BEING HANNES SMÁRASON
On New Year’s Eve 2006, Icelanders sat down after their traditional festive dinners to watch the “New Year’s Skit” on state television. A parody of the passing year’s events, the Skit was a national institution on par with the New Year’s fireworks at midnight. This year the memorable joke turned on a man named Hannes Snorrason, an average Joe who was hounded in his daily life with comments like “Hannes Snorrason, yes, sounds almost like Hannes Smárason except you are missing something,” or more simply, “Why can’t you be more like Hannes Smárason?”
Icelanders found the plight of this average Joe, with a name too similar to a national luminary’s, uproarious. But the joke was on the real man with the name Hannes Smárason—enfant terrible of the business world, who was either a crazed gambler or a genius depending on whom you asked. In a country still in touch with its egalitarian roots, Smárason’s exposure to condemnation and ridicule was inevitable. He was in for more when a song, leaked onto the Internet around the same time, made sport with lyrics such as “you all know my deeds / I am not like the rest on streets / you should all bow to me” and “This is Hannes Smárason here / I only know how to buy and sell.”
But there was abundant evidence that Smárason (born in 1967), a distinguished engineering graduate of MIT and a former McKinsey consultant might be enjoying a laugh of his own. In 2004, he had taken control of Icelandair and in less than two years transformed this national airline, with more than 60 years of business history, into a leveraged investment company. Cultural potshots aside, the irrefutable fact was that in its modern guise, the company had made more money under his brief command than it had in its entire prior existence.
Icelandair became an international carrier in the years following World War II by pioneering discount flights between America and Europe and undercutting the price fixing of other European flag carriers. Luxembourg, the only European nation without a flag carrier, was the first (and only, at the outset) to grant landing permits to Icelandair planes; this relationship later influenced Iceland’s decision to make its first financial foreign expansion in Luxembourg. The airline had always stashed its summer profits to help tide it over during the slow winter months. When Smárason gained control in 2004, he began to invest the excess in the stock market. He soon was convinced that there was much more money to be made trading stocks than flying customers across the Atlantic. In early 2005, the company was officially designated an investment company and changed its name to FL Group.
In the beginning Smárason had been working with the established business elite—the wife of Geir Haarde, then the minister of finance and the soon to become prime minister, was sitting on the board of the new company. However, midway through the year, the entire board resigned, citing as their reason the management style and bellicose investment tactics of their chairman—Smárason. Their complaints were echoed when the CEO quit in October. Undaunted, Smárason pressed on and named himself the new CEO. He managed to raise a new equity offering, and continued to invest. The equity offering was unusual because stocks in other companies were accepted as payments. Since FL Group traded at a premium book value—a reflection of the market’s exuberant belief in Smárason’s business acumen—there was an instantaneous “value creation” when FL’s premium was added onto the value of stocks booked at market value.
FL Group at the outset kept its focus on the airline industry. An early major purchase had been a stake in EasyJet, the UK discount airline, which was sold at a hefty profit in the midst of the Geyser crisis. That autumn, Smárason divested Icelandair out of FL Group and listed it as a separate company on the Icelandic stock exchange, booking another rich profit. In the final months of 2006, FL acquired a 5.98 percent stake in the AMR Corporation—the U.S. holding company that owned American Airlines—and became the third-largest shareholder in that entity. AMR had shown a profit in the first two quarters of 2006, for the first time in six years, and its stock price had subsequently appreciated 36 percent in the last two quarters, realizing another instant profit for FL. When the numbers were all in, Smárason could boast a 40 percent return on his investments in 2006. It had indeed been his year.
Smárason’s achievement received high-profile recognition when “The Market,” the business section of the most widely circulated newspaper in Iceland, chose him as businessman of the year for 2006. In an interview that followed this accolade, on December 28, Smárason boasted that he did not need to deal with Icelandic banks anymore: in fact, he said, he was the bank now. During the stock market sell-off at the height of the Geyser crisis, he had grabbed a 30 percent stake in Glitnir (formerly Islandsbanki) using a foreign syndicated loan.
FL had been operating like a hedge fund, with active proprietary trading, but its modus operandi was to take large enough stakes in its acquisitions to give it a voice on the companies’ boards. That voice exhorted management to undertake “value-adding reforms” and should be loud enough to be heeded. Now focusing on banks, FL bought a stake in the German Commerzbank in 2007. All indicators pointed upward and Hannes Smárason’s reputation as a genius grew for a few more months, anyway. When an economic downturn began in the fall of 2007, airlines and banks were among the first casualties and FL Group was hit by a series of margin calls. Smárason was forced to step down as the CEO in the fall of 2007 and his positions were sold.
A quick rise and precipitous fall: it would not be the last in Iceland.
THE ICEX FROM DAWN TO DECADENCE
The years between 1997 and 2007 were a golden decade for the Icelandic stock market and investment banking. The banks went from rags to riches advising their clients on cross-border acquisitions; in the process they aided the creation of a handful of Icelandic-owned multinationals. In this regard, necessity had been the mother of invention. Even after the country opened up to the world, liberated its economy and embraced Thatcherian free market virtues, it still could not attract foreign equity investment in any sector except for industries seeking cheap energy like aluminum smelting. It was not for lack of trying. In 2002, during the final phase of bank privatization, the government approached a number of foreign banks with invitations to take a stake in the two banks in which it retained interest, but the response was tepid at best.
Perhaps Iceland was just too small, unknown, and remote a market? It had the smallest free-floating currency in the world and was a minute, anomalous linguistic area. International financial markets were accustomed to the presence of resident Swedes, Danes, and Norwegians; Icelanders were still a rarity. Iceland just continued to a universe onto itself.
On the other hand, the willingness of foreigners to lend money to Iceland on the back of her excellent credit ratings seemed almost bottomless. The country needed scale economics, multinationals, and tasks worthy of its ambitious, foreign-educated workforce. (Many Icelandic students attained their advanced degrees abroad, but most returned home when they were ready to raise a family.) By the same token, the investment banks recognized that the mountain would not come to them and so went to the mountain, creating multinationals in a string of leveraged transactions. They spent the first part of the golden decade building successful companies with real agendas in the world markets. What was more, growth was achieved without a single default by a major Icelandic corporation or the issue of any corporate bonds, despite the huge amount of leverage being used.
