Greece’s Goldman Sachs Swaps Spawn EU Dispute on Disclosure

By Elisa Martinuzzi and Gavin Finch
Feb. 16 (Bloomberg) -- A dispute is unfolding about how long European Union officials have known that Greece used derivatives to conceal its growing budget deficit.
Greece turned to Goldman Sachs Group Inc. in 2002, just after adopting the euro, to get $1 billion in funding through a swap on $10 billion of debt, Christoforos Sardelis, head of Greece’s Public Debt Management Agency at the time, said in an interview last week. Eurostat, the EU’s statistics office, was aware of the plan, he said. Risk Magazine also reported on the swap in July 2003.
"Eurostat was not until recently aware of this alleged currency swap transaction made by Greece," spokesman Johan Wullt said by e-mail yesterday.
The disagreement about who knew what and when comes amid the worst crisis in the euro’s 11-year history. The existence of the swaps, which allowed Greece to delay payments and shrink its reported budget deficit, is fueling questions about whether Greece used the contracts to mask the fact it was struggling to comply with the currency’s membership criteria from the early days of its entry into the eurozone.
"Greece falsified deficit statistics, and that can’t be legal," said Wolfgang Gerke, president of the Bavarian Center of Finance in Munich and honorary professor at the European School of Business. "Greece needs to be kicked out of the EU because otherwise there will be new copycats, and that could lead to the next catastrophe on financial markets."
EU regulators pressed Greece yesterday to disclose details of currency swaps after an inquiry by the country’s finance ministry uncovered a series of agreements with banks that it may have used to conceal mounting debt.

Legal ‘At the Time’

One issue is whether Greece was legally obliged at the time to notify Eurostat. Finance Minister George Papaconstantinou said yesterday the use of swaps was "at the time legal." The contracts are now no longer legal, and Greece doesn’t use them, he said during a question-and-answer session at a conference in Brussels yesterday.
Eurostat has required information about swaps since 2007, Wullt said. The watchdog doesn’t need to be notified of individual deals, he added.
"It is legitimate if the underlying exchange rates and the interest rates of such swaps are calculated from the observed market rates and this is something we will have to assess,"
European Commission spokesman Amadeu Altafaj said yesterday.
EU regulators have blessed the use of derivatives contracts to let countries curb their deficits. In 2001, the Commission, the EU’s regulatory arm, approved Italy’s use of derivatives that helped to reduce its budget deficit in 1997. Italy swapped fixed payments on a three-year, yen-denominated bond in 1996, for a floating rate, allowing it to temporarily cut the amount of interest paid on the debt.

‘Lurking in the Shadows’

European politicians this week criticized New York-based Goldman Sachs for arranging the Greek swap and are pressing for more disclosure. Chancellor Angela Merkel’s Christian Democrats aim to push for new rules that will force euro-region nations and banks to disclose bond swaps that have an impact on public finances, financial affairs spokesman Michael Meister said yesterday.
"Goldman Sachs broke the spirit of the Maastricht Treaty, though it is not certain it broke the law," Meister said in an interview yesterday. "What is certain is that we must never leave this kind of thing lurking in the shadows again."
Joanna Carss, a London-based spokeswoman for Goldman Sachs, the most profitable securities firm in Wall Street history, declined to comment.
Luxembourg’s Jean-Claude Juncker said euro-area finance ministers discussed Goldman Sachs’s and Greece’s use of derivatives on the fringes of a meeting yesterday in Brussels.

Cross-Currency Swap

The Goldman Sachs transaction consisted of a cross-currency swap of about $10 billion of debt issued by Greece in dollars and yen, Sardelis said. That was swapped into euros using a historical exchange rate, a mechanism that implied a reduction in debt and generated about $1 billion of funding, he added.
Sardelis declined to give specifics on by how much the swap reduced the country’s reported deficit or debt.
Greece, whose burgeoning budget deficit caused it to fail the criteria for joining the single European currency in 1999, joined the euro in 2001. Member nations must keep deficits at less than 3 percent of gross domestic product and trim national debt to less than 60 percent of GDP under the pact.
Greek Prime Minister George Papandreou, who came to power in October, more than tripled the country’s 2009 deficit estimate to 12.7 percent, and officials last month pledged to provide more reliable statistics after the EU complained of "severe irregularities" in the nation’s economic data.

