THE PLOT AT THE 101 HOTEL
On Thursday night, January 31, 2008, a group of Kaupthing traders and analysts arrived at the bar of 101, one of Reykjavik’s trendiest hotels. They had been invited by an exceptionally buoyant group of foreign investors, who turned out to be a pack of hedge fund managers collected together by dealers and investors from Merrill Lynch and Bear Stearns.
The group had just arrived in the country, but clearly they had availed themselves to plenty of free drinks in the business class section of their inbound flight. The leader, from the Icelanders’ perspective, seemed to be “Joe,” a white-haired American in his mid-fifties, with a floral complexion. He looked more like a New York City cop than a buccaneer and was amusing to watch, less so to listen to.
Joe was restless. He bounced among the guests and quickly took one aside to burble a curious warning. “Boy, you are in tight spot. These people”—he pointed to his drinking companions—“are your enemies. All the people in this party are shorting Iceland, except me. They think Iceland will be the place for the second coming of Christ, a new financial Armageddon.” Joe’s speech seemed to be in fast-forward mode, his message too urgent to contain. “You need to call a friend,” he said. “Can you tell me how you plan to possibly save yourself from the situation so that I can convince them to stop shorting you?”
The “party” moved on to the Seafood Cellar, one of the town’s most celebrated restaurants. Still, Joe could not sit still, nor did he seem to need to eat. Just after 10 p.m.—two hours into the revelry—he simply disappeared. His compatriots, however, were just getting started, although by this point one had passed out. The wine kept flowing and the hedge fund managers, their tongues loosening, confirmed Joe’s warning by loudly boasting of their short positions. The Icelanders grew ever more uneasy as the conversation shifted into interrogation and mockery. It was soon apparent that their hosts were a contemptuous lot who were convinced they had landed in a country full of rubes.
The Kaupthing reps managed to leave without a fight breaking out, and they were glad to escape, like their “friend” Joe, into the cold winter night. But they were also well aware that for a hedge fund, taking down a nation through financial positioning is not just a commendable goal but an ego booster.
A month after this curious event, on February 29, a Bear Stearns analyst who had been part of the group published a report on the Icelandic trip. “Kazakhstan: A Comparison with Iceland” stated that “we have visited both Iceland and Kazakhstan, two countries which recently have been in the market’s eye because of concern for over-heating economies on the back of arguably overly aggressive expansion of their banking systems.” Further, it recommended opposite positions with respect to the two countries: long on Kazakhstan, short on Iceland.
The report’s overview reads like a bizarre exercise in macroeconomics; beyond the facts quoted above, it is extremely difficult to find anything that these countries have in common. Nevertheless, one keen observation stung Icelandic pride to the quick. The country had external liabilities roughly five times the GDP and official foreign reserves of about $2.6 billion, or 15 percent of the GDP. By contrast, Kazakhstan had external liabilities of about 100 percent of GDP but official reserves of about 40 percent. In other words, it did not matter how developed, sophisticated, or rich anyone was if they were not liquid in a time of crisis. As risible as Bear Stearns’s macroeconomic analysis was, this point would stick. The world was in financial crisis by this time, and Iceland indeed was becoming short of liquidity.
And despite the buffoonery, “friend” Joe had been right to point out that Iceland was in big trouble by early 2008. The global crisis intensified in December and the ICEX felt the squeeze. On January 9, Gnúpur, an investment company, was one of the first to throw in the towel and be liquidated by the banks. Gnúpur was small fry, but nevertheless this news prompted concern abroad. Glitnir, which saw a U.S. fund-raising show upstaged by Gnúpur’s collapse, aborted a planned new bond issue. Kaupthing’s operations were also disrupted. In August 2007, just when the crisis arose, it had announced an acquisition—of NIBC, a Dutch bank—that would almost double its balance sheet. The deal required a new share issue in the first quarter of 2008, but in the wake of bad news the markets questioned the viability of the deal and the ability of Exista, Kaupthing’s largest shareholder, to buy the newly issued shares.
It was therefore no surprise when on January 11, a Morgan Stanley’s fixed income research report (titled “Iceland—Unsustainable”) cited these events while arguing for a short position against the Icelandic banks. Kaupthing’s credibility was further compromised when it called off the NIBC acquisition on January 30 (the day before Joe came to town), under pressure from the Icelandic Financial Supervision Agency (FSA). Simultaneously, the credit crisis in the United States had direct effect on the banks, as more and more CDOs containing subprime mortgages went into default and their content was put on the market at fire sale prices. Many of these CDOs also contained Icelandic banking bonds, or long CDS positions on those bonds; thus, the credit market suddenly was flooded with Icelandic debt. The CDS spread, which had been about 50 basis points above the Libor in August, reached 200 points by year’s end. This metric helped distinguish Iceland as the weak deer in the herd, which brought the hedge funds in for the kill in 2008. When Joe and his companions arrived, the CDS spread on the banks stood between 200 and 400; a month later, when Bear Stearns’s Iceland-Kazakhstan comparison appeared, it had widened to 700.
Furthermore, on January 28, Moody’s published a “special comment” titled Iceland’s AAA Ratings at a Crossroads. Inside, a stark question was posed: “How can such a highly leveraged economy be rated AAA?” Moody’s repeatedly had defended this rating in the past, facilitating the flow of billions of dollars into the country; but the comment noted “conditions in the global credit markets have changed radically,” and concluded that “Moody’s top rating must be applied only to those countries able to manage a changing reality.” The writing was on the wall. Just two days later, on January 30, (the day before Joe and friends came to town) Moody´s downgraded Glitnir and Landsbanki on “concerns with regard to the Icelandic banks’ market-sensitive business model.” Kaupthing, left on negative watch for the time being, was downgraded to A1 on February 28; Glitnir and Landsbanki took a second downgrade to A2 the same day. The age of downgrades had dawned in Iceland, and although the ratings were still way above what the CDS spreads implied, the signal was clear: the international financial community was deserting the island.
Joe and company were likely shorting the Icelandic banks—and the Icelandic republic—through the CDS market. While his fund had about $1 billion to $2 billion under management, neither he nor any of the 101 plotters were central to the action. Their boozy hubris had been just that; in fact, they were late arrivals to a game that had attracted far bigger, more sophisticated players.
It is likely that many hedge funds were shorting Iceland at this time, but the leaders of the pack were old “friends.” These were London entities that had shorted the country in the Geyser crisis of 2006 and kept a close eye on the island afterward; they retained prominent Scandinavian employees, typically Norwegians, who knew Iceland well. Some were executing a double play by simultaneously shorting the banks in the CDS and equity market; others, undoubtedly, were attacking through the currency market as well.
Even after its own fate was sealed, Kaupthing could savor a thin sliver of irony: of all the institutions represented on that wild January night in Reykjavik, theirs would be the last to go down. Bear Stearns collapsed first, after losing most of its liquidity in three days. An emergency Federal Reserve loan on Friday, March 14, managed to keep the bank afloat long enough to be practically given away to JP Morgan that weekend by federal authorities. The dissolution of such a large player sent shock waves around the globe and affected international markets. The rise in CDS spreads coincided with the growing mistrust of international banking, which next manifested in a sudden, enormous widening of the iTraxx financial index. But like a volcano that is due to erupt, yet not quite primed for the big blast, the crisis abated after the Bear Stearns takeover. Central banks enacted liquidity-enhancing measures around the same time, and by the end of March the iTraxx, which had jumped to 150, was once again below 100.
