On Wall Street, they call Bill Lipschutz the "Sultan of Currencies." He once turned the legendary investment bank Salomon Brothers into the world's largest foreign currency trading operation. Today Lipschutz runs his own hedge fund, which specializes in currencies.
"I still approach the market the same way. I still approach it as a 24/7 market," says Lipschutz. He trades almost constantly, even at home in his apartment in New York's trendy NoHo district, where there are monitors everywhere. Every night, Lipschutz gets up at two or three in the morning to see what is happening on the European markets.
Europe is indeed currently the hottest topic on the global financial markets. The value of the battered euro has been falling since the Greek government confessed to the actual scope of its debt -- and since it became clear that things are not looking significantly better in the other PIIGS countries (the acronym refers to Portugal, Ireland, Italy, Greece and Spain).
There has never been this much uncertainty. No one knows whether the Greeks will manage to solve their problems, whether and how other countries will come to their aid, whether the crisis can be confined to Greece or whether it will spread like wildfire among the PIIGS -- and end up tearing apart the European currency union.
All of this translates into excellent opportunities for foreign currency traders and speculators. They can either bet on a decline of the euro or a bailout for the Greeks in the form of a rescue effort by other euro zone countries. In the first case, the price of Greek government bonds will hit rock bottom, and in the second case it will rise.
These are the kinds of conditions that make it possible to make a lot of money quickly -- but with devastating consequences, because speculators amplify trends and increase risks. If they bet on a Greek bankruptcy, it will become even more difficult, and expensive, to attract fresh capital. This could lead to a national bankruptcy or the feared conflagration -- or even the collapse of the euro.
The financial industry is back to its old tricks, playing with the greatest possible amount of risk. In the past, it speculated with the debts of American homeowners and, as a result, triggered the biggest crisis in the world economy since the Great Depression of the 1920s. Now it is gambling with the debts of entire countries.
After the failure of investment bank Lehman Brothers, it was governments that saved the financial markets from collapse. Now the governments are being attacked -- with the cheap money their central banks pumped into the market to keep the financial sector afloat.
A new Lehman, triggered by speculation in government bonds, would be disproportionately more dangerous, because it would affect the entire world economy. And who would rescue the economy then?
It is no coincidence, however, that the speculators have not zeroed in on the dollar, the British pound or the yen. Although the United States, Britain and Japan are also groaning under the burden of their debt, the euro is much more vulnerable, for both historic and political reasons.
The weak southern countries, members of the so-called Club Med, have always been seen as problem cases. They have lived beyond their means and neglected the need to be competitive, they have built up -- partly in full view, partly cleverly hidden -- enormous mountains of debt, and they have avoided hard-hitting reforms. These conditions existed before they became members of the euro zone, and they did not improve afterwards.
The other euro countries looked the other way. Initially, before the establishment of monetary union, they looked away because they didn't want to jeopardize their political goal of a European common currency. Later, it was because they themselves were benefiting from the euro. The German export economy, in particular, was able to expand continuously, unhampered by troublesome revaluation and appreciation that would have made its exports more expensive.
Vindicating the Critics
The euro has been a success story until now. During the recent financial crisis, the common currency proved to be a blessing at first, particularly for the smaller countries. But as debt levels increased, the problems, previously suppressed, became more and more evident, including the debt-based economy in the Club Med and the imbalances in terms of competitiveness.
Even before the common currency was introduced in 1999, Nobel economics laureate Milton Friedman was warning that the euro would not survive its first economic crisis. He predicted that the euro zone could break apart after just 10 years.
Ever since the Greeks were forced to admit that their national debt was much higher than originally claimed, the critics of a common European currency have felt vindicated. They had always warned that the northern countries would eventually have to vouch for the debts of the south, that the differences in economic development within the euro zone were too great and that a common currency could not function without a common economic policy.
At the time, politicians ignored the concerns of many economists. Now they realize that this may have been a mistake. The European agreements that define the legal framework of the currency union do not include any provisions to account for the kind of crisis the euro is currently experiencing. For that reason, there are no instruments available to combat such a crisis.