By dividing the golden decade into three general phases, we can better understand the rationale that informed the stock market bubble that began to grow in 2005 and the systematic collapse that followed three years later. Those three phases are:
• The buildup (1997–2000). This initial phase described the maturation of a young, thin market that had been active only since 1992. During this time, 42 new companies were listed on the stock exchange, bringing the total number up to 75 by 1999 and the total market cap to 100 percent of the GDP. The growth was driven by both privatization and rationalization in the corporate sector. The new listings were companies operating for the most part intramurally, although some were producing for the export markets, particularly fishing companies. A small minority were connected to the dot-com bubble. The benchmark index was comprised of the 15 biggest and most liquid companies (ICEX-15); from 1997 to 1999 it approximately doubled before shedding the gain almost completely in 2000–2001. This phase coincided with the dawn of Icelandic investment banking and represented the first step toward a healthy market economy in Iceland.
• Internationalization of the stock market (2002–2005). During this time a number of leading companies became multinationals through leveraged cross-border acquisitions, facilitated by the quickly developing expertise in international investment banking. Most of them mined specialized niches in three oversized industries: health, fishing, and biotech. They facilitated the production and export of “real goods” and, by acquiring foreign companies, they invested in production synergies and market access. Their acquisition targets were bought on low multiples due to generally cheap equity prices. In these years, international policy rates and risk premium both dropped, magnifying returns of leveraged equity investments. The expanding companies followed well-defined strategies and sound business models that in most cases proved successful; they brought extravagant returns to their domestic shareholders and new, well-paying jobs to educated Icelanders.
Kaupthing had been foraying in cross-border investment strategies since 1999 and quickly established its authority; its own expansion was achieved on the backs of successful clients. The ICEX in general was focused on foreign expansion, its growth fueled by a low-dividend payout ratio. Companies bound to the domestic market were subject to a wave of leveraged buyouts generated by the priorities of international players. Dominant shareholders either took these interests private or else were swallowed by larger companies.
At this time, keeping up with the Joneses of Icelandic business meant leveraged equity investments. In 2000 the first company was delisted from the ICEX in a leveraged transaction and there would be more. For example, from 2003 practically all fishing companies were delisted from the ICEX; the number of indexed companies shrunk to 27 by 2005 (from 75 companies in 1999). Simultaneously, the market cap swelled from 60 percent of the GDP to 180 percent as the ICEX index tripled. Now that 70 percent of the revenue of ICEX companies came from abroad, the stock market at last could be described as an international entity. On the other hand, it was still a local concern: foreign investors still were not tapping into the ICEX, despite having many internationals to choose from. But from any perspective, investment banking was enjoying its halcyon days. Its dominance placed the ICEX in step with its Scandinavian counterparts, over which large, niche-playing multinationals were also running herd.
• Fixing on financials (2005–2007). Near the end of this final phase, financials constituted about 85 percent of the ICEX-15 market cap. Listing an investment company that owned shares in other listed companies, such as the banks, had the peculiar effect of counting real value many times over. Cross-border acquisitions by now were composed mostly of pure equity investments made by holding companies, rather than companies focused on nuts-and-bolts production. Furthermore, Icelanders had run out of qualifying candidates for would-be multinationals. Acquisition targets had jumped in price since all multiples in the international equity market continued appreciation along with the economic boom abroad and leverage ratios increased.
This was, visibly, a time of decadence in the stock market. Investment companies and financial engineering, markets that had grown with the economy at large, were experiencing a bubble and dominating the nest. The ICEX market cap was three times the GDP in mid-2007; wealth effects trickled down and took the form of record sales of champagne and luxury cars. In hindsight, this was the point when rational economic calculations came to a halt. The currency was overvalued, household income was unsustainable, and all valuations were skewed. In their ambition, Icelanders had overreached, setting themselves up for merciless punishment in 2008 in which 90 percent of the stock market value was wiped out.
The stock market exuberance began in 2005 but the fatal wrong turn occurred after the Geyser crisis, when the country’s financial market was discovered by the structured credit industry of the United States. CDS spreads of the Icelandic banks remained stubbornly high—30 to 40 points above other banks—even after calm was restored and the crisis had receded from the international newswires. Although Iceland was not yet melting, the London financial community was still demanding an extra risk premium, an especially severe one given the low-spread environment and the lack of new funds coming out of the City. The three Icelandic banks could pass the premium on to their domestic clients, but that option did not exist with foreign clients, who might be lost to banks of other nations. In the end, Icelanders were likely to have been priced out of foreign markets and their expansion would have slowed or ground to a halt. The banks even had to shrink their balance sheets in response to funding pressures.
But fortune’s wheel again seemed to turn in Iceland’s favor in late 2006, when new demand for Icelandic bond issues arose. These bonds combined high yields with high ratings, which made them ideal building blocks for securitization. They were bundled with other corporate bonds in special purpose entities (SPEs) issuing collateralized debt obligations (CDOs). The risk and return to the end investor depended primarily on how the CDOs and their tranches were defined; the underlying assets had only an indirect effect. It actually seems that the majority of investors never gave much thought to what their CDOs were composed of, beyond the basic information supplied by their rating.
Indeed, a high return with a good rating looked almost like a free lunch. We now know that the debt-securitization market contained a structural flaw that contributed mightily to the current financial and banking crises, especially in the United States: the ability to earn large fees from originating and securitizing loans, coupled with the lack of any residual liability, skewed originators’ incentives in favor of loan volume, and return rather than quality. This was most evident in the use of the so-called subprime mortgages in structured credit, and it was this practice that, starting in 2006, sucked the Icelandic financial system into the brewing U.S. credit bubble. When the bubble burst a year later, it was at first called the “subprime crisis.”
But in 2006, the CDO alchemists were a boon to Iceland. They weaved Icelandic banking bonds and bare CDS contracts into so-called synthetic CDOs. This encouraged financiers to go long against the Icelanders in the CDS market by writing insurances against their default. Thus, the banks’ spreads narrowed almost overnight. Simultaneously, the U.S. MTN market opened suddenly to Icelandic banking bonds, prompting all three banks to answer with new issues. The wholesale markets could again be utilized. Out of the blue, foreign credit markets were wide open again, and all the banks rushed forward. The Geyser crisis had, after all, done nothing to curb their desire for growth.
