Getting Greeced

The following is an excellent excerpt from the book “THE DEVIL’S DERIVATIVES: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready To Do It Again” by Nicholas Dunbar from Chapter One: “The Bets That Made Banking Sexy” on page 18 and I quote: “Getting Greeced – On the other side of the divide, one investment bank in particular had a vision.  It went far beyond the commercial banking notion of shedding credit risk from the balance sheet, toward using derivatives as a means of seizing control of the loan market.

Around the same time that I met [Marc] Shapiro and [Peter] Hancock, I was invited to a press party on London’s Fleet Street.  It took place in the sumptuous art deco lobby of what had once been the headquarters of the United Kingdom’s Daily Express newspaper.  After the exodus of print publishing from Fleet Street, the Express building had been purchased by Goldman Sachs.  Most of the journalists present still thought of the investment bank in terms of its stellar reputation for advising companies and governments on privatizations and takeovers, but I was introduced to a man lurking on the sidelines, a rising star at the firm.  Michael Sherwood had just become European head of FICC (fixed income, currencies, and commodities), perhaps Goldman’s least understood but most profitable division. Trading–derivatives in particular–was his forte.

When credit derivatives were invented in the mid-1990s, Goldman held back.  But once the utility of the new tools had been demonstrated, Sherwood became the firm’s leading default swap visionary.  The newly invented tool was going to lead to the “derivatization of credit,” he would tell colleagues.  He believed the market approach to buying, selling, and owning corporate bonds had a massive disadvantage to the much more transparent markets in equities.  If you like the prospects of a company, say, Walmart, an equity trader only has to look at one type of security: Walmart’s stock.  In fixed income, a company might have hundreds of different bonds in the market payable in different currencies, and with myriad maturity dates and interest profiles.  Which one should you buy or sell?  You had to be a geek to figure it out.

With credit default swaps, all that detail could be stripped away.  As with equities, there was a single “reference entity” or “name,” Walmart Inc., whose potential for default drove the price of the swap contract.  Better still, the default swap distilled this crucial credit information out of the hundreds of Walmart bonds.   And for Sherwood, information was power.  He realized that by combining trading in credit default swaps and corporate bonds on the same desk, Goldman would have its finger on the pulse of the world’s biggest corporate borrowers: not only could Goldman control its own exposure, but it would control its clients’ access to the market for credit.

Having “broken down the walls” in this way in 1999, Sherwood duly paved the way for his firm’s FICC division to power to the top, taking him to the level of vice-chairman.  But to Sherwood’s irritation, his management innovation would reveal itself early on, with a huge but highly controversial deal that stunned competitors.  The deal was hatched back in 2000 by Sherwood and his head of sales, Addy Loudiadis.  Rather than a corporate borrower, the deal involved a spendthrift nation that wanted to fiddle the membership rules of an exclusive club of high-performing countries: the Eurozone.  As Citibank discovered in the late 1980s, and Peter Hancock learned through J.P. Morgan’s Korean bank difficulties, a currency crisis can have the same impact on foreign lenders as a corporate default.  That is why weakening foreign exchange rates are a good early warning system that a country and its banking institutions might be able to repay their debts.

When the strong economies of northern Europe created a single currency in the 1990s, they threw out this market-based warning system for detecting spendthrifts.  Instead, the Maastricht Treaty that created Europe’s single currency contained strict rules designed to prevent countries that sought to enjoy the currency’s benefits from overspending.   And these benefits were substantial: the possibility of borrowing money at virtually the same cheap rate as that paragon of fiscal recitude, Germany.

Just as investors in private companies depend on accountants to verify corporate borrowing and expenditure, the European Union (EU) created Eurostat, a Brussels-based statistical agency whose job it was to check national accounts.  But for countries where deficit spending is everyday political expediency, rules are made to be broken.  And fatally for the EU, the feel-good nature of monetary union was not backed up with credible enforcement.

Visiting a government ministry in Athens can feel like a trip back in time.  Offices without air-conditioning have windows flung open to the sounds and smells of gridlocked streets below.   Chair-smoking bureaucrats are hunched behind desks, their in-boxes overflowing as they struggle with long-obsolete computers.  Even the Greeks have a hard time tracking state expenditures, as Eurostat memos plaintively acknowledged.  In 2000, Greece was in breach of the Maastricht rules, but Brussels chose to show the newest incoming member of the Eurozone a degree of indulgence if its government produced budget forecasts projecting that debt and deficit ratios would steadily decline over the next four years.  Forecasting those numbers was easy enough: hitting them was close to impossible.  It would be politically toxic for the Greek government to cut pension entitlements or raise taxes.  Fortunately, with Goldman Sach’s help, a solution presented itself.

