Sigrún Davíðsdóttir's Icelog

At the time, the collapse of the three largest Icelandic banks in October 2008 was blamed on the Brits and Gordon Brown became a hate figure in Iceland. A nine volume report finally told Icelanders what had happened and why the banks collapsed. Only then, did it become clear how politicians had ignored warning signals, regulators were too lax and bank managers were, at best, economical with the truth. Rumours of foul play in the banks led to setting up an Office of the Special Prosecutor, which has already indicted leading bankers and shareholders. – Finding out the truth does not resolve economic woes but it answers the questions necessary to learn the right lessons. This is what Cyprus can learn from Iceland.

The first Icelandic reaction: it’s Gordon Brown’s fault

There is an old Icelandic belief that speaking ill of someone will give this person a hick-up. If that were true, Prime Minister Gordon Brown would have had the mother of all hick-ups during the second week of October 2008. The PM turned into a hate-figure in Iceland where he was blamed for having, single-handedly, driven the two largest banks – Kaupthing and Landsbanki – into bankruptcy. The state had already taken over 75% of the third bank, Glitnir, only to retract on it as it became obvious that even this part of the smallest bank was too much for the sovereign to shoulder.

An emergency legislation was passed late on October 6 2008, i.a. for steering the three biggest banks into resolution if needed. The next day the Icelandic Financial Services Authority, FME, took control of Landsbanki. Although those who understood that abroad the three banks were seen as closely linked and the collapse of one would spell the end of them all, there were desperate attempts to save Kaupthing. This is puzzling since Bank of England had already on October 3 stopped all new deposits going into the bank.

After months of wrangling with the banks’ managers in the UK and with Icelandic authorities and politicians, UK authorities lost patience on October 8 and closed down Kaupthing’s UK subsidiary, Kaupthing Singer & Friedlander. A day later, the FME took over control of Kaupthing.

The irritation and distrust of the British authorities surfaced when the UK Treasury used a freezing order, also used against alleged terrorist organisations, on all Icelandic companies in the UK. The measure was aimed at Landsbanki but the action was only narrowed down later and did cause many Icelandic companies and individuals great difficulty until it was finally revoked in June 2009.

These two actions – closing down of KSF and using the freezing order so broadly –caused angry and bewildered Icelanders to vent their anger towards PM Gordon Brown and British authorities. International media – on its first European banking collapse outing – had a field day, interviewing angry Icelanders.

Substitute the name “Angela Merkel” for “Gordon Brown” – and Cypriots will know how Icelanders felt these days in October 2008. Also Icelanders felt at the time they were under siege from a foreign power.

SIC – OSP

In December 2008, the Icelandic Parliament voted for two novelties: to set up a special investigative committee, SIC, to investigate what led to the banking collapse – and secondly, reacting to rumours about foul play within the banks, to set up an Office of Special Prosecutors to investigate alleged crimes related to the collapse.

Just after the collapse, before the SIC was set up, Kaarlo Jännäri – a Finnish expert – was asked to write a report on the causes of the collapse. In only 30 pages he outlined what was later confirmed and covered extensively by the SIC and concluded that the causes were a combination of bad banking, bad policies and bad luck. Interestingly, the media focused mostly on the bad luck when the report was published in March 2009. Yet, one of his conclusions was that even without an international crisis, the Icelandic banking model was not sustainable and the banks would eventually have failed.

The SIC was chaired by High Court judge, together with the Parliament’s Ombudsman and an economist. The SIC was supposed to take a year but it took longer. Eventually, on April 12 the great day dawned when the committee presented their findings and the report was published, in nine volumes in addition to on-line appendixes. The country came to a standstill on the morning the SIC press conference was broadcasted live. The first 2000 printed copies sold out the same day but the report is available on-line.

The SIC report: much worse news than anticipated

Most Icelanders, suffering from mistrust brought on by the collapse, did not expect much from the SIC and many felt that most things were known anyway. Both these expectations were wrong. The report unearthed events that were much worse than anyone had anticipated – and the report was both extremely thorough and extensive. It laid bare the complete failure of regulators to supervise, ia because as soon as FME staff gained insight into the banks the banks poached them. The economic policy of governments from 2000 and onward had been expansive, even during boom times.

Already in 2006, when things started to go downhill, most politicians only listened to the bankers, not critical voices, especially not if they came from abroad. Icelanders did not realise that funding dried up in 2006 but the banks narrowly saved themselves. Needless to say, the day of reckoning would have been less dramatic and less costly if it had happened in October 2006 and not two years later.

In trying to secure a currency swap in 2008 with foreign central banks the Central Bank of Iceland got no swaps but only stark words of warning in every bank they turned. Warnings the CBI chose to ignore.

Foul play in the banks

The report showed very clearly how the largest shareholders, together with their business partners, had also been the largest borrowers. Collaterals were frequently insufficient when lending to these favoured clients. The banks lent copiously to entities that bought shares in these same banks.

The OSP has recently indicted managers and staff from two of the banks for alleged market manipulation, partly carried out through lending companies to buy shares in the banks. Other cases brought by the OSP i.a. relate to breach of fiduciary duty. So far, around 15 bank managers and employees from the three banks have been indicted, in addition to two large shareholders, Olafur Olafsson and Jon Asgeir Johannesson.

The report was thorough not only because of the great expertise of its authors but also because the SIC had extensive powers to source information. It was i.a. allowed to waive bank secrecy and analyse loan documents.

