Sigrún Davíðsdóttir's Icelog

Today, the Reykjavik County Court has confirmed in a ruling that Icesave deposits are priority claims in the Landsbanki. The case was brought on by others who have general claims on Landsbanki and who refused to acknowledge the priority status of Icesave depositors. The wider consequence is that the emergency measure that made deposits a priority claim in the Icelandic banks has now been legally acknowledged.

The ruling means that the Court supports the position of the Landsbanki Wind-up Board and consequently, the priority status of claims in Landsbanki by the UK deposit guarantee fund and the Dutch Central Bank. This is the second ruling of the County Court related to the emergency measures.

The UK claims in Landsbanki amount to ISK823bn (now ca €500m) and the Dutch claims total ISK276bn (€167m). The ruling will be no doubt be appealed to the Supreme Court. Until its final ruling, Landsbanki can’t start to pay out claims. It also means that any Icesave payments to the UK and the Netherlands has to wait until the Supreme Court rules on the priority status.

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In September 2008, the Irish Government had insufficient and wrong information on the Irish banks when it issued its guarantee of the Irish banks. Consequently, its decision was ill-informed and, most likely, plainly wrong.

This is one of the striking conclusions of the Nyberg report on the Irish banking crisis. But is doesn’t just count for Ireland. It counts for Iceland, the rest of the Europe – and looking beyond Europe, most notably, also for the decisions the US Government made about its banks and the financial system. As to the US, considering how many highly placed officials came from the banking sector, most noticeably from Goldman Sachs, the scary thought is that the officials did actually have a much better insight into the problem-ridden banks but acted more in the interest of the banks than the rest of the citizens.

The EU is feverishly trying to collect bail-out funds worth €750bn. Belgium has called for double that amount. Willem Buiter, chief economist at Citibank, reckons that nothing less than €2 trillion is needed. Truly astronomical numbers at stake.

As pointed out in the Nyberg report and the SIC report on the Icelandic collapse it is abundantly clear that the accounts of the banks in both countries, in September 2008, nowhere near showed the real state of the banks. In Iceland, i.a. Deutsche Bank ‘lent’ credit lines that couldn’t be drawn because they were far too expensive. The liquidity that, from the accounts, appeared to be in the banks was fool’s gold. Nyberg talks about the ‘silent observers,’ i.e. the external auditors. And so on.

Iceland is investigating its banks. Recently, the NY Times posed a pressing question: “why, in the aftermath of a financial mess that generated hundreds of billions in losses, have no high-profile participants in the disaster been prosecuted?” In his report on Lehman, Anton Valukas pointed out possible areas of investigation, i.e. Lehman’s use of a certain repo 105 practice. The NY Attorney General, who has brought some other financial cases, has sued Ernst & Young, Lehman accountants for this accounting practice. As pointed out by the NY Times, a lot more should be investigated.

Governments were badly and/or wrongly informed in September 2008. The information is better now. That information indicates good reasons to investigate banks in the UK, the US, Germany and other countries with big and bloated banking sectors.

The UK Government poured billions into its banks, no question asked and no questions asked ever since. The German banks are huge lenders in distressed EU countries, no questions asked. The Nyberg report, like the SIC report, stresses the necessity of revisiting the banks’ incentive schemes. The banks are now, as before, paying zillions in bonuses, this time profiting from not only low interest rates but basically zero interest rates in the US and the Euro zone.

In the wake of the fall of the Soviet Union, voices got louder that politicians had little power but financial markets had great power. This isn’t true at all. The power to legislate is not trivial. The truth is however that politicians have been unwilling to wield their mighty power. Now, the banking sector in the US and Europe is succeeding in channeling private debt into the public purse. In short, the reason is, on one side the political unwillingness to use power. On the other side, wrong information and blatant lies from the financial sector.

The price of the unwillingness by politicians to use their power will be measured in trillions. Certainly, the leaders in the financial sector were the drivers and still are. But, as Nyberg points out, the politicians and official institution were the enablers. Now, they are enabling the financial sector to let the public sector gobble up its debt. This isn’t happening by a law of nature but because of calculated decisions. In Hamlet, the old king Claudius was killed with a drop of poison in his ear while sleeping. That’s what the financial sector has been doing: dripping poisonous debt into many sleeping ears. How lethal it will be remains to be seen.

