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Greece's debt crisis: not over yet

Greek debt explained: How big banks worsened Greece's woes, and why it's now America's problem as well.

might steamroll across borders. To prevent this, officials enacted regulations restricting how much money countries in the euro zone could borrow. Every government was supposed to comply with the restrictions in order to qualify to use the euro, and they were continue complying indefinitely.

(Watch: The Daily Show tackles the debt crisis)

As 2001 approached and Greece was poised to adopt the currency, its government exceeded the euro zone’s restrictions. Rather than enacting painful spending cuts or raising taxes, it essentially resorted to creative accounting, with the help of Goldman. The Wall Street firm engineered a financial deal known as a cross-currency swap. The effect of the deal was to hide Greece’s debt on Goldman’s balance sheet, letting the country qualify for euro zone membership. As financial journalist Nicholas Dunbar explains in The Devil’s Derivatives (forthcoming from Harvard Business Review Press), Goldman made a handsome profit on the deal. Greece, in turn, got to enjoy all the benefits of the euro. It could borrow in the vast European financial markets at rates that it could never qualify for on its own — a privilege that reduced its borrowing costs, worsening its profligacy.

But Goldman Sachs and Greece did not act alone.

Eurostat, the European agency charged with checking countries' financial books, actually approved of the Greece-Goldman accounting trick, and Italy is said to have used the same trick several years earlier, according to Dunbar. “According to sources familiar with the deal, Eurostat even gave advance approval of Goldman’s contract with Greece (six years later, the agency would deny any knowledge),” he writes.

Also aiding Greece’s debt habit were some of Europe’s biggest banks. By 2004 it was widely known that Greece had cooked its books and that its financial condition was not nearly as sound as advertised. Still, major banks like France’s giant BNP Paribas and Germany’s Commerzbank bought billions worth of the ill-fated bonds. 

How could they be so foolish?

Two reasons. First, the banks didn’t have to worry about foreign currency risk — the bonds were denominated in euros, the currency that they needed, not in drachmas that might be depreciate, driving down the value of their investments. Moreover, Greece’s bonds paid a higher interest rate than those of more fiscally conservative countries, so banks were able to earn more — if, that is, assuming Greece could pay them back.

In other words, Europe’s big banks and pension funds bought Greek debt, ignoring the risks, because it was profitable. “It was a search for yield,” says Terry Connelly, Dean of the Ageno School of Business at Golden Gate University. “Who’s going to be the guy that stands up in the room at Credit Agricole or Deutsche Bank, and say ‘guys, we’ve got to stop making all this money?’ Everyone understood that Greece was borrowing itself into oblivion, but nobody cared enough to blow the whistle, including the Germans." 

Which brings up a key point: the Eurocrats aren’t so much bailing out Greece as they are bailing out themselves. The continent’s banks, and in particular the European Central Bank, are the biggest holders of Greek debt. Another major loss would be difficult to endure so few years after the last crisis.

In a reprise of the 2008 crisis, Greece's toxic bonds are tangled in a web of debt and complex derivates such as credit default swaps (essentially, insurance on debt) that could ensnare banks and financial institutions far and wide. The difference this time around, however, is that Europe — which lacks strong central institutions like the US Federal Reserve — is less well-equipped to untangle the mess quickly, explains Connelly.

So while Greece's bonds will be paid this summer, there are many billions of dollars worth of debt that remain outstanding over the next several years. Greece stands almost no chance of being able to pay these in full, and if economists are right, austerity will only worsen matters by crippling the country's economy. So if Europe balks at rescuing its errant Mediterranean partner, or if it fails to come up with an orderly plan enabling Greece to default, everyone stands to lose. And because American financial institutions are intricately tied in with Europe, the pain would be felt on this side of the ocean as well.

Stay tuned, this Greek drama is not over yet.

Follow author David Case on Twitter @DavidCaseReport.