Fortune extended another gift in early 2007, when Moody’s upgraded all three banks to a triple A rating, a jump of four or (for Landsbanki) five notches. This was the product of a new methodology called joint default analysis (JDA), which estimated the likelihood of default on banking bonds as the likelihood of government support for the respective banks. Moody’s noted that there had been virtually no bank defaults in the last 30 or 40 years, in countries with a history of supporting banks. The JDA was critical to the inflation of the international credit bubble; many banks received rating upgrades with its application, although Iceland’s were the most spectacular. Triple As made the banks’ bonds all the more attractive to weavers of the CDOs, and credit flowed even more readily.
Moody’s responded to explicit and immediate criticism of the Icelandic upgrades in a Q&A it sent out to investors to explain the JDA method. The form pointed out that the three banks represented over 90 percent of domestic deposits and a similar, if not larger, share of domestic loans. Since each individual bank accounted for at least 25 percent of the financial system, Moody’s believed that each of them clearly qualified as “too important to fail.” Concerning the backup support of the nation’s government, the agency maintained that “access to finance will always be available for Iceland—albeit at varying prices. Moreover, adjustments to shocks in advanced economies are made through GDP growth rates and flexible exchange rates, and not by defaulting on debt obligations.”
This explanation did not convince the skeptics. Even Kaupthing’s CEO publicly voiced doubt about JDA. Just days later, Moody’s reversed the upgrades, dropping each bank down three notches, still one or two higher than before JDA was implemented.
THE RISE OF THE HOLDING COMPANIES
During the heady recovery of late 2006, fair-weather friends on both sides of the Atlantic bestowed another gift on the owners of Iceland’s banks. They were now able to pledge their shares as collateral for direct lending from the large international banks. The shares were kept in holding companies, which originally had been of modest size, but grew in tandem with the continued success of the foreign banking expansion. The holding companies had been leveraged from the very beginning. For example, Samson Holdings, the main owner of Landsbanki, had bought a 48.3 percent share of the bank when the state sought privatization in 2002; the deal included a 30 percent equity ratio with the remaining 70 percent vendor financed.
In the old equalitarian Iceland there was little concentration of wealth; there were no “super rich” to speak of, and the small number of old moneyed families rarely could produce the funds for substantial corporate investment. Thus, the owners of holding companies and architects of the new multinationals depended on leverage at the outset, since so few funds were available. It was not until 2006 that success abroad created substantial equity in the holding companies and world-class wealth for their owners. However, when the opportunity arose that fateful autumn of 2006 the capital gains from the past three years were leveraged anew with new external funding. The holding companies transformed themselves into investment bodies by blowing up their balance sheet.
These new investment entities now pursued ambitious international goals. Their initial forays into foreign stock markets were so profitable as to encourage smaller imitators back home who were funded locally. The lofty expectations for these leveraged stock bets can be inferred, for instance, from the fact that ICEX-listed investment companies were being traded around price to book 1.5, which means, effectively, that the market value of their stock was 50 percent above the market’s already elevated valuation of their assets. By mid-2007, one-quarter of Icelandic banking’s total lending had been done with holding companies with collateral, mostly in equity.
The transition from holding to investment companies is well illustrated by a series of mergers and acquisitions that centered on Exista, the primary owner of Kaupthing.
Exista was founded in 2001 (then under the name Meidur) as a holding vehicle for Kaupthing shares owned by savings and loan institutions, which had owned the majority of the bank since 1985. In 2003, two brothers, Lýdur and Ágúst Gudmundsson, acquired a 55 percent stake in Exista. The Gudmundssons had founded an ICEX-listed company named Bakkavör in 1986 and thus came to be known as the Bakka brothers as their profile widened. They were classic auto-didacts who had built their company from scratch, without any specialized education. In the beginning of their venture, Bakkavör was involved in the processing of roe, the same business Gudmundsson père had spun-off from the fishing industry. But the brothers soon transformed their vehicle into a leading producer of fresh convenience foods; they eventually would exit the Icelandic fishing sector altogether. In 1997, they crossed paths with Kaupthing and began their international expansion with a string of leveraged transactions.
The first foreign acquisition was made in France, in 1997, but the Bakka brothers became truly aggressive when they entered the British market in 2000. In 2001, they made the watershed acquisition of the UK-based Katsouris Fresh Foods, a company five times the size of Bakkavör. Four years later they acquired their main British competitor, Geest, which was roughly three or four times the size of their company. By now Bakkavör had become a leading maker of fresh prepared food in the UK. The group’s products, made under supermarkets’ labels, ranged from ready meals, pizzas, fresh salads, soups and dips, to desserts and ready-to-eat fruit. Although the growth to some extent had been financed with offerings in the Icelandic stock market, the company had similar leverage as a private equity fund. After success in the food business had begun to materialize, the Bakka brothers turned their attention to financials and accumulated a substantial stake in Kaupthing; when they became the leading owners of Exista, the brothers brought along their Kaupthing shares and a 39.6 percent stake in Bakkavör.
Now Exista had become the bank’s biggest shareholder, with about a 23 percent stake. The goal here, to ensure stability in the bank’s shareholder base, was based on Swedish models, such as Investor AB, which supports Svenska Enskilda Banken, or Industrivärden, which supports Svenska Handelsbanken. By 2005, Exista was ready to succeed as an investment company, and to that end purchased Icelandic National Telecom when it was privatized. By the end of that year, Exista flaunted a balance sheet of EUR 2 billion and a 60 percent equity ratio.
Exista and Kaupthing had had cross ownership from the outset, with the bank owning a 19 percent stake in the company. This served a limited strategic interest for Kaupthing, since under international capital adequacy rules this share was subtracted from its equity base and the shares were carried on the books at original purchase price. During the Geyser crisis, however, Kaupthing was harshly criticized for this practice and the management devised a clever exit strategy. In a September public offering, Exista was listed on the ICEX as an investment company. When Kaupthing paid out its Exista shares as an extra dividend to its shareholders, overnight Exista was endowed with 36,000 new shareholders. For its part, Exista was intent on becoming a “financial service group,” with northern Europe as its core market. The plan was to benefit from the strong cash flow between the operating units and the investment arm of the company.
