Cyprus Continues to Threaten U.S. Investors

The tiny Mediterranean nation is an unlikely but dangerous powder keg.

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You don't need to know anything special about Cyprus's financial system to understand what a mess it's in. You do need to know, however, that the crisis there is far from over and could still spark a wider European meltdown that could reach U.S. financial markets.

Anybody with a bank account can understand the dicey position Cypriot banks are in. European leaders recently hatched a plan to bail out Cyprus's two largest banks, which are close to insolvent, financed in part by a "tax" on deposits held at those banks. Bank customers in Cyprus reacted the way bank customers always do when they realize their accounts are vulnerable: They withdrew as much money as they could.

[READ: How Cyprus—and Russian Gangsters—Could Harm Your 401(k)]

That panic forced Cyprus to declare a bank holiday. Then it killed the plan to tax bank deposits, with parliament voting it down. Global stock markets, which had dipped on the initial news of the bailout plan, leveled out as if the whole thing was a false alarm.

But it's not. If you had your savings in a bank and the government had shown a sudden interest in seizing a portion of it, what would you do the first chance you got? Right. "As soon as the banks open in Cyprus there will be billions in withdrawals," says David Zervos, global head of strategy and economics at investing firm Jefferies & Co. "There will be a collapse of the Cypriot financial system, no matter what."

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European politicians have proven themselves adept at devising plug-and-fill solutions to keep the euro zone debt crisis from swamping the whole continent. So they could still spring a scheme to keep Cyprus more or less intact. Russia, which has significant business dealings in Cyprus, could bail out the banks, preventing them from collapsing. Or there might be some other way to come up with the relatively small sum—about $22 billion—required to keep Cyprus stitched together for now.

[BROWSE: Political Cartoons on the European Debt Crisis]

But all possible solutions seem to involve an ugly precedent that will be hard to smooth over. Bailout-weary Germany and other northern European nations insist that any eurozone nation getting a rescue must contribute some of the funds itself—but Cyprus doesn't have the money, which is where the plan to confiscate bank deposits came from.

A bailout by Russia or another foreign nation such as China might help Cyprus come up with the money it needs, but backing away from its euro-zone partners—and their conditions for a bailout—could force Cyprus to leave the eurozone.

That's a scenario European leaders have pledged to avoid, because it might not stop with Cyprus. Greece could go next, and that might make Spain and Italy more fragile than they already are.

Whatever the outcome, Cyprus is likely to be left with hollowed-out banks and an epidemic of capital flight. "The spirit, if not the letter, of the euro zone's deposit insurance scheme, which guarantees up to €100,000 in the event of a bank collapse, has been violated," writes Zach Witton of Moody's Analytics.

[READ: Opinion | Cyprus Bank Tax Unnerves Financial Markets]

The ramifications, he predicts, will include a sharp drop in savings in Cyprus, less money available for domestic investment, more foreign borrowing and other negative developments that will make the country's financial problems worse, not better.

One potential savior is the European Central Bank, which could infuse money into Cyprus by buying government bonds. That, however, would violate the ECB's own guidelines for bailouts, so some clever parsing may be required for the ECB to aid Cyprus without wrecking its own credibility.

Some analysts think the whole ordeal could end up working out, since Cyprus is tiny, there are unique characteristics to its financial system (such as the Russian connection), and the bank tax could be restructured to snare only wealthy depositors who have gained the most from Cyprus's low taxes and loose regulations.

But others see a wildfire breaking out. Zervos suggests that investors exposed to risky assets such as stocks take advantage of the market lull to hunker down. "The market has been very cooperative, giving investors ample time and liquidity to get out," he says.

Meanwhile, the bank holiday is scheduled to end soon but could be extended to prevent, or perhaps merely delay, panic. The real question, however, isn't what day the banks will open, but how far the panic will spread when they do.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.