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Follow Up: Goldman Sachs And Greece, Facebook Style…

March 30th, 2010 · 11 Comments
Finance · Follow Ups

I wrote a few weeks ago about Goldman Sachs’ involvement in the problems that are plaguing Greece. This seems to be a confusing topic for everyone, both because it involves a lot of finance mumbo-jumbo and also because journalists have a vested interest in making their stories more interesting by taking somewhat of a “Goldman Sachs is evil, see?” editorial position.

Well, it just so happens that my friend Sean is in fact an editor, and he really wanted to understand this Greece thing. (He’s a really smart kid, so the fact that he is asking me questions highlights how confusing the issue is.) So obviously the best way to address his confusion is via Facebook chat. I think that there are several helpful analogies that came up in that conversation, so I figured I would reproduce it for you here.

(My favorite part is the time stamp.)

1:59amSean
so explain this greece-goldman sachs deal to me

2:00amJodi
ok, so
greece couldn’t join the EU unless it agreed to limit its debt
which apparently it couldn’t do

2:00amSean
k

2:01amJodi
so it sort of cheated by entering into an agreement with goldman that would in effect allow it to temporarily hide its debt
now, and this is one of the more important parts…goldman sachs wants to make money by charging commissions on transactions, NOT by making bets on the market
so it went holy sh*t, we have this big uncovered position, and if greece defaults we’re screwed since we essentially lent money and won’t get paid back
so they took place in another agreement that paid off in exactly those situations where Greece screwed them so overall they weren’t subject to huge swings
in this way, goldman can’t really gain or lose very much in the market, but it already made its money from the commission that it charged to greece
apparently the market doesn’t entirely understand that goldman is not really trying to gamble, at least not in this case

2:05amSean
explain that a little more

2:06amJodi
that last point you mean?

2:06amSean
yeah. about the market not understanding
i’m not understanding

2:20amJodi
sorry, was talking to roommate

2:21amJodi
so the market took goldman buying the “insurance” against Greece as a sign that there was something wrong with Greece rather than just taking it as Goldman hedging its original position
which I sort of understand, since it wasn’t obvious to the outside world that goldman had a risky position that it was trying to hedge against
so it basically started a run on Greece
which made it really hard for Greece to keep borrowing, since would you lend money to a friend who seems desperate and where other people are taking bets on when that friend will get fired from his job or something?

2:23amSean
did goldman do anything illegal?

2:24amJodi
no

2:25amSean
what about hiding greece’s debt?

2:25amJodi
so that is obviously the closest to grey area

2:27amJodi
so here’s a completely unbiased article (snicker):
http://www.nytimes.com/2010/02/14/business/global/14debt.html
(Editor’s note: Even that article explicitly points out that the transactions were all legal.)
to a large degree, the transaction with greece was a common one
that a lot of countries partake in

2:28amSean
i read that
some of these concepts are difficult for me to grasp

2:29amJodi
so the key piece there was that the original deal was a loan that was made to look like a currency trade
currency trades happen all the time and are harmless, since they’re basically a large-scale version of what you do when you go to the bank and buy euros in preparation for a trip to paris or something
so greece was all “oh, this old thing? It’s just a currency trade”

2:30amSean
it would be cool if they said it just like that

2:31amJodi
I’ll make an analogy using the US and Canadian dollar, since I am not sure what the deal was with the euro back in 2001
the deal was the equivalent of goldman giving greece an “exchange rate” of 10 canadian dollars for each US dollar today and then in the future greece was to pay the money back at an exchange rate of 11 US dollars for each Canadian dollar
in other words, goldman gives greece 100 canadian dollars in exchange for 10 us dollars in 2001, and then greece is supposed to give goldman 110 us dollars in exchange for 10 canadian dollars at some point in the future
or something roughly similar to that
the point is that the exchange rate gives greece a profit in 2001 and gives goldman a profit later
(Editorial note: I think I am a little sloppy with this analogy going forward, but all the really matter is that part 1 of the trade gives Greece extra money and part 2 of the trade pays it back.)
see how that is akin to borrowing money?

