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.

Rajan's thoughts on why economists failed to predict financial meltdown

Chicago Booth Professor Raghu Rajan with another stimulating blog post that basically asks, "If us economists are so smart, why did we not see this train wreck coming?"  Some have said it reflects lack of knowledge; others think our profession is too wedded to free markets with even a few questioning whether economists have become ethically challenged by being too close to big business. 

Rajan's take -- he sees three main causes: (1) forecasting turning points is not easy, (2) economists are over-specialized, and (3) all too many economists spend too much time on theoretical abstractions rather than the real world economy.  In other words we had a train wreck because the path ahead was very foggy and twisty, the personnel on board could only see their own roles and not the big picture, and the engineer thought autopilot could handle everything. 

Succinct explanation of 2008 financial crisis

Not from the official Financial Crisis Inquiry Commission, but from three of the commissioners in a one-page WSJ op-ed.  Here is the story in a nutshell:

1. Credit bubble in US and Europe
2. Housing bubble in US (and other places such as Spain)
3. Growth in subprime lending accompanied by lax regulation
4. Failures in credit rating as derivatives based on subprime mortgages get passed on as AAA
5. Broad range of financial institutions become exposed to risk of housing bubble bursting
6. And same institutions are way, way too highly leveraged
7. And they are way too interdependent, so when one firm goes under it creates big problems for counterparties
8. And since almost everyone has placed all their bets on a continued rise in home prices, we see
9. PANIC with failure or restructuring of household name financial institutions
10. Leading to questions about the health of almost all financial institutions, regardless of their exposure to toxic mortgages

The official commission report (all 545 pages of it) appears to place most of the blame on lax regulation and supervision (at least that is what I get from newspaper accounts and the executive summary).  Has the Fed -- the very agency that now has enhanced regulatory powers -- forgotten how its own low interest rate policies provided rocket fuel to this entire scenario?