Greek Bets Sank Top Lenders

Banks at Heart of Cyprus Mess Were Bullish on Athens as Other Investors Fled

By DAVID ENRICH and CHARLES FORELLE

In August 2010, Greece's economy was tumbling into depression amid angry street protests and a €110 billion bailout. Dimitris Spanodimos, the chief risk officer of Cyprus's second-largest bank, remained bullish.

Mr. Spanodimos boasted on an Aug. 31, 2010, conference call with analysts that the bank was expanding faster than rivals in Greece and bulking up on residential mortgages. "We have used our group's comfortable liquidity and capital position to deepen selectively some highly profitable and highly promising client relationships," he said.

His bank, Cyprus Popular Bank PCL, is now ruined. Its destruction—and the near-failure of its larger peer, Bank of Cyprus PCL—was the result of poor choices by bank managers and of a European regulatory system that gave both banks a clean bill of health as their infections festered. The collapse of Cyprus's two largest banks forced the tiny country to seek an international bailout and impose an unprecedented lockdown on its financial system, bringing it to the edge of leaving the euro.

An examination of regulatory documents, conference-call transcripts and financial filings shows that both banks gorged on Greece while nearly everyone else was purging.

In late 2010, even after German and French leaders had openly agreed that creditors of fiscally weak governments should take losses on future bailouts, the two Cypriot banks appeared nonchalant about their exposure to Greek government bonds.

By the end of the year, according to European regulators, the two banks had a combined €5.8 billion ($7.5 billion) of Greek government bonds—€1 billion more than they had held just nine months earlier, and a sum equivalent to about one-third of Cyprus's annual economic output. By comparison, over the same period, Barclays PLC cut its Greek government exposure by more than half.

Both Cypriot banks passed Europe-wide stress tests in 2010, relieving them of pressure to change course. They passed again in 2011.

"Their regulator was clearly signaling it was OK to go on" expanding in Greece, said Christine Johnson, a bond-fund manager at Old Mutual Global Investors in London, referring to Cyprus's central bank and European banking regulators.

Cyprus Popular and Bank of Cyprus have booked combined losses of €4.3 billion on their Greek government-bond holdings.

A spokesman for Bank of Cyprus didn't return a message seeking comment. A spokesman for Cyprus Popular, which is being put through a form of liquidation, referred questions to the Central Bank of Cyprus. A central-bank spokesman declined to comment. Mr. Spanodimos of Cyprus Popular couldn't be reached.

Panicos Demetriades, who became central-bank governor in May 2012, said this week that he could do little more than stabilize Cyprus Popular, known in Greek as Laiki, while the government negotiated a bailout. "We kept Laiki alive, on the respirator, for several months," he said.

Cyprus Popular is the result of a consolidation overseen by Greek banker Andreas Vgenopoulos, who strung together banks and investment firms in Cyprus, Greece and elsewhere. Fatefully for Cyprus, he tied them all together there. In 2009, the Greek unit was merged into the Cypriot parent.

For a while, the Greek business was good, as both banks pursued business with their fellow Hellenophones. The 2006 annual report of Bank of Cyprus speaks of its "dynamic expansion in Greece" and plans for more branches. By the time Greece began to teeter in late 2009, both banks were in deep.

In 2010, they went deeper. After losing access to international capital markets in early 2010, the Greek government floundered for months before signing up to the bailout. Pressure rose on Ireland, Portugal and even Spain. Financial markets became wary of European banks and their heavy lending to such peripheral countries.

In July 2010, a pan-EU regulator conducted "stress tests" of banks to gauge how they would fare if economic conditions worsened. Crucially, the tests modeled the impact of the economy on loan portfolios but didn't contemplate the possibility that government bonds could produce losses.

Cyprus's two main banks passed easily, with a total of €572 million of surplus capital. The Central Bank of Cyprus declared "deep satisfaction" with the results, which it said "demonstrate the ability of the domestic banking sector to withstand shocks under adverse scenarios."

In 2010, after getting that all-clear, Cyprus Popular paid out about €67 million of cash dividends. Bank of Cyprus paid about €27 million of cash dividends in 2010 and an additional €47 million in June 2011. The payouts sapped capital that soon would soon become precious. Both banks also expanded their portfolios of soon-to-be-toxic Greek government bonds.

In February 2011, Cyprus Popular's then-CEO Efthimios Bouloutas said "we're extremely comfortable" with the bank's capital levels, which he predicted would rise as Cyprus Popular churned out profits."We don't have any rush to strengthen them," he said. He couldn't be reached to comment.

Also that month, Mr. Spanodimos, the risk officer, told analysts during a conference call that he didn't think Greek or Cypriot loans would go bad at an increasing clip.

Around the same time, a top executive at Bank of Cyprus told analysts that the lender was "selectively and cautiously expanding its business in Greece," and noted the bank's capital position "remains strong."

In 2011, the European Banking Authority ordered more stress tests. Like the ones the previous year, they didn't contemplate losses on government bonds. The two Cypriot banks were again found to have plenty of capital to withstand a deteriorating economic environment.

Less than a week after the results came out, European leaders reached a deal for a new Greek bailout that included losses on Greek bonds. That plan was never executed—another plan,which saw steeper losses, eventually was—but now the specter of such losses was out in the open.

Still, in August 2011, Cyprus Popular was seeking to expand its residential-mortgage loans in Greece, hoping to create a stream of assets that it could package into "covered bonds" that it issued to drum up funding from investors, executives said.

Three months later, Cyprus Popular executives said they were racing to downsize their Greek government-bond holdings. Mr. Bouloutas told analysts in late November 2011 that the bank was seeing some customers pulling their deposits as a result of "all this adverse publicity," but expressed confidence the trends would quickly stabilize. A week later, he resigned as CEO.

That year, the banks realized huge losses on their Greek government bonds. Both were left with lower capital levels than Cypriot regulators required. Bank of Cyprus scaled back its lending to individuals and small businesses in Greece, but its loan portfolio there stood at about €10 billion. Nearly 12% of the loans were classified as nonperforming.

On Dec. 8, 2011, the EBA tried for the third time to come to grips with the capital deficits at major European banks. This time, the authority factored in possible government-bond losses and concluded that Bank of Cyprus and Cyprus Popular were among 31 banks that needed to come up with new capital.

Bank of Cyprus's estimated deficit was €1.56 billion and Cyprus Popular's was €1.97 billion. The banks had until June 2012 to come up with the new capital.

They couldn't raise enough, and Cyprus needed a bailout.