More regulatory arbitrage by Goldman Sachs

That Goldman Sachs is a master of regulatory arbitrage is well documented. However, hitherto such arbitrage was thought to be confined to itself and its private clients. Now here comes news that Goldman helped Greece hide the true extent of its indebtedness and beat the rigid EU Stability and Growth Pact conditionalities to raise money using clever cross-currency swaps.

Der Spiegel, via Felix Salmon and Marginal Revolution (also Mostly Economics), reveals that in 2002 Goldman helped structure cross-currency swaps for Greek government debt issued in dollars and yen and swapped it for euro debt for a certain period

"Such transactions are part of normal government refinancing. Europe’s governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.

But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks. This credit disguised as a swap didn’t show up in the Greek debt statistics."

In other words, the extra debt was hidden in the currency swap. Incidentally, Goldman shed its risk on this deal after selling the swap to a Greek bank in 2005.

Felix Salmon also draws attention to a similar product structured in 2004 by Goldman for Germany, called Aries Vermoegensverwaltungs, by which Germany essentially borrowed money at much higher than market rates just so that the borrowing wouldn’t show up in the official statistics.

Update 1 (5/3/2010)
It now emerges that Goldman and other banks who helped hide Greece's debt and other hedge funds were using credit default swaps to bet on the likelihood of a Greek default and using derivatives to wager on a drop in the euro. These banks had helped Greece borrow billions to mask its poor finances by creating derivatives that essentially transformed loans into currency trades that Greece did not have to disclose under European rules. See also this account of how Wall Street helped Greece mask its debt.

Update 2 (11/3/2010)
Simon Johnson and Peter Boone argue that Europe's politicians and IMF must step in to provide financial assistance to help Greece restructure its debt if it is to remain within Euroland. The IMF estimates that by the end of 2011 Greece’s debt will be around 150% of its GDP, with about 80% of this debt being foreign-owned, a large part of this held by residents of France and Germany.

Johnson and Boone estimates that every 1 percentage point rise in Greek interest rates (necessary to attract investors to buy Greek bonds required to re-finance debts) means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders. At a 10% interest rate, Greece would need to send at total of 12% of GDP abroad per year, once it rolls over the existing stock of debt to these new rates (nearly half of Greek debt will roll over within three years). This is clearly unsustainable, and the only option is for Europeans to step in and inject cash to bailout Greece.

Update 3 (8/2/2012)

NYT has this account of a lawsuit that claims that Goldman Sachs' conflicts of interest (by having a role on both sides) resulted in El Paso being sold too cheaply in a $21.1 billion buyout of the giant pipeline and energy company by Kinder Morgan.