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Why buying Greek bonds is the same as investing in a Ponzi Scheme

What is a Ponzi scheme? A Ponzi scheme is an investment operation where the investor is given returns that are drawn from subsequent investors.

Let’s assume that investor A invests €1000 in a Ponzi Scheme P, and is promised a net return of 20% in a year. Investor B invests in the same Ponzi Scheme P €2000 six months after investor A. When investor A comes back to withdraw his money after a year he is given €1200 of investor’s B €2000. So, each investor is paid with the money of subsequent investors. When there are no more new investors the Scheme collapses.

What does this have to do with Greece? Well, the same thing is happening practically with Greek bonds. If you buy a 10 year Greek bond today you are promised 16% yield. That is, if you give €100, you will be given back €116 after 10 years. The worrisome fact about long term Greek bonds today is the fact that the money of new investors appear to be going to senior investors. Practically, the €100 you invested in Greek bonds, instead of being invested in business, are used by the Greek government to cover old debts.

This is quite understandable if we give a look at some figures. We are talking of a country whose Government debt is almost 150% of its GDP, whose economy contracted by 6.6% for the last quarter of 2010 and whose budget deficit hit 30% of the GDP in 2010. This country, is promising you a yearly return of 16% on your investment for 10 years. That’s absurd. It is even more absurd that investors are going for it, which will probably prove to be a huge mistake.

In fact, when you invest in Greek bonds you are giving your money to old lenders. To have your money back, like in a Ponzi Scheme, you must hope that new investors keep coming. When new investors stop popping up a default crisis occurs. That’s what happened last year, when Greece was granted a bailout fund of €110 bn. It appears though that those money have not been invested in new businesses but have been used to cover old debts, as the Greek government is asking for additional funds today. In plain language, the Greek-Ponzi Scheme is collapsing.

How do we know that it is collapsing? You know it when you hear that debt restructuring is being taken into consideration. What does debt restructuring mean? It means that if in 2001 you were promised an interest rate of, say, 10% the Government cuts it to 5% due to lack of funds. So if you invested €1000 in 2001 in Greek bonds for a yield(interest rate) of 10%, today you won’t take back the long expected €1100 but only €1050.

Truth sounds absurd sometimes, but it is still truth. Investing in the Greek government is the same as investing in a Ponzi scheme.

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22 Comments

  1. Thomas Hastings says:

    Ernest,

    Government bonds do not work that way in the USA. A 12% Bond (and there have been some in my memory) pay a full 12% of the FACE VALUE, not of the amount invested, EVERY YEAR. If you paid $1000 for a 5 year, 12% bond, you would receive $120 X 5 or $600 in interest in 5 years, plus you would also get the face value of the bond back at maturity($1000). Your yearly return would be 12%; your total return for the 5 years would be 60%.

    So, are do Greek, or European bonds in general, work diffently?

    • Hi Thomas,
      No, Greek and European bonds work the same way. I am sorry for the confusion I caused by resorting to the concept of simple interest rate in the article above, but my point was to make accessible to everyone the argument that investing in Greek bonds was almost a scam (when I wrote the article there were voices of debt restructuring and of denial of a second bail-out plan to Greece).

  2. I’m a greek and I realized this a long time ago. It’s ALL a whole ponzi scheme. They’re borrowing money in order to pay earlier lenders. It’s insane. Needless to say, my money is all invested abroad

  3. As an economist, I believe that whether the yield calculation is mathematically correct or not is not relevant. By using a simple example, the author makes the text more readable and accessible for all. I agree that the Greek crisis really resembles a Ponzi scheme, where the financial sector dupes the tax payers at the end – and before and during…
    Just have a look at the recent restructuring “proposed” by private sector participants. Banks agreed to a great “sacrifice”, by accepting some 15% haircut for their Greek bond holdings, whereas Greek “insurance policies” indicate at least 50% discount… In return, DE and FR banks will get government guarantee for their existing Greek stuff, and with “sweeteners” their sacrifice will not be even 15%.
    As a former banker, I believe and saw that Financial sector development made the world much riskier, particularly for ordinary citizens who are more vulnerable to Ponzi schemes…

  4. Can you clear up an issue for me?

    Does the haircut on Greek debt apply only to debt held by the banks or will it apply to everyone?

    If the haircut is only for the banks, it strikes me that, at a yield this morning of 35%, Greek debt seems like a pretty good investment!

    Trevor
    Bristol

  5. 16% for an original investment of 100 on ten-year bonds do not equate to 116 after ten years, bro…

    16% of 100 over ten years = 260 (interests not reinvested)

    16% of 100 over ten years with interests reinvested = (1+0.16) to the tenth power multiplied by 100.

    Get your facts straight, bro

  6. Pacal Votan says:

    All governments are Ponzi Schemes. They cannot operate any other way. The only difference for a government scheme is that they take your money involuntarily.

  7. Felipe Gadelha says:

    This european policy over peripherals countries´ debt will just increase the exposure of Greece in case of outgoing euro currency area.
    Democracy is the way to save Greece from bigger recession.

  8. Fred said:

    “16% of 100 over ten years with interests reinvested = (1+0.16) to the tenth power multiplied by 100.”

    Hi guys,

    Anyone of you could explain to me this formula in better details? I don’t get the concept! Please, I would really appreciate it.

    Thanks,

    R

    • Hi Rino,

      Fred is referring to the composite interest rate, or the interest rate often applied by banks on your deposit. So let’s assume that you deposit €1000 at Intesa San Paolo at 4% interest rate.

