Sigrún Davíðsdóttir's Icelog

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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