The Speculators' Sharpest Weapon
The speculators' campaign against Greece began in early December. The rating agencies had downgraded the country and the press, particularly in English-speaking countries, was reporting more and more on the Greeks' doctored statistics and high level of government debt. The information wasn't entirely new, but it had its effect, quickly driving up the price of so-called credit default swaps (CDS).
Credit default swaps are the same financial instruments that caused so much damage before the Lehman bankruptcy. They are considered partly responsible for the financial crisis. For this reason, many people called for strict regulation of credit default swaps after the Lehman bankruptcy. But nothing happened, and the results are now becoming apparent.
A CDS contract is, in fact, a sort of insurance policy, which pays out when borrowers, like Greece, go bankrupt. Credit default swaps were invented so that lenders could hedge against such risks. In practice, however, they have become the speculators' sharpest weapon when they go on the offensive against companies or countries, because they make it possible to achieve a maximum impact with a relatively tiny investment. "Dealers can turn the market with only 50 million," says one investment banker.
Because CDSs are traded completely independently of the underlying securities, a gray market with a total nominal value of €26 trillion ($35 trillion) has developed outside the exchanges. The market has shrunk since the beginning of the financial crisis, after it became too daunting even for speculators. But now that money appears to be available in abundance once again, credit default swaps on government debt are among the hottest toys in the financial industry.
The prototype of all currency speculators is George Soros, who kicked the British pound out of the European monetary system in 1992 and became a billionaire in the process. At that time, however, Soros had to take the trouble to speculate with real currency.
"Buying real bonds is much too expensive," says a bond trader today, explaining that this is something that only traditionalists still do. The new speculators are intent on quickly getting in and out of country-specific risk. Borrowing or even buying a bond, says the bond trader, would be too cumbersome.
Because this is much more easily achieved with a CDS, there is a risk that history will repeat itself. Even Soros warns that CDSs are "instruments of destruction." In the first part of the financial crisis, in the years 2007 and 2008, a sharp increase in CDS prices was partly responsible for the bankruptcy of US bank Bear Stearns. Speculators forced governments to bail out British and German banks by unscrupulously driving up the costs of credit insurance.
Now the hedge fund managers are betting on the insolvency of entire countries. The CDS rate for Greek government bonds doubled within the space of a few weeks. Speculators who get in at the right time can take advantage of fears over Greece to turn profits of upwards of 100 percent. For a time, it was costing investors €390,000 to hedge against the default of a 10-year Greek treasury bond with a face value of €10 million. By comparison, the cost of a CDS for a similar German government bond was only €40,000.
The speculative rise in CDSs has a real impact, in that it fans fear in the markets. In early February, Greece had to offer a yield of 6.1 percent in order to sell its five-year bond. This is twice as much as the current yield on comparable German bonds.
Investment banks are among the biggest beneficiaries of uncertainty in the markets. US investment bank Goldman Sachs, in particular, has its finger in several pies at once: as an adviser to the beleaguered governments -- and on the side of the hedge funds that are speculating against the Greeks.
Goldman Sachs was also involved when the Greeks tried to hide their debts from Brussels. In 2002, the US bank helped them exchange a portion of their dollar and yen debts, worth $10 billion, into euro debts. Goldman even granted Greece a loan of €1 billion, which was never reported as such to Brussels, and collected €200 million for its efforts.
Politicians are now beginning to frown upon these cunning deals. "It will be a disgrace if it turns out to be true that banks, which already took us to the brink of disaster, were also involved in the falsification of statistics in Greece," German Chancellor Angela Merkel said in a speech last Wednesday in the north-eastern German state of Mecklenburg-Western Pomerania.
Nevertheless, even the new Greek government, which is breaking with many of the traditions of its predecessors, cannot manage without the US investment bank. Goldman Sachs and Deutsche Bank were among the six banks that placed Greek government bonds worth €8 billion in early February. Perhaps the Greeks were trying to remain on good terms with the two powerful banks. Both were among the most active traders in CDSs, which are often traded on behalf of hedge funds.
Fallen from Favor
Of course, there are also the more traditional speculative transactions. In the week before last, speculators bet a record $10 billion on a falling euro on the Chicago Mercantile Exchange alone.
