Back in 2001, a very curious deal was struck between the government of Greece and Goldman Sachs. It was an exotic dollar/yen swap for euros. What possessed Greece to do such an unusual — and expensive — financial transaction? It needed help to hide its large and rapidly growing debt in order to maintain its status as a euro-zone member in good standing.
Both parties had something to gain. Greece created the false appearance of being in compliance with the Maastricht Treaty. This mandates that European Union member states with high debt levels must reduce their debt-to-gross-domestic-product ratio. And Goldman Sachs scooped up a ridiculously large 600 million euro fee. According to Bloomberg News, this accounted for “about 12 percent of the $6.35 billion in revenue Goldman Sachs reported for trading and principal investments in 2001.”
Once again, a new group of rubes got rolled by The Street.
I know what you are thinking: Those silly Greeks. Something like that could never happen here. Before you begin tsk-tsking, allow me to point you to the latest group of suckers to get taken in by The Street’s three-card monte: the Poway Unified School District in San Diego. It took a page from the Greek school of bad finance, agreeing to an exotic and costly bit of Wall Street shenanigans. Despite the district’s strong tax base and good credit rating, its officials bought a complex Wall Street-originated exotic loan offering.
Reminiscent of the bubble days of exotic mortgages, this debt deal makes no payments for 20 years. Over the course of the 40-year financing, it pays a very rich tax-exempt interest of 6.8 percent. Had the district done a straight-up school bond offering, it would have paid 4.1 percent. Over the course of 40 years, this interest rate differential is enormous. Poway borrowed $105 million. Instead of paying $300 million for a normal bond offering, the townspeople are going to pony up nearly $1 billion.
I learned of this festering financial debacle courtesy of the investigative reporting of Will Carless at the Voice of San Diego.
It appears there are no good actors here. What motivated this absurdity appears to be an attempt to avoid increasing real estate taxes on the school district residents. Rather than live within their budget, the district is trying its level best to become the next Detroit. The worst part of all is that by the time the bill comes due, everyone associated with this awful deal will be long gone. It’s a classic case of “I’ll be gone, you’ll be gone” financing.
It is astonishing to think that anyone involved in this mess thought that the big investment firms would help them come up with “creative financing” to resolve their budget issues. If only they’d had a helpful guideline, a set of rules for dealing with the sharks on Wall Street.
So I present “The Inviolable Rules for Dealing with Wall Street”:
1Reward is always relative to risk: If any product or investment sounds as if it has lots of upside, it also has lots of risk. If you can disprove this, there is a Nobel Prize waiting for you.
2Asymmetrical information: In all negotiated sales, one party has far more information, knowledge and experience about the product being bought and sold. One party knows its undisclosed warts and risks better than the other. Which party are you?
3Good advice is priceless: I know, easier said than done. The Street buys the best legal talent, mathematicians and strategists that money can buy. Make sure you have expert advisers and lawyers working for you as well.
4Motivation:Always ask, what is the motivation of the outfit selling me this product? Is it the long-term stability and financial health of my organization — or their own fees and commissions?
5Legal documents are created to protect the preparer (and its firm), not you or yours: In the history of modern finance, no large legal document has worked against its drafters. Private placement memorandums, sales agreement, arbitration clauses — firms use these to protect themselves, not you.
6Performance: How significantly do the fees, interest rates commissions, etc., have an impact on the performance of this investment vehicle over time? Determining for yourself what the actual cost of money is will avoid more heartache in the future.
7Shareholder obligation: All publicly traded firms (including investment banks and bond underwriters) have a fiduciary obligation to their shareholders to maximize profits. This is far greater than any duty owed of care to you, the client. Always ask yourself whether this new product benefits the shareholders or your organization. (This is acutely important for untested products.)
8Reputational risk: Who suffers if this investment goes down the drain? Who gets fired or voted out of office if this blows up? Who suffers reputational risk?
9Keep it simple, stupid (KISS): It’s easy to make things complicated, but it’s very challenging to make them simple. The more complexity brought to a problem, the greater the potential for things to go awry — not just astray, but very, very wrong.
10There is no free lunch: Repeat after me: There is no free money, no riskless trade, no way to turn lead into gold. If you remember no other rule, this is the one that will save your hide time and again.
If you wondered why the biggest financial firms are fighting tooth and nail to avoid having to maintain a “fiduciary standard,” just look at the fees and expenses in deals like this. There is always big money in the ongoing attempts to turn lead into gold.
The never ending parade of stock scandals continues unabated. As history has shown us — from Mexico to Orange County to analyst banking crisis to derivatives — when the Street comes a-knockin’, best you hide your wallets.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture. On Twitter: @Ritholtz.