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Goldman swap shows Greece was Europe’s sub-prime nation

By Nick Dunbar

All the talk about Greece trying to persuade its creditors to swap some once-valuable bonds for new ones worth much less reminds me of another Greek swap that I wrote about in 2003. That deal with Goldman Sachs, designed to conceal part of the country’s ballooning debt-to-GDP ratio in order to conform to the rules for Europe’s single currency, was analysed by EU statistics agency Eurostat in a report published last year.

Although the report’s credibility is undermined by Eurostat’s straight-faced insistence not to have known about the swap until 2010, it does provide some insight into the Greek governance that got the country into its current mess. In particular, there are some telling analogies between the product that Goldman sold Greece and the mortgage products that U.S. financial companies sold to subprime borrowers during the housing bubble that ended in 2007.

The swap was structured in June 2001 and had two components. One was a series of cross-currency swaps by which Greece’s historic foreign currency borrowings in dollars and yen were converted into euro debt for accounting purposes. Normally, these contracts are transacted at the prevailing spot exchange rate, and have zero value. In Greece’s case, these swaps were transacted at a fictitious exchange rate, reducing the size of the debt by €2.4 billion. According to Eurostat’s accounting rules at the time, this was a perfectly legal thing to do.

The second part of the transaction is where it gets more revealing.
Because the ‘off-market’ cross-currency swaps had a positive value for Greece, they were in effect a loan from Goldman. To repay the loan, Greece entered into a separate off-market interest rate swap which had a positive value of €2.8 billion for Goldman (this amount included a €400 million charge for unwinding some additional swaps). A payment of fixed coupons from Goldman to Greece was more than counterbalanced by a stream of floating-rate payments going the other way that would last until 2019, paying off Goldman’s loan, along with interest and fees.

There was more to this unusual interest rate swap as Eurostat pointed out. The floating rate was not a plain-vanilla money market rate such as Libor. It was ‘actively managed’ according to the report, and was tweaked several times. ‘This is a feature which does not seem to be commonly observed in normal market practices’, is how Eurostat described it. The swap also included a grace period of two years before Greece would actually have to pay any money to Goldman.

In effect, this grace period resembles the so-called ‘teaser rates’ that were popular among subprime borrowers during the U.S. housing bubble. Teaser rates typically lasted for two or three years and temporarily insulated borrowers from crippling mortgage costs that would kick in once the introductory period expired. To avoid foreclosure, subprime borrowers would refinance these mortgages before that happened, an exit route that was possible so long as house prices were rising.

Consider the similarities in Greece’s relationship with Goldman. Like a subprime borrower, Greece was overly indebted and showed little ability to get to grips with the problem. The Goldman swap was akin to a ‘liar loan’, where Greece could keep its troubles secret. The grace period on the swap made the problem briefly look affordable. The analogue of house price appreciation was the deficit, which the Greek government forecast would disappear in a few years’ time, providing enough income to eventually pay down the swap. To keep the illusion going, Greece went back to Goldman and tweaked the deal, extending the grace period for another couple of years each time round.

As with subprime loans, Greece was not really getting an interest holiday during its grace period. The interest and fees were racking up out of sight and getting added to the loan balance. With subprime, this was known as ‘negative amortization’. The Eurostat report shows what the impact was, when in early 2005, Greece refinanced the hidden loan. This time round, Goldman restructured the swap and sold it to a recently-privatized Greek bank, National Bank of Greece. This meant that the swap had to be marked-to-market, at a value of €5.1 billion.

How costly was that for Greece? In 2001, Greece publicly issued ten-year bonds that paid a coupon of 5.35 percent. If Goldman’s €2.8 billion loan had been compounded at this rate for four years, Greece would have owed €3.4 billion in 2005. To get a loan amount of €5.1 billion is equivalent to Greece paying a staggering 16.3 percent annual interest rate. This additional cost may be connected with the structured product nature of the swap which entailed Greece making bets on market moves in interest rates and inflation indexes that performed badly.

Rather than facing up to its problems in 2005, Greece extended the maturity to 2037 from 2019 in order to keep annual costs down, with a new grace period of two years. The efforts were in vain, and in 2010, Eurostat forced Greece to reinstate the hidden debt on its balance sheet.

Today, Greece is widely expected to default on its $350 billion of outstanding debt. In the U.S., $750 billion of outstanding mortgage debt is underwater, and $200 billion is in default. In both cases it was tempting to rail at the spendthrift and insist on full repayment, a position that has been exposed as being futile. Some countries, like consumers, are unable to resist financial products that play on their weaknesses and worsen their problems.