Much has been made of investment banks helping Greece hide its growing pile of debt and propensity to live beyond its means while at the same time benefiting from its problems by being short CDS, or in banker vernacular ‘buying protection’. In fact Goldman was doing what any well run bank would do; finding a solution for a client (banks like to be thought of as solution providers) and actively managing its risks.

The trade was this: Goldman and Greece entered into a currency swap contract on an existing liability Greece had in Yen.  Greece issued a bunch of bonds denominated in Yen at the turn of millennium and back in the 90s when the Euro was a lot weaker.  Greece exchanged the Yen it raised through the bond sale for Euro, and spent the proceeds on ouzo, olives and BMWs.  Because of the depreciation of the Yen (Euro strength), Greece had achieved a massive gain (i.e., cheapened the cost of debt). 

Normally when you enter into a cross currency swap the agreement is to exchange cash flows at the current spot rate. The NPV of paying Euro (swapping a Yen into a euro liability) and receiving Yen is $0.  The difference in the interest payments pays for the forward appreciation/ depreciation of the currencies.  Let’s assume at the time of the bond issue the exchange rate was 100 Yen/ euro.  At the time of entering into the currency swap contract the Yen/euro exchange rate was 120.   Greece entered into contract by setting the exchange rate not at 120, but at 100 Yen/euro.   Say they swapped a Yen 100 billion liability, then using the current spot rate of 120 Greece would have owed Goldman in the future Euro830 million and would have received Yen100bn at maturity of the swap and bond.  The Greeks had done well, reducing the effective Euro cost of borrowing by 20%! 

Now what the Greeks did was to actually exchange at the old spot rate so they owed Goldman Euro1 billion and would receive Yen100 billion (if they had done the swap at the current spot rate Greece would have reduced the amount it owed by Euro170 million).  Goldman then paid Greece the present value difference of Euro1 billion less Euro 830 million upfront.  The variations on this type of deal could be not to upfront the payment, but reduce Greece’s annual interest payment in Euro to Goldman. 

Somehow under the budget rules this extra amount Greece owed did not show up.

However Goldman now has a massive credit exposure to Greece in the event Greece fails to make good on its scheduled payments in Euro.  To hedge the risk Goldman bought credit protection on Greece in the CDS market (which is the equivalent of being short Greek bonds).  Then Goldman has no exposure to Greek credit but has lent them billions.  (Goldman probably bought protection from AIG!).  So, Goldman was not betting against Greece, it was being prudent by protecting itself and hedging the risk of Greek credit.

These trades and similar ones likes it were done on a massive scale by many banks.  The bad thing for Greece is that not only did it hide the borrowing, it was actually really expensive borrowing because of the frictions in the trade and the very, very large profits made by the banks……

-by a Guest Author