Insight: Why did Cypriot banks keep buying Greek bonds?

One day last October, a memory stick containing special software for deleting data was placed into a desktop computer at Bank of Cyprus.

Within minutes, 28,000 files were erased, according to investigators who had wanted to copy the data for an official report into the collapse of the Cypriot banking system.

The deleted files included emails sent and received in a crucial period in late 2009 and early 2010 when Bank of Cyprus, the biggest lender on the island, spent billions of euros buying Greek bonds - at a time when international banks were cutting exposure to the heavily indebted Athens government.

Those Greek bonds lost most of their value in last year's EU-sanctioned bailout, playing a key role in plunging Cyprus into an economic maelstrom. When banks turned to Cyprus's own cash-strapped government for help in plugging holes in their balance sheets, Nicosia too needed an international rescue.

Now people in the small euro zone republic, who have lost money and face years of grim austerity, want to know who decided to plough their savings into the doomed public accounts of their bigger neighbor, and why. But answers are proving elusive, not helped by the mysterious wiping of data at Bank of Cyprus.

There has been public speculation about backroom diplomatic deals or misplaced solidarity with Cypriots' fellow Greek-speakers.

But executives at the failed banks argue that Greek bonds seemed a good investment at the time - though that view is at odds with that of many bankers elsewhere in Europe, who were doing all they could to limit their own exposures to Greece.

The confidential report, prepared for the Cypriot central bank by global consultants Alvarez and Marsal, found that Bank of Cyprus had been willing, from 2009 onwards, to invest in risky, high-yielding Greek debt in a bid to offset an erosion of its balance sheet from rising non-performing loans.

The report, which Reuters has seen, alleges that bank executives may not have revealed details of bond purchases to board directors, avoided showing losses on the bonds, and may later have delayed external investigation of the bond purchases.

In December 2009, managers told media and their own board that most of the bank's Greek bondholdings had been sold - but the bank did not then disclose that it had almost immediately bought more.

Bank of Cyprus has declined to comment on the report. Petros Clerides, the Cypriot attorney-general to whom a copy of the report was delivered, declined any comment on the matter.

Much attention in the crisis has hitherto focused on allegations of poor management at Cyprus's other big lender, Laiki Bank, formerly Marfin Popular. But the Alvarez and Marsal report, whose broad findings emerged earlier this month, raises questions, too, about the former management of Bank of Cyprus.

The report noted "a culture whereby senior management decisions were not challenged".

Michael Olympios, who heads an investors' association, Pasexa, that has complained of mismanagement, said: "There was clear corporate governance failure here, and a lack of disclosure to shareholders."

More broadly, he added: "If one wants to summaries the mess in our banking system, Lord Acton sums it up; power tends to corrupt, and absolute power corrupts absolutely."

Under last month's bailout deal for the Cypriot state, Laiki is being closed and Bank of Cyprus is being recapitalized. Large depositors at Bank of Cyprus have seen virtually all of their deposits over an insured 100,000-euro ($131,000) threshold frozen and stand to see up to 60 percent of those converted into equity.

Many in Cyprus, including hundreds of Russians who placed their faith in its once booming offshore banking products, feel they have been unfairly treated; bank depositors in Greece suffered no losses when that country was bailed out.

"They should have bought from different governments rather than just Greece," said Demetris Syllouris, who heads the Cyprus parliament's ethics committee which is looking into the affair.

"This caused 80 percent of the problem we are in."

Aside from the wisdom of its investment strategy, it is the communication of this strategy to investors that is in question.

On December 10, 2009, Yiannis Kypri, a general manager at Bank of Cyprus, told a Cypriot website, Stockwatch, that the bank had "minimal exposure to Greek sovereign debt" after reducing its holdings from 1.8 billion euros to 0.1 billion.