The ideal and best-known model of this practice was Warren Buffett’s Berkshire Hathaway. Buffett’s company uses the “float” provided by insurance operations (a policyholder’s money, which it holds temporarily until claims are paid out) to finance its investments. To this end, Exista acquired an insurance company called VIS (with about 35 percent market share in the Icelandic market) from Kaupthing in May 2006. In early 2007, Exista used direct foreign financing to build up a 20 percent stake in a Finnish insurance company, Sampo, and a 8 to 9 percent stake in a Norwegian investment company, Storebrand (Kaupthing at that time already held a 20 percent stake in Storebrand). The plan, clearly, was to employ the Berkshire Hathaway model throughout Scandinavia by acquiring insurance companies, with one crucial difference. Buffett sternly warns against leverage; leverage had become Exista’s middle name. By midyear 2007, its balance sheet had swelled to EUR 7.7 billion—and 37 percent equity ratio.
Exista was the largest, most sophisticated Icelandic investment company to emerge in the stock boom, but there were many others. While only the top players could solicit direct foreign financing, all exploited tax incentives that made the formation of a holding company very attractive indeed. Some holding companies were course organized around business involved in real production but others, from the outset, had been little more than stock trading vehicles, but by 2005 it had become common for traditional businesses to use their excess cash flow for equity investment and even to leverage their operational assets. This was the case with Smárason’s FL Group and with many fishing companies as well. The latter were accustomed to financing themselves in the foreign currencies in which they received income or conducted other hedging activities. But most investment companies were in fact the overhauled holding company of some traditional Icelandic business that, after the unprecedented market growth, now held substantial assets. The owners, seduced by the temptation to leverage, would acquire another company or just buy listed shares.
The holding company structure, then, also contributed to the ICEX bubble; in fact, almost the whole financial system had now become a derivative of the successful foreign expansion of Iceland’s three banks. The Savings Bank of Reykjavik (SPRON) was an extreme example of this. In the summer of 2007, its market capitalization was ISK 120 billion ($2 billion at the prevailing exchange rate), which was equal to three times the book value of equity. The SPRON had approximately 20,000 customers. Its main asset was a share in Exista, which traded at 1.6 book value of equity. The main asset of Exista, meanwhile, was Kaupthing, which traded at up to two times equity. The owners of shares in the innocuous-sounding Reykjavik Savings Bank were therefore holding incestuous equity of Kaupthing at almost ten times book value.
Lending against the value of a listed equity does not have to carry a higher risk than, say, lending against the value of a house, if the underlying stock can be sold in a liquid market on short notice. If that is the case, the bank can just liquidize the position by placing a margin call on the loan and recover the funds. The Icelandic banks made the loans to the holding companies based on what they considered to be a comfortable equity buffer, over 50 percent coverage. Some of the companies had engaged in a leveraged buyout along the way and kept what they considered to be a long-term holding of unlisted equity; most held marketable assets and/or listed stocks, which presumably could be sold after a margin call to repay the loan. Iceland was not unique in this area, since the most profitable and fastest-growing segment of banking on both sides of the Atlantic was loans to hedge funds or investment companies.
What was unusual was the precarious liquidity of the ICEX. Despite many Icelandic companies having foreign revenues, the country’s equity market was in essence its own universe, with almost no foreign ownership. A bank could in most cases easily liquidate its holding company’s client portfolio through a margin call, sell it in the market, and recover its loan. However, the portfolios of all the bank’s clients were very similar and therefore highly correlated. That included the bank’s most important customers, owners, and managers. If the need arose, liquidating the whole system in an orderly fashion proved impossible. This, like much else, worked well until stock markets the world over found themselves in a systemic liquidity crisis after August 2007. Both the banks and the holding companies were rendered nearly illiquid by the shock. At the same time, the holding companies were monitored relentlessly by foreign short traders and hedge funds. These predators would jump on any rumor about an immediate sale of foreign holdings and short the company’s main assets, effectively blocking its exit. Exista, for one, was a sitting duck in this game. Shorting its three main listed assets brought down the equity ratio and, the hedge funds hoped, would trigger a margin call and a forced sale. Which it eventually did.
All the while, Icelandic bankers were ambivalent about the investment companies souping up on their own by obtaining loan financing directly from foreign banks. Some were pleased to reduce risk in the home financial system by transferring credit risk to foreign banks and reducing cross lending. In some cases, such as Kaupthing and Exista, the bank goaded the investment company into more outward reach. But there were general worries about loose cannons cornering power through foreign leverage, the most infamous of these cannons being Hannes Smárason and his FL Group.
As it turned out, the balance sheet enlargement of these investment companies with direct foreign funding created an extra layer of foreign leverage on the value of the banks’ stock prices, to the grave detriment of the Icelandic financial system. The inflated sheets crumpled as soon as the foreign banks withdrew their support in response to the crisis inside the international financial markets. Their sheer weight was almost enough to crush the banks.
However in 2006–2007, the aggressive, leveraged giants remained wonderful banking clients, who created new fees in both capital markets and investment bank divisions. They frequently established their own hedge-fund-type proprietary trading arms for short-term position taking as well as strategic long-term positions in selected companies. Some companies even co-invested with the banks in selected projects. Furthermore, a bigger owner could better support the continued growth of the banks with new equity. The relations had gone far beyond the old model of client-partner: this was a symbiotic relationship, or even a strategic alliance.
Inside the Exista-Kaupthing combine, no one doubted that Sigurdur Einarsson and his minions were in charge; Exista was Kaupthing’s creation. Once, a major shareholder told Einarsson he was considering the sale of his share to another major Icelandic investor. “Never mind” said Einarsson. “He will never have any say about this bank, not more than you have.”
