Friday, December 16, 2011

How Greece could build up so much foreign debt - a purely fictional short story

Greece’s foreign debt was 399 BN EUR by mid-2011. It was composed of 174 BN EUR in the central government; 208 BN EUR in the banking sector and 17 BN EUR in other sectors.

Many people ask these days how foreigners could lend so much money to Greece. Let me tell a tale how this could have happened. Any similarities with actual persons and/or banks are strictly coincidental.

Imagine that there are 3 major banks in Europe: the Merkel-Bank AG; the Sarkozy-Bank S. A.; and the Cameron-Bank Ltd. Each of them has a country-desk for Greece headed by Horst at the Merkel-Bank, Jean-Pierre at the Sarkozy-Bank and the charming Charlotte at the Cameron-Bank. All three of them feel very important because, after all, the entire Greek exposure of their respective banks is under their responsibility. They also know each other from meetings, presentations, road shows, etc. where all international bankers having an interest in Greece get together.

Their colleagues responsible for domestic lending operations in each of their banks think of them as “overpaid wine-tasters” because in their view, Horst, Jean-Pierre and Charlotte spend their time like diplomats who mingle amongst their own kind and who feel like being above the dirty day-to-day business of a normal bank.

Let’s take Horst as an example. He is in touch with his Greek customers (mostly bankers like himself) almost daily via phone or email. But two or three, or even four times a year he takes a trip to Greece to meet with all of them personally. They call that “relationship management”.

So, as Horst prepares for his next trip to Greece, he gathers information from all marketing departments within the Merkel-Bank as to what their business activities with Greek customers are and what their business development interests would be. His Syndications Group might complain that they are being left out of good Greek deals because the Sarkozy-Bank and the Cameron-Bank take a much more aggressive posture. His Trade Department might tell him that they would like to transact a lot more documentary business with Greek banks but that they are always told that such business is allocated to the lending banks according to their exposure and that the Merkel-Bank is not quite up to where the others are.

Horst also requests input from his Risk Management Department. They send him the latest summary of the Merkel-Bank’s country limit and actual usage thereof as well as an economic analysis of Greece. Horst studies all the input from the marketing departments as he prepares for his trip. The input from the Risk Management Department he leaves on the side, to be read on the plane and/or in the hotel room once he has arrived in Athens.

By the time Horst has reviewed all the input from his marketing departments, it is clear to him that he cannot return from his trip with empty hands. Instead, he has got to come up with some more business in order not to fall too much behind the Sarkozy-Bank and the Cameron-Bank.

On the plane to Athens, Horst starts flipping through the reports of his Risk Management Department. He doesn’t get very far because, great surprise, Charlotte from the Cameron-Bank is on the same plane. So he postpones the reading until later on in his hotel room and chats with Charlotte about the big picture of Greece.

Horst reads the report of his Risk Management Department in his hotel room. He doesn’t quite get it. These bean-counters write at length about Greece’s budget deficit which seems to be heading out of control; about Greece’s current account deficit which seems to blow all conceivable proportions; about the staggering growth in Greece’s foreign debt. Horst remembers that Charlotte had told him completely different things on the plane and he puts the report to the side.

The next day, Horst has appointments with 3 Greek banks: a breakfast meeting in the morning; then a luncheon; and the third one for late afternoon to be continued with a dinner at Mikrolimano. Since Horst doesn’t speak Greek, he is most impressed by the fluency in English of his Greek counterparts and by the way they handle themselves. He often thinks that if only his primitive domestic banking colleagues could see the type of top-notch internationalist people he is dealing with and how he can handle himself with them. And how well he speaks English!

His counterparts do not request any new loans from Horst. Instead, they talk about how great the Greek economy is developing and how other banks recognize this by increasing their Greek exposures. They express their full understanding that the Merkel-Bank is not quite up to the Sarkozy-Bank and the Cameron-Bank but, somewhat sadly, they say that, because of this, the Merkel-Bank should not be surprised if it gets less documentary business and/or capital markets business from them.

The lunch takes place at the executive dining room of the bank. The dinner in Mikrolimano lasts until the early morning hours and, by the time they all go home, they have promised each other to be best friends for the rest of their lives. Horst wonders if the Chairman of the Merkel-Bank ever has such business experiences.

The next days of his business trip unfold in similar fashion. None of Horst’s counterparts requests credit. All they do is to point out how much market share the Merkel-Bank is losing by not being a bit more aggressive as regards lending to Greece.

