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.