At Landsbanki, the shareholder-management relations skewed in favor of the former, since a single group held a nearly 50 percent stake and had invited the management into their bank. The structure was further complicated by the fact that the owners were active investors, who had come to own a multitude of investment companies as well as Straumur-Burdarás, another investment bank, and all these pieces interacted. What was more, Landsbanki was run by two CEOs who reputedly clashed with each other. One, Sigurjón Árnason, had been recruited with a cadre of loyal followers from Bunadarbanki. He had unquestioned control of the bank and his independence enhanced his credibility outside the bank. His counterpart, Halldór Kristjánsson (born in 1955), had acted as CEO prior to the privatization; his retention was seen as a means to keep a lid on Árnason but it also had political overtones, as will be discussed in Chapter 6.
Islandsbanki traveled the rockiest road during this time, since instead of fostering an investment company it basically was taken over by one. In the process, it was transformed from the most risk-averse bank into the biggest risk-taker. Islandsbanki, since 1989 the only continuously private bank, arguably had the best retail operations in the country in terms of its branch network and corporate loan portfolio. But despite strenuous efforts, it could never gain traction in the investment banking business. Its CEO was Bjarni Ármansson (born 1968), who had worked for Kaupthing from 1992 to 1997 before becoming CEO of the government-owned corporate bank FBA, established in January 1998. FBA merged with Islandsbanki the following year and Ármansson transferred his title to the new bank.
Ármansson was a charismatic and able manager, with an approach to funding and private equity that was conservative by market standards. He was an appealing personality who embroidered in his spare time and ran in highly publicized marathons sponsored by his bank. But for some reason, Islandsbanki still could not fly as an investment banking operation. It might have been that, unlike Einarsson and Árnason, Ármansson never built a stable management team around him; some said this was because he saw able, ambitious employees as threats rather than assets. But he also suffered from the power struggles and disunity of the major owners, which so undermined his own position that he earned the nickname “the Survivalist” in honor of the tap-dancing he managed on top of his shifting shareholder base. Islandsbanki’s owners were typically the traditional, old-money, overwhelmingly risk-averse elite; these were not the people to create a strategic partnership via the formation of an aggressive investment company. Islandsbanki had, though, been a pioneer in fostering investment companies when it established Straumur, originally an equity fund founded in 1986 which became a listed investment company in 2001. However, in 2003–2004 Landsbanki owners were able to snatch the fund from Islandsbanki and upgrade it into an investment bank under the name Straumur-Burdarass in 2005.
However, even these cautious actors could see that their retail bank’s future was threatened by the prowling presence of the Landsbanki and Kaupthing. Islandsbanki lost employees and clients after its competitors were privatized, and it fended off a hostile takeover attempt by Landsbanki in 2004. Outward growth was essential to survival. Ármansson aspired to turn Islandsbanki into an Icelandic-Norwegian commercial bank with a special emphasis on the marine sector and renewable energy. When he acquired two regional Norwegian banks in 2004—Kreditbanken, which concentrated on the seafood sector, and BN, a specialist in long-term mortgages—Islandsbanki became the sole Icelandic bank to make a foray into foreign retail operations. This, then, was to become the soil in which its investment banking operations would take root in Norway. There was even a change of name: the bank was now called Glitnir, a more Pan-Scandinavian name derived, not surprisingly, from Old Norse mythology.
Glitnir’s retail approach carried far less risk, a fact revealed during the Geyser crisis, when its CDS spread was far below that of Kaupthing and Landsbanki. At last, it seemed to have gained a competitive edge. Bjarni Ármansson, previously criticized for his conservatism, now stood vindicated in the wake of the crisis. But the market’s appreciation was truncated when new U.S. funding sources opened up in the fall of 2006 and investment banking enjoyed its resurgence. Conventional wisdom declared that “no foreign bank has ever made money in Norway,” and Glitnir ultimately was unable to contradict that claim. Its Norwegian operations, while not disastrous, did not meet anticipated returns or create a foothold in the corporate market.
It was at this uncertain moment that Hannes Smárason´s FL Group took a 30 percent stake in Glitnir. The stake increased in 2007 when FL partnered with Baugur Group, a retail giant. With two leveraged investment companies for owners, the shift in Glitnir’s overall strategy was obvious and immediate. The bank jumped into two large deals in the fall of 2006: a takeover of the House of Fraser by Baugur and the underwriting for the sale of Icelandair by FL. To bulk up its capital market operations, it acquired Scandinavian brokerages and investment banking units at very high multiples. Glitnir, too, was now an aggressive investment bank, a fact treated with some skepticism, most notably by Richard Thomas, the credit analyst for Merrill Lynch. The Icelandic financial regulators were also quite skeptical about the new owners of the bank, but the precedent set by the sale of Landsbanki to a leveraged holding company in 2003 made it difficult to act, lest the move be seen as discriminatory. Nevertheless, the Icelandic FSA barred the two investment groups from holding more than 30 percent in the bank, to their great annoyance.
As for Ármansson, by April 2007 his new masters had accumulated sufficient shares to fire him. The new CEO, Lárus Welding (born in 1976), was eight years junior to Ármansson, a fact that did not send a message of independence from owners or experience from the helm.
THE RISE OF A ROCK STAR
Baugur Group, a rather mysterious entity, is key to understanding the puzzle of owner-management relations inside the Icelandic banks. The owner and manager was Jón Ásgeir Jóhannesson (born in 1968). He began building his business empire at age 21, when he opened a discount supermarket, Bónus, in Reykjavik’s docklands with his sister and father. Jóhannesson père, a straight-talking, popular man, had not enjoyed much success in business up to that time. Jóhannesson fils didn’t have his father’s folksy charm or way with words and was an indifferent student, but he was an incredibly determined, driven entrepreneur. It took him just five years to modernize the entire Icelandic food market by streamlining supply networks; along the way Bónus became the country’s largest food retailer. When Bónus acquired the largest retail brand, Hagkaup, the new entity was named Baugur (Kaupthing and FBA were advisors to this takeover and, a year later, underwrote Baugur’s IPO when it was listed on the ICEX).
