Sigrún Davíðsdóttir's Icelog

The Icelandic High Court: ‘currency-basket loans’ are illegal

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One of the reasons so many Icelanders have been badly hit by the collapse of the Icelandic banks and the simultaneous collapse of the Icelandic krona is that for years a big share of mortgages and car loans were linked to foreign currencies instead of the krona. Today, the Icelandic High Court ruled that tying loans to the value of foreign currencies was illegal. Loans in Iceland can only be linked to the domestic currency, the krona. The two cases related to car loans issued by two financial companies specialising in these loans but the same principle is thought to apply equally to ‘currency-basket mortgages,’ another popular form of currency loans. According to figures from the Icelandic Central Bank ISK125bn, £660m, in car loans and ISK225bn, £1,3bn, worth of mortgages are currency loans.

The loans were usually a selection, or a basket, of different currencies, hence the name ‘currency basket loans’ – often a combination of yen, euros and dollars. This flight to foreign currencies was a move by the banks as the Icelandic interest rates steadily got higher and higher, to combat the rising inflation.

Interestingly, the ever-higher interest rates didn’t take the pressure off the system and the inflation steadily crept upwards – also because so much of the lending was done outside the realm of the krona and the Icelandic interest rates. Consequently, interest rates close to 20% didn’t punch the inflation down but had the adverse effect of luring foreign capital into Iceland making the krona ever stronger.

In principle, it’s a huge risk to take out loans in a currency that’s unrelated to your source of income. For example a teacher in Iceland with all his or her income in krona and no exposure to other currencies shouldn’t really take out a loan in euro yen and dollars to buy a new car. With more than 10% difference in interest rates and the loans indexed (i.e. moving with the inflation) many people thought this was a risk they could live with: even if the krona lost some value it wouldn’t hurt except in the case of a massive and highly unlikely devaluation. With a krona steadily gaining strength from 2003, when these loans started to crop up, by 2005 it seemed that the krona couldn’t be anything but strong and the loans really took off.

As the banks collapsed in October 2008 so did the krona. Repayments of currency loans doubled or even more. Even prudent borrowers woke up to sky-high debts, in some cases higher than the value of the assets they had borrowed against. This has often been most noticeable in terms of cars: people might have borrowed five million krona to buy a car that now is worth only 3 millions and the loan is at 10 millions – clearly not a good situation to be in.

While the going was good, the krona strong and the interest rates low on the currency loans they seemed a good deal and no one complained. As the collapse in 2008 changed all that there were voices claiming that actually it was against Icelandic law to tie interest rates to a foreign currency. Even more so since those who took out the loan took it out in krona, i.e. no currency changed hands. The currency rate was only a point of reference but the loan wasn’t actually in any currency but the Icelandic krona.

Today, the High Court confirmed what many suspected: loans in Iceland can only be connected to the domestic currency. However, the High Court didn’t rule on the interest rates nor what should substitute the currency link. The banks claim they are already well on their way in solving this issue and that they already have a firm grip on it. The government says the same: that it had already had planned for this eventuality. There are however some financial companies that have mainly operated on currency loans and they might now go bankrupt. The two cases that the High Court ruled on today were related to loans taken out with two such companies.

The government now has two problems to solve: firstly, how to calculate the currency loans now that the currency link isn’t valid anymore; secondly, how to hinder a bias against those with indexed loans in Icelandic krona. Since it’s been known for a while that the High Court ruling was imminent and that this outcome was likely (an earlier ruling had indicated what could be expected) the government has had time to prepare. Having already had to refinance the banking sector it remains to be seen if the loan companies will need to be bailed out and if they really should be bailed out. Many debtors with currency loans will see the ruling today as a vindication of their struggle to meet repayments – anything that smacks of the government robbing people of their victory will most likely be met with great anger.

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Written by Sigrún Davídsdóttir

June 17th, 2010 at 12:40 am

Posted in Iceland

2 Responses to 'The Icelandic High Court: ‘currency-basket loans’ are illegal'

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  1. Very good article. I’ve been following your blog for quite some time and I enjoy the in dept analysis of the current situation in Iceland. Thank you!


    17 Jun 10 at 8:00 am

  2. […] This post was mentioned on Twitter by Janis Oslejs, Projekts Domkalve. Projekts Domkalve said: RT @Oslejs: Islandes lēmums aizliegt ārvalstu valūtu kredītus,pārvēršot tos kronu kredītos – detalizētāk šeit: […]

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