Unfortunately, the report was not translated into English but here is a link to those parts, which have been translated, i.a. an executive summary, chapter 21, 160 pages, which summarises the whole report and an overview especially on the operations of the banks, by Mark Flannery.

No other crisis-struck country has as thoroughly investigated what happened – and specifically investigated alleged crime connected to its financial calamities. Both of these things have, to my mind, greatly benefitted Icelanders. It is easier to live in a country where a catastrophe that touches each and every person is understood and where events are analysed in order to learn from them. And most of all – that those who possibly are responsible for crimes hidden in the catastrophe have to answer for their deeds.

Surely, many Icelanders think that things have not changed enough and the justice is milling too slowly – but there is at least a point of reference as to what happened and why.

And now to Cyprus: the Greek haircut does not explain it all

Already now there are plenty of indications that there are things to unearth and investigate in Cyprus. In an interview with the Economist, former Central Bank governor Athanasios Orphanides says that the former government deflected all attempts from abroad to alert it to the increasingly serious situation and get it to react. Interestingly, Orphanides concludes that the €2.5bn loan from Russia at the end of 2011 was a mixed blessing: nothing was resolved and the loan badly used. It would have been better if no loan had been forthcoming, forcing the government to face reality. – Surely some untold stories here that Cypriots have a right to know of in detail.

As to the banks, why did they offer such high interest rates? How was that possible unless there were some high-risk investments at the other end? Or an unsustainable competition for deposits – the only means of funding for a banking sector, largely isolated from European markets.

The Greek haircut is blamed for the troubles of the two banks – Bank of Cyprus and Laiki Bank – but why did these two banks choose to gamble with €50bn – 250% of GDP – by buying Greek sovereign bonds? It is neither an excuse nor an explanation that sovereign bonds were seen as a safe bet at the time. The banks would surely have bought insurance (?). This high-stake bet on Greek bonds needs to be clarified, as this is the single most fateful action contributing to the recent demise – though it is only the last drop but not the real cause for the demise. The real reasons were actions or non-actions taken over a number of years, both by politicians and bankers.

Iceland and Cyprus: ignored warnings and hubris

And it is not true that no one ever said anything. Some experts have been worried for some years. In 2011, Constantinos Stephanou from the World Bank wrote an article in Cyprus Economic Policy Review, with the telling title: The Banking System in Cyprus: Time to Rethink the Business Model? The article spells out quite clearly the weaknesses of the Cypriot banking system, which in contrast to the oft-cited Luxembourg system relies not on foreign banks like Luxembourg but on few big domestic banks. Stephanou concludes with concrete policy advise on what needed to be done in order to secure safe banking operations. The question is if this advice was heeded – and if not, why not.

In November 2011 an IMF report contained stark warning on significant weaknesses (emphasis mine):

The large banking sector, with assets totaling (sic) over 8 times GDP by the broadest measure, and with significant exposure to Greece, is a significant vulnerability. Banks face significant capital needs to reflect mark to market valuations on their sovereign bond holdings and to achieve a 9 percent core tier one capital ratio, as mandated by the European Banking Authority. Non-performing loans are increasing, and further loan deterioration could add to recapitalization needs. Meanwhile, the system is also vulnerable to an outflow of deposits in the event of adverse circumstances. Cypriot banks receive significant liquidity support from the European Central Bank.

Yes, this was all clear whole eighteen months ago…

The Cypriot story is similar to the Icelandic one: there were warnings but hubris and wishful thinking made politicians immune to them. IMF reports are not the daily reading of the man on the street and if the media ignores them no one outside expert circles hears of them.

A list of Cypriot people and companies that had loans written off in Cypriot banks in previous years has now surfaced. The matter will now be investigated by three former Supreme Court judges. That is a very myopic approach – there is a lot more to investigate in the banks, the government, the regulators. What went wrong because of ignorance – and what happened because of corrupt practices? Do the Cypriots dare to unearth all of this?

The easy option of blaming the foreigners – and “we are all to blame”

As long as nothing is done to clarify what happened and investigate eventual criminal deeds, Cypriots have good reasons to be upset and angry – but less with Merkel & Eurozone Co than with Cypriot politicians in power for the last decade or so and the bankers who over the years made the wrong decisions and quite possibly worse. Blaming the Eurzone leaders – as the UK media has reported so diligently – and saying that “we are all to blame” are two ways of masking what really happened. And that some bear more blame than others.

A financial crash is not a catastrophe governed by laws of nature – it cannot be compared to an earthquake or a volcanic eruption. It is an event that comes about at the end of a long string of wrong or bad decisions. Analysing what happened, over the last few years leading up to the catastrophe, is necessary in order to learn from it. The shock in Cyprus is not just about money lost – it is about betrayal of politicians, civil servants, bankers and others in power. Those who suffer it need to know what happened and why – and they need to be sure that possible criminal acts are investigated.

What Iceland can teach others in terms of economics can be debated – but the SIC and the OSP are two things that can truly be an example for other crisis-struck countries.

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The idea of an doing” an Icesave,” of an “Icesave solution,” for Cyprus pops up again and again. But can Cyprus do an Icesave? The short answer is “no.” If doing an Icesave means Cyprus avoiding to reimburse foreign/Russian depositors Icesave provides no example to follow.

Icesave was a foreign operation. When the Icelandic banks failed, it was decided to keep alive the banks’ Icelandic operations, letting those abroad fail. It also meant that all deposits in Iceland were moved into new banks, the rest was wound up. The governments in the UK and the Netherlands reimbursed the Icesave depositors.

