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07-07-2011, 11:21 AM
source: Nicholas Dunbar
18 February 2010
Risky Finance: Six and a half years ago Goldman Sachs found itself reading about a huge derivatives transaction that was meant to have been kept top secret. The story, which I published in Risk magazine in July 2003, detailed how the bank had used giant customised swap transactions to help Greece’s public debt management agency (PDMA) keep several billion euros in public borrowing out of the country’s public accounts.
Goldman dismissed the subsequent controversy over the revelations as a storm in a teacup. The PDMA’s then head, Christoforos Sardelis, wrote a letter to Risk saying the transaction was “based on prudent debt management rather than accounting concernsâ€. He argued that excessive euro depreciation in 2001 meant the swap was used “to stabilise the nominal debt value†of the debt, much of which was denominated in dollar and yen. Sardelis concluded: “It is hard to see why this merits cover story treatment.â€
Apart from a BBC radio interview, and desultory interest from a national newspaper, my story sat in plain sight, noticed only by derivatives cognoscenti.
Fast forward to the present. Greek debt is a hot topic and Goldman has suffered attacks on, among other things, its role in subprime credit derivatives and the bailout of U.S. insurance giant American International Group. But what gets lost amid the furore is the real context — a decade-long tango between financial innovators at investment banks and institutional clients, including governments, which were anxious to skirt various restrictions. The most significant restraints are accounting rules.
Since their invention in the 1980s, over-the-counter derivatives such as swaps have had legitimate uses. Take the cross-currency swap, the tool that Goldman adapted for Greece. Borrowing in a foreign currency can seem attractive when interest rates are comparatively low abroad, as they are in Japan. The catch is that if your home currency weakens, the size of your debt can balloon in size. A swap removes this risk by converting the future foreign currency payments of interest and principal into an obligation denominated in your home currency. The borrower has bought an instrument that turns foreign debt into domestic debt.
In the corporate world, accountants allow firms to treat liabilities that have been fully hedged from foreign to domestic currency as if they had been issued in their home currency. When the euro zone was conceived, its member states were already big borrowers in foreign currencies. It would have seemed odd for Eurostat, the European Union’s statistics agency and watchdog, not to allow the corporate accounting rules to apply. But, as so often happens, the gatekeeper got captured.
Suppose that you had borrowed $10 billion in U.S. dollars at a time when the dollar and euro were at parity. Now imagine a swap that did not use the prevailing market exchange rate, but instead assumed your home currency was stronger than it really was — say two dollars to one euro. That would shrink your $10 billion debt to $5 billion. In essence, that was how Goldman’s customised swap deal for Greece worked. The derivative, hatched in 2001, reduced Greece’s public debt by almost 3 billion euros. The balancing of this paper gain would come later — in a further series of swap payments to Goldman. The economic reality of the transaction was that Goldman was lending to the Greek government and getting paid back over 20 years.
Eurostat’s bean counters understood the implications of allowing Greece, and other EU states, legitimately to hide debt in this way from the wider world. As I discussed in the original Risk story, debt managers, presumably from the most indebted countries, successfully lobbied Eurostat to amend its rulebook making the disappearing trick possible. The willingness of Eurostat to sanction off-balance sheet transactions amid pressure from the EU’s weakest members exposes it as an irresponsible steward of accounting integrity.
It is unclear precisely how widely the transaction was known, or its implications understood. If the credit rating agencies were aware of it, as has been suggested, they certainly did not reflect Greece’s true off-balance-sheet debt position in their ratings.
Having made what amounted to a off-balance loan to Greece, what did Goldman do with it? Displaying its characteristic aversion to risk, the bank promptly bought credit protection from Irish-German bank Depfa, now part of Germany’s Hypo Real Estate.
In total, Greece’s paid an eye-watering 500 million euros for the instrument. The cost of the off-balance sheet loan was widely criticised in Greece after the Risk article. Shortly before the change of Greek government in 2005, Goldman restructured the deal, unwinding the Depfa credit protection and transferring the swap to the National Bank of Greece. In 2008, a securitisation transaction, called Titlos, reduced the cost of the original deal for Greece.
Clearly, investment banks are in the often lucrative business of advising clients how to use rules to their advantage. And with EU governance permitting Greece and other states to hobble Eurostat in the way they did, it was hard for Goldman’s publicity-shy derivatives innovators to resist applying their skills.
Better oversight of derivatives dealers is long overdue. But it makes even more sense to focus on client governance. In the 1990s, weak accounting rules contributed to a wave of derivatives scandals across corporate America. When these rules were tightened up — to exclude customised derivatives from hedge accounting and to enforce disclosure — the problem went away.
The same thing happened to European companies after the introduction of IFRS hedge accounting. Greece and Goldman simply took advantage of the then generous rules in the 2001 transaction. They would have to break the rules to do the same today.
The current outcry over Greece makes reform of EU governance mechanisms inevitable — if six and a half years overdue.
