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Lessons from Iceland's Financial and Economic Collapse

Economics / Credit Crisis 2009 Feb 06, 2009 - 03:54 PM GMT

By: Jennifer_Barry

Economics Best Financial Markets Analysis ArticleMass protests in Iceland culminated in almost 2% of the population standing outside the Althingi parliament building on January 24, demanding the dissolution of the government. Under severe pressure, Prime Minister Haarde reluctantly resigned, citing health problems. Astonishingly, the head of the central bank and the architect of the economy, David Oddson, has refused to step down.

The tiny island nation has been rocked by the large jump in the unemployment rate, the nationalization of its largest banks, and the destruction of its currency. Its economy has sharply contracted, and inflation has skyrocketed. This sudden fall from prosperity in 2006 to depression in 2008 is shocking in a modern, European country. How could this occur, and is this a future that could happen to the United States?

To find the roots of the Icelandic crisis, we have to go back to 1991, when Oddson was elected Prime Minister on a platform of liberalizing the economy. Oddson privatized many state-owned companies, earning US$2 billion for Iceland's treasury. This seemed like a large sum at the time.

More controversial was his plan in 2000 to deregulate the financial industry and sell off the commercial banks to private investors. Many Icelanders felt this was a sweetheart deal to benefit his political allies.

Free from bureaucratic shackles, the newly private banks eagerly wrote mortgages at lower interest rates, with a smaller down payment than the government Housing Financing Fund. The real estate market boomed, and the value of housing was artificially inflated. Citizens felt comfortable amassing large loans as unemployment was very low.

The Icelandic commercial banks - Glitnir, Kaupthing, and Landsbanki - were able to grow swiftly by leveraging their bloated mortgage portfolios. Icelandic bankers limited by a small domestic economy travelled the world looking for investment opportunities. This new class of international financiers bought everything from toy stores to airlines to soccer teams. Purchases were used as collateral for other acquisitions. Soon the three largest banks dominated the entire Icelandic economy, as their share capitalization equalled 75% of the stock market.

The Icelandic situation has many parallels to the financial crisis in the United States. Many of the abuses in the American banking industry were caused by deregulation as well. While the U.S. banks were always private, they were regulated by the Great Depression-era Glass-Steagall Act, which was designed to limit fraud, speculation and conflicts of interest. In 1999, the last remaining provisions of the Act were repealed. Banks were allowed to combine with insurance companies and brokerages, consolidating into financial behemoths.

Many regional banks exploded in size, gobbling up smaller banks to increase their exposure to the mortgage market. They were aided by the Federal Reserve which slashed interest rates and lending standards, allowing the housing bubble to form. As mortgages could be packaged and resold, bankers had little concern about credit quality, giving large loans to unemployed or even illegal alien borrowers. Mortgage-backed securities were shopped to foreign buyers looking for a low risk investment. U.S. residents took on adjustable rate mortgages, secure in their belief that housing would always appreciate, and refinancing would always be available. Predictably, these huge institutions were not able to restrain themselves from violating their customers' trust or securities laws if there was money to be made.

Financial institutions became a proportionally large fraction of the U.S. economy as well, dominating the S&P 500 by 2002, and peaking at 21% of the index in 2007. Even after the crash in the banking industry, the financial sector still constitutes most of the stocks in the index and 16% of the market value. Five of the 30 stocks in the Dow Jones Industrial Average are banks or have a large financial component, even after the removal of AIG last year.

Like the United States, Iceland's economy was not solely based on bank speculation. Icelanders created real wealth in the alternative energy, biotech, and software industries.

Unfortunately, much of the value of the bank investments was illusory, created out of thin air through fraud. A small group of politically connected entrepreneurs created shell corporations to make trades amongst themselves to magnify their apparent net worth. One corporate raider, Jón Ásgeir Jóhannesson, was convicted on a charge of false accounting designed to make his corporation, Baugur, look larger, but he only received a three month suspended sentence.

Loans of hundreds of millions of kronur to insiders to purchase bank stock were forgiven when the financial collapse became inevitable. Average citizens still have repay their ballooning loans on a much reduced income, however.

The mega banks had little official oversight, so they were able to accumulate assets worth almost ten times the GDP of the entire nation of Iceland. Shockingly, few people worried that the banks could not possibly be bailed out if anything went wrong. These financial institutions lent long term and borrowed short term, and 80% of that capital was borrowed in foreign currencies. Frequent refinancing was required, but that was no problem in an era of easy credit.

However, when liquidity dried up in 2008, international lenders demanded repayment. Since most of the loans were in foreign currencies, the Icelandic Central Bank couldn't just print up a bunch of kronur to get the banks out of a jam, an option that the Federal Reserve used in the United States. In addition, a current account deficit meant that Iceland had few foreign currency reserves to offer to bank creditors.

The United States has also had its share of financial scandals. Enron famously used phony companies and bogus trades to deceive shareholders, abetted by major banks Citigroup and J.P. Morgan Chase. A rash of Ponzi schemes have been revealed recently, as older “investors” were paid dividends from cash raised from new victims.

