This is part 8 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 8, we’ll discuss the role of swaps in more recent times: the Euro-zone crisis.
In June 2001, seeking to shore up its finances as it prepared to use the Euro as a member of the Euro-zone currency union, Greece reached a deal with the U.S. bank Goldman Sachs to borrow €2.8 billion. When the deal was reached, the Greek government had already owed Goldman Sachs about €600 million – not counting the €2.8 it just borrowed.
Just four years later, the costly transaction nearly doubled to €5.1 billion. It turns out that a currency swap agreement was in place to help conceal Greece’s haphazardly constructed balance sheet, which showed that the country was experiencing an unsustainable rise in its debt-to-GDP ratio. Without the deal, Greece wouldn’t have been able to join the Euro-zone, as its debt-to-GDP ratio was in breach of the European Union’s rules for the amount of debt each country could have in order to join the Euro. But a loophole in the law allowed the currency swap agreement in place to not be counted as debt, thereby keeping Greece’s debt-to-GDP ratio within the European Union’s required range.
The arrangement made in June 2011 had two key components. The first was a series of currency swaps. Greece’s debt, which historically was accounted for in Japanese Yen and U.S. Dollars, was converted to Euros for the transition into the common market. Instead of the contracts being transacted at the spot exchange rate, they were measured against a fake exchange rate devised by the Greek government and Goldman Sachs – a perfectly legal move, given accounting rules in the European Union at the time.
Because of the positive value that currency swaps had for Greece, the government needed to pay back what was, for all intents and purposes, a loan from Goldman Sachs. In a separate deal, Greece entered into an interest rate swap which yielded a positive value of €2.8 billion to Goldman Sachs, including €400 million in fees for unwinding other swaps Greece had entered. In its truest sense, this was a fixed-for-floating swap: Greece would send floating-rate payments to Goldman until 2019, while Goldman Sachs would happily send fixed-rate payments to Greece.
Euro-zone crisis vs US housing crisis
Perhaps the best analogy for what happened to Greece is what happened with the U.S. housing crisis. Part of the deal with Goldman Sachs was a two-year period in which Greece would not have to make any payments, similar to what is the teaser rate period. As history showed, without the benefit of rising housing prices, subprime borrowers couldn’t refinance within the teaser window (in which rates were low before springing to unsustainably high levels, hence the housing crash).
Like the teaser loan rates enjoyed by subprime borrowers in the U.S., the payment-free period enjoyed by Greece made it seem like the country’s finances were fine, because the country didn’t have any debt obligations for two-years. Instead of hoping for rising house prices, the Greek government was hoping that an economic boom would spur higher tax receipts, which the government could use to pay down the cost of the currency swap.
While the Greek government enjoyed low borrowing costs, the repercussions were building on the horizon: the deferred interest would have to be paid eventually. In 2005, as noted earlier, Greece was forced to refinance the loan, bringing the total cost of the deal to €5.1 billion. This “actively managed tweak,” as described by Eurostat, allowed Greece to keep the loan a secret, thereby keeping its debt-to-GDP ratio within the European Union’s mandated range. After Greece refinanced its debt, Goldman Sachs sold its obligation to the National Bank of Greece, at a marked-to-market value of €5.1 billion.
But these are just large numbers – why do they actually matter? When Greece initiated the original transaction with Goldman Sachs, it had publicly issued 10-year bonds with a coupon rate of 5.35%. Some quick math: compounding this rate over four years (to 2005), Greece would have owed €3.4 billion; instead, the €5.1 billion obligation represented an astounding 16.3% (!) annual interest rate.
Instead of bringing this issue to light immediately, the government chose to hide the mistake further, extending the maturity of the loan another 18 years to 2037. But by 2010, the costly repayments were too much to handle, and Greece was forced to reinstate the debt onto its balance sheet: the Greek debt crisis was born. Today, it is widely expected that Greece will default on its >€300 billion of obligations, forcing it out of the Euro-zone and back to using the Drachma, Greece’s pre-Euro currency.
In part 9 of 10 of this series, we’ll discuss recent regulatory efforts as a direct result of costly mistakes that have piled up over the past several years directly related to swaps.