18 February 2010
Risky Finance: Six and a half years ago Goldman Sachs found itself reading about a huge derivatives transaction that was meant to have been kept top secret. The story, which I published in Risk magazine in July 2003, detailed how the bank had used giant customised swap transactions to help Greece’s public debt management agency (PDMA) keep several billion euros in public borrowing out of the country’s public accounts.
Goldman dismissed the subsequent controversy over the revelations as a storm in a teacup. The PDMA’s then head, Christoforos Sardelis, wrote a letter to Risk saying the transaction was “based on prudent debt management rather than accounting concernsâ€. He argued that excessive euro depreciation in 2001 meant the swap was used “to stabilise the nominal debt value†of the debt, much of which was denominated in dollar and yen. Sardelis concluded: “It is hard to see why this merits cover story treatment.â€
Apart from a BBC radio interview, and desultory interest from a national newspaper, my story sat in plain sight, noticed only by derivatives cognoscenti.
Fast forward to the present. Greek debt is a hot topic and Goldman has suffered attacks on, among other things, its role in subprime credit derivatives and the bailout of U.S. insurance giant American International Group. But what gets lost amid the furore is the real context — a decade-long tango between financial innovators at investment banks and institutional clients, including governments, which were anxious to skirt various restrictions. The most significant restraints are accounting rules.
Since their invention in the 1980s, over-the-counter derivatives such as swaps have had legitimate uses. Take the cross-currency swap, the tool that Goldman adapted for Greece. Borrowing in a foreign currency can seem attractive when interest rates are comparatively low abroad, as they are in Japan. The catch is that if your home currency weakens, the size of your debt can balloon in size. A swap removes this risk by converting the future foreign currency payments of interest and principal into an obligation denominated in your home currency. The borrower has bought an instrument that turns foreign debt into domestic debt.
In the corporate world, accountants allow firms to treat liabilities that have been fully hedged from foreign to domestic currency as if they had been issued in their home currency. When the euro zone was conceived, its member states were already big borrowers in foreign currencies. It would have seemed odd for Eurostat, the European Union’s statistics agency and watchdog, not to allow the corporate accounting rules to apply. But, as so often happens, the gatekeeper got captured.
Suppose that you had borrowed $10 billion in U.S. dollars at a time when the dollar and euro were at parity. Now imagine a swap that did not use the prevailing market exchange rate, but instead assumed your home currency was stronger than it really was — say two dollars to one euro. That would shrink your $10 billion debt to $5 billion. In essence, that was how Goldman’s customised swap deal for Greece worked. The derivative, hatched in 2001, reduced Greece’s public debt by almost 3 billion euros. The balancing of this paper gain would come later — in a further series of swap payments to Goldman. The economic reality of the transaction was that Goldman was lending to the Greek government and getting paid back over 20 years.
Eurostat’s bean counters understood the implications of allowing Greece, and other EU states, legitimately to hide debt in this way from the wider world. As I discussed in the original Risk story, debt managers, presumably from the most indebted countries, successfully lobbied Eurostat to amend its rulebook making the disappearing trick possible. The willingness of Eurostat to sanction off-balance sheet transactions amid pressure from the EU’s weakest members exposes it as an irresponsible steward of accounting integrity.
It is unclear precisely how widely the transaction was known, or its implications understood. If the credit rating agencies were aware of it, as has been suggested, they certainly did not reflect Greece’s true off-balance-sheet debt position in their ratings.
Having made what amounted to a off-balance loan to Greece, what did Goldman do with it? Displaying its characteristic aversion to risk, the bank promptly bought credit protection from Irish-German bank Depfa, now part of Germany’s Hypo Real Estate.
In total, Greece’s paid an eye-watering 500 million euros for the instrument. The cost of the off-balance sheet loan was widely criticised in Greece after the Risk article. Shortly before the change of Greek government in 2005, Goldman restructured the deal, unwinding the Depfa credit protection and transferring the swap to the National Bank of Greece. In 2008, a securitisation transaction, called Titlos, reduced the cost of the original deal for Greece.
Clearly, investment banks are in the often lucrative business of advising clients how to use rules to their advantage. And with EU governance permitting Greece and other states to hobble Eurostat in the way they did, it was hard for Goldman’s publicity-shy derivatives innovators to resist applying their skills.
Better oversight of derivatives dealers is long overdue. But it makes even more sense to focus on client governance. In the 1990s, weak accounting rules contributed to a wave of derivatives scandals across corporate America. When these rules were tightened up — to exclude customised derivatives from hedge accounting and to enforce disclosure — the problem went away.
The same thing happened to European companies after the introduction of IFRS hedge accounting. Greece and Goldman simply took advantage of the then generous rules in the 2001 transaction. They would have to break the rules to do the same today.
The current outcry over Greece makes reform of EU governance mechanisms inevitable — if six and a half years overdue.