Friday, December 17, 2010

John Cochrane On The Euro & European Bank/Country Bailouts

Back on December 2nd, University of Chicago finance professor John Cochrane wrote a scintillating piece in the Wall Street Journal entitled 'Contagion' and Other Euro Myths.

I appreciate Cochrane's insightful, clear analyses of global economic and financial phenomena, and his recent piece is no exception.

I have long contended that much of the damage of the recent global financial sector crisis was a function of poor balance sheet management, evidenced by over-reliance on short-term borrowing, and Cochrane confirms this. He writes,

"The big culprit in all of this is short-term debt. There would be no crises if governments had issued long-term debt to match long-term plans to repay that debt.

Governments like to roll over short-term debt for exactly the same reasons Bear Stearns and Lehman Brothers did: It looks cheaper- at least until the crisis comes. But buying insurance is always expensive."

Cochrane correctly notes how short-term financing decisions are, in effect, a bet on an ability to rely on markets for continuing pricing and demand. Which is, of course, mistaken. Just like the pricing of mortgage-backed assets during the 2007-08 crisis, sovereign debt becomes problematic when issuers have assumed that markets will always have an appetite for roll-over issuances at affordable prices. In that crisis, you may recall, special-purpose SIVs backed by Citigroup had to be bailed out by the parent when they failed to roll over their short term borrowings due to the unexpected plunge in the assets held in the vehicles.

It's always the same. Funding decisions in low-rate environments veer dangerously short-term in nature, then become problematic as frequent trips to the market make the entity hostage to volatile investor sentiments.

Cochrane makes more excellent points in his piece. He notes that it would be better for Europe's national governments to directly and explicitly bail out their banks, rather than unnecessarily involve the currency union in bailout out an entire country. He further notes that either a blanket, "ironclad guarantee," or clear rejection of any bailout, would calm markets. By choosing the middle path, taking a case-by-case approach, the EU and IMF have magnified investor uncertainty and market volatility.

Finally, Cochrane draws obvious parallels between the European debt crisis and a looming potential one in the US. Specifically, he notes the financial instability of many US states, and the Fed's similarity to European banks in loading up on short-term financing, via QE2. And, similiarly to the ECB, which is buying suspect European sovereign debt, the Fed is buying questionably-valued paper, too.

Cochrane dispels the myth of contagion in Europe, replacing it with sound analysis of the true causes of the debacle, and better alternatives to resolve it.

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