Fraud is easily hidden or trivialized during a boom, as most investors don't ask questions as long as their bank statements keep getting larger. Even when bankers are caught, they rarely suffer a greater consequence than the payment of a tiny fine, as in the recent Countrywide Financial settlement of $1M for predatory loan practices. Despite voter outrage, there are still only token attempts at enforcement, since many of the regulators helped set up this corrupt system and have profited from it.

Even worse than the fraudulent behavior was the moral hazard caused by implicit government guarantees. CEOs at giant U.S. banks knew their institutions were “too big to fail,” so financial executives freely speculated and padded their bottom lines so they could take home huge bonuses. Consumers weren't worried, since various federal agencies like FDIC and SIPC promised to reimburse losses. While the U.S. crisis hasn't been as severe as in Iceland due to these safety nets, portfolios have shrunk dramatically as shareholders of failed financials saw their investments evaporate.

Banks like Bank of America and Washington Mutual were bailed out or folded into larger institutions once they blew up from excessive use of leverage and derivatives. Even after taxpayer money was used to rescue insolvent banks in both Iceland and America, the executives responsible still receive fat salaries and bonuses in both nations. As in Iceland, U.S. bankers haven't realized that their excesses won't be tolerated in this new environment of mass financial suffering. Arianna Huffington calls them the “Marie Antoinettes of the meltdown.”

The U.S. financial sector isn't as large a percentage of the economy as in Iceland, but in some aspects the situation is even more grave. The damage caused by Icelandic banks was mostly confined to their small population and some Northern European savers for a total of 8 billion British Pounds in losses. However, the much larger American financials had counterparties around the globe. This was the argument behind the bailout of AIG last year. The cost of buying the remaining “troubled assets” and placing them in a “bad bank” is now estimated to cost an additional US $4 trillion, and this number seems to expand every week. Even worse, d ue to the trillions of dollars in derivatives issued by the major U.S. banks, an institution like J.P. Morgan Chase is too large to rescue without hyperinflating the dollar .

I don't expect the U.S. to suffer as much as Iceland in the short term, as the USD is still the world's reserve currency. Despite the huge growth in the monetary aggregates, the dollar is still welcomed as payment for goods.

In contrast, Iceland is a tiny country with an independent currency, so it can be pushed around easily by hedge funds and other large speculators. With the current economic and social upheaval, the krona is largely useless for international trade, and Iceland is coping due to foreign currency loans from the IMF and other Scandinavian countries.

However, I don't think Americans will emerge from this financial crisis quickly. The U.S. may not see its economy crash as fast as Iceland, but nevertheless there are serious systemic problems. Broad unemployment is near 14%, GDP has slipped into negative territory, and housing prices are dropping every month. That's just the news the U.S. government is telling us. Who knows what is still hidden. Britain, for instance, just admitted it almost had a complete meltdown last year.

It's not just small island nations that can experience a depression. defines a depression as “a severe and prolonged recession characterized by inefficient economic productivity, high unemployment and falling price levels.” I would argue that the United States is in a mild depression today by this standard.

Please note that most financial commentators imply that a depression is deflationary, but this is not the only type of depression. In a hyperinflationary depression, prices fall in real terms (relative to hard currencies such as gold, for example) but rise in nominal levels as the currency becomes worthless. Zimbabwe is suffering a hyperinflationary depression, and Iceland will too if the krona is allowed to float freely again. Despite its huge and diverse economy, America does not have special immunity to this financial catastrophe.

There are few fundamentals keeping the U.S. dollar at this level, considering the speed at which the Federal Reserve and Treasury are debasing the currency. Confidence in the stability of the U.S. is eroding, and fear of other options can't support the dollar forever. New Treasury Secretary Geithner has already angered America's main creditor China by labelling the nation a currency manipulator in a hypocritical bit of irony.

Due to the ongoing destruction of the dollar, the smart money is already moving out of paper into hard assets like precious metals. I expect that this new “flight to safety” will be the winning trade of 2009. If you haven't stocked up yet, I recommend doing so while bullion is still cheap and available. It may be impossible to find later this year.

by Jennifer Barry
Global Asset Strategist

Copyright 2009 Jennifer Barry

Hello, I'm Jennifer Barry and I want to help you not only preserve your wealth, but add to your nest egg. How can I do this? I investigate the financial universe for undervalued assets you can invest in. Then I write about them in my monthly newsletter, Global Asset Strategist.

Disclaimer: Precious metals, commodity stocks, futures, and associated investments can be very volatile. Prices may rise and fall quickly and unpredictably. It may take months or years to see a significant profit. The owners and employees of Global Asset Strategist own some or all of the investments profiled in the newsletter, and will benefit from a price increase. We will disclose our ownership position when we recommend an asset and if we sell any investments previously recommended. We don't receive any compensation from companies for profiling any stock. Information published on this website and/or in the newsletter comes from sources thought to be reliable. This information may not be complete or correct. Global Asset Strategist does not employ licensed financial advisors, and does not give investment advice. Suggestions to buy or sell any asset listed are based on the opinions of Jennifer Barry only. Please conduct your own research before making any purchases, and don't spend more than you can afford. We recommend that you consult a trusted financial advisor who understands your individual situation before committing any capital.

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28 Feb 09, 16:31
Video on Economic Crisis in Iceland

Good video on the economic crisis in Iceland from the WSJ -

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