Politics & Policy

The Trojan Horse Meets the Vampire Squid

The Greek debt dodge invites the question: Who will regulate the regulators?

You want to see something that makes a trailer-load of dodgy mortgage derivatives look like an old-fashioned savings bond? Look at the Greek government’s crafty technique for borrowing money without having to put any new debt on the books. It’s a fascinating financial instrument dreamed up by our old buddies at Goldman Sachs — and the debt goes right back to Greek banks.

#ad#A little background: Governments in the European Union cannot just go borrowing money willy-nilly, at least in theory. Under the terms of the Maastricht treaty, which established the European Union and led to the creation of the euro, EU states are supposed to keep their government deficits below 3 percent of GDP, and total government debt is not to exceed 60 percent of GDP. Greece has never been particularly good about meeting its Maastricht obligations, but even the Mssrs. Magoo in Brussels could not ignore Athens’s profligate ways forever. So the Greeks needed a way to borrow some money without having to issue bonds or engage in other conventional debt-financing measures that would put the debt on the national books.

So they called Goldman Sachs, the bank that seems dead-set on living up to Rolling Stone’s description of it as a “giant vampire squid wrapped around the face of humanity.” Goldman Sachs loves to help distressed governments borrow money — and then get the risk onto somebody else’s books as quickly as possible. Example: After helping the all-but-formally-bankrupt state government in California borrow a heap of money through issuing new bonds and collecting a multimillion-dollar fee, Goldman recommended to its clients that they be wary of the bonds — which was likely good advice, as Sacramento’s finances are a mess.

But governments don’t just put bonds on the market; they engage in all kinds of complicated financial transactions, often for very good reasons. One of the things governments sometimes do is called a currency swap, which is basically a bet on the fluctuations of their own currency and those of foreign countries. Currency swaps can be useful, because they help governments hedge the risk of sudden changes in foreign-exchange rates. When the Greeks came looking for some spare change, Goldman created a special kind of foreign-exchange swap, called a cross-currency swap, that essentially allowed the Greek government to borrow money without being seen to do so.

As the Spiegel reports, Goldman simply made up exchange rates, which allowed the Greeks to swap an amount of one currency for a different amount of another currency — taking about $1 billion out of the transaction. This money will have to be paid back, but it did not show up on the books as sovereign debt. There’s nothing illegal about that, but there’s plenty that’s sneaky. The European authorities do not keep a very close eye on financial derivatives of this sort, so this Trojan Horse financing didn’t show up for some time.

Greece isn’t alone in doing this: Italy apparently has been doing this for years. Felix Salmon reports that Goldman helped create something with the deliciously Wagnerian name of Aries Vermoegensverwaltungs to help Germany hide some sovereign debt. And the guys at Goldman Sachs are no fools: They sold those Greek swaps to a Greek bank back in 2005.

The European Union today will convene an emergency meeting to stave off the possibility that Greece will default on its sovereign debt. Something on the order of a national bailout is probably in the works, and Greece may not be the end of it: Portugal, Italy, Ireland, and Spain — collectively known, with Greece, as the PIIGS — all are in critical condition. And it’s not just their public finances: The financial bubble was not only an American phenomenon (arguably, it was not even principally an American phenomenon), and Europe’s banks went way out on a financial limb, getting themselves fatly leveraged up and making enormous loans in the now-fragile boomtown economies of Eastern Europe. Many of those banks have exposures to Eastern Europe — alone — that exceed their countries’ GDPs.

#page#The U.S. simply bailed out its banks when they invested in a lot of bad mortgages, but this is a problem of a different magnitude, because in Europe, many of the banks are bigger than the countries in which they are based. If you recall the sorry case of Iceland — a national economy more or less bankrupted by a couple of big bank failures — you’ll remember that the problem wasn’t so much that the losses were so big in absolute terms, but that Iceland is so small. It simply did not have the resources to address the crisis. Spain is not small; nonetheless, Spain’s Banco Santander’s assets exceed Spain’s GDP, and the bank has borrowed a lot of money against those assets — its leverage amounts to about 30 percent of the country’s GDP. And the same is true for many other large European banks: UBS’s assets are nearly 300 percent of Switzerland’s GDP, Espirito Santo’s more than 250 percent of Portugal’s, Paribas’s 150 percent of France’s; and the debt secured against those assets represents an unmanageable chunk of GDP in each case. (See the startling chart here.)

#ad#When people cry out for regulation, it’s worth asking: Who are the regulators? Europe has banking regulations and oversight that are, in many ways, much stricter than those in the United States, and yet its financial institutions arguably are in worse shape than ours. And if you look at the shenanigans the Greek government is engaging in to camouflage its borrowing, it’s hard to believe that it could have much credibility as a financial regulator. Take a good hard look at the government’s books, or at the way Washington is running Fannie Mae, before you think Uncle Sam the guy to run the banks. There are sensible reforms that can and should be enacted, of course. (Some of them are explored here.) But regulators are who they are, which is to say, political animals.

For instance, for all the angst and hollering over executives’ bonuses, the best information we have suggests that compensation structures were not much of a factor in the financial crisis, and the belief that executives knowingly loaded up on risky transactions to fatten their year-end envelopes is a myth. (NR subscribers can read all about it here.) But lambasting rich guys gets votes, so rich guys in Washington are going to yell at rich guys in New York and probably do precious little to mitigate the underlying problems. Keep that in mind: Even as we consider sensible reforms in the financial system, we have to be realistic about the limitations of regulation — and, more important, about the limitations of regulators.

Here’s an example: Here in the year 2010, the National Highway Traffic Safety Administration, under the leadership of Transportation Secretary Ray LaHood, is just getting around to noticing that there is a bit of a problem with some Toyota automobiles. Ray LaHood answers to President Obama, and they both answer to political mandates. State Farm, the insurance giant, answers to its bottom line, which is why it knew about these problems a while back — and warned the NHTSA about the situation back in 2007. Bush administration, Obama administration, take your pick: Regulators do not have the information or the incentives to do many of the things we want them to do, whether the subject at hand is a sticky accelerator on a Camry or a complex currency derivative.

Take a good long gander at how the Europeans deal with Greece on Thursday, or how our Congress deals (or doesn’t deal) with the national and global financial crisis in the coming year, before you decide that the answer to our problems is giving the political authorities an even stronger hand in the economy.

– Kevin Williamson is a deputy managing editor of National Review.

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