It was a different story with the CDS spreads of the Icelandic banks, however. These continued to widen until, on March 25, they reached 1,000 points above Libor: compare this with the “worrisome” level of 100 points the banks reached at the peak of the Geyser crisis!
On March 7, just days before the run on Bear Stearns, the Icelandic currency market collapsed; the ISK lost about 20 percent of its value in the next two weeks. The international spotlight fixed on the banks yet again, and as before the news reports were grim. In response, foreign corporate clients began to withdraw their deposits. While some still doubted that Iceland was under attack by speculators, others now wondered if the debate, coupled with the dire CDS spread, would so shake confidence in the financial system as to make the worst-case scenario a self-fulfilled prophecy.
On March 28, at an annual general meeting of the CBI, the governor of the central bank, David Oddsson, declared that “there is an unpleasant odor of unscrupulous dealers who have decided to make a last stab at breaking down the Icelandic financial system.” He called for an international investigation into attempts to drive Iceland’s economy “to its knees.”
“They will not get away with it,” he said. Nevertheless, the CDS spreads kept moving higher. Then came the weekend.
Many had wondered if hedge funds were feeding damaging and even erroneous information to the UK press in order to better advance their short case against Iceland. These suspicions were confirmed when two UK Sunday papers, on March 30, published news items about Icesave, Landsbanki’s Internet savings accounts, under almost identical headlines. In the Sunday Times: “Icesave gets the chill from the credit crisis. UK savers are pulling funds out of the Iceland’s banks on fears it could be hard hit in the turmoil.” And in the Observer: “Icelandic banks feel the chill as credit crunch stretches north.”
The central fact of the stories was false: Icesave was not suffering a run. But a run could be incited, quite easily, by steamy headlines. Icelanders were convinced the story had been planted, but it took a phone call with a friendly UK journalist to confirm that a number of “helpful” hedge funds had voluntarily provided the press with information about Icelandic banks. Kaupthing lawyers had put in calls to both the Times and the Observer immediately after the stories were published, and both promptly published retractions.
Quick thinking was necessary to devise an effective counterattack and restore confidence in the financial system. It was next to impossible to implicate directly the hedge funds behind the attack, since the CDS market was totally opaque, but the Icelanders knew they had to drop names to have any chance of making the most aggressive funds back off.
Sigurdur Einarsson, Kaupthing’s chairman, went public the next day, March 31, in the Financial Times. He implicated a handful of hedge funds as the culprits, but made his strongest play by stating that Kaupthing was poised to file a lawsuit against Bear Stearns, which could lead to subpoenaed e-mails and records not just from the failed broker, but even from hedge funds connected to it. In truth, such a lawsuit would have little chance of success; Einarsson’s tactics were meant to draw attention to the matter and serve as a warning to hedge funds who believed their methods could never be made transparent.
The next day, Iceland’s FSA opened a formal investigation into an alleged speculative attack by hedge funds on the national currency, banking system, and stock market. The agency was “searching whether some parties have systematically been distributing negative and false rumors about the Icelandic banks and financial system in order to profit from it.” The investigation would proceed in the coming months in cooperation with financial authorities in neighboring countries but fail to produce decisive results due to lack of evidence.
This was an effective stroke indeed. On both sides of the Atlantic it tapped growing concern over market abuses and malicious rumors that were affecting, for example, Lehman Brothers and the UK’s HBOS bank. New York Times columnist Paul Krugman addressed the matter on the same day Einarsson spoke out, under the headline “The North Atlantic Conspiracy.” On April 2, Ben Bernanke, chairman of the Federal Reserve, was asked about the alleged attacks on Iceland while he testified before Congress. The next day, a news report on the activity appeared on the front page of the Wall Street Journal. The political risk of the attack was growing by the day.
Strengthened by the international attention, Iceland’s prime minister, Geir Harrde, threatened direct intervention in the currency and stock markets. “We would like to see these people off our backs and we are considering all options available,” he said in an interview. He refused to talk specifics. “A bear trap needs to be a surprise,” he explained. He then referred to the successful direct intervention undertaken by Hong Kong authorities in the Asian crisis of 1998, in which speculators had also attempted systematic destabilization through shorting currency and stock market.
The Icelanders had won a short-term victory. The attack stopped, and the CDS spreads of the banks dropped to between 300 and 400 points in a few days; the ISK stabilized. The government had expressed its firm support of the banks and calm, if not long-term health, was restored. While the central bank’s support was no longer in question, its ability to sustain that support certainly was. This was reflected in the CDS spreads, after a quick narrowing, still remaining high, in the 600–700 point range. It was imperative for the government to secure foreign currency reserves in order to become a credible backup for the banking system.
Many influential players assumed that foreign support was a given, and this was the primary reason the hedge funds turned back that spring. A Morgan Stanley report from April 4 was released with the heading “Icelandic Banks—the Risk to Your Short.” It observed that, although Iceland had almost no reserves, the republic was virtually debt free in foreign currency. It could easily raise between $10 billion and $11 billion and still maintain a public debt-to-GDP ratio of about 65 percent—still on the lower end of the debt level spectrum for European nations. With facilities from other central banks committed, Morgan Stanley stated that “we can get relatively comfortable with Icelandic banks’ liquidity for the rest of the year.”
Foreign credit, then, was crucial to the prognosis, but all who assumed it was forthcoming were in error. The Central Bank of Iceland (CBI) would soon discover that three major central banks in the Western world had decided collectively not to assist Iceland.
THE SUMMER BEFORE THE DARK
Just months before, there had been little evidence that turbulence was waiting to return to Iceland. The summer of 2007 had been so heady a time for the ICEX that summer holidays were canceled on the trading floors of the banks due to the heavy volume. Earlier that year the largest nonfinancial company on the index—Actavis, a generic drug company—was taken private in a leveraged buyout that netted its Icelandic shareholders about $1.3 billion, cash, equivalent to about 8 percent of the GDP. Actavis, the flagship of the new Icelandic multinational corporations, had been built around a loophole in the international patent rights legislation but had since become one of the world’s largest generic drug companies. Its buyout was leveraged by Thor Björgólfsson, owner of Landsbanki, with funding from Deutsche Bank. Shareholders had received multiple returns on their investment, and many plowed these proceeds back into the ballooning ICEX. By July, the ICEX market cap was above 3,000 billion ISK, almost three times the GDP of Iceland.
By this time, the banks’ focus had shifted from acquiring new holdings to recruiting talent in foreign markets: teams of analysts and traders tasked with bulking up their investment banking divisions. Kaupthing concentrated on retooling Singer & Friedlander, its UK bank, as its investment platform. In fact, there were only a few Icelanders working in London; most of the star employees at S&F were seasoned investment bankers who had been lured by generous earning-share contracts. The strategy paid off: Kaupthing revenue was 22 percent above expectations for the first half of 2007, S&F’s return on capital jumped 10 points, to 16 percent, from the year before. These numbers triggered a “Company Flash” from Citigroup equity research on July 26, which was titled “Strong Results, Management Upbeat” and included a strong buy recommendation. Kaupthing’s shares were up by 44 percent from the beginning of 2007, but Citigroup believed that a 20 percent upside was still in the cards. This was the high watermark of Icelandic investment banking.
Kaupthing had not made a major acquisition in two years. It was not that management had given up on acquisitive growth, but that targets were scarce: in the bull market, banks were expensive and their multiples high. Kaupthing had backed away from several deals due to price but “finally,” on August 15, it announced the NIBC acquisition, with a $3 billion price tag. The transaction would enlarge the bank’s balance sheet by two-thirds.
