Iceland is a fairly big island with a fairly hostile surface and climate which results in a mere 320,000 people living there now. Yet the country in the past several years caused a fair bit of drama and drew an awful lot of attention. Disproportionally so, compared to its population and GDP size. So what is the story of Iceland? Some ten years ago, the financial services sector in Iceland completely de-coupled from the real economy and took a life and ambition of its own. Three largest banks, Landsbanki, Kaupthing and Glitnir, started an ambitious expansion, first domestically, then supporting Icelandic entrepreneurs’ international ambitions and themselves expanding into retail banking in the UK and the Netherlands. At the end, before the party stopped, these three banks accounted for 90% of the Icelandic financial system and about 90% of their assets were abroad.
I remember this all well working as an M&A advisor for a global company with Icelandic origins back in 2005-06. These were the golden years for Iceland with the country’s GDP growing a China-style 7-8% p.a. My client was a company with operations all across emerging markets as well as Western Europe and US. It set its eyes on a large listed target and without hesitation decided to pursue a leveraged hostile takeover. You have to realize that hostiles are actually fairly rare in our world. Apart from the obvious difficulties of integrating a company whose management is fighting you and which you will probably have to let go, it is notoriously difficult to convince its shareholders that you are presenting a better future for their money than the incumbents with whom they have been more or less happy since they invested in the stock. It is even more difficult to convince the financing banks to bankroll you for a leveraged hostile as the banks, unlike the shareholders, will never benefit proportionately if things go well though stand to lose greatly if the takeover fails. So they are naturally more risk averse. The global financing banks on this deal, and we are talking a $2.5bn transaction, so no petty cash, were predictably skirmish and pushing the client to agree a deal with the target’s board. The process was extended and tiring. What happened then just epitomizes the mood in Iceland at the time. The Chief Executive of my client company, a youthful looking 35-year old sporty guy, just turned to the large Icelandic banks instead. The banks put together the essential pieces of the financing themselves, among the three of them, within 48 hours, no further questions asked. Did they know something the venerable UK and US banking institutions didn’t? Or were they just more reckless? With hindsight, it was probably the latter.
In 2008, all three of Iceland’s major commercial banks ran into difficulties in refinancing their short-term debt and suffered a run on deposits in the Netherlands and the United Kingdom. In the spotlight of the Lehman collapse when nervous investors were scrutinizing any perceived weakness in the financial sector anywhere it turned out the Icelandic banks were extending long term acquisition financing en-large, supporting the global acquisition spree by thirty-something self-made Icelandic billionaires Jon Asgeir Johannesson, Thor Bjorgolfsson, Magnús Porsteinsson and a handful of others. That in itself was not fatal but they were funding these long-term assets through short-term debt and on-demand deposits. Investors and deposit customers voted with their feet. In late September 2008, Glitnir bank was nationalised. The following week control of Landsbanki was handed over to receivers appointed by the Icelandic Financial Supervisory Authority. Two days later, the state placed Iceland's largest bank, Kaupthing, into receivership as well. The assets of the three banks taken under state control were €76 billion in mid-2008, or more than 11 times the size of Icelandic economy. Hence there was no possibility for the Icelandic Central Bank to step in as a last lender of resort when they were hit by financial troubles and started to account losses. Relative to the size of its economy, Iceland’s systemic banking collapse is the largest suffered by any country in economic history.
Commenting on this drastic decision, Icelandic Prime Minister Geir Haarde said at the time that the government truly feared that “the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could have been national bankruptcy."
The Icelandic government decided to focus on their domestic market first and foremost, and throw the rest overboard. In doing so, they undoubtedly knew this would cause a huge international uproar but likewise, within 5 years all would be forgotten and forgiven. An emergency law was passed in October 2008 which decreed that all domestic assets of the banks be transferred into new publicly-owned domestic versions of the banks, while leaving the remaining foreign parts of the banks in a receivership and liquidation. It meant that the domestic residents would not suffer losses from the systemic bank failure.
Iceland also decided to pursue the banks’ senior management personally. It charged the former chief executives of all of the island’s three big banks with crimes related to the collapse of its financial system. CEO Sigurjón Árnason and five other executives from Landsbanki were accused of market manipulation by using the bank’s own money to prop up its share price. Kaupthing chairman Sigurdur Einarsson and chief executive Hreidar Már Sigurdsson were charged of market manipulation. Larus Welding, chief executive of Glitnir, was sentenced to jail for fraud late last year and is facing other charges.
Obviously the financial crisis still had a serious negative impact on the Icelandic economy. The national currency, krona (ISK), fell by more than 50% against euro. Foreign currency transactions were virtually suspended through strict capital controls for weeks. The market capitalisation of the Icelandic stock exchange fell by more than 90%. The government budget deficit shot up to 10% of GDP in 2009 and 2010. Iceland underwent a severe economic recession (economy contracted 5.5% in 2009-10). Outside Iceland, more than half a million depositors (compare that with the entire population of Iceland) found their bank accounts frozen.
Faithful to their brethren, the other Scandinavian countries put together a sovereign bailout package of $3.0bn to which the IMF contributed another $2.1bn. Germany provided a €1.2bn minimum deposit guarantee repayment loan to help finance the minimum deposit repayment to foreign account holders of the Icelandic banks. The government adopted a measure much praised abroad of writing down all mortgage debt above 110 per cent of the value of the property (yes, that’s right, in Iceland people routinely borrowed over 110% of value of their houses).
But Icelanders are hard working and tough people, they don’t strike and the weather is too bad for them to sit in cafes lamenting their faith. By 2011 Iceland managed to regain a complete access to financial markets to cover its future funding needs. In first half of 2012 it started to repay the bailout debt. The capital controls are still in place, needed to protect the currency, and will not be lifted until the central bank has built up a substantial foreign capital reserve. The bank receivers worked diligently to liquidate the assets of the three bankrupt banks and were successful in repaying all the minimum deposit guarantees. A new era with positive GDP growth restarted (2.9% in 2011 and 1.6% in 2012), and has helped foster a gradually declining trend for the unemployment rate. Government budget deficit dropped to 3.4% of GDP in 2012.
It may seem hunky-dory from the outside but dissatisfied ordinary Icelanders question the post-crash success. Icelanders went to vote this weekend and they overwhelmingly kicked out the sitting leftwing government which performed the economic resuscitation. They replaced it with the centre-right opposition, coalition of the Progressive and Independence parties that led the country during its extraordinary boom and bust period of the previous years. The centre-right coalition got 51.1% of votes, the ruling Social Democrats just below 13%. The reason is clear: Icelanders think the tightening was too brutal. Many are yearning for a return to the days before they became one of the earliest and biggest victims of the financial crisis. People are lamenting mainly the difficulties connected with the sharp fall in the currency. The 50 per cent drop in the krona meant purchasing power has gone down 30-40 per cent. As the majority of Icelandic mortgages are linked to inflation, the krona fall led not only to price inflation of imported goods but this further contributed to a major rise of mortgage interest payments. That is lamentable but such a sharp devaluation should have been very good for exporters, right? Right but Iceland has overwhelmingly been producing, for hundreds of years, fish. There is a limit on how much fish it can sell even if it is much cheaper.
What is funny is that Icelanders voted back in power the same political parties which were in power when banks were deregulated and hence responsible for the credit-fuelled boom. “It is the problem of the leftwing: they clean up the vomit after the cocaine party of the neocons, who go into rehab and then come back to reap the benefits,” says Birgitta Jonsdottir, head of the Pirate party.