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Last year, the Finnish regulator Peter Nyberg* was asked by the Irish Government to head a commission to make a thorough report on the Irish banking crisis. Nyberg’s report, Misjudging Risks: the Causes of the Systemic Banking Crisis in Ireland has now been published. The period investigated is 1 January 2003 until 15 January 2009, when the Irish Government nationalised the troubled Anglo Irish Bank.

For an avid SIC report reader the Nyberg report is a fascinating read. Compared to the SIC report, Nyberg’s report is only 156 pages, the SIC report 2600 pages so the width and depth isn’t comparable. But the parallels between the whole atmosphere surrounding the banks in the two countries, the consensus, blinding admiration and lack of scrutiny, drawn out in both reports, are striking. Ireland and Iceland are small countries that sought national glory in a fast-growing banking sector.

His report follows two other reports, by two economists Klaus Regling and Max Watson and one by Brian Honohan Governor of the Central Bank of Ireland, both of which I have already dealt with on Icelog.

Compared to the Icelandic SIC report the Nyberg commission couldn’t go into areas protected by banking secrecy. Consequently, Nyberg could not recount loan stories nor go into details about the relationship between the large clients and the banks, i.a. the area where the Icelandic banks allegedly committed financial crimes now being investigated both in Iceland and the UK. I have earlier blogged on what the Irish don’t know – and to my mind, possible fraud in the Irish banks hasn’t been tackled as systematically as I believe is needed. The story of Anglo Irish loans to the ‘golden circle’ – where the bank lent money to ten men (only some of the names have come out), against insufficient guarantees to buy the bank’s shares from the bank’s biggest shareholder in the summer of 2008 has many parallels in the Icelandic banks. Is the Anglo Irish loan really the only example of a bank taking on a possible loss to save favoured clients?

The title of the Nyberg report indicates the major flaw, the misjudging of risks, to be at the centre of the Irish banking crisis. Indeed, a headline for the failings of international banks in judging risk related to individual lenders and whole countries like Ireland, Iceland and Greece.

The Nyberg report, in addition to the SIC report, makes it glaringly obvious that other Western countries need to look at their own banking systems, UK being a case in point because had it not been for Government intervention the situation in October 2008 would have been an unmitigated catastrophe. German banks lent recklessly all over Europe, wrecked havoc from Iceland to Greece. The German Government should take notice and examine its banking sector far more closely.

Below are the topics explored and the main findings.

This Report explores what the Commission considers to be the most important policies, practices and linkages that contributed to the financial crisis in Ireland. A very large amount of documentation was analysed and many relevant people were interviewed. In explaining the simultaneity of the failures in Irish institutions, the Commission frequently found behaviour exhibiting bandwagon effects both between institutions (“herding”) and within them (“groupthink”), reinforced by a widespread international belief in the efficiency of financial markets. Based on this, the Report finally offers some lessons that could help avoid future similar occurrences in Ireland and elsewhere.

Contagion

The willingness of banks to accept higher risks by providing more and shockingly larger loans primarily for commercial property deals was an important reason for the gradual increase in financial fragility in Ireland. This willingness occurred because of the emergence of strong foreign and domestic competitors within both the residential and commercial property lending markets.

Interestingly, the report points out how deteriorating loans led to losses. Interestingly, this also happened in the foreign banks, operating Ireland, which are not part of the report’s investigation. This is a sobering thought since it makes you wonder about the state and status of other European and American banks.

Consensus

One of the striking features of the Icelandic banks, the political class, regulator and public authorities in Iceland in the years up to the crisis was the consensus that the banks could do no wrong, that there was nothing to question. The same appears to have been the case in Ireland.

A minority of people indicated that contrarian views were both difficult to maintain during the long boom and unhealthy to present to boards or superiors. A number of people stated that had they implemented or consistently supported contrarian policies they may ultimately have lost their jobs, positions, or reputations. Other signs were also noted pointing to sanctioning of diverging or contrarian opinions as well as self-censorship because of this. The apparent strength of these expected sanctions is difficult to judge, but the absence of opposition, barring only a handful of identified vociferous contrarians, may have made it easier for institutions to accept toning down the application of vital, tried and traditional prudential practices.

