Two major, seemingly unrelated, financial predicaments are taking place on two continents.  The first is the fraud case being brought against Goldman Sachs – a former investment bank.  The second is Greece’s excessive debt, which has resulted in the bailout by the European Union (EU) and International Monetary Fund (IMF). 

These two problems seem unrelated on the surface.  Nonetheless, they are connected.  The current financial crisis has been caused in part by investment banks, like Goldman Sachs, encouraging lenders to sell bad mortgages that they knew would default.  Goldman Sachs is now under investigation for a more complex version of this problem (explained below). 

In a globalized world, finance move swiftly across borders, and countries can be brought down by the policies of an investment bank.  Greece’s problems though are rather complex; their debt has escalated in part because of hedge funds betting against the country and in part because of irresponsible spending.

This news analysis will address the factors affecting Greece’s economic collapse and the charges against Goldman Sachs.

Goldman Sachs’s Fraud

On April 28, 2010, the Security and Exchange Commission filed a civil complaint against Goldman Sachs for fraud.  Paulson & Co (Paulson) – a hedge fund – approached Goldman Sachs (Goldman).  Paulson asked Goldman for a structured investment product  composed of residential mortgage-backed securities (RMBS)  that it could easily bet against. 

Goldman put together a collateralized debt obligation  (CDO) to fulfill that purpose.  Because mortgages are promises to pay back a loan, banks often do not have the physical money to make investments.  Banks, who have lent mortgages, repackage the mortgages into a CDO that can be sold to investors.  This allows banks to increase their physical assets.

Goldman chose ACA Management (ACA), a highly respectable analyst of credit risk of RMBS, to select the portfolios for the CDO and put ACA’s name on the case.  Paulson actually chose 55 out of 90 of the RMBS.  Paulson chose those specific 55 portfolios knowing they could default.  ACA did not actually put together a majority of the CDO.

These securities could be split: one buyer immediately sells the securities (shorting) , while the other buyer must wait years to sell the securities (long-term sell).  This was done so Paulson could short the securities, and ACA could long-term sell to keep their reputable name.  By going long term, ACA could keep their reliability by claiming they did not know the defaults would occur.

Before ACA met with Paulson, Goldman made a credit default swap (CDS)  with Paulson, who intended to short-sell their RMBS.  Nevertheless, ACA thought Paulson was in for long-term. 

Goldman knew a conflict of interest existed between Paulson and ACA.  Paulson intended to short-sell their RMBS.  ACA intended to stay in long-term.  Because Goldman knew about this conflict of interest, the case against Goldman questions whether Goldman’s actions classify as fraud.

Goldman wanted ACA’s name on the file to sell it – knowing the RMBS would fail.¹  Goldman did not disclose to ACA that Paulson wanted to sell short because ACA had a respected reputation.  This is speculated because Goldman and Paulson made a CDS.²  

Greece’s Debt and Bailout

The EU and IMF recently granted Greece a bailout package worth US $146.2bn.  Greece has a debt of US $400bn – 13.6 percent above its GDP. ³  Greece’s debt can be attributed to three factors: 1. Greece’s reliance on foreign investor; 2. Greece’s investments in the Balkans; and 3. hedge funds betting against Greece (similar to the subprime mortgage crisis).
 
Greece has always had debt problems, but was able to hide them by adjusting its exchange rate.  Since Greece became a Eurozone member, it could no longer disguise the problem in this manner (explained below).  The real cause of Greece’s debts though lies with its foreign investors, investment habits, and most importantly hedge funds betting against the government.

Most of Greece’s foreign investors were in Western Europe.  When the economic crisis began, Greece’s investors withdrew investments from Greece to bailout European banks.  These banks were forced to devalue their assets in line with the market value  and acquired credit losses due to investments in subprime mortgages.⁴

Greece’s banks also had investments in the Balkans, especially Serbia.  After 9/11, the EU lowered interest rates and eased credit spending.⁵   Lower interest rates allowed consumers to charge credit while paying less for the money they borrowed from banks.  Serbia, specifically, was rewarded with lower interest rates because it caught the war criminal Slobodan Milosevic.  (Serbia wants to become an EU member.  In order to do so, they must catch all the major war criminals.) 

After communism collapsed in 2006,⁶  Greece invested in Serbian mortgages.  These mortgages were given in euros (Greece’s and the EU currency).  When the Serbian dinar depreciated as a result of the global financial crisis (explained below), Serbians were unable to pay back their loans.  Thus, Greece’s investment back-fired and caused their debt to increase exponentially.