The deal started with a quite humdrum derivative that was given a dramatic, Goldman-style tweak.  The starting point was the 30 billion euro or so in foreign currency-denominated debt that Greece had outstanding in 2000.  The humdrum derivative that Greece already was using was called a cross-currency swap.  For large national or corporate borrowers, foreign currency borrowing is a matter of finding a broader investor base for their debt and thus lowering their funding costs.  Cross-currency swaps allow them to do this without taking any foreign risk.  There is nothing particularly dramatic about this derivative.  In the same way that a bureau de change allows you to exchange a sum of foreign currency into domestic currency, the cross-currency swap lets big borrowers do the same thing for the repayments on their foreign currency bonds.  Just as owning foreign currency is risky because rates can go against you, owning foreign currency is also risky because of exchange rates.  In both cases, a transaction gets rid of the problem.

Suppose you were based in the Eurozone and borrowed $10 billion at a time when one dollar was equal to one euro.  If the dollar strengthened to the level of one dollar equaling two euros, the amount of debt in euros would double.  Fortunately, with a cross-country swap you don’t have to worry about that because everything is locked in at the one-euro-per-dollar rate.  What Sherwood and his team cooked up for the Greek government starting in December 2000 worked slightly differently.  Imagine you had a thousand dollars that you wanted to change into euros.  A bureau de change proposes a special deal.  Instead of the one-euro-per-dollar rate (before fees) displayed on the wall of the booth, the teller offers a contract paying you double that rate.  Perplexed, you ask, “Are you giving away a thousand euros?”  “Of course not,” replies the teller.  “Actually, I’m lending you the money, and you’ll have to pay it back with interest.  But that’s our little secret.  No one will know because the slip of paper I’m giving you makes it look like you’ve got ‘free’ money.”

In its deal for Greece, Goldman did something equivalent to this mythical bureau de change.  It cooked up a cross-currency swap, and in the blank space marked “exchange rate,” it wrote a wildly incorrect figure.  By using this derivative, Greece had magically reduced its debt by almost 3 billion euros, but this paper gain would have to be balanced out later by a series of swap payments to Goldman.  Over the ten or so years that the swap was to last, the value of these payments amounted to several billion euros.  In other words, Goldman was secretly lending the Greek government money and getting paid back over time.

Incredibly, Eurostat’s loophole-ridden debt-accounting rules allowed the Greek government to do exactly that, and thus “demonstrate” to Brussels that it was sticking to its budget targets.  In fairness to Greece and Goldman, they were not the first partnership of spendthrift country and bank that fiddled the system in this way: Italy is said to have used the same trick to join the single currency in 1998.  According to sources familiar with the deal, Eurostat even gave advance approval of Goldman’s contract with Greece (six years later, the agency would deny any knowledge).   Of course, transparency was precisely what the Greek government was not interested in, and Goldman was happy to oblige, for a price.

When my sources first told me about the deal in May 2003, two years after it had been completed, the price seemed shockingly high–some 500 million euros in return for concealing several billions in debt.  It was not an explicit price in the sense of a negotiated fee, but rather an implicit spread on top of the swap payments that Goldman had calculated as being necessary to balance out the off-market value of the swap.  Given that the transaction costs for standard, market-priced cross-currency swaps were a hundredth of this amount, it was not surprising that people were shocked when I published a story exposing the deal, and that Goldman and its public relations machine were anxious not to see the 500 million euro number in print.

From Goldman’s perspective, the CDS was necessary because, like the “wrong” exchange rate transaction offered by the mythical bureau de change, the swap with Greece amounted to a secret loan from Goldman.  While the likes of J.P. Morgan or Chase Manhattan may have been comfortable with putting such a loan on its balance sheet (albeit a diminishing one).  Goldman was not.   Or as Sherwood explained it to me, “We’re generally conservative on credit risk.  We like to take credit risk at a point where we can lay it off.”

