Whatever happened to the European debt crisis? Last year it was the talk of the town at Davos, Switzerland, where all the world’s “greats” gather to ruminate about the state of the world…

I noted that this year, however, the attention of those same economic, financial and political pooh-bahs shifted:

Their theses include the idea that Europe’s settled down, the recession there isn’t getting worse, indeed economic prospects are improving.

Yet despite all their positive chatter, I wondered:

…are we to believe that Europe, after being in a life and death crisis, somehow is just fine now – just like that? Based on what? (Click HERE for the rest of the commentary.)

The optimism didn’t last far beyond the end of the Davos meetings, as recession indicators, along with economic prospects, began to worsen in Europe. Then came Cyprus. And so our last report focused on the seemingly sudden and shocking Cyprus banking crisis, ending with this:

Assuming it is resolved in some way in the coming days, we plan to report to you next time:

• Three Lessons We All Must Learn from the Cyprus Disaster
• Why the Cyprus Disaster Will Prove to be Bigger and More Important Than Most People Realize

If more comes out of the woodwork in the meantime, we’ll adjust our next report accordingly… What happens in Cyprus in the coming days and weeks will impact all of us, sooner or later.

Well, more has indeed come out of the woodwork.

Tragically, as we all witnessed this past week, terrorism returned to the U.S. in dramatic fashion at the finish line of one of the world’s preeminent athletic events, the Boston Marathon. Our thoughts and prayers go out to all the victims and their families. I’ll have more to say at the end of today’s letter.

In the financial world, despite “everyone’s” warnings to the contrary, bond interest rates, after some enticing gyrations to the downside, continue to contradict the thousands of pages of academic and professional investment analysis by refusing to rise. The legs of the great bond bull market in bonds that began in 1980 refuse to stop running. If you’ve been betting on the bond market “collapse” so many predicted, you know this continues to be a losing trade.

Even more dramatically, after over 18 months of “consolidation”, the price of gold plunged over two days with, in the words of one veteran analyst, “some of the most extreme drops in price I’ve seen in 40 years in this business.” So after months of relative quiet on the political, economic and financial front, it seems nap time is over.

What about those reassurances from the experts at Davos? Experience tells us that most short-term and medium-term predictions rarely play out as expected – even from the “enlightened” ones at these prestigious gatherings. With that in mind, let’s step back and assess where things stand with the long-term “big picture” as we turn to a study released almost three years ago.

This Time Is Different, a scholarly work we first brought to your attention in June 2010, bases its analysis on 800 years of available data. To refresh your memory, it outlines five types of financial crises, and explains why our current crisis will most likely drag us through all five before it’s over. The book received much fanfare when first published, and many financial executives, analysts, and investment managers scrambled to show their clients that, yes, they had read it and were impressed by the scholarship. Of course, once it was clear the stock market had commenced a cyclical bull market, all talk of “crisis” took a back seat to the call to get back in the market before it was too late. Crisis? What crisis?

Some of us, however, read these sorts of studies to actually gain some understanding of the world around us, rather than as a marketing tool to show how on-top-of-things-we-are-and-that’s-why-you-should-invest-with-us-like-right-NOW. And we find the five crises outlined in the book to be valuable benchmarks to mark the progression of our current crisis.

So, once again, here are the five types of crisis that authors Carmen M. Reihnart and Kenneth S. Rogoff discovered:

• Banking crises
• Domestic sovereign debt defaults
• Foreign debt defaults
• Currency crashes
• Inflation outbursts

These stages progress from one to the other, often overlapping. Therefore the banking crises we saw in 2008 aren’t necessarily over now. The third stage, foreign debt defaults, continues to play out. If you haven’t noticed, perhaps it’s because it does so deceptively. To understand how and why, let’s start with a definition of “default.”

With this in mind, let’s now look at government debt. When a government borrows money, it issues debt, typically in the form of a bond, known as “sovereign” debt. Recently the Greek government said it couldn’t fulfill its obligation to pay back the principal on some bonds it had issued. Yes, I realize that you might think that, given the Greek government’s hopeless financial situation, you’d have to have been stupid or crazy to lend them money, and anyone that did simply got what they deserved. But there were some “sophisticated” investors (e.g., banks, hedge funds, etc.) who were not necessarily stupid or crazy who loaned the money and simultaneously bought insurance on the loan. This insurance, known as CDS, or credit default swaps, would pay the lender in the event the Greek government failed to pay back principal when due.

In early 2012, when Greece in fact defaulted on some loans, those who underwrote the insurance – typically a bank – would, naturally, have taken a big hit when required to fulfill their end of the insurance contract (the CDS). They should have paid off the lenders. But they didn’t. Instead, the group that governs these insurance contracts, the ISDA, decided it wouldn’t look good if it came out that Greece had defaulted. So instead of insisting that the parties involved follow the terms of the insurance contract, the ISDA re-wrote the terms of the contract and let the Greek government – and the bank that underwrote the insurance – off the hook. They did this by telling the lenders, aka creditors, that they would be entitled to 53.5% less than the principal actually owed…oh, and they wouldn’t even get that, because the principal would be “rolled over” into another, longer-term bond that would allow the Greek government to avoid paying that reduced principal for a number of years. In effect, the lenders got nothing. The contracts they held were not honored. The Greek government didn’t fulfill their obligation. By any reasonable definition of the term “default,” they defaulted. But it wasn’t called a default.