The Commission suspects that this conformity of views and self-limitation of responsibility would have tended to reduce the perceived need for monitoring, checking and thinking about what was really going on. There would have been little appreciation – both domestically and abroad – of the fact that Irish economic growth and welfare increasingly depended on construction and property development for domestic customers, funded by a growing foreign debt.

Flawed lending: Anglo and INBS

Anglo and to a much lesser extent INBS are important for the wider crisis because they were both seen as highly profitable institutions to which other Irish banks should aspire. As other banks tried to match the profitability of Anglo in particular, their behaviour gradually, and even at times unintentionally, became similar. Accordingly, when the crisis broke, large losses were realised not only in Anglo and INBS but in other banks as well.

In Iceland, Kaupthing was the bank that in record time became the largest bank and very much set the example for the two other banks and the whole financial sector.

Following the strong example, this was the unavoidable consequence:

The Herd: Other Banks

Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect. The few that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning.

The Silent Observers: External Auditors

The auditors clearly fulfilled this narrow function according to existing rules and regulations. They did not, however, generally report excesses over prudential  sector lending limits to the FR. Even if they had, it appears unlikely that anything would have been done about it as in general the FR was already aware of such limit excesses.

The Enablers: Public Authorities

The CB was not powerless; it had the right to direct the activities of the FR and it could advise the Government. There are, however, no records of such direction or advice or even efforts at such. These institutions worked separately and their respective independence was repeatedly stressed; however, this was counteracted by their partly common board members. Until the crisis, many of the staff of the CB and the FR apparently did not cooperate in a sufficiently meaningful way in assessing financial stability.

Policy with Insufficient Information: the Guarantee

The logical but catastrophic consequence of all of this was that when the Irish Government gave the blanket guarantee to all the Irish banks on September 29 2008 (the day that Glitnir collapsed in Iceland) the Government didn’t have the proper information, knowledge and understanding to give this guarantee.

The lack of suspicion and the absence of sufficient information on the underlying quality of the banks’ balance sheets is likely to have had a significant impact on the alternatives that were considered reasonable on September 29, 2008. Proper information is a precondition for any crisis management based on reality. As it turned out, decisions were made on the erroneous assumption that all banks were and would remain solvent. Only on that assumption could the decision to simply provide a broad guarantee be understood.

If accurate information on banks’ exposures had been available at the time it seems quite likely to the Commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated. Indeed, on the basis that such information had been available, banks could have been directed to raise substantially more private capital well before end-September 2008. As it turned out, however, the Government was advised that banks’ insolvency risks were small relative to liquidity risks and it was eventually decided not to consider nationalisation. This proved to be only a temporary reprieve, however. After a series of insufficient government actions and initiatives, Anglo was nationalised on January 19, 2009 following the disclosure of significant governance failings. Shortly afterwards, the solvency implications of several banks’ excessive property exposures started to emerge.

Some Lessons

The lessons that Nyberg draws refer, not surprisingly, to the regulator but also to the governance of the banks, the level of vigilance and scrutiny and the need for a robust discussion of policies and directions, both in public and private institutions. Last but not least: the incentive structure:

Finally, it appears to the Commission that little seems to argue against policies to markedly limit (even properly structured) bonus and pay for management in both banks and authorities, in Ireland and internationally. A consistent message of the bankers interviewed by the Commission has been that money is only part of their work incentive. For people serious about professional public service, money should be even less of an incentive.

*On Peter Nyberg: Since 1998 he has been director general of financial services at the Finnish ministry of finance, where his team is responsible for financial market legislation, supervision of the Finnish treasury and financial stability. He previously worked as a senior economist at the International Monetary Fund and as an adviser to the board of Bank of Finland. He completed his doctorate in economics in 1980.

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Moody’s has announced that it’s not lowering but affirming Iceland’s credit rating  at Baa3/P-3 and maintains a negative outlook. The rating agency is not making any changes post-referendum.