Management thought, however, that NIBC would be a bargain. A Dutch corporate bank, it was owned by JC Flowers, the world’s most active financial investor. NIBC was one of the first European banks to accept losses due to exposure to subprime mortgages; write-downs had wiped out its profit from the first half of 2007. Its price to book, 1.5, and its multiples were low when compared with those of other banks. All the subprime-related assets were to be left behind in a separate vehicle that Kaupthing would partly provide with funding. NIBC shareholders would accept 46 percent of the acquisition price in shares of Kaupthing. As a result, 25 percent of Kaupthing’s revenue would derive from Benelux countries, and JC Flowers would become a strategic shareholder in the bank.
Time has revealed that this was, without a doubt, the single-greatest mistake made by Einarsson and his crew. NIBC was wholesale funded and bereft of market confidence by spring 2007. Its CDS spreads were trading at Libor 800 to 1,000 basis points. Not only was Kaupthing saddled with an enormous new funding burden, the acquisition grew the banking sector yet another size larger relative to the national GDP. Already facing heavy criticism for their reliance on wholesale funding and foreign leverage ratio, the Icelanders were brazenly assuming more.
Then came the international liquidity crisis in August, and a quick slide into darkness.
Icelanders were as surprised as most everyone else in the world’s financial markets when the crisis hit. Most people believed that the subprime debt delinquency was a problem isolated in the United States. As it turned out, the uncontainable crisis spread and deepened with extraordinary speed, and it overturned all traditional, accepted norms of central and commercial banking.
But this time, Iceland played the role of the canary in a coal mine to a tee, and showed early signs of distress. The CDS spreads of its banks rose instantly, and reached 100 by September 2007.
“When clients ask us why the Icelandic banks are considered to have a higher risk profile than their other European peers,” explained Richard Thomas, Merrill Lynch credit analyst in a report dated March 31, 2008, “one does not have to search hard for answers: rapid expansion, inexperienced yet aggressive management, high dependence on external funding, high gearing to equity markets, connected party opacity. In other words: too fast, too young, too much, too short, too connected, too volatile.”
UNDER PRESSURE
Iceland’s banks were not entirely unprepared for a new crisis. In fact, they were better off than many wholesale banks since their funding was more diversified and with a longer maturity—structuring strategies that were the fruit of having survived the Geyser crisis. Unfortunately, the events of 2006 also taught them that the best strategy in hard times was to ride out the storm. This meant, in 2007, that they were too slow in accepting that the financial world was being turned on its head; they also waited to reduce leverage and sell off assets.
As the crisis progressed, it seemed ever more difficult to deleverage except by selling assets at steep discounts that cut into their equity positions and broke covenants on existing bond issues. Breach of covenants would have led to early redemption demands on key parts of the banks’ funding. This placed the banks in a catch-22. On one hand, the crisis seemed to demand that some weight be shed; on the other, the banks’ expansion strategy had been fueled by a virtuous cycle of foreign acquisitions and ratings upgrades that would be reversed if they began selling their holdings abroad. What was more, all banking assets were now trading at large discounts, which meant that sales would result in booked losses and a drop in equity. This helps explain why the combined balance sheet of the banks had shrunk by only 7 percent, measured in euros, by 2008.
Landsbanki, which had very little wholesale debt maturing in 2008, was in the best position at the outset. Icesave, the Internet deposit system had been founded in the UK in October 2006, and it proved to be an important outlet indeed. Since Icesave operated without any retail branch network or any associated fixed costs, it could pay out higher rates than its British competitors and attract more depositors. By mid-2007, Landsbanki’s deposit-to-loan ratio had leapt to 70 percent, more than a two-fold increase. Icesave was utilized not just by individuals but also by institutions, such as charities, municipalities, the London police, and Oxford University. Since retail deposits are considered to be a much more stable source of funding than capital markets, Icesave was applauded by rating agencies and credit analysts alike. However, there was a strange disconnect between the ratings agencies, banking analysts, and sovereign analysts. Whereas the banking analysts applauded Icesave, the sovereign analysts took no note of the increased contingent liability of the state through it’s deposit guarantee.
As a result, Landsbanki’s CDS spreads were 200 to 300 points lower than its two competitors throughout most of the crisis. Its stock price actually rose in October 2007 as at first glance it looked as if the bank would benefit from the liquidity crisis after UK savers pulled out of stocks and bonds and ran for cover in state-guaranteed accounts.
The hitch with retail funding is its exposure to “headline risk”: negative news coverage that can affect its customers’ confidence and, in the worst case, trigger a run of withdrawals. In 2008, the fear in Icelandic financial industry was that contagion between financial wires and popular media could result in a run on Landsbanki, which in turn could jeopardize the country itself; after all, the accounts were under the aegis of Icesave, and they had an Icelandic deposit guarantee. What was more, Northern Rock, a small UK retail bank, had suffered a run in September 2007, the first bank run in Europe for 70 years, which was stopped only when the bank was nationalized. This episode did not have much direct impact on Icesave, which actually saw an increase in accounts as UK investors sought to spread out their deposits. But it did influence actions of the British authorities later in 2008, when it was the Icelanders’ turn to suffer a similar run on their banks.
On the second tier was Kaupthing, which was weakened by the pending acquisition of NIBC as well as a failed attempt at empire building on the part of its main owner, Exista. Exista recently had leveraged up to buy a 20 percent share in Sampo, a Finnish insurance company, and Kaupthing likewise had bought a 20 percent stake in Storebrand, a Norwegian insurance company. Being leveraged and saddled with a low equity ratio is a poor stance to take in the face of a liquidity crisis. Both Exista and Kaupthing were using valuable capital and liquidity to hold listed equity on their books.
Until the NIBC deal was called off, Kaupthing’s CDS spreads were the highest among the three banks. The good news was that Kaupthing’s load of maturing debt was relatively light—EUR 2 billion. Also, it launched its own Internet banking account firm, Kaupthing Edge, first in Finland in October 2007, shortly afterwards in Sweden and then in the UK in January. The Edge accounts concept was similar to Icesave’s, with a crucial difference: Icesave was under the Icelandic deposits guarantee scheme backed up by the nation’s taxpayers. The Edge operated under the auspices of the host country, from which the deposits were drawn. By the second quarter of 2008, it was having a marked effect on the bank’s deposit-to-loan ratio, and by September the liquidity situation had improved dramatically as well.
Glitnir’s funding profile brought up the rear, by a wide margin. It had EUR 2.4 billion debt maturing in 2008 (with a balance sheet half the size of Kaupthing’s), and its attempt at Internet savings, in Norway, was too late and too limited in scope to turn things around. The bank did have good assets in Norway that could be sold off with a profit or pledged for cash.
Nevertheless, after its U.S. road show to issue new banking bonds proved a bust, it was clear that the Glitnir funding model was broken. Knowing full well that the demise of one meant the demise of all, Landsbanki and Kaupthing began to discuss in early 2008 how the bank might be acquired and its assets split between them. A merger or takeover of Glitnir by the two others would have to be assisted by the government and the CBI in some way, but no leadership was coming from the authorities and distrust and animosity among the managers of banks was not helping. As the crisis progressed, the subject was revisited many times without any action being taken.