An “Icesave solution” indicates a division between domestic and foreign accounts. That is of no great use to Cyprus because the major part of the deposits in Cyprus are in Cyprus and that is also where the largest part of their operations are.

Contrary to the Cypriot situation, the largest part of the operations of the three Icelandic banks were abroad, not in Iceland. Kaupthing, the largest bank, had ca 80% of its operations abroad. The two others, Landsbanki and Glitnir, were heading in the same direction.

In Cyprus, the main operations of the banks are in Cyprus. Ergo, a division like the Icesave – or more exactly, in domestic and foreign operations – does not provide a Cypriot solution. EU Directives do not allow for differentiating between foreign and domestic depositors within the same country. Consequently, Cyprus can not decide to insure deposits owned by Cypriots and Cypriot entities and not others. Completely forbidden.

The only way to differentiate between deposits in Cyprus – for levy or any other action – is to differentiate between insured and non-insured deposits, i.e. between deposits under €100.000 and over €100.000. An Icesave “trick” does not help in Cyprus.

*Here is an earlier blog on the EFTA Court ruling re Icesave.

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As Icelog has pointed out earlier, there are many similarities between Iceland and Cyprus. One of them is Icesave.

If Laiki Bank, a badly hit Cypriot bank, folds it will leave some depositors in the UK under a Cypriot Deposit Guarantee Scheme because Laiki, apparently, has branches in the UK, not subsidiaries. As Landsbanki’s Icesave accounts, set up as a branch, showed so clearly these depositors will have to seek to Cyprus for their deposit guarantees. If Laiki operations in the UK had been in a subsidiary it would fall under the UK DGS.

Ever since Icesave the UK Financial Services Authorities have had their eye on branches. But they seem to have reacted somewhat slowly – Icesave collapsed over four years ago, in October 2008. Yet another failure on part of the FSA.

The lesson from Iceland is that if Laiki folds it is very important that insured deposits are moved into a new entity (for which funds are needed) and the rest left to a resolution company. (In Iceland, all deposits were insured, no minimum).

What Iceland did – which has proved very beneficial to uninsured deposits (which were the deposits abroad) – is that in the Emergency Bill (passed into law just as everything was collapsing October 6 2008) deposits were made a priority claims in bankruptcy. This meant that uninsured depositors get paid first, i.e. have hope of getting something back.

This was relevant not in Iceland but in the Icesave branches in the UK and the Netherlands because these deposits were then given priority and will actually get fully reimbursed. But alas, one’s gain is another’s loss – it means that other creditors to Landsbanki’s foreign operations aren’t getting very much.

What happened in Icesave was that the UK and the Dutch did reimburse depositors (to avoid unrest) but then wanted this money back from Iceland. Iceland resisted – and now in January the EFTA Court ruled that because it was a major systemic failure Iceland did not need to reimburse the two governments. (This is a hotly disputed outcome, the European Court of Justice might see it differently).

In a situation like in Iceland and Cyprus, someone will feel the pain. In Iceland, ordinary deposit holders lost 30-40% of their ISK deposits, measured in euro. Exiting the euro is no solution for Cyprus. With banks kept alive since January by the ECB’s Emergency Liquidity Assistance, the Cypriot catastrophe has been on the horizon for a while. It is a pity that it was not better prepared when the crash finally came.

But now it is here and something needs to be done. Iceland managed to do a few things right – helped by the fact that the there were foreign creditors that could be forced to take the greatest loss, ca 5-6 times the Icelandic GDP –  painful though it was. It seems that the Cypriot shock might be greater, no clear cut group of foreign creditors who can be forced to swallow losses. Still, for  Cyprus a quick stab might be better than the lingering pain the Greeks have lived with for far too long.

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As reported earlier on Icelog, the Office of Special Prosecutor has brought charges against managers of Kaupthing and Landsbanki for market manipulation. How did the two banks allegedly manipulate their share price? The SIC shows two basic methods. One was “orchestrated” trading, meaning that the banks themselves placed bids carefully planned in order to influence the price. The other was to lend companies linked to “friendly” and “understanding” clients to buy shares.

The “orchestrated” trading on the Icelandic Stock Exchange is amply documented in the SIC report where trades on single dates are traced in order to demonstrate a pattern, which pushed up the share price in the respective bank. These trades were usually placed just before the ISE’s closing time. On the whole, the banks were enormously large players on the ISE. The last few years before the collapse, trades placed by the banks amounted to 74-80% of all trades on the ISE. – Yes, Iceland is a small country.

The extensive lending to companies to buy the banks’ own shares was a striking feature of the Icelandic banking model. These companies used funds, borrowed from the respective banks to buy shares in these same banks. Some of these companies became infamous after the collapse because there was just something so seriously suspect with these high loans and the individuals who got them. Only with time – and especially with the SIC report – did the whole pattern behind these loans become apparent: this looked like a huge web of companies allegedly all used for one purpose: market manipulation.

This lending to buy shares is connected to another characteristic of the Icelandic banks: generally willingly lending against own shares, thereby cleverly converting the loan book… into equity. – Whenever I hear of banks lending against own shares I take that as a huge big warning sign of something fundamentally wrong in that bank.

The charges against Kaupthing and Landsbanki managers will now test previous suspicion. However, these cases are against the managers who allegedly organised the loans etc. None of the borrowers have yet been charged.

