"Behind each great historical phenomenon," Niall Ferguson has written, "lies a financial secret." So it is with Europe's latest identity crisis. Greece's euro troubles have a lot to do with its fiscal irresponsibility and the instability at the heart of European Monetary Union—a group of countries that sometimes behave like "the United States of Europe" and at other times revert to nationalistic petulance (witness German resistance to a Greek rescue). But the Greek panic—and fears of a euro collapse and another financial contagion—also have a great deal to do with secret derivatives deals orchestrated by big American banks. As a result, the euro crisis is casting, yet again, a harsh light on efforts by Wall Street lobbyists to gut proposed rules requiring transparency in trading.
As always with European crises, we start out thinking they should be left for the Europeans to fix. Then we get dragged in. Only this time, we discover, Goldman Sachs and other investment banks already dragged us in years ago. Their strategy dates back to the '90s, when countries such as Greece and Italy, with chronic fiscal deficits, were eager to join the EMU but couldn't match the standards of budget discipline imposed by the 1992 Maastricht Treaty. So Wall Street helped them hide their true national indebtedness, at a high price. But these deals only made the crisis worse when the market reckoning finally came. This is not a new phenomenon. Many previous currency crises, going back to Asia in 1997–98 and Mexico in 1994–95, were exacerbated by overleveraged derivatives trades that were not revealed until much later. In those earlier cases it was the local banks, not the governments, that cut quiet swaps deals to juice their income. When Mexico decided in December 1994 that it would try to devalue the peso by just 10 percent, hundreds of millions of dollars of off-the-books derivatives deals turned the effort into a market rout. All of a sudden Mexico's major banks were hit with margin calls from U.S. banks, taking Mexico's central bank by surprise. The result was a $50 billion bailout orchestrated by Washington—the first of many, with Wall Street the main beneficiary nearly every time (though to be fair, the Treasury ultimately made a profit from Mexico's paybacks, too). The Asia crisis played out similarly, with Asian banks also badly hit.
A number of publications have exposed the ways in which Goldman and other firms helped Greece, and countries such as Italy and Spain, disguise their true indebtedness using swaps and other complex instruments that make government borrowing appear to be something else, like a currency trade or asset sale. In some cases, like a swap deal Italy did in the late '90s to defer interest payments on a bond issue, allowing it to squeak into the union, such instruments may have helped in the long run—assuming the euro zone and Italy's place in it remain intact. But many such deals, by pulling the wool over the eyes of investors, also "led governments down the wrong policy path of avoiding to take strict measures to rein in their deficits and debt," says Gikas Hardouvelis, an Athens-based economist who has documented Greece's transactions with Wall Street.
Little-publicized deals like these help to explain the mystifying profit levels of Wall Street, even after the crisis. For two decades, Wall Street's biggest money machine has been driven by a formula: create very complex deals with high profit margins and leverage up to do the deals in volume. The complexity is made possible by the freedom that Washington regulators have given the banks to structure little-understood derivatives off public exchanges, or "over the counter." These hard-to-understand deals—labyrinthine structures that combine swaps in different currencies, for example—permit the banks to charge huge "spreads" to customers like the Greek government because the deals are "customized" or one-time-only affairs not subject to public scrutiny or competitive pricing. And it's not over for Athens or other weaker sisters such as Spain and Portugal. The OTC swaps market "is currently pushing Greece to the edge," says Hardouvelis. "Hedge funds and banks can bet on the cost of Greek government debt by taking positions in the CDS [credit default swaps] market without owning Greek debt. In a thinly traded underlying bond market, the derivative CDS market can cause damage and is prone to manipulation by insiders."
The big banks are desperate to protect this cash cow. So while Washington is all a-dither over the deficit and health care—and partisan battles over which party is more partisan—the legal moles of Wall Street are silently at work boring holes in legislation on Capitol Hill. Among other things, the banks are working hard to exempt foreign-currency trading from proposed new rules requiring most derivatives trading to be done on open and regulated exchanges. They also want to exempt "end user" customers of derivatives, like major corporations and governments.
It is precisely many of these end users, like Greece, that are the Street's biggest patsies. Typically these deals, while ostensibly helpful, only make the customers poorer in the end and the financial crises that result from them more frequent and more severe. The Greek government was like a hapless credit-card holder who is mortgaged to the hilt. Athens sold off everything from airport landing fees to lottery revenues to Wall Street and then took on impossible debt at exorbitant rates. Its fiscal deficits are still there—only now, because of the extra interest, they're larger. So it will cost Greece much more to dig out. And the government has fewer options now beyond hoping for a bailout, making the crisis more acute.
Some critics, such as Michael Greenberger, a former deputy head of the Commodity Futures Trading Commission (CFTC) who has followed the new derivatives legislation closely, think that the Obama administration is supporting a forex exemption to help Washington and other governments continue to cut quiet deals to mask their own real indebtedness. "The question is: is the U.S. using swaps to throw financial obligations into the future to make it appear that the deficit is less than it really is? Why else does it matter whether the transaction would be transparent?" he asks. "These are unsavory deals not only because they hide the real parameters of sovereign debt, but the price of the masking is unconscionable to the citizens of the sovereign country. If these deals were transparent, it would be politically impossible to enter into them because they are so one-sided in the long term." The deals also encourage bad behavior and require the governments to pay up more in the end as well distorting the fiscal agreements that admit them entry into the EMU.
The Obama administration has shifted course on this issue. In June it issued a white paper calling for all standardized swaps to be regulated. But then, in August, the Treasury Department proposed legislative language that for the first time included exemptions from clearing and exchange trading for foreign-exchange swaps. The proposed exemption was never fully explained and drew criticism from CFTC chairman Gary Gensler. Among those concerned about such practices is deficit hawk Bob Corker, one of the few GOP senators willing to work on bipartisan financial reform. "I'm very aware of the fact that Greece mortgaged its future…and of the role these types of derivatives have played in hiding current problems," Corker said. Asked about the Senate version of the financial-reform bill (the House has already passed it), which has become embroiled in partisan infighting, Corker said: "We are sort of starting from scratch."
Maybe that's a good thing. Maybe it's time, in the wake of the euro crisis, to reconsider Wall Street's global reach from scratch.
Michael Hirsh is the author of At War with Ourselves: Why America Is Squandering Its Chance to Build a Better World .