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It's All Greek to Me FAQ, Part II: Euroliar Loans

posted by Anna Gelpern

While they hold some allure for the pointy-headed company I normally keep, the old fixing-floating-IMF-bailout handwringing detailed in my last post is nothing to the titillation of the Goldman-CDS angle on the Greek drama.  FAQ series continues with a focus on lying.

Who lied, to whom, about what?

The accusation is that Greek officials reported their debt figures to the European authorities, and by implication, to the world, in a misleading fashion.  I mentioned in my last post that Euro area countries promise to strive for specific deficit and debt targets.  Until Europe’s statistical reporting rules changed in 2005, Greece appears to have availed itself of their flexibility to move some debt off balance sheet.  They are accused of having done so using, among other things, reasonably straightforward currency and interest rate swaps.   The swap rates were “off-market”, calculated to deliver Greece cash up front in exchange for more cash in the future, a.k.a., to act like a loan without counting as a loan.  This was first detailed in Risk back in 2003; Der Spiegel revived the lies-in-general and the lies-with-derivatives narratives as things blew up in recent months. My colleague Ken Anderson was among the first to put this reporting on lawyers’ radar screens, and has been deep and nuanced ever since.

The more subtle accusation of lying goes against Goldman Sachs, which helped arrange the swaps.  First, they may have aided and abetted the Greek lies.  Second, if Goldman had private knowledge that Greece was in much worse shape than its public appearance would suggest, and used that knowledge to “bet against” Greece in the derivatives market, they committed a separate bad act of their own.  However, timing could be important:  did they use inside information about lies in 2005 to "short" Greece in 2010?

This is obscene and unheard of!  How can we tolerate such behavior in our midst?

Obscene, maybe.  But hardly unheard of.  The FT and Reuters recently ran overviews of derivatives and securitizations used by other Euro area countries (including Germany) to work around various virtue targets.  Felix Salmon mentions in passing that Germany securitized its holdings of Russian government debt at a hefty spread over Russia's borrowing cost a few years ago, apparently to avoid on-budget borrowing and Maastricht discomfort.  And while Europeans used derivatives to perfume their liabilities, other countries--famously Thailand--used them to puff up their central bank assets.  No child was left behind, and it has been good for the investment banking business.  Even so, Argentina was ahead of the curve in figuring out how to burnish statistics without paying a penny to Goldman. (See also this one from 1976.  Paul Volcker is right, innovation is a sham.)

Governments are incorrigible fraudsters.  Should we take away their sovereign immunity?

Nah.  Private Japanese banks massaged their bad loan books in the 1990s using derivatives specially designed for them by foreign banks … that got slammed when the authorities discovered that “gambling was going on.”  Jeff Skilling is back in the limelight. And in the normal-but-deeply-ironic category, SIGTARP reports that the bulk of AIG's CDS writing adventures help European banks get capital relief under Basel rules.

More disturbing, it is easy enough to construct a category of deadbeat countries that cannot manage their way out of the fiscal paper bag, until yours ends up among them, and then it becomes all about democracy.  More on democracy in that Ecuador post I keep promising (keep clicking through here to learn more!).  But surely it is part of the sovereign credit decision, just as management quality is for equities, non?

I hear the Fed, the S.E.C., and all of Europe are investigating.  What, how, on what basis?

The Fed is responsible for Goldman because it became a bank holding company in the fall of 2008.  Presumably they will look for fraud, mismanagement, and any threats to safety and soundness.  The S.E.C. might investigate fraud and allegations of trading on inside information.  The Europeans have a host of statistical compliance, plus all the securities and safety and soundness issues to worry about.  But query who would expose both Goldman and Greece without getting the green light from both finance and foreign policy authorities, and an exit strategy for both.

Beyond fraudsters, someone must worry about the implications of the affair for the system as a whole.  For even if the investigators uncover evil, they may feel powerless to sanction it because the world economy and financial markets are still in a fragile state.  The Fed, the ECB and the IMF are probably thinking along these lines, but so far there is no straightforward regulatory path to address these concerns.  We regulate systemic risk by proxy and euphemism.

Wait, Are You Defending Both Goldman and Greece?

