Do you still want to hold your money in Italian banks?  What about Spanish banks, or even in the United States?  The Cyprus bail-out, or bail-in as the EU likes to call it, has not put those questions to rest. They’ve become even more urgent now that the Troika – the alliance of European Union, European Central Bank, and IMF bureaucrats who spend their time going from one country bailout to another – have decided that depositors will be on the hook the next time a bank goes under.

What’s even more worrisome is that they have shown themselves willing to ignore the laws governing bank failures, and that’s why you can’t breathe too big a sigh of relief over the latest version of the Cyprus “rescue”.

It’s true that the deal announced this weekend is better than the one proposed the previous weekend.  Individual depositors with accounts no greater than €100,000 will be protected, even in the second largest bank – Laiki – which is to be shut down.  Insured deposits in Laiki Bank will be transferred over to the Bank of Cyprus – the country’s largest bank – which will become a “good bank” in comparison to Laiki as the “bad bank” that will house only its impaired assets.  Shareholders and bondholders in Laiki Bank will be wiped out, and owners of deposits greater than €100,000 will lose some portion of their deposit, an amount yet to be determined, but expected to be significant.

For the most part, this is how deposit insurance would work if Laiki Bank were to be put into receivership according to the law.  Deposits of €100,000 or under would be protected and passed over to a healthy bank, while deposit amounts in excess of €100,000, which by law would not be insured, would be placed in a queue before the bankruptcy court, to determine how much of this excess would be lost.  The difference in the Cyprus situation is that it seems the entirety of any deposit greater than €100,000 is now subject to a haircut.

The reason for this is that the Cyprus government does not have the financial resources to protect both big and small deposits, and while all 17 Euro countries follow the same rules when it comes to deposit insurance schemes, there is no cross-country pooling of resources.  Thus Cyprus is entirely on its own, and like other small countries, it is not going to have an ability to implement the insurance program fully. Obviously the country which could help – Germany – has refused to do so, as this might set a precedent for all other EU countries in a similar situation.

This tells us two things about Germany. First, Angela Merkel is correctly reading the political tea leaves in her country.  Opinion polls, as well as election results, have shown her that Germans are becoming fed up with having to “save” Europe over and over, especially when those being saved are the southern, periphery countries deemed to be lazy and reckless.  Cyprus is viewed by many in Europe as nothing but a safe haven for drug money and other criminal enterprises. Some Germans are even beginning to say that getting rid of the euro would be better than the current situation.

The second thing becoming clear is that Germany doesn’t have the resources, the liquidity, to bail out any more countries.  Cyprus – the EU continues to remind us – is a very small country with a very small GDP, yet there wasn’t enough money to go around to make its problems go away.  This is very worrisome because there are much bigger problems waiting in the wings for attention; both Italy and Spain have applied to the Troika for relief.  Where is the money going to come from to help them?

The answer to that question has been given to us in the Cyprus rescue.  The depositors in any bank bailout are in the future going to be “taxed” to help pay for the bailout.  Moreover, even with the revised Cyprus bailout terms, none of the members of the Troika has said a word about the importance of protecting small depositors as a matter of policy or routine.  Quite the contrary.  According to the Dow Jones news service,

Dutch Finance Minister Jeroen Dijsselbloem, who heads the Eurogroup of euro-zone finance ministers, acknowledged that it was the first time that senior bond holders had been hit in the euro zone but said “it’s a unique and exceptional situation” that concerned a bank that needed immediate help.

The bondholders, in other words, have much greater priority than individual depositors, in the eyes of the finance officials managing the bailout process.  “Forget the law”, is what they are saying, “and forget what you have been told about deposit insurance.  We will do what we want and what we have to in order to protect the most-favored banks first and foremost.”

What this means for Cyprus is that the game is over as far as being a tax haven, safe haven, or any kind of haven for overseas money, since none of its banks are on the most-favored list.  The country’s banking system will shrink dramatically, and the bank that engaged the most in this game is being put up against a wall and shot.  Meanwhile, Hong Kong and Shanghai Bank, domiciled in London and one of the world’s biggest banks, has admitted to laundering money for Mexican drug cartels for amounts in excess of billions of dollars.  HSBC admitted deliberately and knowingly abetting criminal activity – something Laiki Bank has never been accused of – over many decades, and despite repeated promises to regulators that it would clean up its act and abide by anti-money laundering rules.  Its penalty?  A large fine.  There was no threat to shut the bank down, nobody was asked to be fired, and no one has gone to jail, for what clearly is criminal behavior on a massive scale.

HSBC is a Too Big To Fail bank and it is part of the European club of respectable bankers, where its executives get to mingle with the Jeroen Dijsselbloem’s of the regulatory world.  It thereby enjoys all the benefits of the double standard being applied by the financial regulators.  Whether the large Italian and Spanish banks are members of this club remains to be seen, but you might not want to bet your money on it.  That is because of the point we made earlier: if there isn’t enough money to save tiny Cyprus, there surely isn’t enough money to conduct a bigger country bailout.

