Sigrún Davíðsdóttir's Icelog

The Memorandum of Understanding for Cyprus seems to indicate that restructuring of banks (though possibly only a timid one) should precede any financial aid to them. If this is the case, the Cyprus bailout will be a changing course in the story European bailouts.

With every Eurozone bailout, some new lessons are learnt – but so far, not the only sensible lesson: letting banks fail if needed, aggressively writing down debt and restructuring. That is a pie in the sky for European taxpayers, until the planned banking union, with not only a banking supervision but also a unified resolution structure will come into being. Until that rosy future dawns, banks are bailed out, bondholders and the official sector paid – though, as Greece shows, not always in full now.

But the Cyprus Memorandum of Understanding, the basis of its bailout, indicates that for the first time, restructuring failing banks might be a prerequisite for the bailout. If that is the case, the Cyprus bailout might help the EU turning a page – though the MoU raises the question if the restructuring is tough enough.

How much does Cyprus need?

How much is needed from the troika this time? The first numbers I heard floated earlier this year from a Cypriot source was something like €5-6bn to recapitalise the banks and slightly less for the sovereign, in total around €11bn. The number now mentioned is €17bn. Pimco, having been called in to do an independent estimate of the need, landed on €9.1-9.6bn – while others think it’s too low and €13bn would be more likely.

Much was made of the impact of the Greek writedown in March on Cypriot banks. No doubt, the effect was a serious one but the Greek writedown was only the last straw, not the real reason for the Cypriot failure. Already in the latest available IMF report, from 2011, on Cyprus there were ominous indications (emphasis mine):

The large banking sector, with assets totaling 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.

With all these significant issues further to the significant numbers:

A large banking system with heavy exposure to Greece is a major vulnerability of the Cypriot economy. Bank assets total €152 billion (835 percent of GDP), while assets of commercial banks with Cypriot parents are €92 billion (500 percent of GDP). Exposure of these banks to Greece totals €29 billion, or 160 percent of GDP, including both Greek government bonds and loans to Greek residents. They also hold €1.6 billion of Cypriot government bonds but minimal amounts of sovereign debt of other peripheral euro area countries.

And as to the Greek writedown being the lethal hit to the Cypriot banks the IMF 2011 report puts that in perspective:

Commercial banks with Cypriot parents hold €92 billion (505 percent of GDP) in assets, dominated by three large banks (Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank) which together account for 97 percent of total assets of this group. They have large foreign operations through branches and subsidiaries, primarily through the Marfin and Bank of Cyprus branches in Greece. They hold €23 billion (130 percent of GDP) in loans to Greek residents and €5 billion of Greek government bonds.

Did a 50% writedown of nominal value of €5bn in total assets of €152bn cause the collapse of the Cypriot banking system? Hardly. It was, as the 2011 IMF report shows, already a system about to collapse.

To say that loans are now being negotiated with the troika makes it seem as if Cyprus is still functioning on its own. That is not the case. As the IMF report mentions already last year Cypriot banks were receiving significant support from the ECB. Last May, FT Alphaville wrote on the ECB Emergency Liquidity Assistance Cypriot banks were making use of, gauging the banks had already had €3.8bn shot, which might well be an underestimate since this had probably been going on for a good part of 2011.

Restructuring – or tinkering?

Ever since it became clear that the troika aid to Ireland was a poisonous chalice – it saved Ireland from bankruptcy there and then but burdened the sovereign with private debt – the challenge has been how to avoid this debt migration from the private to the public sector. As is always the case under these circumstances, there are only two options for Cyprus: restructuring – or to borrow to pay its creditors in full.

During the Trichet aera at the ECB the word “restructuring” was unmentionable within the bank.

Cypriot media has published the Memorandum of Understanding between the troika and Cyprus (or at least a draft of it; in a Word version, fresh with “track changes”). Interestingly, key programme objective number 1 is:

to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management;

At least the word “restructuring” is now part of the bailout vocabulary.

Then there is this paragraph:

With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE). In order to facilitate a voluntary SLE, a small premium can be offered in line with state aid rules. To this end, the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.

As far as I understand the EU is not entirely against restructuring. But so far, the ECB cannot bring itself to go further than to junior debt – which is pretty useless in terms of solving the problem once and for all and not in painful steps over many years, à la Greece.

