“If you don’t fully understand an instrument, don’t buy it.”
To the above advice from Emilio Botín, Executive Chairman of Spain’s Grupo Santander, I would simply add one small rider: Don’t sell it either, especially if you are a national government trying to structure your country’s debt.
In a fascinating article in Saturday's New York Times, journalists Louise Story, Landon Thomas and Nelson Schwartz begin to recount the murky story of just how the major US investment banks have been able to earn considerable sums of money effectively helping European governments to disguise their growing mountain of public debt.
Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.
As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.
Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.
In fact, concerns about what it is exactly Goldman Sachs (NYSE:GS) has been up to in Greece are not new, and the Financial Times have been pursuing this story for some time, in particular in connection with the investment bank's ill fated attempt to persuade the Chinese to buy Greek government debt (and here, and here). Nor is the fact that the Greek government resorted to sophisticated financial instruments to cover its tracks exactly breaking news, since I (among others) have been writing about this topic since the middle of January - Does Anyone Really Know The Size Of The Greek 2009 Deficit? - following the arrival in my inbox of a leaked copy of the report the Greek Finance Minister sent to the EU Commission detailing the issues.
What is new in Saturday's report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since "Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere." I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.
So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset "sales," often of public buildings and the like. Following advice paid for from the best of investment banks, many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain "hecha la ley, hecha la trampa" (or in English, when you close one loophole you open another). According to the NYT authors:
"As recently as 2008, Eurostat.... reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”"
So just what is all the fuss about. Well, in plain and simple terms it is about an accounting item known as "receivables." Now, according to the Wikipedia entry:
"Accounts receivable [A/R] is one of a series of accounting transactions dealing with the billing of a customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms."
However, as we can learn from another Wikpedia entry, often the use of "accounts receivable" constitutes a form of factoring, and this is where the problems Eurostat are concerned about actually start:
Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.
But how does all this work in practice? Well, the World Wide Web is a wonderful thing, since you have so much information near to hand, at just the twitch of a fingertip. Here is a useful description of what are known as PPI/PFI schemes, from UK building contractor John Laing:
A Public Private Partnership [PPP] is an umbrella term for Government schemes involving the private business sector in public sector projects.
The Private Finance Initiative [PFI] is a form of PPP developed by the Government in which the public and private sectors join to design, build or refurbish, finance and operate [DBFO] new or improved facilities and services to the general public. Under the most common form of PFI, a private sector provider like John Laing will, through a Special Purpose Company [SPC], hold a DBFO contract for facilities such as hospitals, schools, and roads according to specifications provided by public sector departments. Over a typical period of 25-30 years, the private sector provider is paid an agreed monthly (or unitary) fee by the relevant public body (such as a Local Council or a Health Trust) for the use of the asset(s), which at that time is owned by the PFI provider. This and other income enables the repayment of the senior debt over the concession length. (Senior debt is the major source of funding, typically 90% of the required capital, provided by banks or bond finance). Asset ownership usually returns to the public body at the end of the concession. In this manner, improvements to public services can be made without upfront public sector funds; and while under contract, the risks associated with such huge capital commitments are shared between parties, allocated appropriately to those best able to manage each one.
The private finance initiative [PFI] is a method to provide financial support for "public-private partnerships" [PPPs] between the public and private sectors. Developed initially by the Australian and United Kingdom governments, PFI has now also been adopted (under various guises) in Canada, the Czech Republic, Finland, France, India, Ireland, Israel, Japan, Malaysia, the Netherlands, Norway, Portugal, Singapore, and the United States (amongst others) as part of a wider program for privatization and deregulation driven by corporations, national governments, and international bodies such as the World Trade Organization, International Monetary Fund, and World Bank.
PFI contracts are currently off-balance-sheet, meaning that they do not show up as part of the national debt as measured by government statistics such as the Public Sector Borrowing Requirement (OTCQX:PSBR). The technical reason for this is that the government authority taking out the PFI contract pays a single charge (the 'Unitary Charge') for both the initial capital spend and the on-going maintenance and operation costs. This means that the entire contract is classed as revenue spending rather than capital spending. As a result neither the capital spend nor the long-term revenue obligation appears on the government's balance sheet. Were the total PFI liability to be shown on the UK balance sheet it would greatly increase the UK national debt.
And here are two more examples of what is involved, which were brought to light by a quick Google search. First of all, the case of Italian health payments. Now according to analysts Patrizio Messina and Alessia Denaro, in this report I found online from Financial Consultants Orrick:
In the last years many structured finance transactions (either securitisation transactions or asset finance transactions) have been structured in relation to the so called healthcare receivables.The reasons are several. On one side, the providers of healthcare goods and services usually are not paid in time by the relevant healthcare authorities and therefore, in order to gain liquidity, usually assign their receivables toward the healthcare authorities. On the other side, due to the recent legislation that provides for very high interest rates on late payments, the debtors as well as banks and other investors have had the same and opposite interest on carrying out different kind of transactions. In this brief article we will analyse, after a quick description of the Italian healthcare system, some of the different structures that have been used in relation to transactions concerning healthcare receivables and, in particular, we will focus on transactions concerning the so called “raw receivables”, which are lately increasing in the Italian market practice, by analysing the legal means through which it is possible to ascertain/recover such receivables.
