Sigrún Davíðsdóttir's Icelog

Under the demanding eyes of the IMF, the Icelandic Left Government turned the economy around – growth returned and unemployment went down. But Iceland is far from being on top of things. Both the sovereign and some of the big corporations have to meet tough payments in foreign currency in the next few years, several times more than the current account surplus. This gap can only be met with extended maturity and/or foreign loans. If the Icelandic Government is, at the same time, going to spirit money from the pockets of foreign creditors – in some cases the big banks that will most likely be asked for loans – it is difficult to see a happy ending to this saga.

“Iceland Chamber of Commerce recommends that Iceland stops comparing itself to the Nordic countries since we are way ahead of them in most respect.”  Instead, Iceland should compare itself to champions such as Ireland, Cyprus and Greece.

This statement, from a 2006 report on “Iceland in 2015” was published by the Icelandic Chamber of Commerce, at a time when it seemed Icelandic bankers and the business leaders closest to them could both fly and walk on water. The matter-of-fact statement perfectly captures the hubris in the Icelandic business community during the few years of expanding financial sector and is often quoted to demonstrate the mind-set at the time. Most of the apostolic twelve who wrote the report are tainted by the collapse in October 2008 and one of them has been charged with serious financial misconduct.

Now, anno 2013 the outlook for 2015 is rather different. In 2015, Iceland needs to have at hand current account surplus of ISK120bn, €787m, in order to cover exposure of some large enterprises like the national energy company, Landsvirkjun and Orkuveita Reykjavíkur, the Reykjavík Energy Company, OR. At present, a realistic sum to expect is ISK30-40bn, €197-262m. The outlook for the three following years is similar. The situation is carefully explained in the most recent financial stability report from the Central Bank of Iceland, CBI (so far, only in Icelandic; expected in English this coming week).

Fish and aluminium are the largest components of Icelandic exports – and since both of these are finite resources, i.a. cannot be produced ad infinitum, it is out of the question that increased exports can cover the lack of funds. Something more is needed – and this “something more” should at best be some combination of extended maturities and borrowing.*

During the election campaign, the leader of the Progressive Party Sigmundur Davíð Gunnlaugsson told Icelanders that ISK300bn, ca. €2bn, could be wrenched out of foreign creditors of the two collapsed banks, Kaupþing and Glitnir, and distributed to indebted households – nota bene, not households struggling to pay, just indebted households, which are in fact mostly the best off households (the household debt is explained in a CBI report from June 2012). Fetching this money – never quite explained how (the estates are private companies, unrelated to the sovereign) – would be easy since the foreign creditors were in great hurry to get their money out of a country with capital controls. And consequently, the capital controls would be abolished pretty soon.

None of the other parties in Alþingi, the Icelandic Parliament, wanted to follow this path. Some critics pointed out this debt-relief paid out in cash, would only fuel the already too high inflation. However, this is the promise the Progressives are working on winning support for now that they are conducting coalition talks.

No matter the outcome, finding a way to abolish the capital controls as well as solving the lack of foreign funds is the largest, most complex and most pressing task awaiting a new Government in Iceland. There is no lack of ideas in the public debate, many of them utterly unrealistic bordering on the dangerous, often aired by businessmen who never declare their own personal interests.

But who is really in hurry – and what are the issues at stake? In short, Icelandic entities are under huge financial pressure. This pressure can only be solved by foreign loans – which have to come from financial institutions some of which are creditors to the estates of the two banks, Kaupthing and Glitnir.

The claims, the creditors and the “glacier bonds”

Roughly half of the creditors of Kaupthing and Glitnir – there is quite an overlap – are the original bondholders, most of them big financial institutions. The other half are investors who bought claims post-collapse. The division is not clear-cut – bondholders often put forth some of the financing as they sell the claims in order to have a stake in the possible upside.

The original bondholders lost ca. 5-6 times the Icelandic GDP – at present ca. ISK1600bn, €10bn – the moment the three banks folded. Their losses were no doubt greatly diminished by credit insurance and most likely many of them incurred little losses. Anecdotal evidence indicates that some large loans in 2007 from foreign lenders to Icelandic entities did indeed cause losses because the lenders could not sell them on as they intended to.

Just after the collapse, the claims were sold for a song but the price rose quickly. Much is made of the astronomical profit of the creditors, often called vulture-funds in the Icelandic parlance even by those who should know that vulture funds pray on sovereigns in or facing default (trying to squeeze the sovereign to pay its bonds in full), not creditors to private companies (where the value of the estate depends on the recovery). During the election campaign Gunnlaugsson stated that there was no harm in squeezing the creditors who all, according to him, had bought their claims at 95% write-down and consequently made so much money that they had to accept some write-down. Though far from true, this statement seemed music to the ears of the voters.

For the time being Icelandic experts on the issue think the price of the claims is too high. There is a great turnover in the market for Icelandic claims – one claim has for example allegedly been sold over 60 times – but that seems to have little to do with value and more to do with incentive-structures in funds dealing in claims. The Landsbanki estate recently seized the opportunity and sold its claims in Glitnir.