From an outsider’s perspective, there were mitigating factors that favored Iceland’s banks. Foreign credit analysts perceived that they had problems with liquidity, to be sure, but not with capital. Their equity ratio going into the crisis was higher than that of their Scandinavian counterparts, for example. Most important, they held almost no credit derivatives—which were the first items of collateral damage of the crisis. Meanwhile, the economy at large hummed along nicely in the first year of the crisis. Significant increases in export revenue supplanted slowly declining consumption. As a large exporter of both food and energy, Iceland therefore stood to benefit from the skyrocketing price of both items in 2007–2008. The new Alcoa aluminum smelter on the east side of the island was set to begin production in 2008, which would further increase export revenue.
The banks continued to play the carry trade in reverse, hedging their equity with short positions against their own currency. While it may seem counterproductive to bet, in effect, against one’s own team, in fact they had no other options. On average, about 70 percent of their aggregate balance sheet was denominated in foreign currency, either through operations abroad or domestic lending. With these numbers, keeping the equity in ISK meant that currency depreciation would automatically lower the equity ratio, since a lower value of currency means that the price of foreign items rises. Since Icelandic law required that the banks use the krona as the operating unit of account, converting the equity into foreign currency was the equivalent of taking a short position. Kaupthing actually had begun to hedge out part of its equity in 2005, following the acquisition of S&F, but by late 2007 all three banks were rapidly converting their equity into euros. Many large investment companies followed suit.
At the end of 2007, most Icelandic economists expected the ISK to depreciate in the coming year, with the global crisis still in effect. Nevertheless, the currency and the carry trade held up quite well at first, and the issuing of glacier bonds kept up at a remarkable pace. The CBI also maintained a 10 percent interest rate differential to support the ISK and to keep inflation at bay.
When the currency market finally tanked during the speculation attack, there was a jump in the banks’ capital ratio; Kaupthing, for example, received a £1 billion equity boost in the first quarter. Since inflationary spikes always increased bank profit in Iceland, a second booster was in store via ISK depreciation. The pass through into higher prices in the domestic market is both rapid and widespread, given that about 40 percent of all personal consumption is imported. Also, inflation increases the loan margin of the banks, since most outgoing loans denominated in ISK are indexed, even though the banks are legally forbidden to offer indexation on short-term deposits.
Currency depreciation and inflation typically destroy banks in small, open, and emerging economies in financial crisis. The Icelanders had created defenses against both foes, at least in the short-term, as evidenced by the profits they booked up to the moment they collapsed. In the long term, currency depreciation and inflation will visit negative effects on the client base and loan quality; indeed, the asset quality of Iceland’s banks suffered more and more as the crisis deepened. Liquidity dried up and global equity markets continued to take a beating. The ICEX performed worse than any other European index; by January 2008, it had shed 40 percent of its value since the summer, and loan-to-collateral ratios were in even worse shape. The Icelanders were able to see the trouble these figures posed behind their profits. They feared they were trapped in a downward spiral, in which each margin call made on a leveraged stock position would lead to a further market sell-off, which in turn would trigger new margin calls, further sell-offs, ad infinitum. There simply were no buyers.
It was, in one sense, an enormous game of dominoes. The banks believed they could not allow any large investment company to fail for fear of toppling all the rest. What followed was a de facto dismantling of margin calls as a tool to recover loans made out on the value of equity as collateral. The banks attempted to find new homes for stocks by lending them to other investment companies but on weakening collateral.
Foreign banks, of course, continued to make margin calls. In the first month of 2008 they withdrew much of the funding that had been lent directly to the Icelandic investment companies in 2006–2007 and contributed mightily to the asset bubble. The three banks, again fearing for the safety of the system, became the lenders of last resort for these investment companies whose assets had been rendered illiquid as the foreign banks withdrew. This placed greater strain on their liquidity position, but every investment company was considered too systemically important to be liquidated by an outside margin call. Practically all of these investment companies had large stakes in one of the banks; the banks were bailing out their owners.
The hedge funds were still eager to short the stocks of the banks or, as a next-best alternative, to short-list companies abroad that had Icelanders as major shareholders and perhaps force an asset sale. Shorting an Icelandic stock was not just a bet against a particular company but a bet against the currency as well, since all stocks were denominated in ISK. But there was a catch: to short a stock (sell it forward) one must borrow it first. Since most Icelandic stocks were held domestically, shorting was not such an easy game for foreigners. However, as the liquidity crisis deepened, it became more lucrative for an Icelandic party to lend stock to hedge funds, since they could realize 30 to 40 percent in annual interest.
Kaupthing’s stock was probably shorted most often since it was the most liquid, largest, and most widely held in the country, and it also had a second listing in Stockholm. The pervasiveness of the short position can be demonstrated by the bank’s stock being traded at a significantly positive price on the Swedish stock exchange (2 Swedish krona per share, or 4 to 5 percent of the precollapse market value) even after it had defaulted. Hedge funds wanting to close short positions kept up demand.
The domino approach to evaluating collateral in stock lending did in fact slow the price decline in the ICEX. By late summer 2008, the banks, Kaupthing especially, were trading at high multiples as compared with their Scandinavian counterparts, and especially considering their CDS spreads. But the strategy bought little more than time. The financial system had become hopelessly entangled through cross-lending systemic risk, especially once bank funding replaced foreign direct lending. More and more the banks looked like Siamese triplets, vitally connected through lending on the value of each other’s shares.
It has to be kept in mind that although the Icelandic banks were big in comparison to their home country, they were small on the international scene and not especially large when compared to many of their clients. Through their investment banking activities they had played a leading role in financing comparatively large cross-border acquisitions for the upstart multinationals, and their credit exposure was quite concentrated to begin with. Rescue lending in the early part of 2008 further exacerbated this situation; in 2008, the Icelandic banks had about 23 exposures in their loan books larger than 10 percent of their equity, between 6 to 10 in each bank. The majority of these exposures were to holding companies.
By the time the 2008 crisis peaked, almost all of these holding companies had become too big to fail in the Icelandic financial system. Important clients inevitably come to wield power over their lenders, but in one sense the exceptional nature of this crisis allowed the banks to turn the tables. They began to press big clients, like Baugur, to sell off their holdings silently, without inciting a panic abroad or awakening the hedge funds. But despite these upsets in the bank-client relationship, the banks’ management could only watch as the credit quality continued to worsen as 2008 progressed.
The banks had responded to crisis by jumping clear of wholesale and into retail funding through Internet deposits. The move had a dual purpose, since it also aided recapitalization. All three banks’ bonds were trading at a huge discount (25 to 40 percent, depending on the maturity); if they could obtain enough funds via the Internet to swing a buy-back of their bonds, they could book the discount from par value as a pure profit. Essentially, this was an arbitrage between wholesale and retail funding that had the potential to become intensely profitable.
Landsbanki and Kaupthing were well positioned in this gambit and pursued it aggressively; Glitnir, the weak sister, still had no luck attracting retail deposits. Despite this, the system as a whole was buoyed for a time, but one man’s solution is another’s problem. Foreign central banks were far from assured by this switch to retail.
IN NO-MAN’S-LAND
The Icelandic banking expansion engine received a green light when the country became a member of the European Economic Area (EEA) in 1994. Becoming a member of the EEA can best be understood as acquiring backdoor access to the greater European Union. The flow of goods, labor, capital, and services among member countries was unimpeded, and those countries in turn worked EU directives and regulations into their legal frameworks. By joining, Iceland could access the common European market without becoming subject to the conditions of full EU membership.
