Cyprus Bailout Deal Sets Stage For a Bigger Eurozone Blowup

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European Union officials voiced relief following an 11th-hour Cyprus bailout deal, but in truth, they have little to celebrate.

Not only will this deal worsen the economic crisis in Cyprus, but the damage to the trust in the banking system also has created a time bomb set to go off the next time a Eurozone country – or especially its banks – get into trouble.

Early Monday morning, Cyprus agreed to consolidate its two largest banks and inflict heavy losses on uninsured depositors. In exchange, Cyprus gets $13 billion in international loans to prevent the total collapse of the island nation's banking system.

"It is a bad deal, but the extreme scenario we had to contend with was worse," Lefteris Christoforou, vice chairman of the ruling Democratic Rally party, told Reuters.

Details of the Cyprus Bailout Deal

While this deal does not touch any money of uninsured depositors – unlike a deal resoundingly rejected by the Cypriot parliament last week that would have hit them with a 6.7% tax – it fleeces large depositors.

The Bank of Cyprus, the largest bank, will survive at the expense of the second largest, the Popular Bank of Cyprus, also known as Laiki.

The insured deposits at Laiki will be transferred to the Bank of Cyprus, but the uninsured deposits – those of $130,000 and up, worth about $5.5 billion – will be wiped out. Likewise, bondholders and shareholders in Laiki will probably lose most or all of their investments.

Uninsured deposits at the Bank of Cyprus won't be wiped out, but will get a haircut of about 40%.

The depositor money will be used to resolve Laiki's debts and create a "good" bank that is better capitalized.

When a Bailout Isn't a Bailout

While the Cyprus bailout deal will prevent an immediate collapse of its banks, the longer-term picture is anything but rosy.

Cyprus, well-known as a tax haven, built its economy around its financial services sector.

While that helped make Cyprus prosperous, it was a risky strategy. The Cyprus banking sector attracted deposits of $90 billion – five times the size of the nation's gross domestic product. And the financial sector accounts for some 45% of the Cypriot economy.

"This deal removes a chunk of their economy and the blockage of foreign euro deposits will be further damaging; thus Cyprus is due for a big recession," said Money Morning Global Investing Strategist Martin Hutchinson.

The Cypriot economy could contract by10% or more over the next several years, analysts said.

That eventually will drive Cyprus into another debt crisis that will again threaten the stability of the entire Eurozone.

"These measures have already damaged the financial sector's reputation and business model, and the system's profile as an offshore financial centre is unlikely to survive this crisis," Moody's Senior Credit Officer Sarah Carlson wrote in a note. "The potentially irreparable damage to the country's current drivers of economic growth leaves its ability to sustain its current debt highly in doubt."

How the Cyprus Bailout Deal Could Kill the Euro

While Cyprus itself is still a future threat to the Eurozone, the bigger risk derives from the willingness of the troika that oversees the Eurozone bailouts – the EU, the International Monetary Fund (IMF), and the European Central bank (ECB) – to tap into depositor money.

"It greatly increases the chances of bank runs in other EU countries; PIIGS [Portugal, Ireland, Italy, Greece, and Spain] banking systems are now very unstable," Hutchinson said. "This may have postponed an EU meltdown, but at the same time has made it more likely."

Whenever the next Eurozone country starts to wobble, anxious depositors aren't going to want to take any chances. A bank run in a major EU country like Italy or Spain could easily be the catalyst that finally drives a stake in the heart of the euro.

"The one lesson that you can take from the Cypriot experience is: The race goes to the swift," Lee Buchheit, partner at Cleary Gottlieb Steen & Hamilton and sovereign debt restructuring expert, told The Daily Ticker. "And if you get out of Dodge early, you are completely protected. If you stay, and in effect trust the politicians, they not only come after [your money], they lock it up."

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