(1) Despite the rejection of the revised agreement to resolve the dispute over the Icesave offshore bank deposit scheme, the British and Dutch governments are now expected to receive initial payments from the Landsbanki estate soon for the costs they incurred in covering their citizens’ Icesave deposits. In addition, the Landsbanki estate now expects to be able to make significantly higher payments to priority claimholders as asset recoveries have been much higher than expected earlier. The outstanding Icesave obligation and potential liability to the government might therefore be reduced significantly in the coming months regardless of the referendum outcome.

(2) Moody’s also expects Iceland’s programme of support from the International Monetary Fund (IMF) to remain on track. The fifth review was scheduled for 27th April and there will certainly be a delay while the IMF assesses the implications of the referendum outcome. However, it seems unlikely that there will be a significant delay or blockage of the programme as occurred in 2009.

(3) Public statements indicate that the Nordic governments will likely continue to provide funding to the Icelandic authorities under their loan agreements. Apart from the IMF, the Nordic governments’ financing has been an essential external funding source for the Icelandic authorities.

The outlook on the rating remains negative given the ongoing uncertainty. Moody’s understands that the underlying issue of whether the Icelandic government has a liability under the EU directive on deposit-guarantee schemes will now most likely be resolved through the court of the European Free Trade Association (EFTA). This legal process may take at least a year. There are also uncertainties regarding the timetable for the relaxation of the capital controls and the economic outlook, in particular related to investment.

See here IMarketNews reporting on the Moody’s affirmation.

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In times of towering sovereign debt, there is a constant murmur in the media that countries should do like Iceland: refuse to bail out the banks and the bankers. This shows some lack of understanding of what Iceland did and why. In short, the Icelandic way is no way and the notion that it is rests on ignorance and misunderstanding. Or wishful thinking. On a broader scale the question is why private enterprises are being bailed out on both sides of the Atlantic, why private debt is allowed to migrate into tax payers’ pockets. In short: why have developed countries and institutions, like the ECB, been so willing to help banks to privatise the gains and nationalise the losses? In this, Iceland hasn’t entirely been a shining example leading the say.

In an interview yesterday with Irish PM Enda Kenny Evan Davis on the BBC radio 4 Today programme asked Kenny twice why Ireland wasn’t just doing like Iceland, refusing to pay. Or rather, Davis taunted him on this since Iceland was doing much better than Ireland. Kenny was clearly not deeply versed in the Icelandic way and ignored the taunts rather than pointing out the misunderstanding. There are indeed some interesting similarities between Iceland and Ireland, as I have pointed out earlier (on crisis and corruption and then broader similarities and differences) but the Icelandic way as a way of writing off debt caused by the banks isn’t really a sustainable example.

Yesterday, there was an editorial in the NY Times along these lines, on ‘Iceland’s Way.’ Though more nuanced and more accurate than just saying that Iceland is refusing to bail out the banks it wasn’t entirely correct.

“The government of Iceland failed to rein in bankers’ excesses. But its refusal to take on bank debts, forcing creditors to take losses and share in the pain, looks increasingly smart as Iceland’s economy begins to recover.

The European Union and the International Monetary Fund — their bailouts of Greece and Ireland were designed to make creditors whole — should learn from Iceland’s example. As they negotiate a rescue for Portugal, they should realize that taxpayers cannot bear the entire cost of the banks’ misdeeds.

The government of Iceland wasn’t intentionally daring or smarter than others. It couldn’t afford to bail out its banks, so it let them fail. It transferred domestic deposits and loans, at a discount, into new banks, with some $2 billion in money from taxpayers. And it left the banks’ foreign assets and foreign debts behind. Some foreign creditors could get as little as 27 cents on the euro.”

There is a contradiction here: the editorial both mentions the fact that Iceland couldn’t afford to bail out the banks and is refusing to do so. The former refers to the fact that the Icelandic state couldn’t save the banks in 2008 and the latter seems to refer to the fact that the last, the third, Icesave agreement was rejected in a recent referendum. But the referendum wasn’t about bailing out bankers. At its core is paying a debt to the British and the Dutch Government, rising from deposits guarantees on Icesave, Landsbanki’s internet bank.