Having gathered a healthy market share at home, Jóhannesson was ready to expand abroad. He first targeted the United States in 2000 with a retail advisor, Jim Schafer, who had previously worked at Wal-mart, buying a bankrupt chain of discount stores. The venture was a dismal failure that ended in bitter strife with Schafer. Jon Ásgeir later described the affair as an expensive business school. An advance into London proved far more successful. By 2001, Baugur, cooperating with Kaupthing and other Icelandic banks, had built a 20 percent stake in Arcadia, a UK retail chain. Baugur attempted a takeover the next year and was rebuffed, but when another company successfully absorbed Arcadia soon after, the Icelanders cashed in £100 million. This windfall made Baugur a major player in the UK retail market. Ultimately, it took stakes or full ownership in a pool of businesses that employed over 65,000 and grossed over 10 billion in 3,800 stores. By now, the British press was referring to Baugur as an archetypal Viking raider—it wasn’t just Icelanders who resurrected history.
Jóhannesson went to great lengths to burnish his swashbuckling image. He dressed like a rock star in black suits. The Danish media made fun of the Bundesliga (the German soccer league) hairstyle (his hair falls to his shoulders). His dislike of paperwork and adherence to one-page management were notorious: he didn’t want to be flooded with information, he wanted only the essential details and wanted them “quickly.” He delisted Baugur from ICEX in 2003, compounding his company’s mystique with a public blackout of its balance sheet and income statements. But the Icelanders continued to receive regular updates on the man himself as he took over more UK retail stores, roared about in race cars in Monte Carlo, or par-tied on his yacht in the Mediterranean. At home and abroad, he became the poster boy for the new dawning of the Viking age or, for those who couldn’t swallow the macho act, the descent into crass materialism. There was little doubt about Jóhannesson’s self-image—he kept a 10-foot statue of a Viking, armed with a sword and electric guitar, in the lobby of Baugur’s London headquarters—and perhaps he missed the irony of his attitude. There was even a swaggering element to his choice of investments, and particularly his purchase of Danish national treasures such as the Magazin du Nord, an historic department store, which annoyed locals to no end.
But business remained a going concern beneath the opera buffa persona. The aim behind Jóhannesson’s success had been to create a holding company or private equity fund that would carry relatively little debt along with stakes in retail chains obtained in leveraged buyouts. Quite often these would be management-leveraged buyouts that Baugur assisted. If the chain was not leveraged upon purchase, then it would simply take on more loans and pay its owner a dividend. However it ended up under Baugur’s umbrella, the chain’s management soon had overhanging debt that demanded continued success to keep up with it. The managers ultimately became a very driven lot and in many cases Baugur’s stewardship was to produce operational improvements.
Baugur was, after all, something of a Kaupthing creation like most other successful multinationals and the two powerhouses had cooperated closely, especially in the early phase of the invasion into Britain, when Kaupthing actually owned a 20 percent stake in Baugur (that stake was sold in 2006). By 2002, Jóhannesson was successful enough to be wooed by foreign banks, such as the Royal Bank of Scotland, HBOS, Barclays, and Deutsche Bank, all of which cooperated with him in specific deals. When it came to Baugur’s funding, an Icelandic bank stood by the equity taps, although not always the same banks. He had no trouble finding new partners, as wannabe investment banks considered him the man who could provide access to exclusive clubs in London’s financial community. When Kaupthing began to apply the brakes on its lending in 2002–2003, Jóhannesson became cozy with Landsbanki; when they tightened the screws, he bought into Glitnir. When he reached lending limits with this source, he moved on to savings banks and issued corporate bonds directly into the Icelandic financial market. With each new partnership, the leverage and multiples increased along with the new acquisitions to the empire. By the end, it was rumored that Jóhannesson and companies connected to him owed what amounted to between 70 and 80 percent of the nation’s GDP.
Every empire reaches a point where the center gives. It is clear that Jóhannesson, like most of his countrymen, had lost his edge around 2005. His gifts for retail and wealth creation on the UK’s High Street were undeniable, but he suffered from an ambition that seemed to have no limits. He had many shops—too many—in Britain and real estate in Sweden and Denmark; he tried to establish a free Danish newspaper, a media conglomerate, a phone company, an Icelandic bank, and, last but not least, a partnership with the ubiquitous Hannes Smárason. Jóhannesson, the man who made his fortune by shaking down sleepy corporate conglomerates in Iceland with his lean, no-frills discount stores was now a bloated conglomerate himself. It is likely that by 2007 he retained little oversight of his empire; he had become surprisingly tolerant of incompetence in his managers.
Jón Ásgeir Jóhannesson is the prime example of the players who made and ultimately broke Iceland. He was a self-made businessman of humble beginnings. He came of age in the newly liberalized Icelandic economy and made something out of nothing with little more than wit, work, and daring. But, like many others of lower profile, he fell prey to overbearing self-confidence, reached for the moon, and lost nearly everything for his efforts.
THE ABORTED LANDING
Icelandic economists in the summer of 2006 were in general predicting a downturn. The high jinks in the currency crisis had led to a drop in private consumption and consumer confidence. Since construction on the two aluminum smelters and associated power plants was set to wrap in 2007, investment was also facing decline. It seemed clear that with a cooling economy and lower domestic demand the macro imbalances would correct themselves and the current account deficit, which reached 15 percent of the GDP in 2005, would begin to narrow.
There was ample supportive data for this conclusion. Private consumption had grown at a rate of 10 to 15 percent through 2005 and the 2006 quarters that preceded in the Geyser crisis. In the aftermath, growth slowed to zero, and by the first quarter of 2007 it was in the negative, with households spending 1.4 percent less than they had a year before.
Having grown about 19 percent between 2003 and 2005 (15 percent in per capita terms), the economy was long past the boiling point. With unemployment below 1 percent and the central bank policy rate at 14 percent, there was little chance of squeezing out more growth. These conditions were mitigated, however, by Iceland’s now being plugged into the global market. Demand for labor and capital in the overheated economy created its own supply abroad, so the landing was aborted after the winter of 2006–2007 and the upward economic trajectory was restored and extended. Overheated or not, the economy grew an additional 10 percent (5 percent in output per capita) in the next two years. At its apex, Iceland was probably coming close to being the richest nation on earth in terms of per capita output. The bubble was now a dirigible; instead of narrowing, the current account deficit reached a whopping 25 percent of the GDP in 2006.
