One of the big lessons of the fraught negotiations over bailing out (or more accurately, in) Cyprus’s banks is that deregulating institutions with an implicit or explicit state guarantee is a bad idea. You’ve just given them a license to gamble with the public’s money, and you can rest assured that they will eventually avail themselves of it.

In Cyprus, bank deposits, which in theory are senior (meaning everyone else who gives money to the bank gets wiped out before they lose a penny) are proving to be not so. The reason is that there isn’t much left in the way of equity, there is pretty much no subordinated debt. The senior debt (still junior to deposits) is mainly sovereign or central bank debt. The Germans are insisting on “private sector participation” which means someone other than central banks need to take losses. Joseph Cotterill of FT Alphaville described why the officialdom decided it was too hard to go after the non-central bank bondholders:

As it is, there were lots of good reasons why a sovereign debt restructuring did not happen. I don’t want to downplay them. Notably, the fact that the bonds that were best to restructure were governed under English law, and were likely held by the kind of investor who’s willing to litigate. I listed the problems here. Around it all was the inability to get write-downs out of Cypriot domestic-law sovereign debt, because that was held by the banks which already bore big black holes in their balance sheets. Again we come up to something that could be raised in the defence of the deposit levy — local exposure was so great everywhere, that any distribution of losses would have been painful. For the widow depositor, substitute the pension fund holding local-law bonds.

In the US, depositors have actually been put in a worse position than Cyprus deposit-holders, at least if they are at the big banks that play in the derivatives casino. The regulators have turned a blind eye as banks use their depositaries to fund derivatives exposures. And as bad as that is, the depositors, unlike their Cypriot confreres, aren’t even senior creditors. Remember Lehman? When the investment bank failed, unsecured creditors (and remember, depositors are unsecured creditors) got eight cents on the dollar. One big reason was that derivatives counterparties require collateral for any exposures, meaning they are secured creditors. The 2005 bankruptcy reforms made derivatives counterparties senior to unsecured lenders. Lehman had only two itty bitty banking subsidiaries, and to my knowledge, was not gathering retail deposits. But as readers may recall, Bank of America moved most of its derivatives from its Merrill Lynch operation its depositary in late 2011. As Bloomberg reported:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation… Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

And Bank of America is hardly unique. Bloomberg again:

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

As we wrote at the time:

This changes the picture completely. This move reflects either criminal incompetence or abject corruption by the Fed. Even though I’ve expressed my doubts as to whether Dodd Frank resolutions will work, dumping derivatives into depositaries pretty much guarantees a Dodd Frank resolution will fail. Remember the effect of the 2005 bankruptcy law revisions: derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs. So this move amounts to a direct transfer from derivatives counterparties of Merrill to the taxpayer, via the FDIC, which would have to make depositors whole after derivatives counterparties grabbed collateral. It’s well nigh impossible to have an orderly wind down in this scenario. You have a derivatives counterparty land grab and an abrupt insolvency. Lehman failed over a weekend after JP Morgan grabbed collateral. But it’s even worse than that. During the savings & loan crisis, the FDIC did not have enough in deposit insurance receipts to pay for the Resolution Trust Corporation wind-down vehicle. It had to get more funding from Congress. This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors.

Now unlike Cyprus, the US does not have a financial sector that is a ginormous multiple of the real economy, so that taxpayers almost certainly can and will foot the bill for any derivatives misadventure that digs too deeply into FDIC reserves. And don’t kid yourself about the odds of that happening. Academics that aren’t on bank meal tickets consistently find that FDIC insurance is underpriced. The last time bank losses bled the FDIC dry, in the savings & loan crisis, the FDIC got a Congressional appropriation to make up the shortfall.

A bit more than a week ago, Jim Himes (an ex Goldman officer) and Randy Hultgren introduced bills that not only aim perpetuate this situation but will make it worse. And do not labor under any delusion as to whether this bill has official support. Himes is national finance chairman of the Democratic Congressional Campaign Committee, and Bernanke made approving noises about the legislation.

The proposed legislation, which predictably is not getting much attention from the mainstream media, will grease the wheels even more for banks. And where is Elizabeth Warren when a real bill is moving forward? (The three bills we will discuss are going before the House Agricultural Committee for markup on Wednesday; a Senate version of the most obviously troubling one, as discussed immediately below, has been introduced).

Americans for Financial Reform has written a series of layperson friendly letters opposing each of these bills. The first is to pretty much eliminate Section 716 of Dodd Frank, which would force banks like Bank of America and JP Morgan to take their derivatives operations out of taxpayer-backstopped subsidiaries and house them in separately-financed operations. This is the germane section discussing the House bill (its Senate evil twin is S. 474):

Since the Senate hearings on the London Whale trade confirmed that JP Morgan has an ugly combination of terrible controls and no respect for regulators, allowing banks to continue to gamble with taxpayer deposits is asking for bigger, more costly blowups. Remember, these losses took place when financial markets were calm and JPM had simply made a big, clumsy series of wagers. What happens if we get a repeat of the crisis, of banks choking on their own highly levered bad cooking?