As to the Icelandic way, the three banks failed in October 2008 because they were well beyond sovereign salvation. A fumbling attempt end of September 2008 to save Glitnir, the smallest one, proved the impossibility of that wish. But billions of ISK, ca 60bn, ca €370m, have since been posted into saving banks and an insurance company (interestingly, Icesave III might have incurred a sovereign cost of ca IKS35bn; Icesave has taken the Icelandic mind hostage for more than two years, deflecting attention from other issues but that’s another story). Both the present and the previous Governments have repeatedly said that the Icesave debt to the UK and the Dutch will be paid.

The general truth is that the European endgame needs to involve a different approach from the one the ECB is trying to force through, as eloquently demonstrated recently by Lee Buccheit (the Icesave III chief negotiator) and Mitu Gulati. A more relevant lesson than the Icelandic one is that, as Buchheit has been pointing out in recent lectures (i.a. in Iceland; see the end of this interview) in previous sovereign debt crisis during the latter part of the last century the banks have been rebuffed and forced to take the hit. This time, private debt, i.a. in Ireland, migrates to the public sector, i.a. with the help of the ECB. Yes, governments, i.a. in Greece, have overstretched themselves but the banks over-lent. By far. The Icelandic banks are a case in point.

The question is: why are governments taking on private debt now when it wasn’t accepted earlier? How come, that now it’s taken as a law of nature that private debt migrates to the public sector, all the way to the tax payers?

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Minister of Finance Steingrimur Sigfusson and Arni Pall Arnason Minister of Trade met with Dutch Treasury Minister Frans Weekers today in Washington, during the IMF Spring Meetings. To Ruv, the Icelandic ministers said that the meeting had gone well and that the Dutch would in no way try to make things difficult for Iceland within the IMF.

Later, it seems that Weekers said just the opposite to Dutch media, i.e. that the Dutch Government would indeed try to hamper the Icelandic IMF programme. This wouldn’t be the first time that the Dutch use their standing in the IMF. And yes, you guessed it: it’s because the Dutch are unhappy because Iceland, after the referendum, can’t pass the bill on an Icesave top-up loan.

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Mike, a financial analyst who has been commenting on an earlier log, ‘Can Iceland just pay without any agreement?’ has posted a report by Barclays Capital from April 2006.* BC ran an Icelandic bank credit investor roadshow in Reykjavik end of March 2006, during which BC saw Kaupthing, Landsbanki and Glitnir, as well as the FME, the regulator and the Central Bank of Iceland. Knowing what happened to the banks in October 2008 the report is a fascinating read.

One of the key points was that “At current spreads, we believe the market is pricing in too low a probability of a crisis or a serious asset price correction.”

Further: “Our conclusion is that at current levels, we would still be short Icelandic banks. Since we continue to view the key risks as systemic, we would buy protection on all the banks. It is true that fundamentally we would tend to agree with the market view that Glitnir has the strongest risk profile but in the worst-case scenario, all the banks would likely be tarred with the same brush and valuations would probably weaken equally across the market.”

On management: we sensed they are listening; a positive For the first time since we have been covering the Icelandic banks intensively, we got a definite sense that senior management was listening, and had accepted the fact that the pace of asset and funding growth needed to slow. Kaupthing, for example, will not be funding in the euro currency public market this year, and all banks seemed to have delayed or shelved plans to make further acquisitions this year at least.

On understanding the risks: we still feel nervous; no change One of our main concerns has centred on the ability and/or willingness of Icelandic banks to understand all the risks (direct, indirect, systemic) that are building up around them. We are particularly worried about the amount of indirect equity exposure that banks hold through lending to investment  companies/vehicles and others, which are then on-invested in equities, essentially double leveraging. We came away with the view that there is excessive focus on collateral and loan-to-value ratios and less measurement of ability to service debt.

And here is something that merits a close reading. One wonders why the FSA didn’t keep this in mind.

