Greece, Goldman and finding the Greater Fool

"If you can't spot the sucker in your first half hour at the table, then you are the sucker,” says Mike McDermott in the movie, Rounders.

Gamblers are careful to ensure that there is someone less experienced or more gullible at the table than they are so that, when things go pear-shaped, they can unload their most speculative punts on them.

In the world of investment this is known as the Greater Fool Theory; that no matter how risky your purchase you’ll find some sucker to buy it off you at a profit.  Investors searching for suckers like to disguise their activities and so they call themselves “yield investors”.

IKB Deutsche Industriebank, based in Germany, set up the Rhineland Fund in 2002 in order to buy up US mortgage bonds.  The highest yielding bonds, those with the greatest risk and associated higher interest rates, were the subprime bonds.  In 2006, when the dangers of the US subprime market were becoming obvious to everyone, the portfolio manager of Rhineland, Dirk Rothig, tried to change the focus of the fund and unwind its exposure.  When his proposals were rejected he quit. 

Late in 2007, the whole house of cards came tumbling down and IKB had to be bailed out by the German government at a cost of over $10 billion.

So, who is getting blamed for this disaster?  That’s right, Goldman Sachs.  Now Goldman did make a great deal of money out of IKB’s foolishness, but that hardly means they did anything wrong.  IKB knew what they were buying and the market in these bonds was sufficiently liquid that the price was free to trade.

Despite this, US Senators are pillorying Goldman executives for not making sure that IKB knew the risks they were taking.  Goldman certainly has a duty to disclose all facts about the products they sell.  Should it turn out that they lied about any of this information then they will have to answer charges of fraud. 

However, just as you would be rather surprised if the check-out clerk at the supermarket passed comment on your choice of chocolates and junk-food vis-a-vis your waistline, investors shouldn’t expect the sellers of investment products to judge their suitability as a customer.

Worse, though, is how hypocritical governments are when it comes to where risks lie.

Right now governments are demanding that markets stop discounting Greek bonds and keep buying and supporting their debt.  Greece has debts of almost $400 billion and requires short-term loans of $40 billion in order to keep financing their interest repayments.  Investors are becoming concerned that they won’t get repaid.  In other words, Greek debt is no different from US subprime debt.

In the case of banks, governments’ attitude is that bankers should be doused in petrol and set on fire for daring to sell subprime bonds. 

In the case of Greece, governments’ attitude is that investors should be compelled to buy and hold Greek debt.  Short-selling of stocks on the Greek stock exchange has been banned, effectively blocking market attempts to figure out the real price for Greek bonds.

Greece’s travails started with a debt-fuelled spending spree in which cash was dished out on the lavish 2004 Olympics as well as increasing social benefits.  When the worsening global economy increased the costs of borrowing then the careful balance of taxes-in paying for benefits-out fell apart.

Not very different from a person who borrowed cheaply to buy a new house on the expectation that a greater fool would come along to buy it.  The credit crunch became inevitable when terrifically inflated house prices found no takers and home-owners got trapped in bad debt as interest rates shot up.

On the plus side, Greece is actually better financially managed than either of Zimbabwe or Venezuela, so perhaps Julius Malema can take them in too on his global tour of economic deathbeds.