To sum up, the lender got stiffed and somehow the whole shameful charade was not called by its proper name: a default. You can see that this masks a foreign debt default. It serves to distract and confuse us. It deceives us, if we can’t see past the whole concocted facade. But it doesn’t change the reality behind it.

While we don’t have time to provide other examples, we can note the IMF’s recent Global Financial Stability Report, which warns that as much as a quarter of all bonds as well as debt issued by European companies is “unsustainable.”

We’ll stop with our big picture update here. The example of how Greek debt was recently handled – or perhaps mishandled would be the better description – reminds us that monitoring the big picture becomes especially challenging when you have to deal with the sorts of manipulations and deceptions we’ve just seen. But such is our world today. We simply must do the best we can under the circumstances.

First, it turns out that even as the banks in Cyprus were shut down, the two banks whose accounts will be subject to confiscation kept their offices in London open. And those offices did not impose restrictions on withdrawals of funds. So our first reasonable guess is that the oligarchs did, after all, have direct access to their money all along.

Second, given who we’re talking about here – i.e., the formerly-KGB-currently-oligarch/gangsters, it might be reasonable to speculate that before the public announcement of the plan to steal customer money, a private communication could very well have been “leaked” to the Russians, giving them plenty of time to make the appropriate arrangements.

As you can see, the art of deception conceivably played a significant role on Cyprus, just as it did in the case of the Greek bonds. Are we seeing a pattern here?

So the oligarch-gangsters escape with their money, leaving the local Cypriots in the hands of the bureaucrat-gangsters – hardly a surprise.

Meanwhile, in the latest twist to what was supposed to have been a settled matter, the Cypriot Parliament yet again turned on the EU bureaucrats, refusing to accept the agreement they originally negotiated. The drama continues.

So how, in the end, does this affect all of us? While more questions remain unanswered than answered, I’ll take a stab at three particularly critical areas that should command our attention going forward.

The “what” we refer to is the government closing the banks without telling you they’re going to close them. You may think it ridiculous to think such a thing could happen here in the U.S. If so, you can skip this section.

However, for those of you who aren’t so sure the U.S. will absolutely be exempt from bank closures, consider first how it happened in Cyprus. Banks were closed on the weekend, after close of business, without notice. Now note that this is not unique to the Cyprus crisis. Governments have a long history of closing banks without notice, including the U.S. government, which closed all banks in 1933. (Of course, this was in the midst of the Great Depression.)

Think about it: if a government is going to close its banks, it makes no sense for them to announce the fact, does it? So it goes like this: you go to sleep thinking your money is safe in the bank; you wake up finding out you either can’t get to it, or you can only get a limited part of it, or – as in Cyprus – it’s been stolen.

Knowing how this works, you now have to decide whether the U.S government could conceivably take this sort of action. My own view is that while the possibility at the moment isn’t great, I simply don’t know how sound U.S. banks might be. Remember that while the Fed took a lot of the bad junk the big banks were holding onto it’s own balance sheet back in 2008 – 2009, we never really knew – and still don’t know – how sound what was left really is. We simply have no way of knowing exactly how healthy the balance sheets are today.

Besides the issue of U.S. bank balance sheets, consider that the crisis that caused U.S. banks to close during the Great Depression started with the failure of a bank in Austria. Could the failure of the Cyprus banks play a similar role? I doubt it. But I’m not willing to say that either this or some future incident in another country might not cause a chain reaction that could lead to the closing of U.S. banks.

I suggest you put some thought into this and, if you’re not completely convinced that U.S. banks will never ever face a similar situation, take measures to protect yourself.

Governments Will Lie About Whatever Suits Their Purposes

Again, we use Cyprus as our example. The European Central Bank “guarantees” bank deposits up to 100,000 Euro. You can think of this as something similar to the U.S. FDIC “guarantee” of your bank account. Under such a program, the principal of a deposit up to 100,000 Euro – or in the case of the U.S. $250,000 – will be restored to the depositor in the event the bank goes under. (Note: the principal only is guaranteed in these programs – including FDIC insurance – not the interest.) Right before that “tax” was imposed on bank deposits – that’s what they originally called it when they were going to steal a portion of the principal –the Cyprus government assured its citizens that the guarantee would be honored. They lied right up to the moment the money was taken.

So consider whether or not you believe that the U.S. government could lie in a similar way. Perhaps you might consider whether you’ve ever known the government to lie in any situation in the past.

Please note that I’m not singling out the U.S. government here; it’s simply that most of the readers of this letter live in the U.S. What I am saying, to be perfectly clear, is that all governments will lie when it suits their purposes. The study of history makes this apparent.

As for what you should do under these circumstances, it’s obvious, isn’t it? Does depositing money in banks over the insured limits seem prudent to you?