The second bill also makes banks impossible to resolve through a sneakier mechanism. If you read Sheila Bair’s Bull by the Horns, she recounts that it was particularly troubling to see at Citigroup how its operations took place with no relationship to legal entities. One of her big pushes with the bank was to tidy that up. And in coming up with living wills, banks who were not as loosely managed as Citi have still found it difficult to move businesses into specific legal entities so they could be resolved (as in sold or put into bankruptcy).

One proposed bill would end Dodd Frank restrictions on inter-affiliate swaps. The reason this matters is that swaps can be used to move risk, profits, or other economic exposures from one entity to another. And the effect of this sort of arrangement is to tie entities that might have been separated out legally back into one big economic hairball. That would make it impossible to hive them into pieces, so it would also impede legislation aimed at forcing the banks to break up. Think this sort of thing doesn’t happen now? One of the reasons that AIG was not broken up and sold as originally planned was that its property and casualty operations in the US are tethered together in a dense web of cross company-guarantees, turning what on paper are subsidiaries licensed and supervised in 19 states into one operation overseen by no one (I had a whole team, including two heavyweight economists and two serious insurance accounting experts, one of them a former senior examiner, trying to figure out how to get through all the cross guarantees and figure out the economics of the major subsidiaries, and after spending weeks on it with statutory filings, we concluded it was too hard).

AFR Letter Opposing HR 677 (on inter-affiliate swaps)

The third bill, HR 1003, is a more straightforward “throw sand in the gears” operation. It seeks to neuter the CFTC by requiring it to make more than twice as many cost-benefit assessments of proposed decisions, which will undermine enforcement actions. It effectively subjects regulation to a second screen, by requiring regulators to jump through another hurdle and prove that rules already passed by Congress don’t impose an undue cost relative to the supposed benefits. But that logic is heinous. First, recall that that sort of reasoning led to exploding Pintos. It was cheaper for Ford not to fix its cars and merely pay off the bereaved relatives of people who got fried. Second, the banks will always argue that tail risks, which is what a good deal of regulation is intended to reduce, are lower than they appear. But the cost of tail events, as in financial crises, are so great that it is imperative to be overinsured, since (as Nassim Nicholas Taleb has stressed) is inherently hard to measure and established approaches lowball it. And most important, he has described how complex derivatives risks are inherently unsuited to statistical measurement. Our summary of the key points of his article on what he calls the fourth quadrant:

Nassim Nicholas Taleb gave a presentation in New York yesterday which hews closely to a recent piece of his, although his talk did include some additional interesting charts and anecdotes… First was his “fourth quadrant” construct. He sets up a 2 by 2 matrix. On one axis is phenomena that are normally distributed versus ones that have fat tails or unknown tails or unknown characteristics. On the other axis is the simple versus payoff from events. Simple payoffs are yes/no (dead or alive, for instance). “How much” payoffs are complex. Models fail in the quadrant where you have fat or unknown tails and complex payoffs. A lot of phenomena fall there, such as epidemics, environmental problems, general risk management, insurance, natural catastrophes. And there are phenomena in that quadrant that have very complex payoffs, like payoffs from innovation, errors in analysis of deviation, derivative payoffs. The other part that caught my attention was the estimation of fat tail risk. As most readers know, all the fundamental models of finance theory use Gaussian (normal) distributions…Now supposedly quants have developed some fixes to various pricing and risk management models to allow for tail risk… Taleb casts doubts on these fixes: The tragedy is as follows. Suppose that you are deriving probabilities of future occurrences from the data, assuming (generously) that the past is representative of the future. Now, say that you estimate that an event happens every 1,000 days. You will need a lot more data than 1,000 days to ascertain its frequency, say 3,000 days. Now, what if the event happens once every 5,000 days? The estimation of this probability requires some larger number, 15,000 or more. The smaller the probability, the more observations you need, and the greater the estimation error for a set number of observations. Therefore, to estimate a rare event you need a sample that is larger and larger in inverse proportion to the occurrence of the event. If small probability events carry large impacts, and (at the same time) these small probability events are more difficult to compute from past data itself, then: our empirical knowledge about the potential contribution—or role—of rare events (probability × consequence) is inversely proportional to their impact. This is why we should worry in the fourth quadrant!

So it isn’t just that the CTFC will be snowed under with busywork to justify its efforts, but that they are also likely to be shoehorned into a statistical template which will give the banks the upper hand. Well played!

Please contact your Senator and Representative and tell them you are firmly opposed to these bills since they are all “gimmie my bailout and leave me alone” proposals from the banks. One bit of good news here is that at least on paper, Republicans are not happy about the fact that Dodd Frank resolutions aren’t likely to work even before the launch of this effort to assure they won’t ever be attempted. Spencer Bachus issued a paper last year criticizing the inadequacy of the Dodd Frank resolution provisions. So it can’t hurt to tell Democrats that they need to stand behind Dodd Frank, and remind Republicans that they’ve stood for “no more bailouts” and they need not to allow those sneaky ex Goldman Democrats to allow Wall Street to suck resources away from Main Street. This sort of bill depends on the complacency and indifference of the public to get passed, and correctly painting its as an egregious piece of pro-bailout pork might make some Congresscritters loath to be associated with it.