The EEA agreement traces its roots to a club of countries outside the EU that formed a free trade alliance called EFTA. EFTA once included countries like Britain and the Scandinavian countries, as well as Switzerland. In the early part of the 1990s, there was a partial economic merger between the two unions with EEA agreement. However, shortly afterwards almost all of the EFTA countries joined the EU, leaving only Iceland, Norway, and Liechtenstein in the EFTA part of the contract. The remaining EFTA countries were allowed to tap into the economic benefits of the European Union without having to become embroiled in EU politics. To Icelanders, it was an arrangement that provided the economic gravy while keeping them clear of the European Common Resource Policy, which might have forced them to share their fishing grounds with other EU nations. As EEA members, they were also not permitted formal membership in the European Monetary Union, a requisite for countries that wished to adopt the euro, but this fact carried far less weight in 1994.
With this “European passport,” Icelandic banks could now do business throughout the EU and establish or acquire subsidiaries and branches without undue administrative oversight. But it was also exposed to systemic problems. The primary flaw could be described as a lack of commonality. The EU has a common market in financial services and a common legal framework that provides regulation, but there is no common supervisor, no common deposit guarantee system, no common lender of last resort (except perhaps in the Euro-zone), and no common mechanisms for solvency support in the event of major, cross-border bank failures. Oversight is guided by the Home Country Control Principle, which implies that each country’s government and central bank will take charge in the event of emergency.
There is a saying, sometimes attributed to Charles Goodhart, a professor at the London School of Economics, that international banks are only international in life. In death, they are domestic. This helps define the downside to working with fewer strings attached. Financial crises must be met with systematic and political action; as an EEA member, the nation was seriously handicapped (to put it mildly) by its less-than-formal status. The EEA allowed Iceland to develop a robust international finance sector, but when big, worldwide trouble swept over the island, there was no proper international political framework to deal with it.
As stated, the Icelandic banks had made no friends in the tightly knit world of central bankers when they moved from wholesale to retail funding as the crisis deepened. They also stirred up enormous resentment among domestic banks that had to bear the fixed costs of maintaining a branch network and payment mechanism, only to be outbid by Internet upstarts. The European retail deposits market was a sleepy, cozy place after years of limited competition; now, the Icelanders were driving up the marginal costs of funding and tapping off liquidity at the worst possible time.
Many regulators were suspicious of aggressive investment banks funding themselves with government-guaranteed retail deposits. Wholesale investors are reputedly sophisticated, able to invest without state supervision. If they wanted to roll the dice by funding investment activities, it was to be at their own risk. What was more, for retail investors—private citizens—there were consumer protection issues being raised. Icesave accounts (and Kaupthing Edge accounts in three countries, among them Germany) were offered under an Icelandic deposit guarantee through a subsidiary; as these accounts grew, regulatory authorities, chiefly in the UK, grew increasingly concerned about how much protection the Icelandic authorities would be able to offer in a time of need. By September 2008, there was about £6.5 billion in Icesave accounts and wholesale deposits—about 70 percent of Iceland’s GDP at the current exchange rate—a significant proportion of which was covered by the minimum Icelandic deposit guarantee and thus legally under Icelandic supervision.
By whatever means, Icelandic banks were out to draw liquidity from foreign central banks. Collateralized borrowing was another method of achieving that. This type of repo funding is, of course, commonplace; in fact it is now the second-most-important source of liquidity (after retail deposits) for commercial banks on both sides of the Atlantic. In the first year of the crisis, the time frame for the repo agreement was extended and the standards for collateral assets relaxed. This type of lending carries risk for the central banks, since they are essentially lending money to banks that use their assets as collateral. If the borrowing bank fails or if its collateral loses value, the loss is absorbed by the taxpayers supporting the central bank.
For the Icelanders, repo access to foreign central banks came through their foreign subsidiaries; they wrapped up their assets in exchange for cash. What made these exchanges controversial was that they now obtained euros by pledging Icelandic assets. The Central Bank of Luxembourg became the primary conduit for this action. The Iceland banks would use not just bonds with an Icelandic state guarantee but also bonds issued by each other, a device known in Europe as sending “love letters.”
Iceland was not alone in its creativity. Rather, this was just one result of the European Central Bank’s decision to relax the standards of collateralized lending. Since Iceland was an EEA member, its bonds remained eligible as collateral in the Europeans’ monetary system, its conduct within the rules. Nevertheless, the ECB had reservations about both the quantity and quality of the assets the Icelandic banks were pledging. And it was certainly annoying to watch each easing of lending standards produce a fresh wave of these dubious commodities.
This unpopularity was not unexpected. The Icelanders were behaving like motherless lambs, stealing milk from other ewes and being kicked back. Their banks could not obtain liquidity backup at home, like most other commercial banks, and the ICB could not serve as a lender of last resort. Iceland’s currency was the smallest in the world and the ICB was free to print as many kronur as it pleased. But even an ocean filled with kronur was of limited use to the banks, since 70 percent of their funding needs derived from foreign currency. They could attempt to convert ISK into hard currency on the Icelandic currency market, but this required a willing trading partner. For the first six months of the crisis, the banks did just that through carry trade—double-digit interest rates lured enough investors into buying ISK—but the currency market crash in March 2008 put a crimp in this method. By now, liquidity backup at home was possible only if ICB obtained foreign currency through a line (swap agreement) with another central bank, or through direct borrowing by the Icelandic state.
Not until the speculative attack following the Bear Stearns collapse did government authorities see the need to bolster the country’s currency reserves. Despite the turmoil, the Icelandic republic was almost debt free in foreign currency, and rating agencies assumed that it could raise liquidity if it so chose. The plan, then, was to open lines with the neighboring central banks and shore up confidence in the Icelandic financial system abroad. Then the next step would be for the Icelandic republic to carry out a large bond issue to bolster foreign currency reserves.
The first part of this strategy failed. In April, Iceland’s overtures to the U.S. Federal Reserve, the Bank of England, and the ECB were rejected. Moreover, the ECB went tough on the Icelandic banks and set strict limits on the amount of money they could obtain through collateralized lending. On the other hand, the central banks of Norway, Sweden, and Denmark each opened a EUR 500 million line to ICB in mid-May, which for a time restored some market confidence.
In early June, the Althing authorized the government to borrow up to EUR 5 billion in the international market. With JP Morgan advising, CBI organized a road show in London for a bond issue on behalf of its government. Details of the outcome have not been publicized, but media in Iceland claimed that about $2 billion to $3 billion was available to Iceland at 185 points above Libor. The offer was rejected, allegedly because the spread was high compared with the nation’s rating, and accepting funds at this “high” rate was likely to diminish the nation’s credibility. Then again, this rate was a little below the national CDS spread. The logic seems very flawed. CBI has, however, never shown any remorse about this fateful refusal and has always maintained that it was acting on the advice of JP Morgan. For the financial market, it brought bitter disappointment; the banks watched their CDS spreads trend upward once again.
On July 24, with the CDS spreads of the Icelandic banks again at 1000 points over Libor, Richard Thomas of Merrill Lynch published a report on the Icelandic banks called “Distress and Default.” A highly critical piece, it took the Icelandic authorities to task for their inaction, which had left the market “with almost a complete information vaccuum. ” Richard Thomas was blunt as usual: “The market has inevitably called the bluff of the Icelandic authorities and sent CDS sky high again. It is perfectly understandable, in our view. Markets hate a vacuum and generally assume the worst when they see one.” Thomas went on to ask in frustration: “Is default really the endgame here?”