The interesting aspect is that as again the SIC report shows these two ways of influencing share price can be traced back well before the banks met criticism and exposing analysis abroad, i. This fact poses the question if market manipulation was part of the Icelandic banking model more or less from the beginning of their expansion, after the banking sector had been privatised in 2003.

Update:

Here are all the names of those charged:

From Landsbanki: CEO Sigurjon Arnason, Director of Corporate Accounts Elin Sigfusdottir, director of proprietary trading Ivar Guðjonsson, brokerage director Steinthor Gunnarsson and brokers Julius Steinar Hreidarsson and Sindri Sveinsson.

From Kaupthing: chairman of the board Sigurdur Einarsson, CEO Hreidar Mar Sigurdsson, director of Kaupthing Iceland Ingolfur Helgason, director of Kaupthing Luxembourg Magnus Gudmundsson, director of corporate banking Bjarki Diego, credit committee member and Kaupthing corporate employee Bjork Thorarinsdottir, director of prop trading Einar Palmi Sigmundsson and two private business brokers Birnir Saer Bjornsson and Petur Kristinn Gudmarsson.

*Intriguingly, I have heard that examples of this behaviour can be traced back before the privatisation. Landsbanki did set up offshore companies before its privatisation to hold shares in itself. The purpose was to use these shares as options for employees but then they were actually never used for that purpose. These structures were kept after the bank was sold and slowly filled with shares. In this way, these companies added to the power of the largest shareholder – Samson, owned by father and son – since the managers held the voting power, around 12% in the end.

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The Office of Special Prosecutor in Iceland has brought charges in two large market manipulation cases – one against  Kaupthing managers, another against Landsbanki managers. Those charged re Kaupthing are, according to Icelandic media, are Kaupthing’s chairman Sigurdur Einarsson, CEO Hreidar Mar Sigurdsson, Ingolfur Helgason director of Kaupthing Iceland, Magnus Gudmundsson director of Kaupthing Luxembourg, Bjarki Diego head of lending, three so far unnamed employees in prop trading and one in retail banking.

From Landsbanki there are CEO Sigurjon Arnason, Elin Sigfussdottir and four traders. The charges have not been published yet.

Allegedly, these cases centre on how the banks themselves, through various channels, owned a large part of the banks’ shares, meaning that market movements did not at all reflect the reality. I expect the charges to come out later this week and will then write about these cases in detail.

So far, no large case has surfaced regarding Landsbanki although the SIC report mentions many interesting transactions related to that bank, as well as the other banks. Icelog has earlier reported on another large Kaupthing case, the so-called al Thani case (here is a link to earlier Icelogs on that case).

According to the SIC report, 74-80% of trades on the Icelandic Stock Exchange were generated by the three banks. According to Icelandic media, some well known cases are connected to the new charges, such as a company called Imon, allegedly used to influence Landsbanki shares. Here is an earlier Icelog where Imon is part of the story and gives an idea what has been investigated.

An interesting aspect of these cases is that the alleged manipulation started well before 2008. This is made very clear in the SIC report.

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** No lack of outpour blogs and comments re the Cypriot bailout. Bank shares are falling in London and elsewhere. The sense is that it’s not so much the principle of grabbing part of deposits but the fact that there is no minimum. I would definitely see it as positive to lower the loan and consequently the debt burden to the sovereign.

(This is getting a bit complicated but opinions flood the web – I’ve added to the Monday morning update, marked with *)

What will happen tomorrow? Extended bank holiday? Not (yet?) so, according to Kathimerini.

Guardian running live blog on events.

Cyprus president Anastasiades tells his version of the story via Euractive.

*Needless to say, Goldman Sachs thinks this is a good deal, via Business Insider.

*A digest and opinion from Tim Duy’s Fed Watch, the headline puts it clearly: “War on common sense continues.”

Russia, supposed to make a small contribution to loan and extending earlier loan of €2.5bn, have not made up their mind, according to Kathimerini.

Here is the Prodigal Greek, alias Yiannis Mouzakis, summing up things re the vote in the Cypriot Parliament and other relevant topics.

*Fistful of euros votes down Olli Rehn.

*The banks go free, not the depositors, a Guardian blog by Michael Burke.

Anonymous Pavelmorski writes another blog – after his first one found below – along these lines, what were they thinking.

Paul Krugman dives into the debate with a short blog, confessing he did not see this coming. Wonders how much the Russian element matters.

FT Alphaville looks at the fall-out of the Cyprus debacle as markets open: not pretty but not horrendous.

And FTA also looks at the lessons one can draw from the Cyprus package.

Frances Coppola writes a thorough and critical piece on the Cyprus shock, directed at the ECB.

My favourite blog of the day, so far, comes from Izabella Kaminska. She points out that no, this isn’t a great move but then, these Cypriot banks aren’t great either, which means they have difficult times finding equity. Kaminska writes:

Think of it this way. If I can persuade people to keep giving me money (to look after), I can make as many crappy loans as I want with that money — and I won’t be found out until the funding is either taken away from me completely (in which case I won’t have enough to give back), the bad loans are so bad I can’t even afford to pay the interest I owe (less of a problem in the zero yield environment), or last and not least the loans mature and I suffer principal loss.

The last situation can be easily masked if I can persuade new depositors to fund that loss unwittingly.

And that’s really what has been happening post crisis. All deposits retained in zombie banks (rather than nationalised ones where the equity gap has been funded by government instead ) were already in reality funding these losses unwittingly.