"The pressure on the euro isn't going away," predicts Sophia Drossos, a native of Greece who runs the currency strategy division at US investment bank Morgan Stanley. "The downside risks to the euro right now are the largest that they have ever been since the single currency was launched." It has fallen out of favor, she says, and that sort of thing doesn't change that quickly.
Not even a bailout of Greece would drive away the speculators, says Marc Chandler, chief currency strategist at the New York private bank Brown Brothers Harriman. If that happened, "the market might go after other countries that have similar DNA," he said. "By DNA here I mean financial DNA: large deficits, current account deficits. And so, if Greece is bailed out by Europe in some fashion, it could be: Let's go after Spain. Or: Let's see how deep the pockets are really going to be."
It is precisely this concern -- namely, that they will have to come to the aid of one heavily indebted country after another, until they end up with a deficit of their own that's become too big to handle -- that has Europe's politicians so worried. But do they even have a choice?
German Finance Minister Wolfgang Schäuble, a member of the center-right Christian Democratic Union (CDU), and his senior staff aren't just worried about the euro. They are also concerned that the German banking sector could be thrown out of balance once again if Greece defaults on its debt.
Like Lehman All Over Again
The senior Finance Ministry officials were alarmed by a letter from Jochen Sanio, the president of Germany's Federal Financial Supervisory Authority, known as BaFin. In the letter, which was addressed to Jörg Asmussen, a senior Finance Ministry official, Sanio urgently warned that the consequences of a Greek default could resemble the effects of the Lehman bankruptcy.
German banks could probably cope with a Greek default, but if it led to the financial collapse of other countries, like Italy, Spain or Portugal, the consequences for the banking sector could be catastrophic, Sanio warns. If this happened, the financial market crisis would only get worse.
In his letter, the BaFin president calculates what could happen to individual banks if securities from these countries lost 30, 50 or even 70 percent of their value. The results are horrifying. According to Sanio's scenario, banks that were already hard hit by the effects of the Lehman bankruptcy would be the most vulnerable, particularly German mortgage lender Hypo Real Estate (HRE), which has since been nationalized.
According to BaFin, HRE, which had to be propped up in late 2008 with government loan guarantees worth about €100 billion, holds by far the largest amount of Greek debt out of all German banks, with a total volume of €9.1 billion.
What makes the situation so contentious is the fact that HRE increased its inventory of the troubled securities by almost 50 percent between March and September 2009 -- which was precisely the period in which it was being bailed out with government funds.
But other problem banks would also be affected by a Greek default. According to BaFin calculations, partially nationalized Commerzbank carries €4.6 billion in exposure to Greek debt. Germany's ailing state-owned banks are also heavily exposed, with LBBW and BayernLB having an exposure of €2.7 billion and €1.5 billion respectively.
On the whole, German lenders hold about €32 billion in Greek securities, as well as another €10 billion in insurance holdings.
The situation would spin completely out of control if, in addition to Greece, countries like Portugal, Italy, Ireland and Spain got into difficulties. German banks have acquired debt from these countries with a total volume of €522.4 billion. This is about 20 percent of the total amount owed to German banks by foreign countries, according to a BaFin internal memo. German banks are apparently the "principal creditors in Spain and Ireland, and the second-most important creditor in Italy."
In their report, the BaFin experts even draw parallels to one of the biggest national defaults in recent years. "As in the case of Argentina, the countries named could face the beginning of a downward spiral," they write. As revenues decline in these countries, they are forced to impose drastic savings measures, which then hamper economic development.
"The main risk for the German financial sector lies in the collective difficulties of the PIIGS countries," the BaFin memo reads. "Greece could possibly be the trigger for this."
Betting on a Greek Insolvency
The German financial regulators also assign a significant portion of the blame for the current situation to speculators. "Among hedge funds, in particular, there are those that are betting on a Greek insolvency and a collapse of the euro zone."
If a number of countries do in fact default, the BaFin experts believe that the euro zone will have arrived at the limit of its effectiveness. The EU countries, together with international central banks, could perhaps fend off attacks on Greece, but, as the BaFin document warns, "in the event of speculation and financing problems in all of the PIIGS countries, serious problems could arise, along with substantial market disruptions."