Has Greece chosen to raise a billion euros of debt for twenty years by issuing bonds, it could have placed the debt with actuarially minded investors like Prudential.  The prices of Greek bonds in 2001 suggested that such investors would have been prepared to accept a spread over ultrasafe German government bonds amounting to about 60 million euros over twenty years.   But the Greek government was desperate to avoid public debt markets, because its borrowing was already well over the Maastricht limits.  By using Goldman to raise the money, Greece had to accept the bank’s subjective view of its credit risk expressed as a CDS premium–the 300 million euro price at which Sherwood thought he could “lay it off” in the market.

It took a change of Greek government for the facts of the Goldman swap to be officially acknowledged, although this revelation did not seem to harm Greece’s relationship with
Goldman, which made over $100 million from the deal.  Finding a borrower prepared to pay 30 million euros in default risk premium when a traditional actuarially driven investor would have required $60 million seemed to electrify the firm’s bankers.  Just as Sherwood had envisaged, Goldman had “derivatized” credit.

There was only one obstacle now to Goldman’s dreams of world domination: apart from the likes of Greece, for which desperation or secrecy made it willing to pay for a CDS, why would any sane borrower not stick to the actuarial system, where loans were much cheaper?   If Goldman were going to dominate credit markets as Sherwood wanted, it would have to undermine the rival system, forcing corporate and sovereign loan rates to be pegged to CDS prices.  That led Goldman to publicly campaign against the guardians of traditional lending: the big banks.

So Cheap It Hurts – In 1999, Glass-Steagall was abolished, and U.S. commercial banks were now free to offer investment bank services.  With this new, shareholder-driven philosophy, some of these banks were crowding into Goldman territory, pitching for business such as advising on takeovers.  What most enraged Goldman was how banks such as the newly merged JPMC, Citigroup, and Bank of America were poaching blue-chip clients by dangling the prospect of actuarially driven cheap loans as a sweetner.  For those that depended on traditional credit investors to lend them money, the historical pricing of default risk kept their loans cheap because they were still using accounting rules that kept the value of loans frozen at book value.  This made their loans “cheaper” than those based on the CDS market–if JPMC lent $1 billion to a big customer, and the credit derivative market implied that the loan was now worth only $800 million, then so much the worse for credit derivatives.

Without the ability to freeze the value of loans on its balance sheet, Goldman had to either sell loans at the secondary market price or buy credit derivative protection.  That meant if customers wanted to borrow money from Goldman, they would have to pay a lot more for it, as Greece had done.  So Goldman went on the offensive.  In April 2001 the firm wrote to the U.S Financial Accounting Standards Board (FASB), requesting that a type of loan facility very popular with large borrowers be treated like credit derivatives: in other words, the loans should be recorded at market value on bank balance sheets.

The commercial banks instantly saw the threat here and fought back.  Goldman’s campaign was merely sour grapes about its loss of market share, they said.  But Goldman’s argument that the market pricing of credit derivatives was more “fair” than loan pricing demanded a more substantial rebuttal.  The banks pointed out that a large percentage of their new loans were syndicated–farmed out to hate-to-lose investors, typically medium-size regional banks.  And because these investors accepted the pricing of the big banks that originated the loans, this was “fair value,” which had been established in a market.

Goldman rolled to Princeton finance professor Jose Scheinkman, who argued that his claim by commercial banks was intellectually flawed and anti-free market.  The banks then pointed to the benefits of low borrowing costs to their customers.  Dina Dublon, then CFO of JPMC told me, “If I was Goldman, I’d be careful about arguing that their clients ought to be financed at higher rates.  You can say banks are ‘dumb,’ but they have a staying power, and a market cap that, as an industry, is significantly larger than that of securities firms.”

Goldman lost the argument, and the FASB ruled against its proposal.  JPMC was allowed to keep its actuarial measuring stick (based on the evidence of syndication to other banks).  But Goldman didn’t give up on the “cheap-loan” war, because time was on its side.  With shareholders continuing to demand that commercial banks improve returns on capital, the need for places to dump credit risk off the balance sheet was greater than the loan syndication market could support.  And by the start of 2002, it was clear that the credit default swap was the best tool for the job.