In one of the meetings, Horst hears that Jean-Pierre from the Sarkozy-Bank had recently had a personal meeting with the Minister of Finance. Embarrassingly, Horst has to admit that he has never had the opportunity to meet with the Minister. His hosts say that they could arrange such a meeting but they point out that the Minister does not like to waste time. If he agrees to a meeting, he would like to know beforehand that there will be some outcome.

By that time, Horst is convinced that he is running far behind Jean-Pierre and Charlotte. He better do something to convince his Greek counterparts that the Merkel-Bank is in no way junior to the other banks. As he looks forward to the meeting with the Minister, he briefly does remember that his Risk Management Department was very concerned about taking on more Greek risk but he quickly dispels this thought. After all, those bean-counters are acting from ivory towers and he, the Country Desk Manager of the Merkel-Bank, was truly “in the field” and could assess what the risk really was.

The Minister tells him at the meeting that Greece was about to give the mandate for a new bond issue. The Sarkozy-Bank and the Cameron-Bank had already made their pitches and both looked really good. But if the Merkel-Bank really wanted to improve their standing with the Greek government, this would be the chance to show colors. But they would have to do that soon. The Minister assumes a fatherly role and promises Horst that if his bank made an interesting proposal, he would personally favor it over other offers. Horst leaves the meeting convinced that he now has the chance to really put the Merkel-Bank on the map in Greece.

Waiting for his return flight at the Athens airport, Horst runs into Jean-Pierre who has just arrived and who is in great spirits. Jean-Pierre tells Horst that he would be having meetings at the Ministry of Finance to discuss an upcoming bond issue. At this point, Horst knows that the race was on.

On his flight back, Horst organizes all his papers and starts preparing his upcoming Committee Presentation mentally. When putting together the numbers, he sees that, with the new Greek deal, he would exceed his annual budget quite substantially. He starts making some first bonus calculations in his mind.

Back at Head Office, Horst finalizes his Committee Presentation. One small hurdle is that the Merkel-Bank’s Risk Manager wants to have a conversation with him about the presentation.

That conversation turns out to be less pleasant than the dinner at Mikrolimano. The Risk Manager wants to know of Horst why he recommends such a substantial increase in exposure when the economic analysis of Greece was not favorable at all. Horst has to control his temper. In his mind, the Risk Manager is the epitome of a bean-counter. Horst argues that, regardless of what the economic analysis said, Greece was rated A/A-1/Stable by S&P which made it investment grade. Also, Basel-II did not require any reserves to be held against sovereign bonds of Greece because sovereign bonds were considered risk-free.

The Risk Manager asks why Horst is going for approval of such a large amount. Horst explains that they first had to subscribe the full bond but that they were expecting a large sell-down to end-investors with only a reasonable final take. Who will be the takers, the Risk Manager wants to know. Horst answers that, above all, the Sarkozy-Bank and the Cameron-Bank would take large amounts. He had just recently had discussions with each of them and they were bullish on Greece.

The Risk Manager insists on the question of why a bond and not a loan. He argues that with a loan the bank would have much more direct influence on the borrower whereas with a bond the bank had virtually none. He points out to Horst that he had argued on previous deals that there would be large sell-down’s and at the end of the day they ended up with most of the deals on their books. Horst has 3 answers to that: first, the Syndications Group had messed up the distribution of the previous bonds; secondly, the bank was earning good margins on those risk-free assets so that they were very well off holding them; and, finally, the bank should be guided by what the customer’s interests are and not only by its own. And the customer wanted a bond.

Risk Management adds a critical view to the Committee Presentation but no one takes serious note of it given the investment grade rating of Greece and the new business potential. The deal gets approved and Horst is praised for his accomplishment. And the Minister of Finance accepts the proposal by the Merkel-Bank.

Once the deal is closed, Horst passes it on to the Syndications Group with specific instructions to start the down-selling with the Sarkozy-Bank and the Cameron-Bank. Much to his surprise, he receives feedback that neither of these two banks wanted to take any part of the bond. Horst is confused and places calls to Jean-Pierre and to Charlotte.

Both answer him the same way. Yes, they say, they still had plenty of Greek exposure available but their policy was to reserve that exposure for deals which they had generated themselves. Also, each of them say, they had just arranged a major bond for Greece and they didn’t want to go back to their committees with a new request so soon thereafter. That comes as a bit of a shock to Horst because, until that time, he thought that Greece had only done one deal and that he had outmaneuvered both the Sarkozy-Bank and the Merkel-Bank.

Horst then has a brainstorming meeting with the Syndications Group to plan a new strategy for down-selling. At the end of the day, they can place some portions of the bond with German Landesbanken and second-tier banks of other countries but the bulk of the bond stays on the books of the Merkel-Bank.