In a manner of speaking.  The Euroliar loan imbroglio is a symptom of the bubble-bust cycle and a cautionary tale about fixating on rules and targets.  At the peak of the bubble, lies are either invisible, or more likely, look unimportant. 

"The system did it!"  This is a total cop-out.

This is a partial cop-out.  I recently served on a commission where we struggled mightily with the politics of bubble-bust regulation; I do not think we fixed the problem.  Last week I was struck by the extent to which some economists at the FCIC forum invoked the need for a bad guy narrative.  And there are plenty of bad guys here, and they should be slammed.  But the bad guy narrative--Greece and Goldman alike--lets feckless-rule writers, forbearers, and bubble-boosters act sanctimonious, and tells citizens to go back to sleep now that bad guys are locked up.  Unless we revisit the incentives to lie, new financial products will keep springing up to serve as delivery vehicles for more lies.  It's an old and boring argument--in other words, a cop-out.

Aha!  Financial Products!  Are you for or against Credit Default Swaps?

I am not one to say that guns don’t kill people.  But the factual predicate for the Greek CDS controversy looks thin for now.  Felix Salmon has persuasive reporting on the topic here and elsewhere in his CDS Demonization Watch series; Stephen and Kim Krawiec have lent law gravitas to this telling of the CDS and broader derivatives story.  I will not repeat, but want to mull a minute on why it would not go away.

It is true that the existence of a bigger, more liquid CDS market makes it easier for people to express negative views on a credit—here Greece.  This could help drive up the spreads and have all kinds of feedback mechanisms thanks to stuff like collateral requirements.  Felix convinces me that the availability of CDS insurance today may make the difference between Greece having market access at a high price, and not at all.  Related, several economists at the FCIC forum (no I have not seen any other movies) revived the argument that having a bigger, deeper CDS market earlier might make bubbles smaller/prevent their formation (more people get negative earlier).  The problem is that CDS emerge “at the worst time,” just as the bubble is bursting.   Indeed they do, because you need enough downers demanding protection to have a market, and downers are scarce as the bubble inflates.  A counterargument is that the bubble might have gotten even bigger without CDS.

Yet I stop short of concluding that CDS demonizers are ignorant or cynical.  CDS are part of the embedded leverage and stratospheric growth story that has made finance too big for our collective mental and political disk space.  I do not think that product banishment helps fix this problem; like bad guys, it can be a distraction.  That is why I would sooner go with Volcker and Turner.  They too propose blunt tools, but are much more self-aware.

So what should happen?

After four nominations, Claude Rains should finally get his Oscar for lifetime achievement in the portrayal of financial regulation.


"The more subtle accusation of lying goes against Goldman Sachs, which helped arrange the swaps".
There is another more subtle accusation around: EU institutions knew that Greece, and before Italy, was fudging its accounts to get into Euro therefore benefiting of lower interest rate of euro-zone debt. The point is that after doing that and putting some debt off balance sheet, the same debt has resulted to be far higher and now Greece, and to some extent Italy, pay far higher interest rate than Germany on its debt.
It was a short term view and benefit but I still contend that EU institution knew about it (read Gustavo Piga's report at http://www.zerohedge.com/article/step-aside-greece-how-gustavo-piga-exposed-europes-enron-2001-focusing-italys-libor-minus-16).

Indeed to M.G. ... and another vote for Claude Rains.

Greece and Spain won't pay back. This was a calculated Risk, and a Lesson for the Banking System. What is happening in Greece, is a very well orchestrated show, to get granted €110bn aid, to avert meltdown. A new deception compared with old Trojan Horse. The only thing Germans can do is:
REPOSSESS 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
U.S.A must REPOSSESS 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.
Greece’s problem is too much debt. Greece has a budget deficit of 12.7% of GDP – meaning that the country is spending 12.7% more than the value of one year’s economic output.
Greece is no different to a serial credit card borrower who can’t pay back his loans. But just like a serial credit card borrower, as long as Greece keeps relying on borrowed money to fund itself, the problem won’t go away. It will just get worse.
But don't worry; the ECB, the Fed or both will print the money.
And all of us will share the pain, with our hard-earned money.
Bad is never good until worse happens.

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