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How The Foxes Run the Henhouse (Or Why Goldman Sachs Hates Greece?)…

March 4th, 2010 · 4 Comments
Finance · Incentives · Macroeconomics · Markets

You know, I was previously worried that Goldman Sachs had Washington just a tad too much in its back pocket…good thing then, I suppose, that Greece has allowed me to take an “at least I’m not THAT guy” stance and feel much better.

If you’ve been paying attention to the news, you at the very least know that Greece is pretty much up a creek financially right now. If you aren’t familiar, here’s some background:

The Colbert Report Mon – Thurs 11:30pm / 10:30c
Greece’s Economic Downfall – Scheherazade Rehman
Colbert Report Full Episodes Political Humor Skate Expectations

For the record, I do not get all of my news from Comedy Central…I’ll have you know that I also read The Onion. And I really want to be friends with Prof. Rehman. In addition to what you just saw, here’s what you need to know: In order to be able to join the European Union back in the early 2000’s, Greece had to agree to face fines if its yearly deficit ran more than 3 percent of the country’s Gross Domestic Product (read, value of output) or if its total amount of debt ran more than 60 percent of GDP. (I’m not sure how fining an entity for being in debt is productive, but I suppose there aren’t a whole lot of sanctioning options available. Maybe they’ll borrow the money to pay the fine.) Paying fines isn’t particularly appealing, but neither is only spending money that one actually has, so Greece entered into an agreement with Goldman Sachs to essentially put off some of its debt obligation via a product that was commonly used for other purposes. Because the type of agreement that they used looked like a transaction that a lot of other countries did just to logistically deal with the fact that there are multiple currencies in the world, people didn’t really notice that Greece was effectively borrowing from Goldman to make its deficit look smaller. (For more detail on this part of the matter, there is a decent article here.)

The bottom line here is that Goldman Sachs knows that Greece owes it money, and other parties don’t seem to be aware of this fact. As such, Goldman gets screwed if Greece does the governmental equivalent of declaring bankruptcy and doesn’t fulfill its obligation. So what does Goldman do? It enters into agreements with other, completely non-related entities that say Goldman gets a payout if Greece defaults on its debt. Because of this, the New York Times and other entities are really sniffing around in hopes of finding a scandal. Before we jump to conclusions, however, it’s helpful to actually understand what’s going on.

Allow me make an analogy…people generally like sports more than they like economics, so let’s talk about football. Let’s say, for the sake of good rivalry, that the New England Patriots are playing the Indianapolis Colts. I live in Cambridge, so it’s not surprising that I am happy if the Patriots win and sad if the Colts win. (I hate Peyton Manning. Eli sucks too. Or so the t-shirts sold in Kenmore Square after Red Sox games tell me.) It’s not uncommon for people to bet on the outcomes of football games, so I have the option of either putting my money on the Patriots to win or on the Colts to win. At first glance, it seems to make perfect sense for me to bet on the Patriots- they’re the team I like! (Just assume for the moment that the teams are evenly matched or that the bet is based on a spread or whatever.) But is that really the right thing to do? Consider the following outcomes with a $20 bet:

Granted, the happiness numbers are a tad contrived (though consistent with prospect theory in that I dislike losing $20 twice as much as I like winning $20), but they illustrate an important concept. If I bet on the Patriots, my happiness either goes up by 35 or down by 25. If the teams are evenly matched (or the underlying bet is even odds), my happiness goes up by 5 on average (read, in expected value terms). But, if I bet on the Colts, my happiness is guaranteed to go up by 5. If I am at all risk averse, I prefer the guaranteed bump of 5 units to the possibility of increasing by 5 units on average but at any given time being either 35 units happier or 25 units sadder.

This type of setup is called a hedging strategy– you are offsetting one swing of happiness (the game outcome) with a gamble that pays off when you are sad and costs you money when you are happy so that your overall result is more stable. (And yes, this is at least loosely related to what hedge funds do, but that is a conversation for another time.) Hopefully you feel that, in this context, the hedge that I described is a perfectly reasonable transaction. (You may have even entered into the bet with a Colts fan who was doing the same thing that you were!)