However, compared to the Greek MoU from February, there is a significant change in the Cyprus MoU: in Cyprus, it seems that restructuring will – or should – precede any financial assistance. In the Greek one, this was not the case. How this Cypriot restructuring will be carried out is a key thing. If it is just junior debt and not something more forceful this will be a tinkering and not the really necessary cleaning up, so lacking i.a. in Ireland.

Bailing out Cyprus – (in)directly helping the Russian Mafia?

Cyprus poses a particular problem: it is awash with Russian money. The historic ties go back before the collapse of the Soviet Union, strengthened by the Orthodox church. Later, Cyprus was the predilected offshore haven for Russian oligarchs and they actually followed the money. Limassol has the nickname Limassolgrad for a reason.

According to Spiegel, the German secret service, Bundesnachrichtendienst, BND, has warned that financial assistance to Cyprus amounts to assisting the Russian Mafia. A bailout for Cyprus is bound to raise not just the usual questions of why and how and who is paying more than others – but also how it will affect the shadowy side of the Cypriot banking system.

A year ago Cyprus got a loan of €2.5bn from Russia. This autumn, it hoped to negotiate another €5bn but the loan never materialized. The existing loan apparently has a tenor of 4 ½ years, meaning it would most likely come due during the time Cyprus is under the troika’s intensive care. The troika has to ask itself how it feels about paying back the Russian loan.

Cyprus is not only a haven for Russians. The island has all the attributes of an offshore haven, including a huge flow of money of uncertain origin. It is an international finance centre, allegedly with 40.000 companies registered on the island. Active companies pay a levy of €350 but dormant companies don’t pay anything. One of the possible revenue streams now under preparation is to let all companies, active or not, pay the levy.

My feeling has been that Cyprus was mini-Greece, i.e. unclear as to the real size of the problem though with much lower numbers in a much smaller economy. My Cypriot source tells my I’m completely wrong – 17bn is the max number sought but most likely the island will use €15bn. I am not entirely convinced, given the huge and fast-growing, ballooning banks – I’ve seen too much of the Icelandic banks – not to mention the offshore environment. Qui vivra verra.

*For those who want to see an overview of the structure of the Cypriot banking system, i.e. types of banks and business areas, with thought-provoking numbers, take a look at the very informative Box 4 in the IMF 2011 report (ah, where would we be without the deliciously juicy IMF reports… and, since I’m mentioning names, enticing Eurostat data)

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People, mostly pensioners, who previously took out equity release loans with Landsbanki Luxembourg, have for a decade been demanding that Luxembourg authorities look into alleged irregularities, first with the bank’s administration of the loans, then how the liquidator dealt with their loans after Landsbanki failed. The Duchy’s regulator, CSSF, has staunchly refused to consider this case. Yet, following criminal investigations in Iceland into the Icelandic banks, where around thirty people have been found guilty and imprisoned over the years, no investigation has been opened in Luxembourg into the Duchy operations of the Icelandic banks so far. Criminal investigation in France against the Landsbanki chairman at the time and some employees ended in January this year: all were acquitted. Recently, investors in a failed Luxembourg investment fund claimed the CSSF’s only interest is defending the Duchy’s status as a financial centre.

Out of many worrying aspects of the rule of law in Luxembourg that the Landsbanki Luxembourg case has exposed, the most outrageous one is still the intervention in 2012 of the State Prosecutor of Luxembourg, Robert Biever. At the time, a group of the bank’s clients, who had taken out equity release loans with Landsbanki Luxembourg, were taking action against the bank’s liquidator Yvette Hamilius. Then, out of the blue, Biever, who neither at the time nor later, had investigated the case, issued a press release. Siding with Hamilius, Biever stated that a small group of the Landsbanki clients, trying to avoid paying back their loans, were resisting to settle with the bank.

Criminal proceedings in Iceland against managers and shareholders of the Icelandic banks, where around 30 people have been found guilty, show that many of the dirty deals were carried out in Luxembourg. Since prosecutors in Iceland have obtained documents in Luxembourg in these cases, all of this is well known to Luxembourg authorities. Yet, neither the regulator, Commission de Surveillance du Secteur Financier, CSSF, nor other authorities have apparently seen any ground for investigations, with one exception. A case related to Kaupthing has been investigated but, so far, nothing has come out of that investigation (here more on that case, an interesting saga in itself).