By Elisa Martinuzzi
Feb. 17 (Bloomberg) -- Goldman Sachs Group Inc. managed $15 billion of bond sales for Greece after arranging a currency swap that allowed the government to hide the extent of its deficit.
No mention was made of the swap in sales documents for the securities in at least six of the 10 sales the bank arranged for Greece since the transaction, according to a review of the prospectuses by Bloomberg. The New York-based firm helped Greece raise $1 billion of off-balance-sheet funding in 2002 through the swap, which European Union regulators said they knew nothing about until recent days.
Failing to disclose the swap may have allowed Goldman, a co-lead manager on many of the sales, other underwriters and Greece to get a better price for the securities, said Bill Blain, co-head of fixed income at Matrix Corporate Capital LLP, a London-based broker and fund manager.
"The price of bonds should reflect the reality of Greece’s finances," Blain said. "If a bank was selling them to investors on the basis of publicly available information, and they were aware that information was incorrect, then investors have been fooled."
Michael DuVally, a spokesman at Goldman Sachs in New York, declined to comment.


Legal ‘At the Time’

Goldman Sachs, Wall Street’s most profitable securities firm, is being criticized by European politicians including Germany’s ruling Christian Democrats, who have questioned whether the firm helped Greece hide its deficit to comply with the currency’s membership criteria. Greece is also being faulted by fellow euro-region countries for failing to disclose the swaps to EU regulators.
The swaps used by Greece to manage debt were "at the time legal," Greek Finance Minister George Papaconstantinou said on Feb. 15. The government doesn’t use the swaps now, he said.
Eurostat, the EU’s statistics office, this week ordered Greece to hand over information on the swaps transactions by the end of this week in an investigation that may extend to other EU countries.
Goldman Sachs earned about 735 million euros ($1 billion) underwriting Greek government bonds since 2002, data compiled by Bloomberg show. Goldman Sachs underwrote 10 bond sales.
Prospectuses for six of them, obtained by Bloomberg, contain no mention of the swaps. The other four couldn’t be obtained.

‘Fear the Worst’

The yield on Greek 10-year government bonds jumped to as much as 7.2 percent on Jan. 28 amid the worst crisis in the euro’s 11-year history. The premium, or spread, investors demand to hold Greek 10-year notes instead of German bunds, Europe’s benchmark government securities, widened yesterday by 18 basis points to 323 basis points.
The spread reached 396 basis points last month, the most since the year before the euro’s debut in 1999, compared with an average of 57 basis points in the past decade. A basis point is
0.01 percentage point.
"When people start to fear that the numbers aren’t accurate, they fear the worst," said Simon Johnson, a former International Monetary Fund chief economist who is now a professor at the Massachusetts Institute of Technology’s Sloan School of Management in Cambridge, Massachusetts.

No ‘Smoking Gun’

Goldman could face legal liability "if it could be established that they were knowingly hiding risk, and therefore knew or had reason to know that the bond disclosure documents were misleading," said Thomas Hazen, a law professor at the University of North Carolina at Chapel Hill. "But that would be a tough hill to climb, in terms of burden of proof. There’d have to be some sort of smoking-gun memo."
The swap enabled Greece to improve its budget and deficit and meet a target needed to remain within the region’s single currency. Knowledge of their existence may have changed investors’ perception of the risk associated with Greece, and the price they may have been willing to pay for the country’s securities.
"From what we know, this is an egregious example of a conflict of interest" for Goldman Sachs, MIT’s Johnson said.
"Even if the deal had been authorized, it doesn’t let them off the hook."
A Greek government inquiry this month identified a series of swaps agreements with securities firms that allowed the country to hide its mounting deficit. Greece used the swaps to defer interest payments, causing "long-term damage" to the Greek state, according to the Feb. 1 document, commissioned by the Finance Ministry.

