Greek Debt Management Guy Thought His Partners In Obscuring The National Debt Would Be The Last People To Rip Him Off

Bloomberg's story about the Greece-Goldman swap-debt-whatever kaboodle, so let's talk about the philosophy of derivatives for a minute. First the story: Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start. On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said. There are at least three reasons to use derivatives. First you could be into some actual informed shifting of risks from those who want to pay to get rid of them to those willing to be paid to bear them, or from those who have Risk X and want Risk Y to those who etc. Boy are there a lot of textbooks that talk about this. And I suppose it even happens sometimes. You could imagine that a vanilla interest rate swap entered into by a corporation on its bonds or credit facility could qualify as this. I guess people who trade listed options to do covered-write strategies or speculate on takeovers or whatever fall in this category, maybe modulo the "informed." (Sometimes!) Then there's tax and regulatory arbitrage. This is time-honored and much of it, particularly the stuff with the best names, is focused on tax dodging, but there are also various other regimes - securities laws, accounting, whatever - that you might want to get around with derivatives. Paying $10 for CDS with a maximum payout of $10 purely to lower your capital requirements is a recent amusing/egregious example. The thing that wasn't mentioned in the CFA Level I derivatives primer is principal-agent arbitrage. This is ... first of all, let's say this isn't a derivatives issue, or a financial-industry issue, it's like a life issue. (Some would say it's why there's an M&A business, for instance.*) But it's also a derivatives issue! And you can see why if you're as baffled as I am by the Bloomberg story. So this:
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I can't even comprehend Bloomberg's story about the Greece-Goldman swap-debt-whatever kaboodle, so let's talk about the philosophy of derivatives for a minute. First the story:

Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start. On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.

There are at least three reasons to use derivatives. First you could be into some actual informed shifting of risks from those who want to pay to get rid of them to those willing to be paid to bear them, or from those who have Risk X and want Risk Y to those who etc. Boy are there a lot of textbooks that talk about this. And I suppose it even happens sometimes. You could imagine that a vanilla interest rate swap entered into by a corporation on its bonds or credit facility could qualify as this. I guess people who trade listed options to do covered-write strategies or speculate on takeovers or whatever fall in this category, maybe modulo the "informed." (Sometimes!)

Then there's tax and regulatory arbitrage. This is time-honored and much of it, particularly the stuff with the best names, is focused on tax dodging, but there are also various other regimes - securities laws, accounting, whatever - that you might want to get around with derivatives. Paying $10 for CDS with a maximum payout of $10 purely to lower your capital requirements is a recent amusing/egregious example.

The thing that wasn't mentioned in the CFA Level I derivatives primer is principal-agent arbitrage. This is ... first of all, let's say this isn't a derivatives issue, or a financial-industry issue, it's like a life issue. (Some would say it's why there's an M&A business, for instance.*)

But it's also a derivatives issue! And you can see why if you're as baffled as I am by the Bloomberg story. So this:

The derivative [GS salesperson] Loudiadis offered [Greece finance person] Sardelis in 2001 was also complex. Designed to provide a cheap way to repay 2.8 billion euros, the swap had a “teaser rate,” or a three-year grace period, after which Greece would have 15 years to repay Goldman Sachs, Sardelis said. All in, the deal appeared cheap to officials at the time, he said.

“We calculated that this had an extra cost above our normal funding cost on the yield curve of 15 basis points,” Sardelis said. ... Sardelis said he realized three months after the deal was signed that it was more complex than he appreciated. After the Sept. 11, 2001, attacks on the U.S., bond yields plunged as stock markets sold off worldwide. That caused a mark-to-market loss on the swap for Greece because of the formula used by Goldman Sachs to compute Greece’s repayments over time.

“If you calculated that when we did it, it looked very nice because the yield curve had a certain shape,” Sardelis said. “But after Sept. 11, we realized this would be the wrong formula. So after we discussed it with Goldman Sachs, we decided to change to a simpler formula.”

It goes on; note that "simpler" appears to have meant "more complicated." But note also the dynamic: this is not two market participants trying to rip each other off - which, for all its occasional faults, makes the world go round. It's GS trying to rip off Sardelis, and Sardelis trying to rip off his constituents. He was happy to be ripped off! The deal "appeared cheap" because he thought it only increased their funding costs by 15bps running. Well how is that cheap? Because, of course, in addition to costing more than a straight funding deal, it allowed Sardelis to hide the ball on how much debt he was running up.

Like many of the squickier deals, that has an element of regulatory arbitrage (where here the regulators were Maastricht gatekeepers who had set caps on debt levels but allowed off-market swaps to reduce them**), but also a significant element of constituent arbitrage. So, for instance, banks that use goofy noneconomic CDS contracts to reduce their capital requirements aren't just lowering their cost of funding, they're also reducing reported leverage ratios and so are able to tell investors that they're safer than they perhaps actually are. Similarly with Greece Maastricht bleep bloop blah blah, but you may have noticed even without leaving the comfort of these United States that voters prefer to be told soothing rather than terrifying things about the amount of their national debt.

I'm not a fan of people going around and saying that all financial derivatives are "complex" so no one should even try to understand them. One reason is that, out in the world, that doesn't work: it's all well and good to say "OOOH GOD COMPLEXITY" in a newspaper, but if you're trying to get a customer to do a deal, saying "you can't possibly understand this but it's good" is not generally a way to do it. So in fact those risk-transfer derivatives are designed to be relatively easy for customers to comprehend (like, covered calls, man), and even the regulatory-arbitrage trades are designed to be as comprehensible to clients as possible consistent with jumping through regulatory hurdles.

But the principal-agent derivatives are ... different. Where the primary goal of the trade is to create opacity, well, any bank will be happy to oblige. But if you're an agent looking for a trade that will bamboozle your principals, you can get as much bamboozlement as you want. Except that you'll probably be getting more than you think you are. And while your constituents may get bamboozled about whatever it is that you think you're hiding, it's a safe bet that you're getting bamboozled on the price.

Goldman Secret Greece Loan Reveals Sinners [Bloomberg]

* So the fact that merger targets are disproportionately run by 65-year-olds can be read that way. You could also imagine a related reading of all the weeping and wailing and gnashing of teeth over El Paso. Like "The question at this point is surely why any client would ever trust Goldman on anything." Sure, whatever, but another question is whether "clients" are hiring investment banks to, like, tell them whether mergers are "fair."

** Here a GS spokesperson, of all people, told Bloomberg "Greece actually executed the swap transactions to reduce its debt-to-gross-domestic-product ratio because all member states were required by the Maastricht Treaty to show an improvement in their public finances."

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