However, it now seems that not only the Landsbanki Luxembourg clients have their doubts about on whose side the CSSF really is. Investors in a Luxembourg-registered fund claim they were defrauded but that the CSSF has been wholly unwilling to investigate their claims. Their conclusion: the CSSF’s only mission is to promote Luxembourg as a financial centre, which undermines “its responsibility to protect investors.”

That would certainly chime with the experience of the Landsbanki clients. Further, the fact that Luxembourg is a very small country, which greatly relies on its financial sector, might also explain why the Landsbanki Luxembourg clients have found it so difficult even to find lawyers in Luxembourg, willing to take on their case.

A slow realisation – information did not add up

It took a while before borrowers of equity release loans from Landsbanki Luxembourg started to suspect something was amiss. The messages from the bank in the first months after the liquidators took over, in October 2008, were that there was nothing to worry about. However, it quickly materialised that there was indeed a lot to worry about: the investments, which had been made as part of the loans, seemed to have been wiped out; what was left was the loan, which had to be paid off.

In addition, there were conflicting information as to the status of the loans, the amounts that had been paid out and the status on the borrowers’ bank accounts. The borrowers, mostly elderly pensioners in France and Spain, many of them foreigners, took out loans with Landsbanki Luxembourg, with their properties in these two countries as collaterals. To begin with, they were to begin with dealing with this situation alone, trying to figure out on their own what was going on. It took the borrowers some years until they had found each other and had founded an action group, Landsbanki Victims Action Group.

Landsbanki clients in Spain are part of an action group in Spain against equity release loans, The Equity Release Victims Association, Erva. The Landsbanki clients have taken the Landsbanki estate to court in Spain in order to annul the administrator’s recovery actions there. Lately, the clients have been winning but given that cases can be appealed it might take a while to bring these cases to a closure. The administrator’s attempt to repatriate Spanish court cases against the bank to Luxembourg have, so far, apparently not been successful.

Criminal case in France, civil cases in France and Spain

Finding a lawyer, both for the group and the single individuals who took action on their own, proved very difficult: it has taken a lot of time and effort and been an ongoing problem.

By January 2012, a French judge, Renaud van Ruymbeke, had opened an investigation into the loans in France. The French prosecutor lost the case in the Criminal Court of First Instance in Paris in August 2017; on 31 January 2020, the Paris Appeal Court upheld the earlier ruling, acquitting Landsbanki Luxembourg S.A., in liquidation and some of its managers and employees at the time. The case regarded the operations before the bank’s collapse, the administrator was not prosecuted. The Public Prosecutor as well as the borrowers, in a parallel civil case, have now challenged the Paris Appeal Court decision with a submission to the Cour de cassation.

While this case is still ongoing, the administrator’s recovery actions in France were understood to be on hold. According to Icelog sources, that has not entirely been the case.

Landsbanki Luxembourg: opacity before its demise in October 2008

The main issues with the bank’s marketing and administration of the loans has earlier been dealt with in detail on Icelog but here is a short overview:

As Hamilius mentioned in an interview in May 2012 with the Luxembourg newspaper Paperjam, the loans were sold through agents in Spain and France. After all, the whole operation of the equity release loans depended on agents; Landsbanki Luxembourg was operating in Luxembourg, not in France and Spain.

The use of agents has an interesting parallel in how foreign currency loans, FX loans, have been sold in Europe (see Icelog on FX loans and agents). In the case of FX loans, the Austrian Central Bank deemed that one reason for the unhealthy spread of these risky loans was exactly because they were sold through agents. Agents had great incentives to sell the loans and that the loans were as high as possible but no incentive to warn the clients against the risk. Interestingly, the sale of financial products through agents has been found illegal in some European cases regarding FX loans.*

Other questions relate to how the equity release loans were marketed, i.e. the information given, that the bank classified the borrowers as professional investors, which greatly diminished the bank’s responsibility in informing the clients and also what sort of investments they would choose for the investment part of the loan. Life insurance was a frequent part of the package, another familiar feature in FX loans.