You can see this best in a part of this crisis that has escaped public notice but is vitally important.  Last week the EU ministers announced that, deal or no deal, by Monday of this week Laiki Bank would no longer be eligible for financial help from the EU because it had run out of acceptable collateral to support the loans it needed.  Acceptable collateral, as far as government lending is concerned, is what are called “money good” assets – highly liquid, easily tradable, and readily priced securities like US Treasuries.

Laiki Bank is not alone in this problem; the ECB has already complained about the deteriorating quality of the collateral being offered it by banks from Italy, Spain, and elsewhere, and it has lowered its money good threshold several notches in order to keep these banks afloat in liquidity.  You might ask – where has all the liquidity gone, especially since the US Treasury is issuing over a trillion dollars in new debt every year?

The answer is simple.  The Federal Reserve is buying up its own country’s debt almost as fast as it is printed – to the tune of 77% of all new paper.  Most recently, the Fed has begun-announcing which bonds it wants to buy, by serial number, before the bond is even issued by the Treasury.  The same day the paper is issued, it is gobbled up by a large US bank and sold that afternoon to the Fed.  The Fed says it is buying up all this paper because it wants to help the economy recover, but this is a simple falsity that no one in the markets believes.

The Fed is buying this paper because it has to, because the usual buyers no longer have the money to purchase a trillion dollars of new Treasuries each year.  The Chinese government is no longer in the market because its trade surplus is shrinking, and the Japanese government is in an even worse situation – its trade surplus has switched to a deficit for the first time in half a century.  American fiduciaries are another source of buyers who are low on cash, because what Treasuries they do own pay close to zero percent interest.  The investing community has been starved for interest income for so long that it has no desire to buy a financial instrument that offers no yield.  Much better, they reason, to speculate in junk bonds, to the point now that we find junk bonds, even with a very high risk of default, replacing default-free Treasuries in the portfolios of many fiduciaries.  The spread between the yield on junk bonds to Treasury yields has shrunk to an all-time low as a consequence.

This is a highly unhealthy situation that cannot last, because at some point a corporate default will occur and scare the whole market, prompting a massive sell-off in junk bonds and a corresponding leap up in interest yield on these instruments.  Here is where it gets interesting.  There is a very big business at the TBTF banks – chiefly JP Morgan Chase, Citibank, and Bank of America (but also Goldman Sachs, Barclays, Deutsche Bank, HSBC, etc.) – in which the banks sell credit derivatives that act as insurance against just such a market sell-off of junk bonds.  These credit derivatives have collateral provisions embedded in the legal documentation; the beneficiary of the protection has the right to receive money-good collateral if the issuer of the derivative suffers a credit rating downgrade, which would almost certainly happen if one of these TBTF banks suddenly had an obligation to post tens of billions of dollars of collateral to support its credit derivatives portfolio.

This is exactly how AIG went under, or more precisely, why it was nationalized by the US government.  Since then, the credit derivatives market is even more concentrated than ever, with almost all of it in the hands of the big American banks.  In any significant market shortfall of collateral, these banks in particular would be exposed, even though they have access to the Federal Reserve discount window.  This gives them access to liquidity, but that is not the same as collateral – a bank cannot suddenly transfer its reserves at the Fed to another bank as easily as it can post Treasury securities, and it certainly can’t transfer its reserves to a corporation that is not a bank.

You might also want to remember something we learned from the MF Global collapse. Banks “rehypothecate” their assets, which means their Treasury holdings serve as collateral for more than one bank.  Sometimes three or more banks can be promised the same bit of collateral, unaware that the others have a legitimate claim on the collateral until all of them one day show up in a bankruptcy court as petitioners against a failed bank.  Nothing has been done to change this situation; we have no real knowledge of how high an inverse pyramid of claims is resting on top of the world’s shrinking pile of money-good collateral.

A problem of this sort erupting in the financial markets is less likely to occur than the collapse of Laiki Bank, which was well-telegraphed over a year ago.  But it is much more likely to occur than five years ago, when the financial crisis first hit.  The pool of money-good assets available to the global markets has been shrinking rapidly, to the point where $4 trillion of such liquidity at year end will be locked up on the Federal Reserve’s balance sheet (up from $800 billion at the start of the crisis).

The simple fact is, money-good assets are disappearing world-wide.  Collateral is in short supply everywhere.  The global financial system is more exposed to a collateral crisis than it was in 2008, and we are back to where we were five years ago at the height of the crisis.  Back then, investors learned it isn’t so important what your return on assets is.  It is more important that you receive a return of your assets when you want them back.  This is what the good people of Cyprus, and the customers of Cypriot banks, have just learned, and if we trust the regulators and our financial overlords at their word, we are all going to learn this lesson again sometime soon.