This system thus has two advantages (apart from the fact that it effectively hides debt). In the first place, the healthcare providers gain liquidity in order to continue to run hospitals, pay doctors, etc, while those who effectively intermediate the transaction earn very high interest rates for their efforts, interest payments which have to be deducted from next year's health care provision, and so on.
As the Orrick report points out, Italy’s national healthcare service (servizio sanitarionazionale, “nhs”) is regulated by the legislative decree of December 30, 1992, no. 502 (“decree 502/92”).The reform introduced by decree 502/92, as amended from time to time, provides for a three-tier system for the healthcare service, as outlined below: State level -The central government provides a national legislation limited to very general features of the NHS and decides the funds to be allocated to the single regions according to specific criteria (density of population, etc.) for the NHS.
As the Orrick analysts note: "the Healthcare Authorities usually pay the relevant Providers with a certain delay."
Usually, when healthcare funds are allocated, in the national provisional budget, the central government underestimates the amount of healthcare expenditure. Since the central government does not provide regions with enough funds, regions are not able to provide enough funds to Healthcare Authorities, and payments to the Providers are delayed. Since the Providers need liquidity, they usually assign their receivables toward the Healthcare Authorities. To deal with all the above issues, Italian market practice has been developing an alternative system of financing through securitisation and asset finance transactions of Healthcare Receivables.
As the analysts finally conclude:
Despite of the risks concerning the judicial proceedings, Italian market players are still very interested on carrying on securitisation transaction on this kind of asset, principally because Legislative Decree no. 231/02 provides for very high interest rates on late payments (equal to the interest rate applied by ECB plus 7%) - my emphasis
Another technique Eurostat have identified as a means of concealing debt relates to the recording of military equipment expenditure, as described in this report I found dating from 2006. At the time Eurostat were worried about the growing provision of military equipment under leasing agreements. Basically they decided that such provision was debt accumulable.
Eurostat has decided that leases of military equipment organised by the private sector should be considered as financial leases, and not as operating leases. This supposes recording an acquisition of equipment by the government and the incurrence of a government liability to the lessor. Thus there is an impact on government deficit and debt at the time that the equipment is put at the disposal of the military authorities, and not at the time of payments on the lease. Those payments are then assimilated as debt servicing, with a part recorded as interest and the remainder as a financial transaction.
However, a loophole was found in the case of long term equipment purchases:
Military equipment contracts often involve the gradual delivery over many years of a number of the same or similar pieces of equipment, such as aircraft or armoured vehicles, or including significant service components, such as training. Moreover, in the case of complex systems, it is frequently the case that some completion tasks need to be performed for the equipment to be operational at full potential capacity. Some military programmes are based on the combination of several kinds of equipment that may be completed in different periods, so that the expenditure may be spread over several fiscal years before the system, globally considered, becomes fully operational.
In cases of long-term contracts where deliveries of identical items are staged over a long period of time, or where payments cover the provision of both goods and services, government expenditure should be recorded at the time of the actual delivery of each independent part of the equipment, or of the provision of service.
Payment for such items are only to be classified as debt at the time of registering the actual delivery, which may explain why, if my information is correct, the Greek military, as of last December, were still officially "testing" two submarines which had been provided by German contractors, since final delivery had still to be formally registered, and the debt accounted.
A lot of information about the kind of things which were going on before the 2006 rule change can be found in this online presentation from Europlace Financial Forum. Here are some examples of private / public sector cooperation in Italy.
Click to enlarge
And here's a chart showing a list of advantages and possible applications:
Now, at the end of the day, you may ask "what is wrong with all of this?" Well quite simply, like Residential Mortgage Backed Securities, these are instruments that work while they work, and cause a lot of additional headaches when they don't. I can think of three reasons why debt acquired in this way in the past may now be problematic.
a) They assume a certain level of headline GDP growth to furnish revenue growth to the public agencies committed to making the payments. Following the crisis these previous levels of assumed growth are now unlikely to be realized.
b) They assume growing workforces and working age populations, but both these, as we know, are now likely to start declining in many European countries.
c) They assume unchanging dependency ratios between active and dependent populations, but these assumptions, as we also already know, are no longer valid, as our population pyramids steadily invert.
Given all this, a very real danger exists that what were previously considered as obscure securitization instruments, so obscure that few politicians really understood their implications and few citizens actually knew of their existence, can suddenly find themselves converted into little better than a glorified Ponzi scheme.
And if you want one very concrete example of how unsustainable debt accumulation can lead to problems, you could try reading this report in the Spanish newspaper La Verdad (Spanish, but Google translates if you are interested), where they recount the problems being faced by many Spanish local authorities who are now running out of money. In this case it the village of San Javier, where they have until the 24 February to pay a debt of 350,000 euros, or the electricity will simply be cut off! The article also details how many other municipalities are having increasing difficulty in paying their employees. And this is just in one region (Murcia), but the problem is much more general, as Spain's heavily overindebted local authorities and autonomous communities steadily grind to a halt.