The Sad, Strange Death of Hate-to-Lose Banking – The takeover of J.P. Morgan by Chase had one ironic twist: it turned out that Peter Hancock was a much better risk manager than his successors at the top of the firm, such as Chase’s head of risk, Marc Spapiro.  Recall that Chase preferred the actuarial method to offset credit risk, and now deployed it for its biggest and most lucrative client: the fast-growing energy company, Enron.  Shapiro had known Enron’s chairman Ken Lay since his old Texas banking days, and the company paid Chase tens of millions annually in fees.   Enron could only sustain itself by fraudulent borrowing and was enabled by banks bending over backward to skirt the boundaries of legality.

What Enron’s CFO Andy Fastow invited Chase to do in the late 1990s was typical of the complex secret borrowing that would eventually land him and Enron CEO Jeff Skilling in jail and get Chase slapped down by the Securities and Exchange Commission (SEC) with a $135 million fine.  Like Goldman and Greece, Chase and Enron started out doing something that appeared routine, trading “prepay” forward contracts, a kind of derivative based on natural gas.  However, the derivatives were a red herring.  As with Goldman’s deal in Greece, the derivatives were set up to carefully balance out leaving behind a $2.6 billion loan from Chase to Enron.  As a condition for extending this secret loan, Chase bought default protection.  Rather than using a default swap as Goldman did, it bought traditional-style protection from ten insurance companies, including Allianz, Travelers, and The Hartford, that provided $950 million in protection using surety bonds.  A remaining $165 million in protection came as a letter of credit from the German bank WestLB.  To keep things secret, they did this through a shell company called Mahonia, which Chase controlled.

The last bit of credit insurance was bought in September 2001.  A month later, Enron’s fraud was finally coming to light, and Chase’s bankers learned that their favorite client had borrowed much more than they realized.  “$5 B in prepays!!!!” emailed one Chase banker to another when he heard the news: “shutup and delete this email [sic],” came the immediate reply.

In December 2001, Enron filed for bankruptcy.  The ten insurers and WestLB argued that they had signed up to insure the credit risk of bona fide natural gas payments, not secret loans, and the discovery of fraud at Enron meant that they didn’t have to pay.

Early in 2002, I visited Enron’s bankruptcy auction in London.  There was a palpable sense of shock at Chase that its risk neutralization hadn’t worked out as planned.  The stress of dealing with the recalcitrant insurers was enough to give one of Shapiro’s minions, a credit officer named Jim Biello, a heart attack.  He was invalided out of the bank into early retirement.  The man who replaced Biello, David Pflug, paid tribute to him in what would serve as an epitaph of the hate-to-lose banker: “They killed themselves trying to save it and then they killed themselves trying to collect it.”

A couple of years later, Chase managed to secure in court about 60 percent of the $1 billion pledged by the insurers but by then was facing prosecution for abetting Enron’s fraud.  It settled those charges by paying that $135 million SEC fine, and Shapiro apologized to Manhattan District Attorney Robert Morgenthau: “We have made mistakes,” he said in 2004.  “We cannot undo what has been done but we can express genuine regret and learn from the past.”

One of the many things Shairo no doubt regretted was depending on a flawed risk management strategy.  Using insurance policies to protect against default was obviously a risky move.  But that was a problem with the strategy, based as it was on the insurance tradition of demonstrating loss ex post and checking for fraud.  Meanwhile, the market approach to hedging credit risk passed the Enron test with ease.  Unlike with surety bonds or letters of credit, it was hard to argue with the ISDA’s definitions of the events that triggered credit default swaps.  You couldn’t argue, as Chase’s surety bond counterparties did, that fraud somehow voided the contracts.  Even insurance companies on the other side of default swap contracts had to pay up.  Federal Reserve chairman Alan Greenspan spoke warmly about how default swaps made banking safer as a result.

With this apparent certainty that providers of credit protection would have to pay up, traditional loan-based banking was now a love-to-win game.  The only remaining obstacle was price.  If the price of credit derivative protection was higher than what borrowers expected to pay on a loan, the big dealers resolved to find some other way to get that protection at a lower price.  After all, actuarially driven credit investors still were willing to accept a lower return on bonds that passed the ratings agency health check.  Using tricks developed at J.P. Morgan and elsewhere, the market-based world would soon figure out how to play these gatekeepers to get money at the price they wanted . . . and then use that to reap astounding profits.  And in the process, they used credit default swaps to subvert–and nearly destroy–the financial system.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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