Nice interview of Prof. Alexander Arapoglou of Kenan-Flagler Business School. He has worked as a financial trader and knows a thing about these games.
He points to how Greece fudged its accounts while entering Euro in 2001. Needless to say who advised the govt on the deal:
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.
Now you have a pair of foreign exchange transactions which are agreed to simultaneously. They’re off-market. The net effect, if the accounting rules allow it —and this is something that has gone on for quite some time — is for me to show a profit this year and a loss next year. 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: When I was working on the trading floor and I was head of risk management for Chemical Bank worldwide, the rules were that you can’t enter into these transactions. They were frowned upon because they create reputational risks for the bank. The basic principle of them is almost always unethical. 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.
One keeps wondering how things became this bad in financial industry. Historically, people in finance were highly condemned and looked down upon. It took quite a bit of an effort to give finance a role of prominence and esteem in the society. So much so that it became the profession. And then the tide turned and profession is back to its cheating ways. Though, the sector still remains promising and continues to invite top talent given the salaries and perks that come with the sector.
Ethics and morality in finance seems to have become as important a course as corporate finance.