Sigrún Davíðsdóttir's Icelog

A foolproof way to erode own capital

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Soon after the fall of the Icelandic banks in Oct. 2008, news of questionable practices started seeping out. Much of this reporting related to loans to staff, at the beginning mostly at Kaupthing, but later it’s appeared that probably all the banks practiced this in one way or another. The banks all financed the buying of their own shares – even on a gargantuan scale.

As liquidity dried up in summer 2007 foreign banks made margin calls against the main protagonists of Icelandic companies expanding abroad. Since many of the big players had pledged their Icelandic bank shares against foreign loans it was obvious that as soon as foreign banks would start making margin calls the markets would be awash with Icelandic bank shares – and the shares would go into free fall in an already weak market.

‘Hell is other people’ said Sartre. For the Icelandic banks in winter 2007-08 hell was other banks, foreign banks – and in order to escape this hell the Icelandic banks all cranked up what they were already practicing: lending money to buy their own shares, with only these shares pledged against the loans. The hellish consequence was a massive erosion of own capital. It can be argued that already by summer 2008, months before the FSA intervened the UK operations of Kaupthing and Landsbanki, the banks own capital had evaporated.

All the banks used a variety of investment schemes to lend against their shares and to absorb the flood of shares from late 2007: unrelated loans were increased so there would be a sum for share-buying; bank staff was encouraged to borrow money from their respective bank to buy shares, often way beyond what was reasonable compared to their salaries. Just around the fall of Kaupthing all personal guarantees tied to their loans was cancelled. The legality of this and the tax aspects haven’t yet been settled.

In some cases there was cross-lending for this purpose: one bank lent against shares of another bank. (Cross-lending was also practised for other reasons but that’s another story). Recently, a banker in one of the collapsed banks told me that not later than early 2008 cross-lending and other similar practices had firmly tied the knot between the banks: should one bank collapse it would drag the two others down with it. In his report in March 2008 Kaarlo Jännäri concluded that the collapse of one bank would unavoidably have meant the end of the other two.

However, as the situation did nothing but deteriorate week by week and month by month through 2008 the ghastly side-effect of this diabolic scheme became ever more clear: the banks could neither make margin calls on the share-buying loans nor could they sell the debt off or in any way slash or shrink this part of their balance sheet. This scheme turned into fetters – and it eroded the banks’ own capital, consequently leaving them much weakened.

It’s been suggested that by then the banks had lent ISK1700bn against their own shares but the banks’ combined capital was only 1000bn. – Last year, I asked a banker at one of the major American banks if his bank would lend money to buy its own shares. ‘You know, it’s such an insane idea that I don’t even know if it’s legal,’ he answered flabbergasted.

But was the lending against own shares purely a salvaging policy? One of the three banks seems for certain to have practiced lending against own shares for quite some time before the credit crunch hit. It was part of its business model: when a potential big client walked through the door he would invariably be offered the bank’s shares – and asking for the purchase to be financed by the bank was no hindrance. Most likely, the master plan here was to prevent a hostile takeover and make short-selling less likely. – Since the three banks followed similar practices it’s quite likely that this was also done in the two other banks.

Another side of this scheme might be market manipulation on a grand scale and that’s what the Icelandic Financial Authorities (FME) is now investigating as is the Special Prosecutor. It’s interesting to note that there seems good reason to believe that this scheme didn’t only came into use around and after summer 2007. My sources indicate that this practice can be traced a few years back, even back to 2004 – which would make for some intriguing questions to be asked related to the whole banking sector in Iceland well before the collapse in 2008.

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Written by Sigrún Davídsdóttir

February 20th, 2010 at 8:51 pm

Posted in Iceland

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