The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (12 page)

Before the year was out, all three of those ‘Big Three’ banks – Glitnir, Kaupthing and Landsbanki – had collapsed, basically bankrupting Mr Oddsson’s Central Bank as they did so. Iceland became the harbinger of a new phase in the crisis, a phase in which countries, not just banks and individuals, were going bust, finding themselves left on the wrong side of the default line. In Iceland Mr Oddsson would become a national hate figure, and the bat-cave would find itself besieged by angry protesters.

The roots of Iceland’s woes go back a quarter of a century. In 1986 the world’s two superpowers met on this chilly rock in the Northern Atlantic. The Reykjavik summit proved to be a historic staging post on the way to the worldwide financial crisis, a staging post at which Ronald Reagan and Mikhail Gorbachev, representing the West and the Soviet Union, met as equals. But they were not equal. Cold War had turned to economic freeze for the Russians and to hot boom for the United States and Europe. The summit witnessed the birth of a hyperpower, yes, but also the beginning of a hyperbubble, as, in a mood of triumphalism, borrowing, debt and deregulation all swelled to unsustainable dimensions – hence the scale of the subsequent financial calamity.

In the official photographs from the Reagan–Gorbachev summit there was a third man. This was the then mayor of Reykjavik, Davíð Oddsson, who was playing host to the two superpowers. A decade later, Oddsson – now prime minister – had followed the Chicago-school formula for growth and had stopped most regulation of Iceland’s banks. Two decades on came my uncomfortable interview with a man in denial about the coming financial collapse of his institution, his financial system – and his nation. Meet Davíð Oddsson, the Forrest Gump of the financial crisis.

The extraordinary tale of how Iceland had got to this point, of the global pressure placed on this tiny country immediately after the crash, and of how it subsequently began to extract itself from the mess, is one with lessons well beyond its own shoreline.

Some back-story first. In fact, let’s take things back to the early twentieth century, the setting of
Independent People
, a 1930s novel by Halldór Laxness, who was to go on to win the Nobel Prize for Literature (published in Icelandic in two parts, 1934 and 1935; English translation published in 1946). After two decades of humiliating servitude, a peasant called Bjartur attempts to forge a livelihood as a debt-free sheep farmer as part of his ‘eternal struggle for independence’. The four parts of the novel are called ‘Icelandic Pioneer’, ‘Free of Debt’, ‘Hard Times’ and ‘Years of Prosperity’, which could well describe his nation, a century later. Prosperity comes with the First World War, when the price of Icelandic mutton soars. Near the end of the novel, however, following the return of peace and a collapse in demand, Bjartur is facing a return to penury. ‘To die of starvation,’ Laxness writes, ‘such a fate, surely, was infinitely preferable to being ensnared by the banks, as people are nowadays, for at least they had lived like independent men, at least they had died of hunger like free people.’ Bjartur is then sent into debt enslavement and rationing to pay the interest on his loan after his bank is recapitalised by the Icelandic state, via a loan from ‘a certain bank in London’. His bank? National Bank, now known as Landsbanki, by 2008 one of the disastrous Big Three. In Iceland, financial history seems to move at the speed of its glaciers.

Iceland once took huge pride in the fact that its government used to owe nothing. The phrases ‘net debt free’ and ‘debtless’ would pepper the briefings of its senior financial officials – before the crisis. Iceland’s national debt in 2006 was no more than a few hundred million pounds, not even 8 per cent of the size of its economy. For two years at the peak of the boom, Iceland’s annual haul of fish exports was worth more than its entire historic national debts. But few had accounted for the crazed ingenuity of Iceland’s bankers.

At a stretch, the saga begins in 1976, when Iceland won the Cod Wars with the UK after threatening to close an important NATO base. Victory in the Cod Wars was followed by overfishing, and as a response this nation of fishermen began to dabble in high finance. In 1984 Iceland introduced a quota system for its fishing stocks that limited trawlers to a certain number of tonnes or a certain number of days on the high seas. By 1990 the government had allowed these permits to be freely traded. The winners were the ‘Quota Kings’, those active in the fishing industry in the early 1980s, who were effectively gifted the mining rights to Iceland’s ‘silver of the seas’. The losers were those small-scale fishermen who had worked in fishing villages that had lost their quotas. It was a massive legal transfer of wealth of what had previously been public property. The spoils of the Cod War had gone to fishermen-financiers rather than ordinary Icelanders.