International subsidiaries do not help in distress: Much of the market commentary concerning the banks’ fundamentals has centred on using consolidated accounts. In particular,  the banks themselves are keen to defend their expansionary strategy by suggesting that it will help diversify both their asset side and their funding mix. We would highlight that although this type of diversification/expansion may be beneficial  for equity valuations, for our purposes, as credit analysts, it is not that helpful. Fixed income investors are exposed to legal entities alone. In this case, exposure to the Icelandic banks means exposure to the parent bank in Iceland. Dividend upstreaming from subsidiary to parent is helpful, and can ease liquidity pressures, but they are not dependable, and in itself, depending on equity dividend  income  to  pay  debt  coupons  is  leverage.  Unless  the  parent  has  a  call  on  the assets/liquidity of its subsidiary, the benefit of holding that subsidiary is otherwise useless in a distress event. It has been made abundantly clear from our conversations with the Icelandic banks, if we didn’t already know, that they have almost no ability to bleed liquidity from their foreign regulated subsidiaries, even if they wanted or needed to. Kaupthing’s plans to seek deposit funding at subsidiary FIH in Denmark, and Glitnir’s ownership of BN Bank in Norway do not diversify the parent bank’s own (solo) funding sources. They make the consolidated liquidity ratios look better (deposits/loans) but they are no real comfort to us as credit  analysts. Equally, disclosing consolidated cash/liquid asset positions is meaningless since the parent bank creditors have no call on subsidiary assets. This fact seems to have  been  lost  in  recent  commentary,  and  also seems to be conveniently ignored by bank management. We have asked the three banks for detailed parent bank (solo) unconsolidated accounts.

Underpriced risk wasn’t peculiar to Iceland. Greek risk was underpriced, probably the same in Ireland and other EU peripheral countries etc. But having read the BC report, as well as keeping in mind the serious criticism that hailed over the Icelandic banks already in early 2006, one wonders why the criticism softened as 2006 passed. Perhaps, it had less to do with Iceland and more to do with the general risk gluttony in the financial world. But still, the Icelandic banks, i.a. because of their interconnectedness, pointed out the BC report and elsewhere, posed a very special risk that the markets didn’t pay enough attention to.

*Thanks, Mike!

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Steingrimur Sigfusson Minister of Finance is in Washington for the IMF spring meeting, together with Mar Gudmundsson Governor of the Central Bank of Iceland. Today, Sigfusson was interviewed on Reuters where he expressed his view that a downgrade of Iceland’s credit ratings, now in the air after the Icesave ‘no’ in the referendum last Saturday, was wholly unjustified now that the economy was showing signs of improvement.

“If you look at the underlying strength of the Icelandic economy we are doing quite well. We are resuming economic growth, and we are through the worst crisis. We are on the way up again and a downgrade now would be strange,” Sigfusson said.

In the interview with Reuters, Sigfusson underlined his position from the day after the referendum that Iceland will pay, that the Dutch and the British Government will get their money back. Or rather, as much as comes out of the Landsbanki assets. If this is so easy and simple one wonders why Icelanders tried three times to negotiate. The answer is that it’s not that easy and simple. Icesave is about money that the Dutch and the British consider an outstanding loan and loans are paid with interests. In Icesave III, the interests were halved, compared to earlier agreements.

What the Icelandic government appears to be saying now is that it will pay as much as it can. In particular the Dutch seem piqued by this stance and are now looking at what option the Dutch Government has, i.a. within the EU, to put pressure on Iceland for something more orderly than just paying as much as the Landsbanki assets cover, with no mention of interests.

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From the collapse of the Icelandic banks in October 2008, the Icelandic Chamber of Commerce has regularly published a status report of the Icelandic economy. Here is the press release to latest one and here is the report itself.

This time, the report comes in an extended and improved version – everything you ever wanted to know about Iceland in facts and figures regarding the economy, info re the EU membership application process, Icesave, competitiveness, the IMF programme etc.

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Standard & Poor’s Ratings Services has announced it is reviewing Iceland for a possible downgrade, following the Icesave referendum this weekend.

“The prolonged dispute over the Icesave issue could weaken Iceland’s relationship with other European countries, increase its external financing risks, and hinder Iceland’s economic prospects as well as delay the lifting of capital controls and its return to international capital markets.”

S&P expects the dispute to return to the EFTA court and that it might take a year or more  for a ruling to come down. S&P has Iceland’s foreign currency credit rating at triple-B-minus, the brink of junk territory, and its local currency rating one step higher at triple B.

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