2:32amSean
ok

2:32amJodi
but it wasn’t on Greece’s books as a loan
since, narrowly and technically speaking, it wasn’t

2:33amSean
right

2:33amJodi
as far as I know, goldman is completely within its rights to make this deal
the aforementioned grey area is due to the fact that I don’t know how explicit the “hiding” was or what the implications of that would even be

2:35amJodi
so in 2001 goldman took in 100 US dollars and paid out 1000 canadian dollars or whatever
and then realized that it would get screwed if greece couldn’t close that open position

2:37amJodi
so it bought insurance
but rather that being called insurance explictly, it’s just a contract that gives goldman a profit if greece defaults on its debts
(and a loss if it doesn’t, since even goldman doesn’t get anything for free here)

2:38amJodi
and as a result the world decided there was something wrong with greece
and wouldn’t lend it money

2:39amSean
are you saying there wasn’t something wrong with greece?

2:40amJodi
unclear
certainly not as much as there is now, but it did have a lot of debt

2:40amSean
so what’s the trouble now?

2:41amJodi
so say hypothetically that your bills were more than your income and no one would give you a credit card…what do you do?

2:45amSean
borrow

2:45amJodi
but you have bad credit, so no one will give you a loan
what do you do?
-or- they’ll only give you a predatory payday loan

2:47amSean
i dunno
ask my parents
:):)

2:47amJodi
ok, so Greece asked France and other EU countries for a bailout, so that isn’t a bad guess
they either told greece to sit and spin, or they pointed out that bailing out another country was against EU rules
so your parents told you to go f**k yourself…what do you do?

2:49amSean
illegal stuff is out of the question?

2:49amJodi
let’s go with yes

2:49amSean
find a different job?

2:50amJodi
ok, so, continuing the analogy, greece could raise taxes (i.e. get a better job) such that it wasn’t running a deficit and thus didn’t need to borrow…but this would have a negative impact on its output
it could also declare bankruptcy
technically, Goldman could get screwed even if Greece didn’t declare bankruptcy
since greece is killing (read, devaluing) the euro right now
which is why other EU countries kind of want to bail it out
so goldman faces the possibility of having given 1000 canadian dollars for 100 US dollars, and when it comes time to exchange 100 canadian dollars for 1100 US dollars, the US dollars aren’t worth the paper that they are printed on
see the problem?

2:53amSean
yes

2:53amJodi
so that is what is going on
and the reason that the EU had these debt rules in the first place was so that this couldn’t happen

3:02amJodi
I find it interesting that Greece is more pissed at Goldman than anyone else
since they are the ones that wanted the transaction
it’s not like it was predatory
“While Greece did not take advantage of Goldman’s proposal in November 2009, it had paid the bank about $300 million in fees for arranging the 2001 transaction, according to several bankers familiar with the deal.”
see? they make money from fees, and don’t really want gambles

3:23amSean
right

——
And then I passed out from exhaustion.

Tags: Finance · Follow Ups

11 responses so far ↓

  • 1 question // Mar 30, 2010 at 5:58 pm

    I have a question. The deal goldman made was in 2001. They bought the cds to cover the exposure they had with greece in 2001.

    So how does that increase the cost of borrowing 9 years later.

    “since it wasn’t obvious to the outside world that goldman had a risky position that it was trying to hedge against so it basically started a run on Greece which made it really hard for Greece to keep borrowing”

    Maybe it has something to do with something more recent like taking a lot of debt or a budget deficit.

    You mentioned “since would you lend money to a friend who seems desperate and where other people are taking bets on when that friend will get fired from his job or something”

    If this friend has been burrowing a lot of money from people and might not be able to pay back the loans back, i think it’s prudent not to give her any more money until she sorts her self out.

    like the blog, will bookmark it 🙂

  • 2 tim // Mar 30, 2010 at 7:39 pm

    out of curiosity, was your roommate telling you to ‘knock it off!’ from 2:06 to 2:20?

    🙂

    how many other people find that while they feel like they understand this stuff, have an enormously difficult time explaining it to others?