During this time, Horst once runs into a colleague from the domestic lending operations of the Merkel-Bank in the bank’s cafeteria. Horst proudly explains what a large deal he had just concluded with Greece. His colleague from the domestic lending operations inquires what the purpose of that financing was. Specifically, what Greece was going to use the money for. Horst doesn’t even reward that petty question with an answer. Such petty questions could obviously only come out of the narrow minds of domestic lenders.

By the time 2008 comes around, the Merkel-Bank, the Sarkozy-Bank and the Cameron-Bank (and many other banks) have gone through this process several times. With the crisis of 2008, the banks’ liquidity comes under pressure and their appetite to increase bond volumes on their books declines. Also, by mid-2009, the foreign debt of Greece surpasses the 400 BN EUR mark and it begins to look substantial. An election campaign is under way in Greece and the banks want to await the outcome of the election.

Shortly after coming to office, the new Greek government shocks the world with revised budget deficit figures. Hectic breaks out among board members of the Merkel-Bank. They urgently request presentations of the bank’s total exposure to Greece. Horst as well as his Risk Management Department are busy compiling all the information.

The Board Committee expresses surprise at how large the total Greek exposure is. The Risk Manager points out that they had reviewed and approved the frequent exposure increases themselves. The Committee feels that action must be taken. The first action will be to reduce the exposure limit to current outstandings so that at least no further money would go out the door. Then they want to hear proposals as to how the current outstandings could be reduced.

As it turns out, most of the outstandings are bonds which the Merkel-Bank holds on its books and the Syndications Group informs that there aren’t really any buyers offering reasonable prices in the market. So they turn to the loan outstandings which represent short-term lines of credits to Greek banks for the purpose of trade financing. These lines are so-called “internal lines”; there are no written loan agreements and, thus, they can be cancelled any day. Horst is assigned to “run down” those short-term internal lines of credit.

Horst then calls one Greek bank after another to inform them of the Merkel-Bank’s new policy. The Greek banks are shocked. They remind Horst of the dinner at Mikrolimano where they had promised each other to be friends for the rest of their lives. That, at that time, they were doing him the favor of giving him business which other banks had wanted as well; that they now had the impression like Horst was selling umbrellas when the sun was out and was now running away as soon as the first raindrops fell. Horst has no better explanation than to say that he is instructed to implement the bank’s new policy.

Billions and billions of Euros are called back by the Merkel-Bank and by all other banks during this period. Had the Greek banks not been able to get refinancing from the ECB, they would have gone under.

Meanwhile, there are new developments at the Head Office of the Merkel-Bank. Their chairman, one of the most prominent bankers in the world and a key advisor to the German government, had convinced policy makers that the ECB should buy Greek bonds. Otherwise, the markets would collapse. Eventually, the ECB agreed to do this and the Merkel-Bank manages to sell off, at near-par rates, a large part of its Greek bonds.

Horst received a very good bonus twice. The first bonus he received when he had successfully run up the Greek exposure and the second bonus he received for successfully calling back the short-term lines for Greek banks and for unloading such a large amount of bonds to the ECB. Unfortunately, he lost a few “eternal friends” in Greece, but Horst is happy.

A year later, a new challenge comes up for Horst. The bank’s chairman had to grudgingly agree to a socalled “voluntary debt forgiveness” in the order of 21%. That is not good news for Horst. However, the basis for calculating this 21% had not been clearly established. “Forgiving 21%” means that the Merkel-Bank will receive a new bond with EU-risk for the other 79%. Horst is now charged to come up with proposals as to how a formula could be implemented which would assure that the damage to the Merkel-Bank would be as small as possible.

Horst comes up with a net-present-value calculation (NPV). An NPV-calculation is routine work for Horst. Essentially, it means adding up all future cash flows from a loan (interest, principal) and transforming them into a net present value applying a discount rate. The higher the future cash flows and the lower the discount rate, the higher is the amount to which the 79% will be applied.

Horst is very clever and he constructs long tables of numbers using certain assumptions. At the end of this exercise, it turns out that the Merkel-Bank’s voluntary participation in the debt forgiveness will be less than 10% of the nominal value of the bonds which it has on its books.

This is when Horst is awarded his third bonus.


  1. This upsets me, a lot.

    The root of the problem? Interest Rates are too low, and Greece couldn't just live within it's means.

    Great post.

  2. Very interesting.

    I always wondered how any banker could be so short sighted to put out those greek bonds.
    But in the end it all worked out well for them and the big banks are still in the game.

    Though for a small banker like Horst the risk seemed real, I can't quite believe that the banks' management didn't know that they would be saved by the central bank if in peril.