Cross-Currency Swap

European Union officials said this week they only recently became aware of the transaction with Goldman. The swaps don’t necessarily break EU rules, European Commission spokesman Amadeu Altafaj told reporters in Brussels on Feb. 15.
The transaction with Goldman consisted of a cross-currency swap of about $10 billion of debt issued by Greece in dollars and yen, according to Christoforos Sardelis, head of Greece’s Public Debt Management Agency at the time.
That was swapped into euros using a historical exchange rate, a mechanism that implied a reduction in debt and generated about $1 billion in an up-front payment from Goldman to Greece, Sardelis said. He declined to give specifics on how the swap affected the country’s deficit or debt.
European politicians such as Luxembourg Treasury Minister Jean-Claude Juncker this week criticized Goldman Sachs for arranging the Greek swap and are pressing the firm and Greece for more disclosure. Chancellor Angela Merkel’s Christian Democrats aim to push for new rules that will force euro-region nations and banks to disclose bond swaps that have an impact on public finances, financial affairs spokesman Michael Meister said.
"Investment banks are guilty of being part of a wider collusion that fudged the numbers to make the euro look like a working currency union," said Matrix’s Blain. "The bottom line is foreign exchange and bond investors bought something sellers knew not to be the case."

‘The risk of [Greek] contagion is low but…’


Posted by Stacy-Marie Ishmael on Feb 17 17:14.


Brian Yelvington, formerly of CreditSights and now director of fixed income
research at Knight Libertas, on Tuesday published his thoughts on the
possibility of systemic contagion in the eurozone.
By his reckoning:

We believe a transmission mechanism exists between Euro
sovereign risks and the global financial system. The possibility of
Greece (or another problem country) becoming a systemic threat is a
nonzero probability. However, we do feel that central banks across the
globe have their eyes wide open at the problem, and this diminishes the
probability that such contagion could occur

That said, in the event that “non-zero” probability turns into
reality, Yelvington believes eurozone banks face two main problems, as
far as the possibility — real or imagined — of spillover from the
unfolding Greek drama is concerned:

1) the amount of ratings arbitrage they have with respect to same currency sovereign credit risk
2) the enormous amounts of emerging markets lending they engage in – some 70% of the world’s total according to the BIS.

On the first point (emphasis FT Alphaville’s):

. . . under Basel II guidelines, a financial institution
that went long same currency sovereign risk benefitted from low risk
weightings. This caused a large base of natural appetite for Euro area
sovereign risk. As downgrades and mark-to-market losses have
mounted, there is no doubt some need to shed this risk. To our
reckoning, this was no small part of the credit undulations over the
past month as banks have shed assets.

The need to shed these assets is obvious. Higher risk
weightings damage capital ratios and wider spreads cause losses –
further damaging capital ratios. This key link between the
sovereign risk and the financial institutions of the Euro area are the
largest cause for concern with respect to the problem becoming a
systemic issue that would cause global financial problems.
Recall in the credit crisis, a crisis of confidence ensued whereby
levered players were shut out of interbank repo markets and some
ultimately failed. Under a fractional banking system all that is
required to bring down a financial institution is a similar crisis of
confidence.

As for the second, Yelvington published the follow table to
demonstrate the heavy exposure of European banks to emerging markets
(click to enlarge):



Yelvington highlighted (in yellow, above) the fact that European
banks have more than 70 per cent of the $4,300bn in total exposure to
developing country lending risks.
As he put it:

This exposure to emerging market risks can only serve to
cause more worry about interbank lending in our view – and raise the
possibility of a crisis of confidence for the EMU bank region. A spike
in LIBOR-OIS owing to fears of bank failure in Europe would have
similar impacts upon liquidity and leverage as the latter part of
2008/early 2009.

But the most interesting aspect of his note were his comments on the
hot-button issue of sovereign CDS. Yelvington’s clients have been
clamouring to know just what those credit ‘default’ swaps actually
imply:

We are also often asked about the implied probabilities
of default embedded in Euro area spreads – specifically with respect to
CDS. While it is true that given a recovery rate and spread, default
probabilities are easy to map out using a simple risk formula. For
instance, Greece’s recent 360bp spread on 5Y CDS maps to a cumulative
risk neutral default probability of 26.6% assuming a 40% recovery rate.
The question is always phrased something like “do people really
believe Greece will default with that level of certainty?” The answer,
however, is a mix of influences. For one thing, CDS are also
used to invest on the relative value of credit. No doubt a portion of
the spread for Greece not only reflects the default risk, but also the
risks inherent in the uncertainty surrounding the resolve in the
situation. Speculators and hedgers alike are not merely hoping
for a default. There are a myriad of ways short of default that can
monetize their position. CDS is merely the chosen instrument for
shorting credit (and oftentimes going long as well) owing to its lack
of dependence on the repo market and non-funded (or nominally funded)
nature.