How had the hard landing been avoided? To begin with, Iceland had become a member of the common European labor market in May 2006, effectively removing all barriers between the island and migrating workers from the Continent. Much of that labor force was supplied by Poland and the Baltic countries that had recently joined the EU; given the low wage level at home, these workers embarked on a great western migration. The Icelandic krona was strong enough to attract workers at a rate of 1,000 people per month (adjusted for population size, this influx would be comparable to a million immigrants in the United States a month).
This was no less than a paradigm shift. Historically, labor shortages had produced bottlenecks during the Icelandic economic upswings, since the unemployment rate was almost always very low, around 2 percent. Now, thousands of ready new workers swelled the labor supply by 6 to 7 percent in one year. By the end of 2006, about 9 percent of the labor force was foreign born, a 4 percent jump from 2005. Naturally, housing rents in Reykjavik had appreciated steeply.
Recent crisis be damned, the carry trade came back to town with a vengeance in the summer of 2006. The central bank acted as a welcome wagon by raising interest rates to nearly 14 percent to strengthen the ISK and contain inflation. High interest rates in a small, open economy not only attract foreign capital but provide the domestic market with the incentive to borrow in foreign currency. Sure enough, speculators inside and out took the bait. First, hedge fund carry traders were lured in. Then issuing of glacier bonds resumed with furor. Meanwhile, the pumped-up ISK boosted purchasing power for Icelandic households and underwrote a spending boom.
The last piece of the puzzle was political in nature. National elections were scheduled for the spring of 2007; the gigantic fiscal boost was a direct play to win over votes. The Icelandic government had taken heat at home and abroad for its lax fiscal policy, and the election year budget just showed that the political leadership had taken no heed of these warnings. Since revenues in Iceland are derived mostly from indirect taxation—such as a 24.5 percent value added tax on most consumer items—a spending boom always produces benefits for national coffers. Thus, the government maintained a surplus throughout the boom despite steady spending increases. It can even be argued that its budgeting was neutral rather than expansive. Either way, two governing parties were intent on delivering the mother of all election budgets, a weighty mix of pork barrel spending and deep tax cuts. Its immediate effect was a 5 percent increase in households’ purchasing power in the first quarter of 2007.
The macroeconomic development of Iceland from 2006 to 2008 demonstrates that independent monetary policy in an interconnected world of free factor flows is futile, while the consequences of misguided policy are profound. Nevertheless, Iceland’s boiling economy was not the engine that drove the stock market boom; rather, higher stock prices created wealth effects, which in turn drove the real economy. Iceland’s housing bubble and lending boom were massive, evidenced by the proliferation of construction sites swarmed over by Slavic-speaking workers, but not atypical. In fact, its bubble was more benign than in other European countries, since it had less time to inflate.
The country had been more or less exempt from the global housing boom of the 1990s, due to the state’s strict controls on mortgage lending and the banks’ role as lenders being a secondary one. Housing prices first spiked when the banks moved into the market in 2004, but just two years later all three of Iceland’s banks had applied the brakes to their lending in this sector; by 2007, the average loan-to-value ratio in their mortgage portfolios was between 50 and 60 percent. Research conducted by the central bank in March 2009 shows that 89 percent of households held their mortgage debt solely in domestic currency, 3 percent in foreign currency, and 8 percent in a mix—ample proof that the banks were reluctant to use anything besides the krona in mortgages. These lending practices qualify as conservative both in terms of leverage and foreign currency exposure, especially when compared with the practices of the United States, Eastern Europe, Spain, or Ireland.
Population pressure and rising incomes had a greater effect on the Icelandic housing market than any other factors. Households were indeed leveraged but not grossly so, given the ownership rate of 80 percent and demographics weighted toward the young. Even after an 80 percent depreciation of the krona and a 25 percent decline in the real prices of houses by the end of 2008, about 80 percent of households retained positive equity in their homes. Iceland mirrored many Western nations in the excessive lending on the value of inflated asset prices, but, unlike most of those countries, its housing sector did not inflate the bubble.
LIVING IN A BUBBLE
The Icelandic bubble is best explained by stock market exuberance. Given the prominent role played by investment banking and holding companies, the most apt comparison is with the Roaring Twenties in America that led up to the stock market crash of 1929. Since Icelandic investors really were not betting on their own economy, most observers were not overly concerned by the prospect that history might repeat itself, with the boom ending in a hard landing. So the investors continued to place bets on the world equity markets, but on a scale likely unprecedented in the world’s financial history.
Companies operating on a small, distant island do not have the luxury of a piecemeal approach to their expansion. Once they hit the limits of their domestic markets, they must either take a giant leap overseas or be content with stasis at home. A savvy business plan is not preparation enough. Aspiring multinationals also must have access to equity and debt financing to break through in larger markets. Little wonder, then, that the financial sector called these cross-border expansions útrás, literally translated into English as “outward attack.” This term, along with many other images, symbols, and phrases employed during the expansion, was borrowed from the Sagas: words attributed to Old Norse chieftains became common in the public discourse.
Throughout the centuries, Iceland had come to feel like a fortress, which provided comfort at the price of isolation. By the end of the twentieth century, its people were tired of waiting for multinationals to make the first move toward an integration with world markets. When Kaupthing challenged the government’s monopoly on mortgages in 2004, Sigurdsson proclaimed on national television that “we are the international-foreign bank people have been waiting for.” The banks had broken out of their own fortress walls by securing foreign loan financing. With little equity at the outset, they took care with their initial acquisitions to ensure that they received good value. They lucked into good timing, and benefited by shunning the dot-com bubble; after 9/11, equity came cheap for them.
From 2003 to 2005, shareholders in these útrás received rich rewards that the banks could not fail to notice. Kaupthing, then Landsbanki, and last Glitnir, at the tail end of the boom, all waged their own útrás. By 2006, all three had constructed international banking platforms, while their actions were mimicked by smaller players in the domestic market. The revenue models needed fees, large concentrations of equity called for returns, and employees were hungry for bonuses and returns on their stock options. But here, again, the country’s diminutive population created a shallow pool of potential employees. The limited domestic opportunities led to a cross-border, leveraged buyout frenzy, which could be viewed as a good concept taken to unfortunate extreme, industriousness shifting into hyperactivity.