      After 1 year your deposit will amount to: 1000*(1+0.04)=1000(deposit at the beginning of the first year)+40(4% of 1000)=1040.
      After 2 years your deposit will amount to: 1040*(1+0.04)=1040(deposit at the beginning of the second year)+41.6(4% of 1040)=1081.6.

      As this case shows, the deposit after 2 years is equal to:
      D(2 yrs)=1040*(1+0.04)=1000*(1+0.04)*(1+0.04)=1000*(1+0.04)^2

      If you try after 3 years you will see that it is equal to 1000*(1+0.04)^3 and so on…by mathematical induction you can prove the following formula:

      D(n yrs)=D0*(1+i)^n where D(n)=the value of the deposit after n years, D0=initial deposit, i=interest rate.

      Hope it helps.

    • Investing in greek bonds is not convenient because the Greek economy is lingering and there will be haircuts for at least 3-4 years unless Greece defaults on its debt altogether sooner. I strongly recommend you to invest in the Rhenman Healthcare Equity L/S Fund instead. It ranked first among more than 75 global Hedge Funds in the March issue of EuroHedge, a renowned industry magazine. Their annual target is of 12% and their capital under management has been up by 50% since the conception of the fund in 2009.

  9. Ernest I thought it was more difficult than it really is. You have been brilliant anyway!

    Thank a lot,

    Rino

  10. I love the little lesson on interest rates in the middle of the blog comments. Well done!

  11. Yeah I never understood how interest rates were calculated either. Thanks for taking the time to do that.

  12. I might be missing something here, but it’s common practice for Sovereign issuers to raise new debt to retire old. The problems arise when an issuer can no longer raise new debt, in which case it defaults. Then the question of restructuring arises, and it’s been common practice to reduce the interest rate payable, and the repayable amount. There are lots of South American examples to draw on. The current market for Greek 10 year bonds is telling you that a restructuring may get you about 20% of face value. I think this is about right. Greece’s fundamentals are nothing like Japan’s, say, after WWII. Japanese debt which had defaulted was repaid in full with accrued interest.

  13. Hi Ernest, I’m a student finishing a bachelor in Quebec and i would like to get some fact strait about Greek bond. Let’s say i would have bought a 10 y Greek bond when there YTM were at there highest. So 1000$ future value at 40% in 10y is a price of 34,5$ today.

    Then i sell it 6 month later when the YTM drop at 10% so the current price goes up at 385$. About 11 times the buying price. Since i sell before maturity I do not expose myself to Greece not paying and the actual interest rate insure that there is a buyer out there for my bond.

    What kind of other risk do i expose myself to? (except, of course, the obvious gamble that YTM will go down.)

    Thank you!

  14. Jean-Michel,

    When writing the article I was referring to the risk of having to deal with a piece of paper on which an 80% face value cut is applied 1 week/1 month/4 months after you purchase it at 40% yield (10-YTM/2-YTM).

    Hope that clarifies my perspective.

  15. yes it does,

    somebody on the other side of the 40% cliff would indeed see his money disappear in a few weeks.

    My intention were not at all to argue with you on the content of your article. On the opposite, I’m trying to clear some detail about international bond selling/buying which is why i have landed on your article.

    I was just wondering if it’s possible for someone to make the gamble of riding the YTM down and win even with such a risky asset? If so, what kind of risk would be associated with such a move?

    Thank you for your time!

  16. (I am speaking of zero-coupon bond of course. Otherwise, it makes no sense.)

  17. Jean,

    Your point is valid, yet it was not my intention, at the time of writing, to nourish such expectations. I am not in the defensive, but I think understanding the reasons and the purpose of the article will show how your idea might be a calculated bet today but was a scam few years ago.

    Not that I am driven by perverse motives, but I would have preferred a default on Greek bonds rather than continuous restructurings. Unfortunately, we have had to witness palliative financial policies by the ECB which are nothing but confusing for investors. Going back to your question: can you bet on lower YTM on Greek bonds? Two years ago the only answer to that question would have been NO, ABSOLUTELY NOT. Why? Because the Greek economy was in free fall, unemployment, high public debt, sclerotic industry, suvranational monetary policy and so on. If I don’t err 10 year bond offerings were out of question but only 2 YTM and in November 2011 they even released 6 MTM bonds (not so sure though). So, investors were in the midst of a storm with a broken compass (ECB vs Germany) and there was no reason even to dream that the Greek economy would be revitalized anytime soon. Hence, no reason to believe that Greece’s borrowing capacity would improve, no reason to believe you could drive YTM down.

    Today, with the billions pumped by the ECB one might take such risks, yet I would leave it to hedge funds and not recommend it to families in Australia and Canada looking to make an investment.

    A textbook example on which your strategy would have worked perfectly was Italy. High public spending, an inefficient legal system and with one of the most inefficient fiscal systems in Europe, Berlusconi’s Italy seemed to be headed to the same fate as Greece. The spread with the German Bund rose quickly in the last days of Berlusconi’s government, yet if you were in Italy you could have made such bet as all political sides were pushing for a technocrat government. A common event in Italy, which had already happened under similar circumstances in the early 90s, whenever politically unpopular decisions are to be made. And in fact withing weeks after the establishment of Monti’s technocrat government the spread decreased substantially.

    To conclude, your strategy makes sense but it would be extremely risky to apply to Greece.

    Hope I answered your question this time.

  18. Absolutely!
    Thank you so much for such a complete answer!

    I look forward reading you.

    with my best regards,

    -Jean-Michel de Passillé, Québec

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