The Dark Side of International Finance
BSSB.BE http://ineteconomics.org 04.08.2015
Alexander Arapoglou, Professor of the Practice of Finance at UNC’s Kenan-Flagler Business School, teaches risk management and applied investment management to MBA students. He has also been a derivatives trader and head of risk management worldwide for various global financial institutions.
Lynn Parramore: There’s been a lot of talk lately about financial engineering and what role it may have played in the Greek debt crisis. There are even claims that Goldman Sachs may face legal action from Greece over certain complex financial deals made back in 2001, when the Maastricht Treaty required all eurozone members to show improvements in public finances. Can you explain how such deals work?
Alexander Arapoglou: I’ve not seen the original deal document so I don’t know exactly how any deal with Goldman was done, but I can speak to the very basic principle as well as the rules that surround those types of transactions — at least those that are supposed to be followed. There’s a whole class of transactions called “off market” transactions. I’m not sure that this was the exact mechanism that was used, but it’s useful to talk about it in terms of principle.
LP: Let’s talk about how this practice of off market transactions actually works.
AA: Yes. We know, for instance, that the euro today is about 1.09 to the dollar. Suppose I entered into a transaction today that would allow me to buy euros, and instead of paying 1.09, I would pay 99. That would be very favorable to me. I would get more euros that way. Let’s say that with the same party, next year, I would exchange euros at 1.20 to the dollar. That works to my disadvantage.
The reason I can do this is that instead of marking these two transactions to market simultaneously, where there would be a small difference — and that difference would largely be the profit to Goldman Sachs or whichever bank did the deal — I show a big difference this year and then the following year I show the loss and then some, which amounts include the fee to the financial institution.
So those are off market transactions. You do the same thing using derivatives. You take a pair of transactions, you don’t mark them to market, and you account for them on a cash basis. In other words, as they actually accrue, as you make each settlement, you report a profit or a loss.
That way, you can move profits from one accounting period into the other. This was done extensively by the banks in Japan in the 1990s. I remember a line from a book on the subject written by a guy who used to work at Lehman and now teaches in San Francisco: “It’s earning season in Japan and so now it’s time to sell derivatives.”
LP: How are these deals viewed in the industry? Why are they suspicious?
AA: The idea is to take advantage of an accounting rule in order to fool somebody. Somebody is being fooled — maybe it’s a corporation fooling its shareholders. Maybe you’re fooling your creditors. If it’s a country, maybe you’re fooling your citizens. Or maybe you’re fooling the other people in the European Union.
The essence of this transaction is a fraud. So I don’t think in the Greek case they were 100 percent prohibited, but certainly it’s the sort of thing where if I had to deal with the Federal Reserve toward the end of my career, I would be worried because it doesn’t look good. One of the things the examiners ask for is, what is your policy with respect to these things? It’s just not a good idea.
LP: So this unethical approach was actually used in Greece in 2001?
AA: Yes. It was done in order to meet the budget shortfall requirements to enable Greece to enter into the euro. I think Italy actually did something similar, but I don’t know the details. The basic idea was an accounting fudge.
What that means is that in effect the public really may not be prepared — even at that point — to make all of the compromises to sovereignty that were required in order to join the euro. To be part of the euro, you’ve got to be a lot like everybody else, and a lot like everybody else wants you to be. Of course, there is a bit of a double standard because shortly after Greece joined, I think both France and Germany broke the rules in terms of their deficit, but let’s leave that aside for the moment.
LP: Do you think there would be some basis for a lawsuit?
AA: The legal problem is, the lawsuit would be against whom? And for what purpose? It’s like any fraud. It’s not just the question of a lie. You’d have to show how you were damaged. There has to be both a fraud and also reliance upon it and then a loss that follows. I’m not sure exactly where you would point the finger. If it’s authorized at the highest levels of a particular country, then can officials turn around and say, you know what? You, the financial intermediary, you’re responsible. I just don’t know if they can do that or not.
LP: Is part of the problem that we don’t have sufficient international rules to deal with this financial engineering?
AA: Yes. I think the real issue is not only the off market transaction in isolation, but also the accounting standards which allow them to take place. In other words, there’s no economic substance to these transactions. Ordinarily, the purpose of a derivative is to hedge some kind of a risk or possibly to speculate, if you will, on some kind of price movement.
To use a derivative in order to achieve an accounting result and move a profit or a loss from one period to another — there’s just no economic substance to it. There’s no reason that people who read financial statements ought to be misled by that. But the auditors should have known better and the accounting rules should not have allowed it.
LP: Is there any relationship between the financial deals we’ve seen in Greece and what you’ve observed in the U.S. at the municipal level?
AA: The municipalities have a different set of issues. But the fact is, the accounting standards for municipalities are very weak. I’ll give you one simple example. In a pension, in determining what your pension liability is, you have to project an earnings number on all of the assets that you’ve set aside to service the pension.
Why should that be different between U.S. corporations and U.S. municipalities?
LP: How do you view the current negotiations over the Greek debt?
AA: Clearly they bungled it. Austerity isn’t the only thing that’s involved here. There’s also integrity. The Greek political system is rife with corruption, from both the New Democracy and also with PASOK. If you travel in the northern suburbs of Greece and look around at the big houses, some of them are owned by ship owners, but many of them are owned by politicians. They’re really big houses. Those aren’t achieved just on the basis of peoples’ civil service salaries. The fact that these political dynasties could go on for several generations of wealth is a very problematic situation. This is the sort of cronyism that really undermines Greece. Austerity doesn’t help with growth, but neither does a lack of political integrity.
As far as the negotiations go, my comment on that is that Varoufakis’s goal from the very beginning was not inconsistent with the International Monetary Fund’s (IMF) idea that a debt restructuring is necessary for the program to be successful.
The problem is that you’re not in a good negotiating position to get that debt restructuring until you’re in primary surplus, that is, a situation in which government spending on programs is less than tax revenues.
So if Greece were able to maintain a primary surplus, then they would be in a position to repudiate the debt without having the banks closed and without thinking that they’re going to have to stop everybody’s pension payments. The first step would have been to achieve that primary surplus somehow at all costs so that the government was ready later — and this may happen yet — to be more forceful. Then you have the cards to renegotiate a restructuring of the debt. I think they didn’t realize how weak their hand was.
LP: On a personal note, how are your friends and family members faring in Greece?
AA: It’s just unbelievable that things should reach this point. People I know in Greece are at their wit’s end. It’s completely unexpected. They never anticipated that they would have to go through anything like this. For any European country — or for any country — to have to go through something like this is just awful.
Senior Research Analyst