Útrás became a cultural phenomenon, and every second business, it seemed, was trying to leap outside the country. The business schools theorized about what made Icelandic entrepreneurship “special”; considering the profile of champions like Jón Ásgeir Jóhannesson, perhaps it is unsurprising that the special ingredients were identified as fast decision-making, informal workplaces, tireless work ethic, and can-do spirit. Útrás ran their successful course, after which the banks relaxed their lending rules and foreign acquisitions were carried out with much less concern for value.
By 2006 the útrás was past its prime as a viable growth strategy as it had become a “me too” journey of all kinds of business that used the all too available loan financing from the banks to purchase companies abroad. At the same time the banks themselves became the focal points of the útrás. In February 2005, Prime Minister Halldór Ásgrímsson publicly floated the idea of making the nation into a new global financial center. To achieve this, Ásgrímsson maintained, “we have to have our goals clear and keep on going on the same road and show the same daring that we have shown so far.” The response received nearly unanimous popular support.
And why not? The banks were wonderful milking cows, paying high taxes and creating good jobs and wealth that was trickling into almost every corner of the country. It was difficult in such a heady time to see the downside to the strategy. The national institutions had no resources that would enable them to serve as a lender of last resort for the banks or to offer guarantees to their creditors. What was more, the unhealthy competition among the giants led to an inevitable relaxation of the lending standards. These facts did not seem prohibitive or alarming in the good times. With every year the boom lasted, the number of skeptics would diminish, until at the very end there were almost none, even as the fundamentals of the fabled útrás were getting weaker and weaker. The five-year boom also had a decadent effect on the stock market, making investors too complacent and insensitive to risk. In that respect the story of the Icelandic financial markets parallels that of the world.
The Icelandic bankers were not villains or fools, however tempting those labels may be in hindsight. They were aggressive investors and lenders, and their biggest fault was a willingness to accept equity as collateral. Iceland had funneled much of its top human capital into them. Indeed, the Icelanders often displayed more cunning in their operations than other investment banks—U.S. banks, for instance—by mostly steering clear of the subprime credit derivative bubble. They were wholesale funded, but after the Geyser crisis they managed their funding far more sensibly, with a longer maturity profile, than most of their foreign competitors. But they worked in unique circumstances, in a financial system centered on foreign-funded investment banks with an incredibly high level of systemic risk. The biggest difference between the Icelandic banks and the banks abroad was first and foremost the level of assistance their government would be able to grant in times of crisis.
It is also important to remember that despite being an early casualty of the global crisis, Icelanders were not alone in their bullishness. Most financial institutions, especially investment banks, were delivering extravagant returns in 2005–2007 and their stock was favored by analysts. The established financial centers, such as London, all contributed to the unsustainable boom times and will in all likelihood take a hard hit due to the crisis. Speculation on consolidation and cross-border integration was all the rage in European banking; it was assumed that many European financial companies eventually should trade at some “takeover” premium. This was especially true of Scandinavia, which was home to many small and mid-size banks that seemed ripe for either merger or acquisition. The new center-right government in Sweden was contemplating the sale of its shares in Nordea, which many believed would be a starting point in a Scandinavian consolidation. But the fierce 2007 fight between Barclays and Royal Bank of Scotland to acquire the Dutch bank ABN Amro better defines the spirit of the immodest era. RBS won the bid and bought the bank for $98.3 billion that October; the telling coda is that RBS is now all but nationalized.
The first years of the century had shown great promise. But it was not until late 2006—following a crisis that had looked like the end—that funding constraints truly seemed unlimited, thanks to structured U.S. credit. It is now breathtaking to consider just how much foreign leverage the Icelanders amassed in less than two years. This is evidence enough of the worldwide credit bubble. During Geyser, Iceland was criticized harshly for hosting a banking system five times the size of its economy, with an external debt three times the GDP, but two years later, those figures, unbelievably, had nearly doubled. Of course there were assets against these debts and many of them were held abroad. Asset bubbles in small, open economies are invariably inflated by foreign leverage that is then used to buy domestic assets; this then creates a currency mismatch between the assets and liabilities. Meanwhile, the banks play the carry trade and take out loans at cheap foreign rates—in yen and Swiss francs, for instance—then relend at the higher domestic rate.
Here again, Iceland’s bubble had its own way of doing things. Its bankers used foreign leverage mainly to buy assets abroad or at least in Icelandic companies that had their own foreign operations. They also were immersed in a reverse carry trade to offload currency risk, which will be explained in more detail in the next chapter. Last, their bets were mostly on foreign markets. An odd arrangement indeed, but for a long time it worked beautifully. The foreign net asset position of the country improved throughout the golden decade of 1997 to 2007. For the first time, Iceland had a class so wealthy that many of its members made it to Forbes’s list of the richest global citizens, and it didn’t take long for their spending to trickle through a population of 300,000.
But these individuals and their companies had bet the farm on one supposition about their equity premium, namely, that their stock would always outperform bonds over time. They also underestimated the liquidity premium of holding equity, that is, the precarious access to the international markets that funded their positions. And they did not consider that in a liquidity crisis, the fundamentals of a stock are of little consequence. So it was that most of the equity wealth accumulated in Iceland evaporated in the liquidity crisis that began in August 2007.
A tragic finale, then, was in store for those who enjoyed the bubble of 2005–2007, or was it comic? After the stock of cod collapsed in 1988, the Icelanders seemed to do everything right. They had privatized and liberalized, they had opened their arms to the world at large, and when no one answered they went forth to seize the fruits of globalization with both hands. Their self-reliance and self-assuredness served them well throughout. Had they heeded the warnings and called it quits after the Geyser crisis, they could have divested their foreign equity investment at a huge profit, as is true of all speculators. But of course, being spoiled as gamblers, they were unable to quit while ahead. With each goal attained, new and more challenging ones were set at once. Overbearing ambition took down the best.
It is sometimes said that the life of each person will be judged by its end. If that is so, it would be sad indeed if the great accomplishments of over 20 years of creative hyperactivity were to be judged by the total collapse of the Icelandic financial system in 2008.