The above set of actions, taken back to the financial realm, is pretty much exactly what Goldman Sachs did. Yes, it was a little sketchy for Goldman to make agreements that would help hide Greece’s true debt level, I will acknowledge that. But once that is done, it makes perfect sense to want to take an opposing bet to avoid big losses. In the analogy, the side bet on the football game plays exactly the same role as the credit default swap that Goldman entered into, since this enables Goldman to get paid at least in part if Greece defaults on its original obligation (i.e. loses the game). It is important to note that the credit default swaps have nothing to do with Greece directly, and the swap contract is between two parties that are just watching the game of the Greek financial system to see how things play out. (Yes, these financial products actually exist.) So where is the problem?

Coming back to the football analogy, I really doubt that my bet on the game has any effect on the game’s outcome- I’m not exactly Pete Rose here. (There I go, mixing my sports…also, Pete Rose contends that he only ever bet for his team and not against it, so he was more of a speculator than a hedger.) However, I am not as important as Goldman Sachs. The claim by the media and some finance professionals is that people see Goldman buying what is essentially insurance against a Greek bust and they think “uh oh, what does Goldman know that I don’t?” and then they are more hesitant to lend to Greece. Then more people see the reluctance to lend to Greece and say the same thing. It then becomes very hard (or at least much more expensive) for Greece to borrow money, and the whole Greek bust thing becomes a self-fulfilling prophecy. This is an unfortunate scenario, but is it Goldman’s problem that the finance world really pays attention to the signals that it sends?

Like I said before, the media is sniffing around for a scandal. From the New York Times:

“It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich.

(I can only imagine what this guy says about people who take out life insurance policies on family members.) So people are now implying that Goldman Sachs is deliberately trying to crush the Greek financial system so it can profit? This reminds me of the scandal and lawsuits that broke out because Wal-Mart took out life insurance policies on its employees. The important question underlying this accusation is whether Goldman profits or loses overall (not just on the secondary bet) when Greece ends up in the toilet. If Goldman on net wins when Greece stays solvent, then there isn’t really incentive to try to crush an entire foreign country. (Though I have a suspicion the folks at Goldman could make it happen if they tried.) I did some digging (here, for example), and I couldn’t find anyone who was actually accusing Goldman of being “net short” on Greece, which would have meant that Goldman profits when Greece loses. Even if Goldman was net short on Greece, it has an incentive to not deliberately harm the country, since I’m guessing it wouldn’t get a lot of follow on business if it adopted a “here’s some money now, but we will probably use it to crush you later” strategy. Therefore, while it might be fair to criticize Goldman for the original deal it made with Greece, can you really blame it for covering its own behind?

For the record, the same is true for Wal-Mart- the life insurance policies partially covered the cost of training a new employee in the event that something bad (in or out of work) happened to an existing employee. So no, the policies didn’t actually give Wal-Mart the incentive to trample its employees with forklifts or whatever. As far as I know, Wal-Mart employees only get trampled by customers.

Tags: Finance · Incentives · Macroeconomics · Markets

4 responses so far ↓

  • 1 Al // Mar 18, 2010 at 5:26 pm

    Wow, this was exactly what I learned in my 2nd year Micro class yesterday! (Except the prof used some other example to explain it.)

    Love this site! Keep it up.

  • 2 Avenger // Dec 13, 2010 at 11:24 pm

    A fed Bear is a dead bear.
    Feeding the Serbian bear with $20 billion grant aid from the West, and with $20 billion in weapons from Russia East, ended in 10 years war with 500000 innocent civilian dead, through execution, torture, raping, kidnapping and forcefully displacing millions of Croatian, Bosnian, and Kosovars. Shame on EU, shame on Russia.
    The actions of Serbian beast ended in dismembering of Yugoslavia, and creation of many independent states, sworn enemies to Serbia. If you go to Croatia they say don’t forget VUKOVAR, don’t forget Srebenica in Bosnia, Vojvodina in Hungary, “Western Outlands” in Bulgaria, and about Kosova there never will be peace without justice. So, Serbia will end a dead Bear if not protected from outsiders forever.
    Feeding Greece with grant aids, the West is creating another beast. Greece has created a virtual reality, with a very strong military, (330 Leopard tanks, F 16 jet fighters, a very powerful Navy, included up to date submarines, and more.)
    The Greek people never learned to pay their taxes …. because no one is ever punished.
    To make things more interesting Greece has FREE HEALTH CARE, LUCRATIVE PENSIONS, and HIGH PAID JOBS, which they cannot afford either.
    So the WEST is feeding another Bear that soon or later will end in a DEAD BEAR.

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