What Cyprus (Initially) Got Right — Remembering The 2008 WaMu Capital “Run”

There’s no shortage of criticism of the Cyprus “bail-in” — the one-time tax the government had proposed levying on insured and uninsured depositors to rescue the nations’ banks.

And there is no shortage of criticisms that I could levy either on Cyprus and the EU’s slapdash approach, which now looks like it will be rejected by the Cyprus parliament. The biggest being that the failing financial institutions should have been put through a bankruptcy system rather propped up — whether through this levy or general taxation. Having said that, the initial Cyprus approach could have been much worse, and what comes next may be much more likely to spread contagion.

There is one fundamental thing the initial plan got right. Depositors must not be considered sacrosanct in a bank failure, and, conversely, a bank’s contractual obligations to creditors such as bondholders cannot be ignored. The controversy should also open a much-needed debate about the role of ever-expanding deposit insurance in spreading moral hazard, as it encourages a lack of due diligence among customers of banks.

As unveiled this weekend, the plan called for a one-time tax of 6.75 percent on deposits of less than 100,000 Euros and a 9.9 percent tax on holdings of more than 100,000 Euros. Cyprus President Nicos Anastasiades then proposed exempting depositors with less than 20,000 Euros.

At present, according to The New York Times, “Cyprus’s Parliament is likely to reject an international bailout package that involves taxing ordinary depositors to pay part of the bill.” It’s unclear if by “ordinary,” it is also meant “insured,” or if the Cyprus legislature means that some uninsured depositors above the 100,000 Euro limit should also be made whole.

Almost as controversial is the part of the Cyprus that imposes no losses on senior creditors. According to the Times,  the plan “would wipe out 1.4 billion euros held by junior bondholders in Cypriot banks. Only senior bondholders, who have paid a premium to be first in line for repayment of their investments, would be fully protected.”

A big fear in much of the discussion has been “bank runs.” What’s important to note is that there is more than one type of “bank run.” A “run” or “strike” by a bank’s creditors, though not as visible as one by depositors lining up outside banks, can be just as damaging to the financial system. The U.S. found this out during the failure of Washington Mutual in the cataclysmic month of September 2008.

With its mortgages souring, the large thrift known as WaMu was seized by the Federal Deposit Insurance Corporation (FDIC). To avoid a classic bank run, the FDIC decided to make all depositors whole. As a consequence, even though the deposit insurance limit was then $100,000 per account, folks with more than $1 million in deposits got every cent back.

Yet these uninsured depositors were covered by almost completely wiping out WaMu’s senior bondholders. As John Allison, at the time chairman and CEO of BB&T Corp (and now president of the Cato Institute), observes in his recent book The Financial Crisis and the Free Market Cure, “The bondholders suddenly realized that there is no rule of law when government regulators are involved.”  As a result, “the decision to treat WaMu bondholders this way closed the capital markets for banks.”

Allison argues that the wiping out of WaMu bondholders “was an even more significant event than Lehman Brothers’ failure.” He recalls that after Lehman imploded, “it was a choppy market” but BB&T (widely regarded as one of the most well-managed banks) “still had been able to raise capital funding.” But after WaMu, “the capital markets closed for all banks.”

But putting aside the sanctity of contracts, isn’t it regressive to impose losses on depositors and award claims to bondholders. By even the most progressive standards, looking at bondholders and depositors as a whole, the answer is no. 100,000 Euros is $129,000, so someone who has that in a Cyprus bank is hardly what we would call “middle-class.” Yet middle-class savers and retirees are indeed served by pension and mutual funds who were bondholders with WaMu and could be among the senior bondholders of banks in Cyprus.

Speaking of that, the U.S. needs to reduce it over-generous level of deposit insurance here, or very soon taxpayers will be on the hook for more reckless behavior. Letting the unlimited deposit insurance for non-interest accounts from the Transaction Account Guarantee program, put in place during the crisis in 2008 and extended by the Dodd-Frank “financial reform” law of 2008, expire last year was a good first step. Not only did financial markets not implode, as some has predicted, the stock market has seen some significant gains. There may be a connection, as more folks have stopped parking their money with this guarantee and are moving it into relatively safe but productive investments.

Now, the federal deposit insurance limit should be reduced from $250,000 to the $100,000 that had been in place before the crisis. It’s hard to argue that folks with more than $100,000 in the bank need a “safety net” and can’t do their own due diligence.

Meanwhile, sounds as if Cyprus 2.0, a rumored 20 to 30 percent levy on only Russian depositors in return for a stake in a speculative energy project, may be the real spreader of contagion. Hang on tight!