Beware Greeks bearing bonds

Many of you thought that last year's Greek debt crisis was "solved" with a bailout package from the European Union and the IMF in May 2010.  Guess what?  Without further help soon, the Greek government will have to default on some bonds.  Chicago booth finance professors John Cochrane and Anil Kashyap spell out in an op-ed in yesterday's WSJ what we should expect:

1. Greece cannot and will not (even if it could) pay off its current debt obligations (150% of GDP).  Some bondholders are going to get burned.  
2. Count some large European banks and the European Central Bank among the parties that will get burned, despite the so-called improvements in financial regulation that took place after the 2008 meltdown
3. Greece is a small country, so a Greek default would not be that big a deal.  But Portugal, Ireland, Spain and Italy are in basically the same boat and this is where it starts getting ugly.  Private individuals and corporations will (if they have not done so already) dump their bonds on governments and government-insured banks, thereby shifting the liabilities to the taxpayers in various European countries.  

To prevent a total meltdown and a new global financial crisis, Cochrane and Kashyap suggest the following --

Prepare for the worst. Europe needs to expunge the rot from its banks so that the inevitable write-downs do not imperil its financial system. Sovereign debt and sovereign exposure must face large capital buffers. Sovereign debt must be marked to market. Banks must run serious stress tests to find implicit sovereign exposure. Banks with inadequate capital must raise it, find buyers, or reorganize. If that means bailouts of "systemically important" banks, then governments must do so, face their taxpayers, and make their regulators explain how they let this happen.