must be recognized and they must be taken by someone. In my main piece on Cyprus I point out how it ought to work under the rule of law. But in the US, the bankruptcy of GM was conducted contrary to the prescription of law and precedent. In Cyprus, they do not appear to be respecting the rule of law.

    When the end is reached in the US (years hence), will it play out in this way with depositors getting the ax prior to creditors? I don’t think there is any way to know. It’s a good bet that it will be a dirty game of back-room deals, betrayals, no respect for the rule of law, and horrible losses for most participants.

    JR: why are US bonds the best of the paper lot? A topic for another day! :)

  2. JackJ says:

    I read an interesting opinion the other day that said
    any bond rollover – government or corporate – is a de facto default.

    That is the bond should be retired – paid back – on the maturity date.
    If not the rollover becomes a Rob Peter Pay Paul event.

    I’m not the smartest guy and admit I never stopped to look at it that way.

    Would it be possible anymore that to end this *every* new issue Treasury include a sinking fund? Or is that a silly question at this point in the process?

    T/y any comments …

    • Keith Weiner says:

      Jack: I agree. An honest bond should be fully amortized by the end. I am not sure I would call it a default, but it is at least borrowing from Peter to pay Paul. The new bond to pay off the old one is counterfeit credit, certainly.

      A sinking fund is to solve a different problem. Under gold, the rate of interest was stable, though an individual bond price could move up or down. A sinking fund guaranteed bondholders that if the price of the bond fell, the company would buy its own bond to bring the price up and avoid capital losses to bondholders. Today, with the rate of interest totally unhinged, I don’t think a sinking fund would be practical. It would not be needed until the moment it was, then it would be overrun.

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