In other words, the moment you gave deposits to a bank whose loans were failing or were set to fail you were effectively providing loss absorbing equity anyway.

The Cyprus move makes overt what was already the case.

This is why there is a good chance that depositor funds and creditors of this type will now become a lot more information sensitive.

Depositors should now realise that governments which can’t afford to take the hit on their behalf or support positive deposit returns indefinitely (like the US can by giving away free national equity by means of paying IOER ) mean they are funding the gap instead.

This is the ultimate negative interest rate because it shows that the privilege of having deposits (delaying spending) is associated with principal loss, from the offset.

Which makes me think of a blog I wrote recently, on the crisis and the curse of cheap money.

– – – – – –

More from yesterday:

*It seems there is an ongoing discussion tonight about changing the levy so it won’t fall so harshly on those with low deposits – that the olive farmer will pay less and the oligarch more. OpenEurope blog recounts what went on earlier and how the finger-pointing is going. Weirdly enough, the Cypriot Government does not seem to have been defending the interest of the small deposit holders. BuisnessInsider indicates it fears pricing itself out of the money laundering business (which would be scary).

FT Editorial doesn’t mince its words: “Europe botches another rescue.”

FT Alphaville writes about the novelty of the deposit levy, not a positive surprise though.

WSJ has gathered fascinating details as to how the deal came about – a who, where and when story. A bit of credit to the unpopular Olli Rehn: “Mr. Rehn was the first to take the floor with a specific proposal. To raise funds, Nicosia should impose a special levy on deposits, taxing accounts of less than €100,000 at 3%, those up to €500,000 at 5% and those above at 7%.” – At 1 a.m., after numbers being thrown around and the Cypriot president firmly saying no, the bold and brutally clear Jörg Asmussen spelled out the problem: the two main banks were about to go bust, there was no time to mull over this much longer. Asmussen even pulled up his phone and called Mario Draghi, telling him the ECB might now have to deal with two collapsed banks (was Draghi really on the line or was this just Asmussen’s clever trick?) President Anastasiades gave in but insisted on the levy not going over 10% – and the 6.75%/9.9% deal was clinched.

And now, according to Reuters, it seems there is a real possibility that some of the original ideas, of a much lower or no levy on low deposits, may do a come-back. Here is a news summary of how things stand in Cyprus right now.

Below is what I posted earlier:

– – – – – –

Not much said in favour of the bailout but an outpour of dismay, shock and anger in every direction. Here is an overview of some of it, not in any particular order – but first some varia related to Cyprus:

The statement from the European Council.

Cyprus data from ECB’s statistical warehouse, on Cyprus.

An NYTimes article from April last year, just to add some flavour to the topic “du jour.”

Slides from a January presentation by the Ministry of Finance in Cyprus on the state of the Cypriot economy.

How much Russian money is there in Cyprus? Ekathimerini makes a guess: ca €35bn – in a €17bn economy.

On the bailout package:

The view from Cyprus, via Cyprus-Mail: Cyprus left reeling from the haircut on depositors.

FT’s Peter Spiegel tells the story how the deal came into being – in Berlin.

Hugo Dixon talks about “legalized bank robbery.”

Mohamed El-Arian finds the deal “muddled and risky.”

Karl Whelan wonders if the depositor tax spells the end of the EU.

Joseph Cotterill pulls a phrase from Whelan for his headline: “A stupid idea whose time has come” – rich in material and documents.

Edmund Conway writes on the “Tragedy of Cyprus,” drawing interesting US parallels.

Economist’s Schumpeter calls the deal “unfair, short-sighted and self-defeating.”

Business Insider on reaction from some financial analyst, wondering if the bailout will trigger havoc in Europe.

Felix Salmon writes a substantial piece on earlier developments, concludes that the bailout shows that Germany rules the Med countries.

The anonymous fund manager Pawelmorski talks about “a brutal lesson in RealPolitik.”

WSJ Stephen Fidler adds some points to earlier observations.

The Danish economist Lars Christensen adds some musing to Conway (see above), re NGDP targeting.

FAZ analysis (in German) speaks of loss of trust among European deposit holders.

Economist on the sanctity of bond holders in European bailouts.

My own blog re Cyprus – the unfairness and the loss of faith in the European Union.

I’m not sure what Rehn, Lagarde, Asmussen, Dijsselbloem e.al. expected when they announced the deal late Friday night (or early Saturday morning, depending how you divide the hours of the day and night) – but if good friends are those who tell you loud and clear what they think they can at least rejoice that they have many such friends.

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Five European sovereign bailouts, five ways of doing it – but one thing is common to them all: reckless lenders are spared (except in the last Greek round) and hedge funds rewarded. This time, even the smallest deposit holders are hit. One clear consequence: the European Union is rapidly losing support in its member states.

Now, with the experience of five European bailouts it is safe to say they come in different sizes – from the Greek one now totalling €240 to the latest, €10bn for Cyprus. Apart from the Greek haircut (finally after two attempts to stabilise Greece) bondholders have not been touched. In Cyprus where 48% of public sector debt is held by domestic banks, a haircut à la grecque would have felled the banks and not been of much help.

One particularity of the Cypriot banks is that although their assets are roughly eight times the island’s GDP they are mostly funded by deposits, not by whole-sale loans like i.a. the Icelandic banks were. After being badly hit by the Greek haircut last year – more like the last drop rather than the real reason for their troubles – equity in Cypriot banks has evaporated.