Once hedge funds saw the instability of Greece’s financial system caused by its massive debt that it could not repay, the hedge funds began betting against Greece.   This betting against Greece is still causing investors to withdraw from the country, thus devaluing government bonds.  Greece is losing even more money causing even more debt from a lack of income.  Further exasperating the situation is Greece’s lack of tax income from its citizens, who are unable to pay taxes (explained below).

The Global Economic Crisis

The global economic crisis sheds light on the connection between Greece and Goldman Sachs.

Subprime mortgages are mortgages lent to people, who are likely to default.  In 1993, prime interest rates  were low, and real interest rates  were negative.  The more one bought; the more one got back.  People flocked to get loans to receive this benefit.  President Clinton also eased credit regulation on mortgages to help economically disadvantaged people buy houses.  With subprime mortgages, interest rates increase over time to insure against defaults. 

Banks took advantage of these opportunities to sell these mortgages as RMBS.  Knowing subprime mortgagers would default; banks knew they could repossess houses to sell them for a profit.

Further taking advantage of the situation, hedge funds encouraged banks to lend these mortgages so hedge funds could profit as well.  Hedge funds sold securities that were expected to depreciate, then bought them back to make a profit. 

When subprime mortgages collapsed, two things happened.  Firstly, banks lost billions in loans they lent to subprime buyers.  Secondly, larger international banks started pulling back investments and loans to smaller banks and businesses out of fear of losing money.⁷

This is what happened in Serbia.  International investors pulled out of local Serbian banks causing the dinar to depreciate.  The depreciated dinar made it impossible for Serbia homebuyers to make mortgage payments causing Greece to accrue massive debts.⁸

What Does This Have to Do with Goldman Sachs’s Fraud?
 
Goldman Sachs is another example of how hedge funds’ risky speculations can help magnify financial meltdowns.  Hedge funds contributed extensively to the subprime mortgage crisis and still continue to bet against Greece, causing Greek government bonds to depreciate, thus increasing Greek debt.⁹   Greece’s debt problem may potentially lead to the breakup of the Eurozone and a collapse of the international financial economy.

Eurozone

The Eurozone is a union of EU states that use a single currency.  Therefore, Greece cannot pump money into its economy because that would pump money into the entire Eurozone.  Greece cannot adjust its currency rates because that would make non-debt, Eurozone countries’ currency lose value. 

While the debt increases, Greece’s government faces the problem of cutting its spending; one of the cuts has been to civil servant wages.  Many of these civil servants will find it difficult to pay taxes with the salary cuts.  With less tax income, Greece’s debt will continue to increase.  The EU and IMF’s bailout money does not cover all of Greece’s debt.  Greece must find a way to increase its income, but it has had difficulty doing this.  Credit rating agencies have downgraded Greece provoking fears of devaluing government bonds. 

Experts fear these problems will worsen forcing Greece to leave the Eurozone to produce money.  If Greece leaves the Eurozone, experts fear other countries in similar situations such as Spain, Portugal, and maybe Italy will follow, causing the breakup of the entire Eurozone.¹⁰  

This debt crisis would cause countries outside Europe to suffer immensely, since many countries, specifically China, have large investments in the Eurozone.  The U.S. might also be impacted since it receives most of its loans from China.

U.S. Financial Regulation

The Senate and House both passed their own version of financial regulations.

The Senate passed its version on May 20, 2010.  The reforms include tighter restrictions on large banks, a watchdog agency, a revamp of derivatives, and new regulations requiring proof that homebuyers can pay their mortgages.¹¹

The House bill passed on December 12, 2009.  Congress could breakup financial institutions it deems a threat to U.S. interests.  The Consumer Financial Protection Agency could audit the Federal Reserve if it feels it has threatened the global financial world.  Regulations on large financial institutions would be enforced and greater fees required.  The Federal Deposit Insurance Company could collect insurance fees from “Too Big to Fail” institutions.  The maximum overdraft charge would be $39.  Shareholders could have an advisory role on executives’ pay.¹²

Since both the House and Senate have passed financial regulation, a merger of the two is needed.  If these regulations had existed a few years ago, investment banks like Goldman Sachs could not have contributed to the subprime crisis, Greece’s debt, a possible Eurozone breakup, and even a possible meltdown of the world financial system.  The only real question that remains is whether these regulations will become so bureaucratic that financial institutions can no longer operate profitably, thus, creating an even larger problem.