In addition to the creditors of Glitnir and Kaupthing there are the owners of the so-called “glacier-bonds” – bonds sold in the years up to 2008 to profit from high interest in Iceland. The largest issuer was Toronto Dominion.

The assets at stake – and the core of the problem: ISK assets owned by foreigners

The creditors own assets worth roughly ISK2500bn, ca. 150% of GDP, whereof ISK-denominated assets amount to ca. ISK800bn. The foreign part, ISK1700 consists of ca. ISK1000bn in foreign currencies, cash and roughly ISK700bn in foreign assets, such as stakes in retail, foreign property etc. The “glacier-bonds” amount to ca. ISK400bn. All in all, the ISK “problem” amounts to ca. ISK1200bn (and could well be ISK100-200bn more, depending on valuation etc).

When the split between the old banks and the new banks was effectuated, the old banks were made to lend assets to the new banks in order to make them sustainable. This means that the estates of Glitnir and Kaupthing own the new banks almost entirely, their stakes valued at ca. ISK250bn – the Icelandic state owns 5% in Íslandsbanki and 13% in Kaupthing.

Because of the Icesave problem, Landsbanki (owned by the Icelandic state) is in a category of its own. When the new Landsbanki was founded, the new bank got a forex loan worth ca. ISK350bn, from the old bank, which it has to start repaying in 2014 but the largest repayments come in four instalments, 2015-2018. The loan being a forex loan it is a forex liability and has to be paid back in foreign currency.

The general understanding amongst those working on these issues in Iceland is that the repayment problems rising from the repayment of the Landsbanki bond, as it is generally called, have to be solved first, i.e. before the problems related to the foreign creditors. Some extension might be possibly but it is essential for new Landsbanki to refinance the loan by borrowing, obviously in foreign currency, i.e. borrowing abroad.

The core of the problem is assets owned by foreigners in Icelandic króna, these ca. ISK1200bn (though of different origin, the Landsbanki bond is part of this sum) – because there is not enough foreign currency to pay out the ISK assets. Although the scale of the problem was not clear, capital controls were put in place – weirdly late, not until November 27, 2008, almost two months after the collapse. Until the CBI and the coming Icelandic Government have figured out how to secure an orderly solution – most discussed is some sort of an exit levy, a write-down through the currency rate or a combination of both – the capital controls cannot be lifted unless greatly jeopardising the financial stability in Iceland.

None of this is news to most of the creditors many of whom follow things in Iceland closely, i.a. by being part of “Informal Creditors Committees of Kaupthing and Glitnir,” the ICCs, represented by restructuring firm Talbot Hughes McKillop Partners and the law-firms Bingham McCutchens and the Icelandic Logos Legal Services. There is now also an ad hoc committee with members from the IMF, the ECB and Icelandic institutions to discuss various ways of solving these problems. The ad hoc committee is not part of the process of solving the issues but is expected to come up with thoughts and ideas, so sorely needed. – In the end, the CBI and the Icelandic Government will have to solve the problems related to the capital controls.

But the creditors do not only have an eye on their ISK assets – they are very much vying for getting hold of their foreign assets, worth in total ISK1700bn, whereof there is ISK1000bn in foreign currency, ready for picking. Since these are foreign assets in foreign currency, they do not affect the stability of the Icelandic economy. However, the CBI will hardly want to let go of these assets until it is clear how the ISK assets are dealt with and eventual haircut.

The feeling is that the foreign creditors are ready to accept some write-down on the ISK assets against getting the entire foreign assets. As in any other Western country, the creditors are protected by property rights – and should be rather sure of their right to the foreign assets. The ISK assets are more problematic – there is not the currency to pay it out.

Composition or bankruptcy?

During 2012 creditors in both banks worked on terms of the compositions of Glitnir and Kaupthing. Because of the capital controls the CBI needs to agree to the composition. Both estates had hoped to have the composition in place by the end of last year but the CBI was not ready to negotiate the final terms. The feeling is that the CBI wanted to wait until new Government was in place; there might be some Icelanders quaking in their boots at taking these vital decisions that will affect the Icelandic economy for years to come.

With changes to laws on capital controls, made just before the Alþingi went into recess, the CBI now has to confer with ministers. When new Government is in place this will be one of its first tasks. As to time, it is difficult to imagine this will go speedily. Once source said it could take as much as 5-8 years – and obviously the repayment of the ISK assets might stretch over a very long time indeed.

There are clearly huge interests at stake but there are wheels within wheels here. The creditors want composition, which means that the estates (now holding companies not banks) will operate in the coming years to maximise recovery of assets, most noticeably the stakes in the two new banks, Íslandsbanki, owned by Glitnir creditors and Arion, owned by Kaupthing creditors. According to this plan, the banks would be sold when good buyers were found. The CBI has aired the view that it would be best to sell the banks to foreigners, or at least for foreign currency, not króna.