The One Lesson Most People Will Not Get From the Cyprus Debacle But You Should: Stop “Reaching for Yield”

We now come to a point that has gotten virtually no coverage or commentary. The banks in Cyprus were offering yields on deposits that were outrageously high. Interest rates on the Euro were 0.5%. The banks in Cyprus offered rates on deposits of 5%.That’s 10 times the market rate!

When you see someone offering you a rate of return like this, you must understand they will be playing games with your money. If a bank in the United States offers you even 2% on your deposits, where short-term treasury rates run between 0.01% – 0.20%, that’s 10 times the market rate!

I can’t tell you how many times people tell me they want a higher return on their cash. I understand perfectly. I don’t like getting nothing on my cash. But I’m not willing to put the principal of my cash at risk to get a return significantly in excess of the market rate. That’s called “reaching for yield.” And reaching for yield was the root cause of the debacle in Cyprus. If you follow the lead of the Cypriots who trusted their “safe” money (i.e., money in the bank) to banks returning outsized returns like this, can you expect the ultimate result to be different for you? It may not happen right away. But no one can offer such returns and not face a disaster at some point in time.

You have to decide for yourself whether you think it prudent to reach for yield. If you decide it is not, then stop wasting time looking for outsized returns on your “safe” money.

When we initially discussed the “bail-in” solution – stealing customer deposits to “save” collapsing banks – it was natural to wonder whether the EU had let the cat out of the bag: would stealing from customers bank deposits become a new “template” for solving future banking crises? Lo and behold, Dutch Finance Minister Jeroen Dijsselbloem blurted out that such would be the case going forward. Markets immediately tanked, at which point European Central Bank head Mario Draghi immediately announced the Dutch minister’s comments were not to be taken seriously, followed immediately by Dijsselbloem’s claims that he had been misunderstood, followed immediately by various EU and IMF officials tripping over each other to “reassure” everyone that none of the authorities have or even had any intention of pursuing “bail-in” solutions in the future – really.

To paraphrase Shakespeare: They doth protest too much, methinks.

Proving the point, recently Canadian authorities concocted legislation to deal with potential crises in their six “too big to fail” banks. An initial draft included confiscation of funds from their version of “insured” accounts. It was quickly removed from consideration, but not before the proposal had leaked, causing an uproar. Indeed, the reaction compelled Mark Carney, current Bank of Canada Governor, to respond. The Winnipeg Free Press published an interview with Carney (who, by the way, is set to become the next head of the Bank of England). Responding to questions about whether Canadian depositors need to worry about being subject to “bail-in” solutions:

“…it’s hard to fathom why it would be necessary,” the Bank of Canada governor said.

Asked if this would include non-insured deposits — those over $100,000 — Carney referred to a previous statement from Finance Minister Jim Flaherty’s office that depositors were excluded.

But later in the interview, Carney seems to shift his view a bit (emphasis added):

…Carney said the idea of a bail-in would be to set up a queue of capital buffers that banks could dip into to avoid failure. It likely would include some types of deposits.

“You should have a sense of the hierarchy, you should have a sense of the presumptive path in which entities would be bailed in and in what order, you should have comfort that it’s going to be co-ordinated across jurisdictions and within all that context, investors, regulators, shareholders, broad creditors of the institution of a bank should have a sense that there is a sufficient set of buffers of pure capital, but also bail-inable capital,” he explained.

“We’re working deliberately to get it done and Cyprus came a little early.”

Did you catch that: “Cyprus came a little early”? They were working on a model to deal with a banking crisis that included bail-ins before the Cyprus debacle hit. But didn’t Mario Draghi and a host of EU officials say…?

I’ll let you draw your own conclusions here. But remember: Carney was creating protocols that included bail-ins for Canadianbanks, said to be among the strongest and safest in the world. What about all the rest?

Next time we return to our special mission for 2013: seeking solutions to our ongoing crisis. But before signing off, one more thought about recent events in Boston.

A Family Trapped by Terror

Bill Richards lost his 8 year old son Martin. His wife and daughter were seriously – and horribly – injured. I hadn’t realized that the family was running from the first explosion only to be felled by the second. They were caught in a perfect trap conceived in the darkened minds of two young men who chose to commit an evil act – the killing and maiming of innocent people. Despite his personal tragedy, Mr. Richards took the time to release a statement:

“We thank our family and friends, those we know and those we have never met, for their thoughts and prayers. I ask that you continue to pray for my family as we remember Martin. We also ask for your patience and for your privacy as we work to simultaneously grieve and recover. Thank you.”

As a husband and father who treasures his family, I cannot imagine what this man must be going through now. But I was particularly struck by the mixture of grief and hope he expresses here.

I think Mozart best captures this same combination of grief and hope in the “Lacrimosa” from his “Requiem.” I listened to it after reading Bill Richards’ words. The piece builds its poignant sadness in the key of D minor, with a plea for God’s mercy and eternal rest. Then, right in the midst of the “Amen,” a ray of hope appears with the final triumphant D major chord. It was the last piece Mozart would write before he died at the age of 35.

The piece lasts a bit more than 3 minutes. Click HERE if you want to listen.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com