Laiki Bank is a case in point: its assets and liabilities is €30.4bn, its equity paltry €1bn. By turning 10% of deposits into equity, as the stability (or more sweetly, solidarity) levy roughly does – bingo, the equity is miraculously a much more sustainable 8% and the troika doesn’t need to provide lending to save the banks. Assuming there will be any deposits left in the Cypriot banks when banking resumes after an, apparently, prolongued bank holiday later this coming week (the banks were due to open on Tuesday, after a long weekend, but there is now rumour they will not open until Wednesday or even later).

By looting bank accounts the total sum needed is brought down: instead of a bailout sum of one Cypriot GDP, ca €17bn, “only” €10bn will be needed.

This is a drastic measure. If this could solve the problem it might have some merit – it would be a quick stab instead of the lingering pain in Greece – but that is more than uncertain. I find it very difficult to stomach that there was not a minimum sum left untouched. Let us say a pensioner with €30.000 would have kept his savings unscathed. Or even holding a sum equivalent to the minimum deposit guarantee of €100.000 untouched but putting a levy of 15% on everything above that. Perhaps none of this would have sufficed to bring the total loan down but yes, I still find this measure extremely brutal and this measure needs to be strongly underpinned and justified. The FT (paywall) has an account on how the deal was reached – it will not make the Germans more popular and it is still incomprehensible how this part of the bailout packet could end where it did.

It follows from the way Cypriot banks were funded that they have been stuffed with money, not from Cypriot pensioners and small savers but with Russian money and other foreign money hiding from attention. It has been known for a long time and what did the European Union or the ECB do about it? Not very much or at least nothing that drove this money away. Now, both Russian oligarchs and a Cypriot olive farmer are hit by the same measure. How fair is that?

One frequently mentioned thing over the last months is if Cyprus should chose the Icelandic way in terms of deposit holders. This advice normally comes without any explanation as to what was done in Iceland and seems to imply that deposit holders should or could be treated differently according to nationality. However, what was done in Iceland can’t possibly apply to Cyprus.

The deposits the Icelandic Government refrained from saving were deposits in Icelandic branches abroad, in reality so-called Icesave internet accounts in Landsbanki branches in the UK and the Netherlands. When deposits were moved into the new banks, where deposit holders could then access the funds previously held with the old banks, only deposits in Iceland were moved. – The Cypriot Government could not, on the basis of the Icelandic way, differentiate between, let us say foreign and Cypriot depositors in Cyprus. For the Cypriot Government, the problems relate to deposits in Cyprus, not abroad. Suggesting that the Cypriots follow the Icelandic course of action seems based on some ignorance about or misunderstanding of what was done in Iceland as the three banks collapsed in October 2008.

Interestingly, I am told that Greek and the Cypriot officials did ask the European Commission informally if the Icesave judgement – where the Icelandic state was not deemed to be obliged to guarantee the Deposit Guarantee Fund nor was it seen to have discriminated against deposit holders abroad (because deposits in Iceland were moved to the new banks, without the use of the Icelandic DGF) – could be of any consequence, i.e. use for them. The answer was a succinct “no.” The EU and the ECB firmly believe that the sovereign is the last guarantor of the financial system in each country – and now, in one case, a state has been allowed to confiscate money from depositors, olive farmers and oligarchs alike.

Cypriots are understandably furious – but the Cypriots, just like Icelanders some years ago, should be furious with their own politicians. There is little point in talking about neo-colonial powers. The EU, the ECB and the IMF have a say over the Cypriot economy because the way things were run in Cyprus. Being mired in debt – no matter if it is a person or a sovereign – leads to a loss of independence. That is the harsh and painful reality.

That said, it is interesting to reflect on the role of the European Union in the five bailout countries. All these countries, as well as some other Eurozone countries, made a huge effort during the 1990s to meet the EMU criteria and join the euro. But once these countries had cut off a heel there and a toe here, to fit the euro shoe the EU stopped being strict. As late as 2011, Mario Monti wrote a brilliant article in the FT, blaming the euro troubles on the EU being too deferential and too polite to its member states. The powerful states, i.a. Germany, have time and again intervened to prevent monitoring etc. (Icelog on Monti’s article here.)

Five countries have suffered from this laxness in the EU, apart of course from mistaken domestic policies. As Mervyn King wrote to his Icelandic opposite number in April 2008, explaining that the Bank of England refused to do a swap: “among friends it is sometimes necessary to be clear about what we think.” – Brutal clarity is sometimes needed but the EU failed to behave like a true friend.

And yet, there was all the time abundant evidence of things heading in the wrong direction. Olivier Blanchard, the chief economist of the IMF, lately berated by EU commissioner Olli Rehn for unhelpful additions (read “clarity”) to the debate, ended an article on Portugal in 2007 thus:

I began by arguing that Portugal faced an unusually tough economic challenge: low growth, low productivity growth, high unemployment, large fiscal and current account deficits.

I then examined various policy choices, from reforms increasing productiv- ity growth, to coordinated decreases in nominal wages, and the use of fiscal policy in this context. I want to end on a more positive note. There is a large scope for productivity increases in Portugal, and a set of reforms which could achieve them. A decrease in nominal wages sounds exotic, but is the same in essence as a successful devaluation. If it can be achieved, it can substantially reduce the unemployment cost of the adjustment. Fiscal policy can also help. While deficits must be reduced, temporary fiscal expansion could be part of an overall package, facilitating the adjustment of wages. The challenge is there. But so are the tools needed to meet it.