But in many ways the quota system was a success. The fish stocks were replenished, giant fishing conglomerates thrived, and a tradable market in fishing quotas began. ‘The fishing quotas created a capital base in Iceland where there was none before,’ writes former stockbroker Jon Thoroddsen. The quotas, he continues, ‘added plenty of fuel for the nascent Icelandic stock market’. Iceland’s fish had become the nation’s seed capital. As it turned out, however, the future spawn of those fish had merely been mortgaged.

Even in the mid-1990s Iceland’s economy was still overwhelmingly based on seafaring. As recently as 1993 the Central Bank devalued the króna by 7.5 per cent solely on the back of lower fish quotas. But cod capital had been deployed and by the late 1990s was pushing up the prices of both houses and stocks and shares. More ominously, Iceland’s fishing wealth became concentrated in the hands of a few family networks.

The essential philosophy and structure for the later calamity was in place by the early 1990s, when Oddsson’s cabinet colleague, future prime minister Halldór Ásgrímsson, was fisheries’ minister. At that time, Oddsson himself – as mayor of Reykjavik – was merging and selling off the city’s largest fishing firm. Ásgrímsson was to serve on the committee that privatised Iceland’s banks under Prime Minister Oddsson, handing the banks to investment bankers. Then, after a job-swap, Prime Minister Ásgrímsson appointed Oddsson as Central Bank governor in 2005.

For a dozen years, from 1995 to 2007, Mr Oddsson’s centre-right Independence Party and Mr Ásgrímsson’s liberal, agrarian Progressive Party ruled Iceland in coalition. By 1999
The Economist
, otherwise a fan of the Viking free-marketeers, had noticed one source of rot in ‘… the closed nature of Icelandic society where about 20 prominent families dominate many of the leading businesses as well as the political scene. These coalesce in two groups, known as the Octopus group and the Squid. Inside the Octopus camp are many members of the Independence Party and some of the country’s largest privately owned companies. The Squid group embraces the cooperative movement and many members of the Progressive Party.’

Crony capitalism is rather difficult to avoid in a country of 300,000 people, where everybody seems to know everybody else’s business. A regular source of dismay for British corporate financiers was how most of Iceland seemed to know which British retailers, banks and football teams were on the target list of the Icelandic billionaires. The secrecy required to close a takeover was often broken by the billionaires themselves. In one case, a takeover of Newcastle United FC was scuppered when the Icelandic billionaire concerned arrived with his aide at Reykjavik airport sporting matching Geordie football shirts (though it’s said a customs officer misread the name ‘Owen’ on the back of the billionaire’s shirt for the word ‘Owner’).

So perhaps the Octopus and the Squid were unavoidable in a tiny country. And it was their interwoven tentacles that were to entrap the entire island in their embrace, contributing hugely to the coming calamity.

In 2013, half a decade on from the economic collapse of Iceland, I returned to the office of the Central Bank governor, overlooking Mount Esja. I met a rather jovial successor to Mr Oddsson called Már Guðmundsson, who has, with considerable care, been trying to put Iceland back together again. At the time of the disaster, Mr Guðmundsson was working with the Bank for International Settlements, based in Basel, in a team that was noted for the repeated warnings it gave about the credit bubble. In May 2007 he returned to Reykjavik to make a speech in which he gave a clear warning to European bankers. ‘Emergency liquidity assistance,’ he told his audience, ‘will be complicated or even impossible for central banks to deliver when internationally active banks face liquidity problems in currencies other than that of their home country. Iceland is a case in point.’

So back then he had suggested that the Central Bank of Iceland would not be able to offer the traditional central-bank facility of lender of last resort to its overgrown banks. Every bank in the world, ordinarily, has the backstop of a central bank that can give it funding in an emergency, when there is a run on deposits or other forms of financing, in order to repay depositors. But not in this case. At the time that Guðmundsson was giving his speech, the UK regulator was giving Icelandic banks the green light to take billions in deposits from ordinary British savers.

