Cyprus Deep Value Part 2Adventures in Capitalism
After 5 days, a few hundred miles of driving, a few dozen kebobs and some fascinating meetings; I got a feel for Cyprus. While the rest of the Eurozone’s economy is stillborn, Cyprus is actually recovering. Foreign investment, often related to buying “Golden Visas” is going into the property sector. Cranes that have been stalled for years are coming back to life and property projects are finally getting completed. Everyone is convinced that property prices are up a good deal more than the government statistics would indicate. Even more importantly, the offshore gas projects are moving forward. While the total number of people involved in these offshore projects may be small, the multiplier effects on the economy will be massive. Finally, EU domiciled companies continue to move operations to Cyprus for tax reasons. In summary, the bottom is in and I am bullish on Cyprus.
When a country starts to recover, often the largest banks are the way to “play” that recovery, especially in a place like Cyprus where 2 banks control 70% of total deposits (ironically, the word “oligopoly” comes from the Greek words ὀλίγος (olígos), meaning ‘few’, and πωλεῖν (polein), meaning ‘to sell’). As should be obvious, oligopolies are attractive investments as they tend to earn outsized returns on capital.
In most small countries, domestic banks primarily focus on local property lending (as they’re best positioned to understand local property values), with the remainder of their lending focused on small domestic SMEs, often collateralized by property. Conversely, larger domestic corporates tend to go seeking cheaper funds from international banks and tend to be outside of the domestic banking system. Therefore, domestic banks effectively act as leveraged plays on domestic property prices—if prices are strong, the banks are strong and if prices decline, well, you get what just happened in Cyprus.
Once a crisis hits, property values collapse—particularly as banks stop lending, taking the bid out of the market—which usually makes the problem a good deal worse as collateral values decline. At the same time, banks are hesitant to take a loss by repossessing properties—especially in a small place like Cyprus where everyone knows each other. Therefore, you end up with a lot of NPEs that are hard to solve and the banking system freezes. I realize that I’m generalizing here and taking a complex situation and simplifying it, but sometimes it really is that simple. Property prices are down, banks don’t want to take the loss and cannot lend so that people can purchase properties. The banks are mostly making their own problems worse—with the ECB cheering them on.
Nothing quite sums up Cyprus like the stock exchange sitting behind a stalled out property development…
At the same time, property owners aren’t stupid—properties act like perpetual call options. The borrowers feel no need to pay their mortgages when they owe more than the property is worth. When property prices do recover, suddenly these out of the money calls get into the money and borrowers magically have capital to get their mortgages current again. No longer do banks need difficult restructurings—their loan books simply stop sucking.
Everywhere I went, people were convinced that property prices were recovering. Though you didn’t need to ask, all you needed to do, was see the cranes turning and sales offices staffed up ready to sell. Cypriot banks are about to see their underwater loan books come back into the money—particularly as the government has undertaken a number of initiatives like the ESTIA Scheme to help those who cannot seem to help themselves.
My working hypothesis was that Bank of Cyprus (BOCH – UK) was the way to play this recovery—particularly as it trades at about a third of book value and less than two times PPI (silly cheap valuations for a country’s largest bank). However, after meeting with BOCH management, I had something of a pause. You see, the Eurozone is all interconnected through the same currency and interest rate policies. So, when you’re a higher interest rate country (relatively speaking), you end up in a squeeze where you have to pay more for deposits (since you are still Cyprus after all), but Eurozone banks encroach on your home turf and can undercut you on the lending side as they have cheaper deposits. BOCH is getting squeezed—meanwhile their liquidity continues to build up as deposits return to Cyprus seeking higher deposit rates.
It’s hard to grow out of a book of NPEs if you cannot find good opportunities to lend. Meanwhile, government paper doesn’t yield enough to support deposits. In sum, BOCH is sort of in a bind—which likely gets worse as the stigma of lending into Cyprus subsides. Of course, BOCH will always have the domestic mortgage market, but they got burnt badly a few years ago and are gun-shy—besides, most current buyers are “Golden Visa” buyers who are all cash buyers. In some ways, BOCH got into this mess in the first place because their island got encroached upon and they decided to seek yield enhancement in Greek sovereign debt.
I personally think it will sort itself out and BOCH will do just fine—as an economy grows, the demand for credit grows and the representative offices of larger European banks will not take all of this business away. In the near term, I expect BOCH lending volume to be anemic and the loan book may continue to shrink. While I’m bullish, I’m a bull on the sidelines. I don’t know what the catalyst will be that gets me involved or if I will ever get involved, but I’ll be watching closely.
I visit companies and countries to learn. My macro research was spot-on, Cyprus is indeed recovering. But it’s the things you can only learn on the ground that make or break an investment decision. A bank on the periphery of an economic bloc using NIRP and tied into the block by a common currency, isn’t exactly in as strong of a position as its Oligopoly status would imply.
In summary, I’m glad I went to Cyprus.
Article by Adventures in Capitalism