The first decade of the new millennium – and incidentally the first decade of the euro – is turning into a lost decade for Europe. The European Union, with its new currency, allowed the periphery – earlier with understandably high interest rates – suddenly to bask in low euro rates with the unrestrained banking systems in i.a. Germany and France only too happy to lend. When worst came to the worst, the lenders have (mostly) been spared and the inhabitants punished. No wonder the European Union is losing popularity in all of Europe as fast as the money flows out of Cypriot banks. It is painful to see that in spite of its rich intellectual heritage, Europe is now governed by extremely by narrow-minded policies and no understanding for their social consequences.

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Today, Althing – the Icelandic Parliament – in a flurry of Bills, which need to be finalised before the prime minister calls an election, changed the Law on capital controls.* Earlier, the Law was set to expire at the end of this year, meaning that the controls would expire. Now, that time limit has been removed, meaning the controls can stay forever. That is however not the intention. The Government, or rather the Central Bank of Iceland, is working on a plan to make them obsolete though it is clear it will neither happen today nor tomorrow. The appropriate minister will now have to report every six months on how that plan is going.

There are however two changes which, to my mind, are much more interesting. One is that from now on, it is not only the CBI that can give exemption from the controls. Any exemption will have to be accepted by the appropriate minister (most likely the minister of banking rather than the minister of finance though I’m not entirely sure – it doesn’t say outright), only the appropriate minister.

The other is the following (my translation; n.b. not legally binding): “The CBI can set rules on exemptions from the limitations in paragraph 1-3. The CBI can set conditions to the exemptions in the rule. These conditions can i.a. regard the origin of assets, ownership of assets, the purpose of the relevant transactions, the amount in the relevant transactions, the CBI’s supervision and reporting to the CBI. Before setting rules regarding exemption according to paragraph 1 relating to entities with a balance sheet over ISK400bn and that can have a considerable influence on the sovereign debt level and the ownership of retail banks, the minister (of finance?), as well as the minister responsible for the financial markets must be conferred with. The rules must be confirmed by the minister (of finance?).”

The reason I find this interesting is that I interpret this as the political powers wanting to meddle have a say in this matter. It could be entirely innocuous – but nothing is quite innocuous when it relates to the ownership of the two largest banks, Islandsbanki and Arion.

These two banks are now owned by foreign creditors (half of them had the mistaken belief that it didn’t matter though the banks’s balance sheet was many times the size of the economy; half have bought claims following the collapse in October 2008). There are strong forces in Iceland, very strong forces, that want to wrench the banks from “these foreigners” (as the saying goes in Iceland) and sell the banks at knock-down prices – no harm forcing more losses on “foreign banks and hedge funds” who only want to make money anyway, as if Icelandic owners would run the banks as charities. A fire-sale of the two banks would enable mostly moneyed men and pension funds to get the two banks for a song.

Those with money now in Iceland are mostly the same who had money before the collapse (with a few new names whose origin of wealth is not entirely clear) and this would enable the banks and the main businessmen and financiers to continue as if nothing had happen: own big stakes in banks and miraculously be the greatest beneficiaries of favourable loans, as was the pre-collapse custom.

This is, I admit, a rather cynic interpretation of what is going on and I would be very happy to change my mind but so far, there has not been much reason to. It is crystal clear that there is now a ferocious battle going on for assets in Iceland and the two trophy assets are these two banks: he/they who rule banks rule the country. That the political powers have now edged closer to the centre where all this will be decided is, to my mind, an indication of this ferocious battle. The battle for socially responsible banking is not lost in Iceland – not yet – but those with good political connections have won an important victory today.

*The Bill is here, in Icelandic. Earlier logs on the fate of the new banks see here.

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Although plenty is known about the collapse of the three Icelandic banks, given the SIC report, there is still one major unknown chapter in this saga: a loan of €500m granted by the Central Bank of Iceland to Kaupthing on October 6 2008, due to be repaid four days later. It is clear that about half of this loan will never be repaid. Now a parliamentary committee is investigating the loan. The only documentation of the loan is a recording of the phone call between David Oddsson then governor of the CBI and prime minister Geir Hard but so far the CBI is not assisting.

At 4pm on October 6 2008 prime minister Geir Haarde addressed the stunned nation on all media channels ending his speech with ,,god bless Iceland” – an uncustomary ending in a country where god is seldom called upon in the political realm. Interestingly, Haarde did not say the banks were failing but he talked at length about the dire situation abroad, which now could also be felt in Iceland with its outsized banks compared to the country’s economy. In these tough times for banks in many countries, he said deposits in Iceland were safe and the government would in the coming days do its utmost to hinder chaos and confusion in case “the Icelandic banks become un-operational to some extent.” He also announced the emergency legislation, which was passed later that day.

But when did the prime minister and the government actually known that the end of the banks was nigh and unavoidable? In the SIC report Haarde, Ossur Skarphedinsson minister of foreign affairs, trade and banking minister Bjorgvin Sigurdsson and minister of finance Arni Mathiesen all recount they understood this around 2am on this fateful October 6 when the ministers met three bankers from JP Morgan, called to Iceland to advise the Central Bank of Iceland. At this late hour, the three foreigners explained in a few but clear and concise words that there really was nothing to be done – the three banks were beyond salvation.