“The Icelandic authorities’ steps to address this have so far been inadequate in our view,” he added, “and the apparent inaction has merely fanned the flames of speculation. Though there is no evidence that we are heading in this direction, it is true that default is actually a macroeconomic tool peculiarly well suited to dealing with situations of over-indebtedness.”
Through the press at home, the Icelandic government vehemently denied that there was any consideration of so drastic a measure. By autumn, however, the authorities still had constructed little or no defense against another speculative attack on the nation’s financial system.
More than a year later, it is still unclear why Iceland was frozen out by the three main central banks. The only public comment came from the U.S. Federal Reserve, which stated in September that it had not understood that Iceland had needed any assistance at all.
CBI posted an official statement concerning this issue on its Web site on October 9, 2008:
The request for assistance was well received at first in March 2008. The bank of England suggested that an analysis from the IMF on the situation would be helpful. A small IMF team went to Iceland in April which then wrote a short appraisal that in the main supported the Icelandic request, although stating very clearly that such swap agreements only bought time to address the fundamentals of the issue; that is the large size of the banks relative to the capacity of the CBI and the size of the economy. In late April the friendly attitude had turned and the three central banks rejected the plea for help. It was obvious that these foreign Central Banks were acting in collaboration.
The reason given for the central banks’ inaction was that a swap agreement with Iceland would be of little or no use given the disproportionate size of the Icelandic banking system, and that the size of any agreement that might be effective would be unacceptable to the central banks. The CBI made the counterargument that the size of the line would not really matter—just obtaining a line regardless of its size would boost confidence in the Icelandic financial system and give the CBI room to deal with the situation. But to no avail.
Even today it is rumored that CBI or another government ministry bungled the application for swap facilities, either by withholding information or by pretending that everything was fine. If this is true, it means that the Icelandic authorities asked for money without ever admitting that it really was needed. Information available is insufficient to substantiate these rumors.
A logical reading of the three central banks’ decision to leave Iceland without a line is straightforward. First, the cost of solving the problem might have been large, the loans necessary to buoy the country risky. Second, the Icelanders had not hatched a credible plan for deleveraging the country or cutting the banking system down to a manageable size. Third, they seemed not at all ready to abandon their international banking system, an impossible dream made real. Perhaps the central banks considered Iceland’s banking sector too big—and too far gone—to rescue; perhaps they believed a hands-off approach would save the island from itself by not allowing it to borrow more money and prop up a behemoth that was doomed in any event.
Furthermore, bailing out Iceland would be a small boon to the greater good. As a small, idiosyncratic entity of international finance, Iceland could fail without threat of systemic risk for the international financial community. Although it was a Nordic country, other Scandinavians kept a safe distance from it. Most of the major Scandinavian financial institutions owned by the Icelanders, such as FIH, were fire-walled, separate entities. From the international perspective, Iceland as a country simply was not too big to fail.
Or was it? Iceland’s banks had wide exposure to banks in the Eurozone, in excess of $30 billion, more than two-thirds of it concentrated in German banks. One would surmise that that fact at least was considered by the ECB, or by the German government at any rate. But since the analysis of Iceland’s requests is still classified, it is impossible to know what facts the central banks considered.
However valid this conjecture is, it still does not go far enough. It doesn’t explain why the big three withheld even token assistance that might have helped Iceland maintain confidence, much less why they turned a deaf ear when the country cried for help in the wake of the Lehman Brothers collapse. No explanation will do, unless one considers how the central banks benefited from Iceland’s annihilation.
Staying on the sidelines meant that the central bankers could rid themselves of a nuisance. Once liquidity dried up at home, Iceland’s international investment banks were out to tap it off of their neighbors’ systems; they had become negative externalities for other nations. What was more, the success of their Internet banking models carried the threat of their turning into important European retail banks, even though they remained aggressively focused on investment banking. Any coordinated international efforts to enhance global liquidity with looser rules for liquidity provisions would likely benefit them, since they would get greater leverage to peddle Icelandic assets for euros.
Rumor had it that the Bank of England and the ECB had decided to open lines to Iceland at first, but changed course after heavy lobbying by their own domestic banks, which were infuriated by the online deposit gathering. Considering the furious reaction to one line opened by a central bank—in Sweden, a country where Kaupthing did brisk Internet deposit trade—the rumor is hardly implausible.
Furthermore, it is likely that Iceland was supposed to serve as a warning to other indebted small countries that they could not expect a bailout from the big central banks—they just had to face the painful task of deleveraging head on.
Iceland after all remained an anomaly, one foreigners never warmed to. There had been a standing offer to join the EU, but Icelanders themselves had never seen a need for such intimate connection, especially when the common market was so accessible. That their special friendship with the United States, forged during the cold war, had ceased to exist was a reality that eluded the political leadership until the very end. That alliance had been based on military strategy and Iceland, as an outpost from which to monitor and defend against Soviet nuclear submarines and airforce, had received assistance when it was needed. When the United States withdrew and closed its base in Keflavik in 2006, it was the end of an era.
At the end of March 2009, Kaarlo Jännäri, retired director general of the Finnish Financial Supervision Authority, produced a report on banking regulation and supervision in Iceland. It succinctly explains how the country was left out in the cold: “After all, Iceland is a very small country in the far reaches of the cold North Atlantic, and has few friends in high places outside the Nordic countries.”
THE ICELANDIC POLITICAL LEADERSHIP
In the boom times, policy authorities had looked upon the banking expansion, with its bountiful tax revenue, good jobs, and infusions of national pride, as a gift with no downside. Their cheerful unpreparedness betrayed naïveté and provincialism that proved to be devastating. The government simply never allocated the resources—such as foreign reserves—needed to build an infrastructure around the three ever-growing giants.
The Icelandic FSA operational capacity had not followed the banks in their expansion and also faced severe difficulties in hiring competent staff. In 2006 there were only 45 people working for the agency that was responsible for supervising all the actors in the Icelandic financial markets, and that year the staff turnover was about 25 percent, as good employees were attracted to the financial sector. The situation had improved with a new managing director and a larger budget; in 2008 the agency had about 60 people employed and much better operational competence. Nevertheless, in hindsight it is clear that the FSA was too weak. Yet even if they had exercised keener foresight, it is doubtful the national regulatory authorities could have contained the Icelandic banking industry. The construction of the EEA leveled its members’ playing field and limited their discretionary powers. After the turn of the century, Icelandic regulators had a much smaller stick in hand than did, for example, U.S. regulators, even if they had been inclined to swing it.
Moreover, expansionist fever had spread to the governing agencies. In 2005, the prime ministry appointed a committee to draft policy proposals with the objective of turning Iceland into a new international finance center. Sigurdur Einarsson was appointed chairman, and he was surrounded by a collection of high-level government officials and business leaders. However, this body’s report, published in October 2006, was essentially hot air. Its proposals skipped past any meaningful actions that have any bearing on achieving the stated goal because they were either prohibitively expensive or laden with political dynamite, such as taking full membership in the EU and the euro area.
When Landsbanki began to offer the Icelandic deposit guarantee abroad, the potential hazard for taxpayers—and the country itself—was never grasped by trade publications, the political leadership or the general public. When Landsbanki’s CEO, Sigurjón Árnason, described the Icesave method as “clear genius” in an interview, it was not challenged. An editorial in the January 27, 2007, edition of Morgunbladid, a leading Icelandic daily, declared that “the root of this great success in attracting deposits must be an interesting subject of study for marketing specialists.” The business section of Frettabladid, another daily chose Icesave as the best business concept of 2007 (it also lavished Jón Ásgeir Jóhannesson with the title of Businessman of the Year). Critics have pointed to the irony that Morgunbladid was owned by Björgólfur, Landsbanki’s main owner, and Frettabladid by Jón Ásgeir Jóhannesson, Baugur’s main owner, himself.