Partly as a result of the pressure caused by the Sanio letter, Schäuble and Asmussen decided to clear the way for assistance to Greece. There are essentially three options, although two have already been discarded. The first option -- a joint bond issued by all the euro zone members -- was considered unrealistic right from the start. Assistance from the International Monetary Fund (IMF), which has helped countries out of financial crises in all regions of the world, is no longer an option. Schäuble, for one, would consider it an embarrassment if Europeans were unable to help themselves.
This leaves the third option, bilateral assistance, which Schäuble has discussed with his French counterpart, Christine Lagarde. The French are particularly insistent that action be taken quickly, a point President Nicolas Sarkozy has repeatedly made with Chancellor Angela Merkel.
Early last week, the German-French duo brought the remaining finance ministers in the euro group on board. Officially, all are still cloaked in silence and behaving as if bailouts will not be necessary. Nevertheless, the package of measures is beginning to take shape.
The German Finance Ministry expects support for Greece to amount to between €20 billion and €25 billion. All the members of the euro group are expected to participate, including those, like Spain and Portugal, who also might find themselves needing help soon. The individual countries' contributions will be determined on the basis of their respective shares of the capital of the European Central Bank (ECB). Under this scheme, Germany would be responsible for about 20 percent, or €4 billion - €5 billion.
The assistance is to consist partly of loans and partly of loan guarantees. KfW, the German state-owned development bank, will process the German share. Schäuble's experts want to tie the measures to strict requirements. For example, one credit tranche would only be transferred once the Greek government demonstrated that it had begun reforms of its pension system. The procedure is copied from the IMF. But is it legally valid?
For years, the validity of Article 125 of the "Treaty on the Functioning of the European Union," one of the EU's core treaties, was considered irrefutable in Germany's political debates. The regulation bars the euro countries from helping each other get out of debt.
This passage is also partly responsible for having convinced a skeptical German population to accept the introduction of the euro. Article 125 "tolerates no compromises," says Otmar Issing, the former chief economist at the European Central Bank.
Hence the legal experts in the German Finance Ministry had to go to great lengths in order to justify the planned bilateral assistance. After an initial review, they concluded that the measures were inadmissible. Schäuble was irate and ordered his staff to continue their review until all objections had been swept aside.
Now, the official version is that the participating countries will not assume any of Greece's debt, which would be forbidden under the treaty. Instead, they will add new debt to the existing debt, something that the rules do not prohibit.
Schäuble's officials know all too well that the interventions will nevertheless strain the framework of the agreement and the equilibrium of the currency union. For that reason, they intend to introduce new future-oriented provisions once the current measures have been taken.
They believe that the Stability and Growth Pact, the sole purpose of which is to coordinate the debt policies of member states, is no longer adequate, and that the euro countries will have to coordinate their economic policies with each other more effectively in the future. They also say that it will be necessary to develop a regulated procedure for national insolvencies within the framework of the euro group.
European Inflation Union
The Finance Ministry officials are also thinking about creating a new institution, modeled after the IMF, to handle future bailout efforts. This European fund would provide financing to countries in difficulty.
It is still unclear how the new rescue fund will be financed. There are two conceivable options: Each member state's contribution could be based on either its share of ECB capital or the level of its deficit.
The second solution would be fairer: the worse a country's financial policy, the higher its contribution. In other words, the biggest sinners would be required to pay the highest indulgence.
Such an institution doesn't exist yet, which means that European politicians will have to make do with what they have. The financial strength of the donor countries could soon be depleted. This could force ECB President Jean-Claude Trichet to buy up the debt of the countries facing bankruptcy -- which is tantamount to printing money. Although this is prohibited under the Maastricht statutes, the EU finance ministers already demonstrated that the treaty could be amended if necessary when, in 2005, they stealthily relaxed the 3 percent criterion for government debt.
Such a bailout would come at a high price: It would turn the European monetary union into an inflation union.
ARMIN MAHLER, CHRISTOPH PAULY, CHRISTIAN REIERMANN, WOLFGANG REUTER, THOMAS SCHULZ