The same day, according to the investigators' report, Andreas Eliades, then Bank of Cyprus's group chief executive officer, instructed his treasury department to begin new purchases of such bonds. With these new instructions, that day the bank bought debt worth 150 million euros, and a total of 400 million by the end of 2009, according to the consultants.

There is, the report says, "no evidence" the public comment about "minimal exposure" to Greece was ever "retracted or subsequently corrected by any of the bank's executives".

Kypri told Reuters he could say little while an official inquiry continues, but he was quoted by the investigators saying he had been unaware of the plan to return to buying Greek bonds.

Andreas Eliades, who was chief executive until July 2012, told Reuters Kypri's statement to Stockwatch referred only to a temporary sell-off in response to short-term market fluctuation.

Another member of senior management at the time, Nicolas Karydas, gave investigators and Reuters the same explanation.

On December 11, the day after the bank resumed purchases of Greek bonds, Karydas told the bank's board that most of its Greek bonds had been sold. But, the Alvarez and Marsal investigators, add: "The board was not informed that the repurchase of Greek government bonds had commenced the prior day, after the divesture."

Karydas, group general manager of risk management and markets, who left the bank at the end of August last year, rejected any suggestion the board was unaware of the investment strategy or that he misled the board. He said in an email response to Reuters "all the executives" agreed to a policy that included possible Greek bond purchases at a meeting in November 2009.

"The ... suggestions ... were also approved by the board of directors in their December 11 meeting," Karydas said. "It seemed to be a consensus view that Greece would overcome the crisis."

By April 2010, the bank had expanded its holding of Greek government bonds to 2.4 billion euros, a third more than the amount Kypri had told Stockwatch had been sold four months before. The investigators said this went beyond the bank's own approved 2-billion-euro limit but was approved retrospectively in May 2010.

Eliades, the former group CEO, said that Greek bonds were still well rated at the time and in demand internationally: "We cannot judge, with today's circumstances, actions which took place at a different time when Greek bonds had very high demand," he said. "Everyone was buying into Greek bonds."

By comparison, however, data from "stress tests" carried out by EU authorities concerned about the health of their banks, showed that at the end of 2010, most of the 10 biggest banks on the continent, many times larger than the Cypriot lenders, held nothing like as much Greek debt as did Bank of Cyprus and Laiki.

They had 2.2 billion and 3.3 billion euros respectively, outstripped among top 10 banks only by French giants BNP Paribas and Societe Generale. The same EU data showed that Britain's Barclays had only 192 million euros and Lloyds none at all.

As investors' fears over the solvency of Greece grew, the value of the Greek bonds fell. The Bank of Cyprus made changes to the way it accounted for the bond holdings, according to the Alvarez and Marsal report, with the result that the growing potential losses were not spelled out to investors.

In April 2010, it moved about 1.6 billion euros of Greek bonds from its trading account to its "held to maturity" book. This meant the bank did not have to mark down the value of the bonds.

The accounting move was made on the grounds that Greece would redeem the bonds. The report authors said: "The justification provided does not appear to be strong."

Eliades told Reuters: "Nobody could possibly expect that a European country, in the euro, could possibly default."

Last year, however, the EU and IMF bailout terms relieved Greece of the need to repay up to 80 percent on its bonds, leaving the Bank of Cyprus with losses of 1.8 billion euros.

The bank declined to respond to an allegation made in the report that data that could have been relevant to understanding why it bought so much Greek debt may have been deleted.

That data, the authors say, was wiped from the computer of Christakis Patsalides, an executive involved in buying bonds, using special software on October 18 last year. When investigators examined it, there was a 15-month gap in emails in 2009-2010.

There is no suggestion Patsalides himself deleted them. He told investigators that he was unaware of any missing data, according to the report. Patsalides declined comment to Reuters but told investigators for the report that had thought the bank's ceiling for its Greek bond holdings had been set at "too high a limit".

(Additional reporting by Renee Maltezou; Editing by Richard Woods and Alastair Macdonald)