So when the Icelandic banks reached the edge of the cliff in 2008 in an international crisis, Iceland was saddled with a bureaucracy of domestic scope, size, and efficiency. Its regulators and central bankers enforced the common European rules concerning capital adequacy ratios and liquidity in a diligent, almost robotic manner. The country had no officials with the oversight and mandate to make independent observations about systemic risk and viability. This lack was the result, in part, of supervisory powers being spread among three or four ministries and several institutions; this muddied the division of labor, causing all channels of communication to become clogged and confused, and making coordination among the various agencies all but impossible.
A generation gap was another root cause of the paralysis. The banking and business communities were dominated by a youthful, under-40 crowd that knew little of what had occurred before the recent age of loosening regulation and openness. These leaders were bold and well-educated, but also overconfident and inexperienced. Dialogue did not come easily between them and the political bureaucracy, which was controlled by people 15 or 20 years older with no international perspective. The politicians seemed unable to fathom what was really happening, and the bankers were not inclined or able to enlighten them.
Like other Scandinavian nations, Iceland has a four-party system and a coalition government. Unlike its Nordic neighbors, however, Icelandic politics in modern times has been dominated by the center-right Independence Party, with about 30 to 40 percent of the general vote, rather than the center-left Social Democrats. Given its egalitarian antecedents, it is not surprising that Iceland never developed a taste for class-based politics; the Independence Party marched through the twentieth century under the slogan “Class with class.” This was a party that collected a variety of groups and views beneath its umbrella, and its fortunes were brightest when a charismatic, unifying leader gave the rallying call. After spending the 1970s and 1980s in the wilderness without an initiative, the party returned to power in 1991 when its new leader—David Oddsson—was elected prime minister.
Like him or not—and many didn’t—Oddsson (born 1948) was a natural leader. He was the son of a single mother and raised by his grandparents in a small town, one hour’s drive from Reykjavik. A comedian in his youth, he could use his wit gently in politics (he liked to relate folksy wisdom inherited from his grandmother), or to sting his enemies with one-line jabs laced with sarcasm. His gifts of persuasion were remarkable; whether he was addressing private meetings, large public gatherings, or the entire nation on TV, he could move even the most stubborn and negative audience to cheer once he had spoken. This colorful exterior was tempered, not surprisingly, by his skill as a political fighter. Opponents criticized him for intransigence and intolerance of their views, and felt he would justify any means to carry out his agenda. National polling would often see him chosen as both the most and least popular politician in Iceland.
Oddsson became a mayor in Reykjavik in 1982, then an MP, before attaining the prime ministership at the age of 43. He embraced Thatcherian free-market liberalism and provided the political muscle needed to effect privatization, tax cuts, and a free market. When these measures began to bear fruit from 1995 onward, Oddsson won nationwide admiration and the Independence Party started to define itself as the guardian of prosperity. As such, it remained in power for 17 years; Oddsson held the prime minister’s chair until he stepped down in 2004, at that time the longest-serving leader in Europe.
After a brief stint as a foreign minister, Oddsson became a governor of the Central Bank of Iceland in September 2005, even though he had no formal training in economics or finance, or any working experience at a financial institution. For Iceland, this was not an outrageous move, since it was commonplace to appoint former politicians to CBI irrespective of their background. What was questioned was Oddsson’s having moved into his governor’s chair with enough political baggage to make building mutual trust among the three banks all but impossible.
As probusiness as Oddsson’s policies of the 1990s were, he took a dim view of the youthful nouveaux riches as they flexed their foreign-leveraged muscles in the face of the traditional business community. He went on record with his criticisms early. In a public speech delivered in 1999 he compared the upstarts to Russian oligarchs. It later became abundantly clear that, like Putin, Oddsson feared state capture from the rising multinationals, which he considered too big for the country. After the turn of the century, he used his office to wage what seemed to be a personal campaign against the influence of the multinationals. Baugur and its main owner, Jón Ásgeir Jóhannesson, were singled out for abuse; Oddsson referred to Jóhannesson as a “street hooligan,” and worked to obstruct the younger man’s acquisitive tendencies.
He also soured on Sigurdur Einarsson and Kaupthing, and sought to foil the bank’s attempted purchase of stakes in the state-owned banks. The maneuvering became almost comic in 2003, when Oddsson withdrew his deposits from Kaupthing and then made a public announcement condemning Einarsson and his crew for greed and generous option contracts. Here was a national prime minister effectively trying to incite a bank run!
Despite the absurdity (or danger) of this political theater, many of Oddsson’s worries were legitimate. His supporters now point to the collapse as proof that the oligarchs were taking the country to the dogs all the while. But at the time, his adversaries accused him of carrying on either a personal vendetta or a power play that undercut the country’s policy of economic liberalization.
Oddsson fueled these assessments when it seemed that he had been playing favorites. As prime minister he approved the sale of 46 percent of Landsbanki to Samson Holding, with about 70 percent leverage, even though there were two higher bids on the table. Afterward, Oddsson’s closest Independence Party associate, managing director Kjartan Gunnarsson, became vice chairman of the board at the new private bank. The Icelandic FSA, which opposed this sale initially, grudgingly gave approval after months of lobbying.
Jännäri’s analysis of Landsbanki’s privatization concludes that the deal set a legal precedent that actually accelerated the concentration of ownership in the banking sector. Baugur’s takeover of Glitnir, in 2006, was impossible to reject as a result. Others have argued that Oddsson’s aggression, not at all out of keeping with the Viking Sagas, actually stirred up sympathy and popular support for the oligarchs he targeted. In fact, the publicized persecutions have undoubtedly made it much more difficult for the regulatory agencies in charge to wield their power against the nouveaux riches, since they would always cry foul. Jóhannesson would, for example, frequently, and even shamelessly, play the “Oddsson card” and claim he was a victim of a political vendetta to stir up public sympathy.
By the time Oddsson moved to CBI his biases toward each bank were widely considered to be evident. Two of the banks, Kaupthing and Glitnir, were owned or controlled by “bad” oligarchs Oddsson had tried to drive out of business. Landsbanki was in the hands of “good” oligarchs, who owed much of their good fortune to him. Trust between these players was compromised by their relations with Oddsson, and consensus became unattainable. When Glitnir’s funding model crumbled after its failed fundraiser in January 2008, there was an excellent case for taking action. But what action could Oddsson initiate that would not look like another eruption of a personal grudge? Such was the dilemma of an old political fighter turned central banker.*
During the early part of his career, Oddsson played an important role in opening up the country, but when internationalization had gathered steam he seems to have veered toward the isolationist camp. He was a staunch opponent of Iceland joining the European Union and would publicly attack those who would advocate that the euro supplant the ISK as the legal currency. Regarding this issue, the Independence party was almost evenly divided. The probusiness lobby of the party was generally in favor of the EU. Oddsson’s faction of the party would earn the nickname “Home Rule party,” a name referring back to a forerunner of the Independence party that had been very active in the struggle for independence from the Danes in the early twentieth century.
