A growing furor about financial stratagems that prettied up government balance sheets in Europe is rattling Wall Street and unnerving investors.
At the heart of the controversy are transactions arranged by Goldman Sachs Group Inc. for Greece back in 2001, all entirely legal, that masked the full extent of its borrowing.
Hidden in plain sight, the deals were well known to a small group of traders but have burst onto the public stage as Greece struggles to stave off a full-blown debt crisis and counter skepticism about its bookkeeping.
Faced with mounting criticism, Goldman took the unusual step of posting a statement on its website late Sunday, where it described the deals, which involved derivatives known as swaps. The transactions were consistent with European principles at the time, Goldman said, and had a "minimal" effect on the country's overall fiscal health.
A senior Goldman executive went further yesterday in a hearing before a British parliamentary committee. While there was nothing inappropriate about the transactions, Goldman's Gerald Corrigan said "the standards of transparency could have been and probably should have been higher."
Goldman's defence is unlikely to quiet the controversy. A series of other transactions, from Portugal to Italy, is also coming under the microscope as investors examine whether they helped governments cast their finances in a more favourable light.
For investors still stung by the financial crisis, revelations featuring obscure derivatives and the banks that sell them raise instant warning flags. Even if the deals under scrutiny aren't particularly large, the effect is to undermine confidence in Europe's public finances at a delicate juncture. Greece, for instance, intends to sell bonds later this week.
"It's not the size [of the transactions] but the intent, and the practice of being not entirely truthful that bothers investors," said Stephen Jen, managing director at BlueGold Capital Management, a London hedge fund. "How many skeletons are still in the closet?"
Mr. Jen says doubts about the reliability of government figures are a sore spot for the countries that share the euro. Members of the currency union are supposed to stay below specific targets when it comes to debt and deficits to prevent countries from straying too far from a certain degree of fiscal responsibility.
The fact that Greece was seeking ways to massage those figures shows that right from the outset it was having difficulty meeting those targets. By last year, its deficit was 12.7 per cent of gross domestic product, more than quadruple the limit for countries using the euro.
While Greece's deal with Goldman is by far the most controversial, other European nations have tried to make their debts appear smaller. In the early days of the euro's history, Italy, Portugal, Greece and Belgium all engaged in asset-backed securitizations, transactions that allowed them to shift some of their liabilities, according to Reuters.
Greece's deal with Goldman started out with a series of relatively common manoeuvres known as currency swaps, which allow a party to exchange a flow of money in one currency for another at regular intervals at an agreed-upon rate. Such derivatives can be a helpful way to manage exposure to rapidly shifting exchange rates.
But because of the way they are accounted for - usually at the agreed-upon exchange rate - they can make debts look smaller than they are.
In December, 2000, and June, 2001, Greece and Goldman entered into new swaps using a favourable exchange rate, which reduced Greece's debt by €2.4-billion. That in turn trimmed Greece's debt as a percentage of GDP from 105.3 per cent in 2000 to 103.7 per cent in 2001. Goldman reportedly collected as much as $300-million (U.S.) in fees for the deal and related work.