The balance sheets of Iceland’s banks grew from under twice GDP in 2003 to ten times GDP by mid-2008. Of course, since banks were invented many have thrown caution to the winds and lent out vast amounts of money. It is rarer, however, for banks to make the bulk of their financing abroad, in a currency that their own central bank cannot print. The majority of Iceland’s ‘Big Three’ banks’ lending and funding was from abroad. Two-thirds of their balance sheets were denominated in a foreign currency.

‘It wasn’t even cross-border banking, it was off-border banking,’ Mr Guðmundsson told me. ‘Much of it was booked here in Iceland, even though it had nothing to do with Iceland. We had never seen this before. It revealed deep flaws in the whole EU single market. The banks were allowed to operate freely across the area, but the whole safety net was national. Deposit insurance, lender of last resort, and the resolution regime were all national.’

The core of the problem lay in Iceland’s semi-detached relationship with the EU. As a member of the European Economic Area, which gives Iceland access to the EU single market, there was little really that the government could do to stop Iceland’s banks from marauding through the European Union on a lending and funding binge. Had Iceland been a full member of the Eurozone, its banks could have accessed the liquidity facilities of the European Central Bank in full. But Iceland was stuck in the middle.

So Iceland’s bankers and multinationals ran riot in the banking, retail and property markets of northern Europe. On top of that came the trophy assets such as football clubs. Chief executives would discover oddly named companies popping up on their shareholder register. The Vikings would turn up in the offices of their prey to proclaim their new status. Someone had found a pot of gold on this rock in the mid-Atlantic. Private jets and parties with pop stars on the guest list – Reykjavik had become the northern Riviera. Yet, unlike a decade previously, this time the boom was not even secured on fish. This entirely new northern European financial centre had no foundations. ‘I hope they have done good shopping,’ was Davíð Oddsson’s comment when I raised that concern several months before the crisis.

As it turned out, it was the manner of their shopping more than anything they’d put in the basket that had begun to spook the markets in 2006. A bizarre spider’s web of cross-shareholdings, intertwined ownership and mutual loans made Icelandic balance sheets rather opaque. Assets were traded between different arms of the same allied companies at aggressive prices, creating illusory accounting profits at every turn of the carousel. Kaupthing, one of the ‘Big Three’ banks, also liked to lend hundreds of millions of euros to its owners. Its leaked loan book showed its largest loan went to Exista, in turn the biggest shareholder in Kaupthing. Even more curiously, in 2009 a Kaupthing fund manager and stockbroker were jailed for manipulating share prices in order to prop up Exista’s value.

That is just one tiny example of the curiosities of capitalism, Reykjavik-style. Investigations continue into a variety of dodgy goings-on: an Icelandic bank tried to manipulate credit-derivatives markets to give a false impression of its own health; the lending of money by banks to clients to buy shares in the same bank; and – my favourite – the use by the client of one Icelandic bank of bank shares, funded by loans from the very same bank, as collateral for further loans from the same bank.

It was Alice-in-Wonderland stratagems such as this that served to mask the true levels of capital in Iceland’s banks. Officially the Icelandic banking system was hugely leveraged; unofficially it was leveraged at a quite monstrously high level. As a consequence, a tsunami of credit raced across the North Atlantic and washed ashore in Europe.

In late 2005 and early 2006, Iceland endured the so-called Geyser Crisis, a sudden slump in market confidence. Iceland’s banks and currency came under justified speculative attack from the global markets, an early warning of the turbulence to come. But the warning was ignored, and the crisis abated – for a while. The credit-insurance markets, known as credit default swaps (CDS), constituted a key feature of the Geyser Crisis. Essentially they became a measure of the risk of default of a bank or government, but it was expressed as a number, a percentage rather than the alphabetical ratings (AAA, AA, etc.) used by the credit-ratings agencies. When CDS contracts were first written on Kaupthing, its bankers celebrated. They had arrived. But the celebrations didn’t last long.

Norway’s $455 billion state-backed oil fund had made a commercial decision to bet on the misfortune of Iceland’s banking sector. Merrill Lynch, Denmark’s Danske Bank and, ironically, RBS joined in with critical reports about Iceland’s opaque banking system. Iceland was furious that Norway’s sovereign wealth fund had started what seemed to be a speculative market attack on its banks. Norway’s giant national piggy bank was filled with the proceeds of oil money, but run on strict market principles. The investment decisions of such state-owned funds were beginning to have a diplomatic impact. The Norwegians retreated.