There are forces at large in Iceland who have been airing the opinion that the two estates should be denied composition and instead should go into bankruptcy. A bankrupt company cannot own assets, meaning that the two banks would be sold right away at an accordingly low price. This is very much against the interest of the creditors and very much in the interest of whoever wants to buy a bank at a fire-sale price.

It is another saga but the idea of the two banks again being owned by a few Icelandic shareholders with controlling stakes makes me shudder. The battle for the ownership of the two banks will be the largest battle of interests and ownership ever to be fought out in Iceland, since the 13^th Century.

The unmentioned interest group: Icelandic owners of offshore ISK

During the election campaign the Progressives, who wanted to fetch money from the creditors for the party’s generous promise of debt relief, made much of their claim that the creditors were in a hurry to get their money and run.

Surely they would no doubt want to see their assets soon but these are financial institutions and investors, many of whom have great expertise in the field of distressed assets and will be familiar with the circumstances, even with operating inside capital controls. There is nothing to indicate they are in such a hurry that they have no patience for negotiating. On the contrary, they have both knowledge and experience to deal with whatever problem is thrown at them.

The development of the ISK rate in the CBI auctions indicates that investors who bought “glacier bonds” are satisfied with the high interest rates in Iceland, compared to rates in Europe and the US. It is safe to say that there is no particular rush among many or most of the owners of “glacier bonds.”

Those who might be in a rush to release their offshore króna are Icelanders who happen to own ISK, either legally or less so. Some Icelandic businessmen have been drumming on about the importance of solving all these issues – and abolishing the capital controls – as soon as possible. Preferably by a big haircut on the foreigners and preferably by bankrupting the estates, denying them composition. These people no doubt have the decency of having the interest of the country at heart but it is less clear where their own personal interests lie. Some of these people are rumoured, in Icelandic media, to be special advisers to the leadership of the Progressive Party.

And now to the real problem: Icelandic current account surplus doesn’t cover repayments in the near future

Capital control, the ISK assets that need to be paid in foreign currency and the Landsbanki bond are problems that need to be resolved in conjunction. But quite apart from this, Iceland is facing serious current account drought – there is not enough foreign currency coming into the country to meet outstanding obligations of payment.

This is very clearly described in the latest report on financial stability from the CBI (my translation):

Domestic entities, others than the sovereign and the CBI, are facing large payments on foreign loans until 2018. The expected payments rise from ISK87bn 2014 to ISK128bn 2015 when the repayment of the Landsbanki bond will start with full force. For comparison, current account surplus in 2012 is calculated to have been ISK52bn. If the surplus remains similar in the coming years, as it has been in the past years, ca. 3-3.5% of GDP, other entities than the sovereign and the CBI need to refinance what amounts to ISK265bn until 2018.

The repayment of the Landsbanki bond is too heavy for the economy as a whole. Its maturity must be extended or it must be refinanced. Without extended maturity or considerable refinancing it is clear that there is no scope in the coming years for using the surplus to release ISK assets owned by foreigner. The interaction between abolishing the capital controls and the repayment of foreign loans is the greatest risk in the system.

Really, the risk facing the Icelandic economy cannot be stated more clearly than this. And for foreigners holding ISK assets this is bad news. Again, the creditors are highly aware of the situation – the dire situation.

Iceland has been seen as the first of crisis-hit European countries to recover. True, the economy is in its third year of growth and unemployment has peaked. But until these issues of refinancing payment obligation are safely solved, Iceland is not free of the problems that hit when the three banks collapsed in October 2008.

Now, it is also pretty clear who is in a hurry to solve the issue of refinancing debt – it is Icelanders themselves, the sovereign and others who need to repay debt in foreign currency. As pointed out in the CBI report, it is important – really of vital importance to the Icelandic economy – that foreign financial markets stay open for Icelandic entities. Arion recently borrowed money in Norway. But with interest rates above 6% this loan was more to show it could borrow than this being some sustainable solution. OR borrowed recently from Goldman Sachs but it only seems to be a facility stretching over 18 months – again, no sustainable solution. Until we see loans of 10 years maturity with sustainable interest rates the problems facing Icelandic entities are not over.

The sovereign only has debt of 58% of GDP, below the European average. We all know that Ireland, Greece and Cyprus had to turn to the troika when they lost market access. The frosty reality in Iceland is that among the creditors of Glitnir and Kaupthing there are big financial institutions to whom Icelandic entities will have to turn sooner rather than later for refinancing. Election promises to fleece foreign creditors will hardly pave the way for the kind of sustainable solution Iceland needs – and in the end, these promises could turn out to be much more expensive than just their nominal value.

*Here is a video from Bloomberg where Sigríður Benediktsdóttir director of financial stability at the CBI explains the situation.

DISCLAIMER: please observe that these are complicated issues. Certainly, none of the above should be taken as advice for any financial transactions.

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