    Your post very well illustrates the moral hazard involved in the long term lending business and your description really seems sound to me. Have you worked specifically in that field? It's also a great example for behavioural economics btw.

    In my opinion this moral hazard is clearly amplified by the too-big-to-fail-mentality inside the big banks which right now are just a vehicle for bonus-hungry individual speculators. In conjunction with the mutual distrust between banks this mentality has become the biggest problem for the global economy. Many banks now simply lend to different countries where there is ECB-guaranteed money and still a lot of collateral that may be privatized to pay them off. Others bet against the same countries. If some banks go bankrupt others win. But the bankrupt ones will often be saved by the tax payers and stay in the market - and there are still banks and hedge funds failing. This puts even more burden on countries and leads to more indebtedness.
    It becomes clear that this is not even a moral hazard anymore but a rigged system. As long as the banks are not restrained, lead or crushed by politics this system will go on shifting more money and power to the banks. Until total collapse.

  3. During my banking career (now retired), I spent some years belonging to the "overpaid wine-tasters" and some other years belonging to the "primitive domestic bankers". You can rest assured that this tale reflects reality.

  4. so everyone is ready to deplore the Greeks and express its utter discontent towards their "attitude", but nobody's ready to do the same to the bankers -

    in other words, everyone's ready to blame the subprime borrower rather than the subprime lender.

    what a pity.

  5. Lovely "story" thank you. As a risk manager in a Cameron-Bank it rings painfully true, despite so obviously being a work of fiction. One lesson I draw from it (and my own professional experience) is that when it comes to bean counters being able to block bonus making/bank destroying deals, its the culture of the individual bank that's key regardless of its credit policies, procedures, models etc., Essentially, are bean counters able to say no without destroying their careers and if so are they listened to.

  6. I agree with you totally about the importance of culture. You may be interested in this letter which addresses that aspect in detail.

  7. Prof. Yanis Varoufakis published this tale in his blog ( There were many comments to it and below is my response to them.

    After reviewing the comments to my tale (thanks to Yanis for distribution), I would like to comment on comments.

    My tale was about BEHAVIOR of banks and bankers and not about technicalities of banking. Having spent some of my banking years as “overpaid wine-taster” and some others as “narrow-minded domestic banker”, I can assure everyone that my description reflects quite accurately the behavior of large banks with international activities.

    I did not want to attribute blame to anyone. While I took Greece as an example, the tale applies universally and I would guess that it is timeless.

    One reaction was that I didn’t talk about the betting among banks against, say, Greece. That is correct. I could have easily concocted a couple of very biting paragraphs about that but, then, there are other aspects which I didn’t cover either. The tale had become longer than intended already.

    Regarding the mean bankers/speculators who are allegedly out to “kill” countries and economies, I have never met any person fitting that description. However, there are many bankers/speculators out there who are chasing high financial returns, preferably short-term gains, and they can definitely destroy real values. Theoretically, if economies/markets were in complete balance (not possible in practice), these people would be out of a job. They thrive on imbalances and they have an amazing ability to detect imbalances. Oftentimes they can even create them. But they are out to (profitably) transact business and they are not out to (unprofitably) wage geopolitical campaigns.

    The word “parasites” was mentioned and I find that very interesting. In the Middle Ages, that term was used against people who were deemed to take advantage of real economies without contributing to them. What we have today are entire industries who take advantage of real economies without contributing to them (other than recycling the financial wealth which they generate for themselves).

    Even today, most banks (the medium-sized and smaller ones) understand that banks are not an end per se but a means towards an end. That their end is to support customers in the real economy so that there can be real wealth generation. Despite their quantitative majority, these banks really cannot influence large international capital markets. Instead, they are influenced by them. The much fewer large players have developed a mindset where the bank is an end per se and where it is the customers who become the means towards that end. They think less of “customers” and more of “counterparties”. Instead of visiting customers, their top executives visit institutional investors, attend analysts’ meetings, talk to consultants, etc. “Real” customers often, and rightfully, criticize them for speaking a language which no “real” customer understands. However, without a real economy somewhere out there, they could not transact any business. From that standpoint, to use the word “parasites” to describe them is mean but not false.

    Part 2 follows below.

  8. For individual banks/bankers caught up in the midst of the herd behavior, it is next to impossible to break out. Horst would have been fired if he had fallen too far behind Jean-Pierre and Charlotte (and replaced by someone who could successfully compete with them). Even a CEO like Josef Ackermann would have gotten into serious personal trouble if Deutsche Bank had fallen far below the 25% ROE which he had promised his investors. And he promised that return to investors to safeguard his job in the first place. A notable exception would be Warren Buffett who has built such a myth around himself that he does not really need to report to anyone (and, so far, no one has dared to question him); they all trust him blindly. When Warren Buffett decided not to take part in the IT-bonanza/bubble because he didn’t understand it, he could do so. Most everyone else would have lost his job for “not understanding” such (perceived) enormous profit opportunities.

