A Greek Tragedy: The Hazards of Deregulation

JURIST Guest Columnist Dimitrios Ioannidis of Roach, Ioannidis & Megaloudis, LLC, says that the deregulation of US financial markets coupled with the strategic use of complex financial instruments has played a significant role in the Greek debt crisis...

On April 16, 2010, the Securities and Exchange Commission (SEC) filed a civil action against Goldman, Sachs & Co. for the structuring and marketing of a synthetic collateralized debt obligation (CDO). The synthetic CDO, a complex financial security used to speculate or manage the risk that an obligation will not be paid, was tied to the performance of subprime residential mortgage-backed securities sold to investors in early 2007 when the US housing market began to show signs of distress. According to the SEC complaint, these types of synthetic CDOs contributed to the financial crisis by magnifying losses associated with the downturn of the housing market.

Undisclosed in the marketing materials prepared by Goldman, Paulson & Co. Inc., a large hedge fund, with economic interests directly adverse to investors in the CDO, played a significant role in the creation of the CDO. After this, Paulson effectively bet against the mortgage-backed security it helped create by entering into credit default swaps, a form of insurance that protects the lender in case of loan default, with Goldman to protect itself against losing its investment in the CDO. Given this, Paulson had an economic incentive to create a CDO which included securities that it expected to default in the near future. Goldman did not disclose Paulson's adverse economic interests or its role in the creation in the marketing materials provided to investors. That is, Goldman arranged a transaction at Paulson's request in which Paulson heavily influenced the creation of the CDO to suit its economic interests, but failed to disclose to investors Paulson's role or its adverse economic interests.

The deal closed on April 26, 2007. Paulson paid Goldman approximately $15 million for structuring and marketing the CDO. By October 2007, 83 percent of the mortgage backed securities in the CDO had lost value and the remaining 17 percent were soon to follow. By January 2008, 99 percent of the portfolio had followed suit. As a result, the CDO's investors lost over $1 billion, and Paulson yielded a profit of approximately $1 billion.

The SEC alleged that Goldman had engaged in misconduct and also directly or indirectly engaged in transactions, acts, practices and a course of business that violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. The SEC sought injunctive relief, disgorgement of profits, prejudgment interest, civil penalties and other appropriate and necessary equitable relief.

Shortly after filing the complaint, the SEC and Goldman agreed to a settlement approved by the US District Court for the Southern District of New York whereby Goldman would be permanently restrained and enjoined from violating the Securities Act in the offer or sale of any security, disgorge $15 million, and pay a civil penalty in the amount of $353 million to Deutsche Bank, the Royal Bank of Scotland and the SEC. At the same time, the settlement imposed strict conditions upon Goldman in establishing a product review committee and adopting a series of compliance mechanisms in order to prevent Goldman from repeating this practice.

While it may not seem relevant at first glance, the Goldman case provides a revealing analysis of the economic crisis plaguing Greece as unregulated Wall Street practices affect smaller nations vulnerable to market fluctuations. In April 2010, Bethany McLean argued the credit crisis in the US was the result of congressional inaction to curb the frenzy of easy loans, the refusal to regulate derivatives and the repeal of the Glass-Steagall Act, which separated investment from commercial banking, without making further adjustments in the regulatory scheme.

Here is how it all worked: Deregulation of the US financial industry allowed commercial banks to underwrite and trade instruments such as the mortgage-backed securities and CDOs (at the heart of the Goldman case), and to establish structured investment vehicles that purchased those securities. Naturally, and in the spirit of increasing profits, banks and other financial institutions began to invest in government bonds and housing securities, fueling the unprecedented growth in the US housing bubble. Following this, all bets were on for the large financial institutions and the wizards of Wall Street as the free market provided fertile ground for hedging on default.

What is remarkable is the fact that Wall Street financiers continued to generate billions in profits by structuring and selling such securities when the US was experiencing depression-like market conditions in 2008-2009, and Congress was debating legislation to re-regulate certain sectors of the financial industry. Just for illustrative purposes, the top 10 hedge fund managers in the US made over $11.6 billion in profits in 2008 and over $22.5 billion in 2007. AR Magazine reported the following profits: James H. Simons, Renaissance Technologies, $2.5 billion in 2008 and $2.8 billion in 2007; John Α. Paulson, Paulson & Co., $2.0 billion in 2008 and $3.7 billion in 2007; John D. Arnold, Centaurus Advisors, LLC $1.5 billion in 2008 and $480 million in 2007; George Soros, Soros Fund Management, $1.1 billion in 2008 and $2.9 billion in 2007.

In February 2010, it was reported that major hedge funds in the US were repeating this treatment of the housing market by betting that the euro would fall to parity with the dollar, representing significant potential profits for the funds. Richard Parker, an economist at the Kennedy School of Government at Harvard University, explained:

As 2010 began, the Street's 'best and brightest' saw what suddenly looked like a new source of even easier money, playing what insiders like to call "The Headline Risk Game" on little Greece. Here's how it works: Greece's recovery, like our own, still looks pretty shaky—but, for Headline Risk players, that's an opportunity to bet against their recovery, then pounce when the inevitable bump in the recovery road appears. Their payoff comes as weaker investors rush out of the market for bonds, leaving Greece unable to borrow—and potentially forced to default. (Default, for Headline Risk players, can promise even bigger profits.) ... Central to Wall Street's 2008 nose dive were the billions wagered in credit default swaps—the cheap derivatives-based bets with lottery-size payoffs that speculators had placed on US homeowners. Today exactly the same sort of swap bets are what Wall Street has placed against Greece in their Headline Risk Game—and right now we're looking at what could become a replay of the same disastrous consequences. ... Had Washington closed off credit default swaps—and similar derivatives-based betting—from this sort of pernicious gaming of global financial systems, this appalling risk of European meltdown could have been avoided.
In February 2010, hedge funds increased their bets on Greece's economic troubles by shorting its bonds or buying default protection. Even hedge funds without direct exposure to Greece have been insulating their portfolios against collateral damage in the currency or credit markets given the concerns that Greece may not be able to service its heavy debt.

In summary, the economic crisis in Greece is partly the result of the meltdown of its social entitlement programs, the vastly unproductive central authority and the public companies that have been operating at significant losses over many years. Yet, the development and marketing of complex financial instruments by Wall Street strategists and the deregulation of the banking and investment sectors in the US during the Clinton administration have opened the floodgates of profits for a select group of investors who can affect credit events around the globe with the push of a few buttons. Therefore, the economic crisis in Greece cannot be linked to failed domestic policies alone, but must be viewed in the context of the legalized bets placed by financiers who stand to make billions when, and if, Greece defaults; and there is nothing illegal about that in an unregulated financial world.

Dimitrios Ioannidis is a partner at Roach, Ioannidis & Megaloudis LLC., and counsel to the Consulate General of Greece in Boston, Massachusetts. He has done investigations for large financial institutions on matters in Greece and has served as an expert witness in international business transactions and regulatory compliance matters.

Suggested Citation: Dimitrios Ioannidis, A Greek Tragedy: The Hazards of Deregulation, JURIST - Sidebar, June 30, 2011, http://jurist.org/sidebar/2011/06/dimitrios-ioannidis-greek-tragedy.php.

This article was edited for publication by Nathan Marinkovich, an associate editor for JURIST's academic commentary service. Please direct any questions and comments to him at academiccommentary@jurist.org


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