During his years as a CBI governor Oddsson seems to have come to the conclusion that the systemic press toward internationalization was threatening the viability of Iceland’s sovereign institutions, the Icelandic krona not the least. He believed that the banks’ expansion abroad had rendered the CBI monetary policy almost powerless, while their shameless lobbying for euro-ization and even EU membership further undermined the currency and CBI authority. After the currency market tanked in March 2008, he placed the blame squarely on the banks and attacked them openly in the media for shorting the krona. He even asked the FSA to look into the matter, but its investigation found no evidence of misconduct.
*Einarsson is the only bank manager who has been candid about his relationship with Oddsson since the collapse. In March 2009, he published a newspaper article in which he cataloged Oddsson’s alleged mistakes and biases as governor. In the article, Einarsson accused Oddsson of leaking details from private meetings to the press; one instance concerned Kaupthing’s financing proposal to take over NIBC in the summer of 2007.
Oddsson’s tenure at CBI included three years leading up to the 2008 collapse. In that time, he met with Einarsson four times in official meetings. One unofficial meeting was perhaps the most memorable. The two men sat at the same table at a CBI banquet in 2007 and, during an ensuing argument, Oddsson threatened to take down Kaupthing unless it backed away from its intention to adopt the euro as an operating currency.
Meanwhile, the banks insisted that the shorting was done with the license and supervision of the CBI, and for a sound purpose: to hedge their equity ratio, given that their operational currency was ISK but 70 percent of their assets were denominated in foreign currency. Moreover, in 2006 and 2007, Kaupthing had lobbied for approval to shift its operating currency over to euros, a natural move given the scale of its international operations. But the CBI had opposed this idea vehemently, although it never clearly explained its reasoning. It seems that the central bank believed that one defection from the ISK would lead to the exodus of the entire corporate sector. Whatever the reasoning, Kaupthing and the other banks were stuck with ISK and no recourse beyond hedging their equity ratio through a reverse carry trade.
Kaupthing had also considered moving its headquarters to another country such as Sweden or Britain. That would have implied higher corporate taxes, since Iceland’s tax rate was lower than its neighbors, but simultaneously the leverage ratio of Iceland would have been slimmed down considerably. This move was first contemplated seriously after the financial crisis hit in August 2007, too late to gain traction or be fully useful. If the acquisition of NIBC had been finalized, it probably would have been a reverse takeover, and the HQ would have been transferred to Holland. Just before the collapse Kaupthing had made arrangements, due to be announced in October, to transfer all its operations outside of Iceland and into its subsidiaries Singer & Friedlander in the UK or FIH in Denmark. If implemented, the move would have downsized the mother company in Iceland considerably and relieved CBI of at least some pressure.
Oddsson’s successor, both as prime minister and the chairman of the Independence Party, was Geir Haarde (born 1951). Previously finance minister and Independence vicechair, he was Oddsson’s opposite in almost every way. While Oddsson was defiant, opinionated, and a brash straight talker, Haarde was polite, congenial, indecisive, and dissembling in public. One story, appearing in the yellow press, had Oddsson being asked about his successor’s leadership qualities, to which he quipped, “How can you take a house-trained cat and make it into a lion?”
Others claimed that Haarde’s favorite policy was to just wait and see if things improved on their own. But he was a distinguished economist (he had a master’s degree from the University of Minnesota) and in time became popular. Whereas Oddsson polarized, Haarde was a unifier.
During their reign the Independents worked with three other parties in coalition governments, but they retained control of the prime ministry, the ministry of finance, and the CBI. Almost two decades of prosperity and growth had sown blissful ignorance among the top brass, who never tried to foster a policy of economic stabilization in the boom years. Oddsson had mocked economists as “econ-technicians” when they criticized the loose fiscal policy during the dot-com bubble. Once ensconced in CBI, he criticized his former colleagues for the expansionary fiscal policies they had presided over. At last he came into alignment with professional economists inside and outside the country. Much was made of the government’s having raked in exorbitant tax revenue during boom years—and spent it almost instantly.
In the months after the collapse, Haarde seemed eerily disconnected from the events. In an interview with the Associated Press on November 29 he stated, “I do not feel personally responsible. . . . I cannot take responsibility for the actions of the banks.” One has to wonder if Geir Haarde forgot to read the liability clause of his contract before becoming prime minister of the nation. True, he was not an investment banker, the republic had not accumulated foreign debt on his watch, and of course the banks were to blame for their own defaults. But a prime minister need not be Harry “The Buck Stops Here” Truman to be personally and politically responsible for seeking a solution to a financial crisis.
Jännäri’s assessment does not name names:
When the culmination of the crisis was approaching, the FME [the Icelandic Financial Supervisory Authority] and the CBI expressed grave concerns and requested information from the ministries on what kind of commitments and actions the government was prepared to take. I had the impression that the sense of urgency was felt less keenly by some of the ministries’ representatives than by the FME and the CBI. On the other hand, the ministries’ representatives sometimes felt that they were not receiving enough information about the seriousness of the situation and therefore believed there would be time to prepare for action later.
But whoever was responsible, when the clock struck midnight no preparations had been made.
COULD ICELANDIC BANKING HAVE BEEN SAVED?
This question will also be academic until we have achieved sufficient distance from the events of 2007–2008, and beyond. What is certain is that with larger foreign reserves and lines to major central banks, Iceland easily could have withstood the systemwide bank run that began after the collapse of Lehman Brothers. But what then? All three banks had significant funding needs in 2009, and asset quality had begun to deteriorate in Iceland and in operations abroad. For them, as for everyone, investment banking is a dead, or at best dormant business concept for the foreseeable future.
Icelandic banking probably had reached a point of no return by 2008, since it had not unloaded some of the weight of its assets in the prior months. Glitnir, at least, was a dead bank walking, and should have been restructured early in the year via a government-assisted merger. Kaupthing and Landsbanki both needed to deleverage aggressively by selling off foreign subsidiaries. This would have entailed major losses for their shareholders and the writing off of their shares’ value. Most of the large, leveraged investment companies were also bound to be wiped out.
So deleveraging was inevitable; the question is whether the Icelanders could have been orderly about it. The banks would have needed new capital from the government, and perhaps bondholders would have agreed to turn debts into equity, at the cost of some financial institutions defaulting. In this regard, time would have been working for the Icelanders had they withstood the backlash from the Lehman collapse, after which the attitude of the international financial community toward debt restructuring would drastically change and the lenders of the Icelandic banks would probably have been cooperative, given how much they stood to lose from a default. All this was doable, provided the republic had sufficient foreign reserves to ensure the system’s credibility; the banks meanwhile would have had to accumulate more foreign retail deposits and then buy back their own bonds. An unpleasant, tricky business perhaps, but anything would have been preferable to systematic collapse, for both bondholders as well as the population at large.
Speculation aside, the Icelandic government, which secured no foreign reserves and had no solutions, bears a heavy responsibility. True, three key central banks had washed their hands of the country, but there were still options available to the governing authorities. They could have bitten the bullet and obtained the foreign funds with a major bond issue in mid-2008, expensive as that option would have been. They also could have solicited the IMF for assistance, to be sure an unpleasant option and even one of last resort, since IMF loans are granted only under stringent conditions that compromise the sovereignty of the nations they aid. Iceland’s political leadership was hesitant to engage the IMF and deal a blow to national pride: Iceland was an advanced country, after all, not a fledgling state. But stringency, however painful, might have drawn the outline for a credible plan to deleverage the nation. Painful decisions needed leadership, but that was not forthcoming: the prime minister lacked the decisiveness and the central bank governor the credibility.
As it turned out, doing nothing in the face of danger was the most reckless behavior imaginable.