September 20, 2021

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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This Is The Last Greek CDS Post Ever*

There's that famous scene in Liar's Poker - are there non-famous scenes in Liar's Poker? - where the much maligned equity department sends a program trader to impress Michael Lewis's jackass fellow Salomon trainees with his brilliance. It does not work: He lectured on his specialty. Then he opened the floor to questions. An M.B.A. from Chicago named Franky Simon moved in for the kill. "When you trade equity options," asked my friend Franky, "do you hedge your gamma and theta or just your delta? And if you don't hedge your gamma and theta, why not?" The equity options specialist nodded for about ten seconds. I'm not sure he even understood the words. ... The options trader lamely tried to laugh himself out of his hole. "You know," he said, "I don't know the answer. That's probably why I don't have trouble trading. I'll find out and come back tomorrow. I'm not really up on options theory." "That," said Franky, "is why you are in equities." This is totes unfair to the actual equity vol traders I know, but I kind of felt like that guy after talking to a CDS lawyer yesterday about this craziness in Greece. It went something like this: Me: As an equity derivatives guy, I expect derivatives to transform into derivatives on whatever their underlying transforms into. And I'm troubled by them not doing that. Lawyer: You should not be troubled by the concept of cheapest to deliver. Yeah fair! That's the thing about CDS. Dopes like me think of it as just a rough proxy for default risk but when things get real like with Greece it turns into a cheapest to deliver convexity play and then I slink away in embarrassment. But yeah, as a matter of rough justice, if you can go be opportunistic about finding the cheapest to deliver bond, Greece can go be crappy about leaving you with only expensive to deliver bonds. I guess.

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One Last Greek CDS Post Before It All Goes Poof

One of the side benefits of Greece taking whatever somewhat irreversible steps it is now taking is that something will happen to CDS written on existing Greek debt and that will mean that we can stop talking about what will happen to CDS written on existing Greek debt and start talking about more interesting things like quasi-CDS written by the EFSF on shaky Eurozone government debt. For now, though, we've got at least a few more weeks of surprisingly and unsurprisingly ill-informed fretting that triggering the $4bn of Greek CDS will Bring Down The Entire Global Financial System. That seems sort of silly because notionals aren't that big, mark-to-market collateral is mostly being posted, and at this point the marks are pretty close to what you'll get from Greece so it doesn't look like there's tons of unknown unrecognized losses lurking out there. On the other hand, we're mostly through with the speculation that not triggering Greek CDS will Prove That CDS Is Worthless and thereby Bring Down The Entire Global Financial System, so that's nice. The reason that's mostly over is that it sure looks like Greek CDS will in fact trigger, as Athens has moved to adopt a collective action clause that will flip the Greek restructuring from "voluntary, heh heh heh" to "involuntary" and thus trigger the ISDA restructuring event definition. You can argue that the mechanics of the cash settlement auction will mildly screw CDS holders but I'm not so sure, and in any case this is pretty solidly in the category of derivatives nerdery rather than Bring Down The etc.

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So Maybe Greek CDS Won't Be Fine, Who Knows, I Give Up

ISDA decided today that there has been no credit event for purposes of Greek CDS. Obvs! And by "obvs!" I mean what I said the other day, which is that with 100% certainty there's been no credit event yet, but with 100% certainty there will be, so everyone should just chill out. Except that it seems like that last part may be wrong. So go ahead and panic. I used to make convertible bonds and some of my time was spent answering questions about what happened to things upon Events. The most popular was: what happens after a merger? If you have a convertible that converts into 10 shares of XYZ stock, but now XYZ is being acquired and each share of XYZ is being acquired for $30 in cash and 4.5 shares of PQR stock and a pony - what happens to the convertible? And the answer I would give usually started with "don't trouble your pretty little head about it." Like, it's fine: you have a convertible that converts into 10 Things, and before the merger each Thing was an XYZ share, and after each Thing is exactly what an XYZ share transformed into, so you convert into $300 and 45 PQR shares and 10 ponies. It just works because it has to work. Economic interests follow without interruption from changes in form; derivative securities poof into derivatives of things that the underlying poofs into. There is no arbitrage! That assumption is central to doing any sort of derivative work, and it spoiled me a bit. Sometimes people would come up with more complicated scenarios involving dividends, multiple-step transactions, weird splits and spinoffs and sales, etc. etc. And I would generally start from the bias "it has to work, so I am sure the document written in the way that works." Where "works" means "the economics and intent of the trade are preserved after the change in form." But of course the document was written by humans, often specifically me, and those humans, often including me, are fallible. So there may well be documents from my former line of work that don't "work" in the sense that an issuer could do some structural tricks that would screw holders out of their economics - where the derivative doesn't follow the underlying everywhere it might go. These tricks are unlikely enough that I don't lose sleep over them. You can't predict everything. I sort of assumed that Greek CDS also had to just work but here is Felix Salmon at Reuters saying no. Lisa Pollack at FT Alphaville said something similar a week ago but I could not fathom that she meant it so I read it to mean something else. But she means it, and Felix does too. Go read it but the basic gist of this theory is:

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This Is Really Only The "Second" Greek Bailout?

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Mandatory Greek CDS Post

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So Maybe Greek CDS Will Be More Than Fine?

Gaaaaaaaaaaaaaaaah Greece. Okay so all systems appear to be go on the Greek debt exchange, which means its time to decide What This Means, and, I just. Really. Greece. Come on. All I want is to talk about 13D reporting requirements, and now I have to pay attention to Portugal? No. Just no.* Still here is arguably a fun factoid: On Wednesday, Swiss bank UBS AG started quoting a "gray market" in new Greek sovereign bonds ... using as a guide details of the debt swap Greece has put on the table for private investors to accept until Thursday evening. The "bid" price for a batch of future Greek bonds due in 2042, or the highest price the dealer was willing to pay, was around 15 cents on the dollar; the "offer" price, or the most the dealer was willing to sell at, was 17 cents on the dollar, the first person said. ... The prices quoted by UBS imply that losses private creditors to Greece will take are more like 79% of face value, not the original haircut of 70-75% many had expected. Yeah but. If you believe this horrible CDS mechanics stuff that various people including me have been yammering about for weeks - here is the best explanation - that means that if for some reason you had the foresight to be long Greek bonds and hold CDS against them you'd end up with a package worth (1) 21 on the bonds and (2) 83 on the CDS (assuming that the 17 offer for the 2042 bonds represents a real price for the cheapest-to-deliver new bond in the Greek auction) for (3) 104 total which is (4) more than par, so you win this particular game, yay. Which you were at risk of losing - a week ago one of our fearless commenters spotted the longest new bonds at 25ish vs. 24ish for the old-bond-y package, for a total of 99 for the hedged holder - losing 1 point versus par.**

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