    Goldman Sachs was cited as the villain. Actually, G+S is the epitome of perfection in this game. Not only do they often profit the most from being in the herd. As “leading steers”, they push the herd onwards but they are smart enough to leave the herd before it goes over the cliff (and sometimes they even save themselves by driving others over the cliff). It is the nature of the game which needs to be criticized. If one justifies the nature of the game, one should not criticize its most successful (albeit it reckless) performer.

    G+S was criticized for advising Greece how to “cheat” with the level of her debt and for collecting high fees for that. The reality is that every major player in international finance employs entire divisions of supremely intelligent people who spend their time developing new products/ideas for making money. Regulations are a great opportunity for them because for every regulation there are possible ways around it. Maastricht is a case in point. The fee income earned so far by bankers, lawyers, accountants, etc. through advising governments how they can legally circumvent these regulations is probably beyond imagination. Some of the better known circumventions are: cross-border leasings; private-public partnerships; outplacing debt into SPVs; or – as in the case of Greece – cross-currency swaps. I cannot imagine that G+S got the mandate for Greece’s cross-currency swaps because they conspired with the Greek government how to cheat the EU. Instead, I would suspect that every major player had pitched for that mandate and G+S got it because they were the best. As far as I know, there was nothing illegal about the structure of the cross-currency swaps and Greece is definitely not the only country which is “optimizing” its sovereign debt for the purpose of reporting it (Austria’s reported sovereign debt would be about 20% higher without “optimization”).

    These are some of the behavioral aspects which I tried to bring across and I appreciate the feedback from those who understood this. I attach a video below which came out almost 4 years ago. Not all of you may know it yet. It is priceless for its humor, and --- quite reflective of reality!

  9. Thank you for your further insights, kleingut.
    I totally agree. (i wrote the second comment btw)

    However, there's something i would like to add.
    If I was a true believer in self regulating markets first I would (of course) see the root cause of the recession in government failure. We all know the typical accusations like e.g. too much regulation, central banks overly expanding money supply etc. which in part are hideous or where there's even some truth to them. But once you examine the connections between banks like G+S and government officials all over the world it becomes obvious that corruption was/is the main reason for the recession and also the essential force behind the success of the biggest players like Government+Sachs. In fact legal bribery like the revolving door has become so overtly recognizable that you don't even have to be a mediocre political analyst to know who in the government institutions primarily works for the big banks or any other corporation. Obviously, the terms government failure and market failure don't apply anymore because government and corporations are already too intertwined.

    So although I see your point in focusing on the behavioural aspect of banking I still wished you would have emphasized a little more on the corruption/blackmailing aspect e.g. on how the chairman of the Merkel-Bank "convinced" the ECB to buy Greek bonds.
    Furthermore, of course, to become a highly successful bank like G+S you also need those supremely intelligent people to efficiently relieve your customers or someone else of their money. But the framework where you get away with all these scam-like activities was set up and lobbied for by the banks' political networks.
    So regarding Greece I doubt that they could have performed that "debt optimization" in a well regulated and overseen eurozone or at least not in such a dimension. In a way G+S and the other banks bribed this business field into existence. And it's hard to believe that they didn't make a second profit by betting against Greece knowing that their books were cooked.

    So in my opinion the moral hazards in the day-to-day banking-business are at least partly based on the foundation of ongoing massive financial corruption.

    Since you spoke of Varoufakis here's a very interesting conference organized by James Galbraith several weeks ago:


  10. Dear Mr Kleingut

    It was Einstein who said "If you want to make your children intelligent, tell them fairy stories. If you want to make them more intelligent, tell them more fairy stories” Well in this case it is quite obviously the case that it works for grownups too. If not by making them more intelligent then by revealing insights.

    I would like to add a note to your comment "Regarding the mean bankers/speculators who are allegedly out to “kill” countries and economies, I have never met any person fitting that description" I had a recent experience with a bailiff and whilst not out to kill me, had no interest in my ability to pay than the amount in my bank account.

    Anything else was like discussing flower arranging with a brick wall. Worse in fact: usually I can sense the person at the other end of the telephone, It was as though I dropped my words down a hole and they never hit the bottom.

    One further thought: to me, a bank is not funcioning properly if it focusses on money. The job of a bank is to invest in people, it is people that generate real capital. The money must be secondary to that, for without humans it has little value.