  • 3 Kirk // Mar 30, 2010 at 7:42 pm

    The answer to your question of the cost of borrowing is the risk premium. In any transaction of choosing to lend money you take your cost, in the case of goldman or their ilk, that would be the interest at the discount window at the fed or another bank, and then you add on a risk premium based on the borrowers ability to repay. In this case, the market had numerous reasons, logical or illogical, to increase that risk premium to cover the chance of default. Sovereign debt usually carries a low risk premium, but in this case the negative perception in the market made lending to greece an expensive engagement.

    This is a great writeup of the issues with greece and goldman, the media was a bit quick given recent events to call out goldman for having their hand in the proverbial cookie jar again. In this case it seems to be simply that goldman had a profitable racket moving greek debt around and recently the possibility of that debt shifting blowing up in goldman’s face forced their hand, which sent shockwaves through the credit markets.

  • 4 econgirl // Mar 30, 2010 at 10:06 pm

    @ tim: I don’t remember specifically, but I think that roommate had just gotten home from work and the conversation was regarding the animal pictured here:

    I am pretty sure that she is going to claw my face off while I am sleeping one of these days.

  • 5 econgirl // Mar 30, 2010 at 10:06 pm

    Also, for clarification, by “she” I meant the cat, not the roommate.

  • 6 tamara // Mar 30, 2010 at 10:21 pm

    love this teaching method of your honestly… who says facebook is only for photo albums of drunk people and farmville… I don’t like cats ¬¬ also working at high hour of the night is better for my brain and econerdiness 🙂
    a friend with a bad debt record is likely to stay that way and is hard to get out of the situation because “that” friend keeps rolling around in a vicious circle where he needs to pay and can’t.

  • 7 Charles Dolci // Mar 31, 2010 at 2:14 am

    Interesting ideas about “hiding” and “illegality”.

    Illegal under which jurisdiction? If GS was doing a deal with the Greece government then who could claim that it was illegal? Peru, Chile, Burkina Faso? The US? Certainly Greece can not claim it was illegal.

    Jodi says “but it wasn’t on Greece’s books as a loan” Do countries have “books” in that sense? They certainly are not bound by generally accepted accounting rules (if they were – Katie bar the door!) or SEC reporting requirements so why would they need to “hide” anything? OK, so maybe they don’t want to appear as having so much debt. Do they really need to “hide” these transactions from the EU or from other entities or countries that might want to lend them money? Does the EU have that kind of regulatory control over a sovereign member state? But who are they fooling?

    In a business financial transaction certain transactions may be “kept off the books” as loans or debt in the conventional sense that they do not have to be recorded as debt. But they are not hidden. The transaction still is reported, maybe in a footnote or somewhere. Moreover, when private entities make loans the borrower has to make a cazillion reps and warranties to make sure there are no hidden transactions (“OK, so the accountants say you don’t have to call it “debt” but we know what it is”). So nothing is hidden. If Greece was playing games with how they wanted to “book” these transactions (in the sense of “hiding” their true nature from their citizens or the EU) then that is their problem.

    It seems to me Greece is in financial trouble for a lot of reasons and they just want to divert the blame from themselves and their policies to a convenient and foreign villian such as GS.

  • 8 econgirl // Mar 31, 2010 at 5:28 pm

    @ Charles: Yeah, it’s the EU that does actually look over the books in whatever form they may be in. In joining the EU, Greece contracted to limit its debt to 3% of its GDP or something like that, and apparently there are budget overseers in Brussels who keep tabs on these things. So if you wanted to argue that Goldman was accountable in some way, you could try to make the argument that it conspired to break EU rules. I’m not saying that it’s an argument worth making, I’m just letting you know what the rules of the game are.

  • 9 econgirl // Mar 31, 2010 at 5:30 pm

    @ question: If the position was hedged back in 2001, I am not really sure why it would matter now, but that is what was reported. My guess is that nobody paid attention to the position until Greece started having other problems.

  • 10 blue monkeyg // May 7, 2010 at 11:25 pm

    Greece and Spain won’t pay back. The only thing Germans can do is:
    REPOSES 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
    U.S.A must REPOSES 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
    Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.

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