“… this was a really weird moment,” said Sigurdsson in his statement to the SIC. “Suddenly this was clear like morning light. The man just drew it on the white-board. Just all of a sudden. This was a sort of moment of truth after this insane roller coster ride weekend, which was in hindsight perhaps more or less based on wishful thinking.” (SIC report, vol 7, p. 104; only in Icelandic). – That is what it felt like to realise that the Icelandic banking system was failing: a simple drawing on a white-board.

At this meeting, Haarde finally realised he would have to address the nation and pass the emergency legislation and that is what he sat in motion as the day dawned.

On October 27 2008 the CBI put out a press release saying that on October 6 it had, after conferring with the prime minster, issued a loan of €500m to Kaupthing in order for the bank to meet its obligations to UK authorities related to the bank’s UK subsidiary.

What is known about this loan is that there is no proper documentation in the CBI regarding it. The only tangible evidence of the loan having been issued is apparently a recording of a phone call between the then governor of the CBI David Oddsson and Haarde. Kaupthing held some sort of “receipts” (but nothing resembling a loan agreement or any other formal documentation) for this amount having been paid to the bank. The loan had maturity four days later – i.e. it was a bridge loan but yes, an awfully short bridge. The collateral was nothing less than Kaupthing’s Danish subsidiary FIH Bank, at the time reckoned to be worth €670m and the interest rates set at 9%.

That Monday in the late afternoon, the loan was paid from a CBI account abroad into Kaupthing’s account with Deutsche Bank in Frankfurt in three instalments, totalling €500m. If or how it left Deutsche is not known. The €500m might have been enough to salvage Kaupthing Singer & Friedlander – the preceding week the FSA had demanded that £400m be paid as a guarantee since money was flowing fast out of the bank – but the €500m never seemed to reach the UK authorities.

The loan was not repaid four days later. Eventually, the CBI sold the collateral but the sale only brought in around half of the loan and less, if interest rates are taken into account. Consequently, this undocumented loan has caused the Icelandic state a huge loss of about €250m.

All this is now known – but it is still unknown why CBI and the prime minister thought it was necessary, let alone a good idea, to issue a loan of ca 4% of the bank’s total foreign currency reserve to a bank, which by the time the loan was issued hardly seemed a going concern. When and why the Kaupthing managers secured this loan is not known. It is not clear why the CBI issued a loan without any proper documentation or why, if there was no time right on the Monday, this was not put in place in the following days. And if the CBI really intended the loan to shore up the Kaupthing UK operations why did the bank not pay the money directly to the UK authorities?

A year ago, an Icelandic parliamentary committee started enquiring about this loan, which had caused the state such a loss. When it transpired that the only documentation regarding the loan is to be found in the recording of the phone conversation of the CBI governor and the prime minister the committee asked for a transcript. So far, the CBI has procrastinated. Last week, when the committee was finally going to publish a report on its findings, obviously pointing out the CBI’s lack of answer, the CBI sent a letter to the committee saying it was considering its options. It hinted at the possibility of  inviting the committee to read the transcript but then backtracked and has since been quiet on the issue.

Thus stands this intriguing story, so far without an ending. The report by the parliamentary committee might now be published in the coming days but apparently without information from the transcript.

There is however no lack of rumours and guesses as to why this loan was issued and what it was bridging. The most persistent rumours regard Kaupthing’s alleged Russian clients but it should be stressed that nothing has ever surfaced to corroborate the rumours. There is however a Russian element in the collapse saga: on October 7, the prime minister announced Russia was lending Iceland €4bn to strengthen its foreign reserve. This loan never materialised and it was never clear how this “offer” was made or by whom.

*The Icelandic Parliament has now published its report (in Icelandic but it is short; alors, Google translate is an option) – without an answer from the CBI on the transcript of the fateful telephone call mentioned. All the facts re the loan mentioned above can be found in the report.

**Update 31.3. 2013: Geir Haarde has recently stated that the recording of his conversation with CBI governor Oddsson was done without his knowledge and he would not agree that it was made public. As in many other countries, it is illegal in Iceland to record a phone conversation without making others on the call aware of it.

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The case that the Icelandic Office of the Special Prosecutor is bringing against three Kaupthing managers and Olafur Olafsson, at the time Kaupthing’s second largest shareholder, is coming up in the Reykjavik County Court today. It seems that now all legal quibbles the defendants brought up have been dealt with – all of them brushed aside – which means that the case can now take its course. Not quite now though, that will happen in mid April when the main proceedings are due to start. The Kaupthing managers charged are Sigurdur Einarsson, Hreidar Mar Sigurdsson and Magnus Gudmundsson.

This is by far the largest case brought so far by the OSP. There are fifty names on the witness list. One of them is the man who has given the case its name, Sheikh Mohammed bin Khalifa al Thani. The Sheikh is not accused of any wrongdoing and has not been charged but the OSP would like him to bear witness. It is not known if he will answer the request.

This case has been extensively dealt with on Icelog, i.a. here. The interesting UK angle to the story is that there are striking parallels of this loan story – a Middle Eastern investor being lent money by a bank to invest in that same bank, which then uses that investment as a sign of its rude health – in the Barclay story, also from 2008, now being investigated by the SFO, also covered earlier on Icelog.

Middle Eastern and Russian money is famously finding its way into many London-based investments and investment companies, adding glamour and building cranes to the city. The question is how sparkling clean and healthy all this money is – but as we know from the HSBC money laundering case even major banks are not too squeamish when it comes to the choosing their customers.

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