Europe: The Saga Continues…… How Derivative Magic Can Turn Into A Black Hole

Posted By on February 22, 2010

 Dr Joe Duarte
February 22, 2010

 How Derivative Magic Can Turn Into A Black Hole

The Euro rallied for a period overnight, as rumors of a bailout package from Germany aimed at Greece surfaced. But a denial from the German Ministry of Finance knocked the European currency below Friday’s close. That’s the scenario with which trading will open in the U.S. on Monday.

The situation in Greece isn’t going away. In fact, if history is any guide, just as the subprime mortgage crisis was a big effect on the global financial markets for months, so is Greece likely to have some sort of effect for some time to come. There are some differences to be sure, as the subprime mortgage meltdown was a bigger problem from a tangible standpoint. Yet, Greece, even though it’s a small country, is at the very least a symbol of what could eventually cause major problems for the Euroepan Union.

It’s widely known and accepted now that Greece’s problems started in 2001, when Goldman Sachs engineered a currency swap with the country that allowed it to take significant liabilities off their books by pushing them forward via the swap agreement, which is a derivative. The central tenet of the swap, though, was that Greece’s public transportation revenue was used to pay for the swap, which means that money that was supposed to go into the Greek treasury, instead went into paying for the swap, and that left a whole in the Greek books.

Now, investors are starting to wonder if there are other small European countries that have significant surprises to reveal, as they too may have used derivatives to make their books look better than they were in order to meet the criteria to join the EU.

In fact, it’s more accurate to say that the news media has made it its business to reveal what the European nations have been doing for years, hiding their complex “sometimes in secret” deals according to The Wall Street Journal that were designed “to hide the true size of their debts and deficits” so that they could show that “cap debt levels at 60% of their gross domestic product and their annual budget deficits to no more than 3%.” In other words, European nations, unlike the United States at least to the same degree, have been hiding the awful state of their books making the Euro a potential reserve currency for the world that may have been based to a significant degree on smoke, mirrors, and complex derivatives.

The Europeans have in fact been running a wild one past the markets for years. According to The Journal: “To try to meet the targets, which were aimed at building trust in the stability of the euro, governments over the years have sold state assets, bundled expected future payments into securities to hawk and even, in the case of Greece, insisted to the Eurostat statistics authority that large portions of its military spending were “confidential” and thus excluded from deficit calculations. In 2000, Greece reported that it spent €828 million ($1.13 billion) on the military—about a fourth of the €3.17 billion it later said it spent. Greece admitted to underreporting military spending by €8.7 billion between 1997 and 2003.”

For example, according to The Journal: “Portugal classified subsidies to the Lisbon subway and other state enterprises as equity purchases. After learning that, Eurostat made Portugal redo its accounting in 2002. The country revised its 2001 deficit from €2.76 billion, or 2.2% of GDP, to €5.09 billion, or 4.1%—well over the limit.” But they were not alone as “France arranged a deal with the soon-to-be privatized France Telecom in 1997 under which the company paid the government a lump sum of more than €5 billion. In return, France agreed to assume pension liabilities for France Telecom workers. The billions from France Telecom helped narrow France’s budget gap to around €40 billion in 1997; it reported a deficit for that year of 3% of GDP—right on the target, and helping it to join the euro.”

And Germany “Europe’s largest economy, tried to reappraise gold reserves for a fast fix in 1997, though it backed off after resistance from the country’s central bank.”

In fact, European countries, until 2008 were allowed to do these swap transactions and to use derivatives to hedge the risks, which means that there could lots of other such problems that pop up in the future, if the countries can’t meet their obligations to counterparties involved. According to The Wall Street Journal “In some cases, governments undertook numerous such transactions, often without publicly disclosing them, making it difficult for investors to gauge the impact on a country’s finances.”

The Journal reports that Goldman Sachs did 12 swaps for Greece from 1998 to 2001, while Credit Suisse also helped Athens with at least one swap during the same period. To be sure, some swaps are part of normal business. According to The Journal “Deutsche Bank executed currency swaps on behalf of Portugal between 1998 and 2003” which according to Deutsche Bank spokesman Roland Weichert ‘were within the “framework of sovereign-debt management,”‘ and “intended to hide Portugal’s national debt position.” For its part, Portugal declined comment only to say that “Portugal only uses financial instruments that comply with EU rules.”

The bottom line is that this is not a new problem. In fact it’s been brewing for nearly a decade. According to The Journal: “Eurostat tried for years to change the rules on use of swaps. European finance ministries in 2000 overruled Eurostat, arguing that they needed as much flexibility as possible to manage debt loads.”

Swaps are a two edged sword. On one side, they let the country that uses it lock in a future exchange rate. That’s the good part as it lends the current books some stability. The problems is that stability is cosmetic as any drop in the Euro, despite what the books showed would be a negative in the real world, which means that at some point, the real price of the transaction would have to be faced.

In many ways, swaps act like adjustable rate mortgages, which means that you can live in a million dollar house for $450 a month for a few months or a few years. But at some point, the real rent, maybe $4500 per month will come knocking at the door. And that’s why investors are particularly nervous about Greece and other nations in the EU. No one really knows what the real rent is going to be when it comes due.


Derivatives, by definition, are takeoffs on reality. Their outcome is derived from current events, but are placed into the future. And while they take away the pain in the present, they are just a way to store the pain for later examination.

In a perfect world, at least in the eyes of politicians, and other folks who don’t want to live within their means, they hope that when one derivative expires, they can just buy another one and thus continue to put off the pain indefinitely. You can play that game for a while but at some point, something will happen which makes the game expensive and dangerous. In Greece’s case, it wasn’t even worth the trouble, especially the trouble that it’s caused.

According to The Journal: “In exchange for the good deal on rates, Greece had to pay Goldman. The amount wasn’t revealed. A payment would count against Greece’s deficit, so Goldman and Greece came up with another twist. Goldman effectively loaned Greece the money for the payment, and Greece repaid that loan over time. But the two sides structured the loan as another kind of swap. Treated as a swap, the deal didn’t add to Greece’s debt under EU rules. All told, the marginal benefits were small. Greece’s total debt as a percentage of GDP fell from 105.3% to 103.7%, and its 2001 deficit was reduced by a tenth of a percentage point in GDP terms, according to people close to Goldman.”

Two things here have become increasingly important, aside from the fact that Greece got duped. One is that the world is flooded with dollars and euros. The other is that central banks want to mop up that excess liquidity. So far, China, the U.S. and Australia have begun to tighten, in varying degrees. At some point, tightening will spread elsewhere and easy money will be gone for a long time.

That’s when the stinky stuff will really hit the fan. What we’re saying is that if Greece and others who have been clever for a long time think they have problems now, wait about six to twelve months when China and the U.S. are both raising interest rates in tandem. And that’s when the cleverness can turn into despair, just as what happened in Fantasia when the apprentice’s magic tricks went all wrong.

One final thought: “Greece’s remaining exposure to the complicated arrangement remains unclear.” From a trading standpoint, until proven otherwise, the dollar remains a solid long trade.

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