Again, given rulings by the European Court of Justice on FX loans, it seems incomprehensible that the same conditions should not apply to equity release loans as FX loans. After all, there are exactly the same issues at stake, i.e. how the loans were sold, how borrowers were informed and classified (as professional investors though they clearly were not).

How appropriate the investments were for these types of loans and clients is an other pertinent question in this saga. After the collapse of Landsbanki Luxembourg, the borrowers discovered to their great surprise that in some cases the investments were in Landsbanki bonds, even in its shares, as well as in shares and bonds of the two other Icelandic banks, Glitnir and Kaupthing.

That the bank would invest its own loans in the bank’s bonds is simply outrageous. Already in analysis of the Icelandic banks made by foreign banks as early as 2005 and 2006, the high interconnection of the Icelandic banks, was seen as a risk. Thus, if the CSSF had at all had its eyes on these investments, made by a bank operating in Luxembourg, the regulator should have intervened.

It was also equally wholly unfitting to buy bonds in the other Icelandic banks: their credit default swap, CDS, spread made their bonds far from suitable for low-risk investments. – Interestingly, the administrator confirmed in the Paperjam interview 2012 that the loans were indeed invested in short-term bonds of Landsbanki and the two other banks: thus, there is no doubt that this was the case. – Only this fact per se, should have made the liquidator take a closer look at the time.

The value of the properties used as collaterals also raises questions. The sense is that the bank wanted to lend as much as possible to each and every borrower, thus putting a maximum value of the properties put up as collateral.

One of many intriguing facts regarding the Landsbanki Luxembourg equity release loans exposed in the French criminal case was when French borrowers told of getting loan documents in English and English borrowers of getting documents in French. As pointed out earlier on Icelog this seems to indicate a concerted effort by the bank to diminish clarity (at least in some cases, clients were promised they would get the documents in their language of choice, i.e. English borrowers getting documents in English, but the documents never materialised).

Again, this raises serious questions for the CSSF: did the bank adhere to MiFID rules at the time? And did the liquidator really see nothing worth reporting to the CSSF?

Landsbanki Luxembourg: opacity after its demise in October 2008

After Landsbanki Luxembourg failed in October 2008, Yvette Hamilius and Franz Prost were appointed liquidators for Landsbanki. Following Prost’s resignation in May 2009, Hamilius has been alone in charge. As the Court had originally appointed two liquidators the Court could have been expected to appoint another one after Prost resigned. That however was not the case. Not in Luxembourg. There have been some rumours as to why Prost resigned but nothing has been confirmed.

Be that as it may, the relationship between Hamilius and the borrowers has been a total misery for the borrowers. One of the things that early on led to frustration and later distrust were conflicting and/or unexplained figures in statements. Clarification, both on figures on accounts, and more importantly regarding the investments, was not forthcoming according to borrowers Icelog has heard from.

Hamilius’ opinion of the borrowers could be seen from the Paperjam interview in 2012 and from the remarkable statement from State Prosecutor Biever: the liquidator’s unflinching view was that the borrowers were simply trying to make use of the fact the bank had failed in order to save themselves from repaying the loans.

The interview and the statement from Biever came as a response to when a group of borrowers tried to take legal action against the Landsbanki Luxembourg and its liquidator. In the interview, Hamilius was asked if she was solely trying to serve the interest of Luxembourg as a financial centre, something she staunchly denied.

The action against Landsbanki Luxembourg has so far been unsuccessful, partly because Luxembourg lawyers are noticeably unwilling to take action against a bank, even a failed bank. In that sense, anyone trying to take action against a Luxembourg financial firm finds himself in a double whammy: the CSSF has proved to be wholly unsympathetic to any such claims and finding a lawyer may prove next to impossible.

Why was the investment part of the Landsbanki Luxembourg equity release loans killed off?

The key characteristic of equity release loans is that this product consists of a loan and investment, two inseparable parts. However, that proved not to be the case in the Landsbanki Luxembourg loans. Suddenly, after the demise of the bank, the borrowers found themselves to be debtors only, with the investment wiped out. This did fundamentally alter the situation for the borrowers.

The liquidator seems allegedly to have taken the stance that to a great extent, there was nothing to do about the investments in these cases where the bank had invested in Icelandic bank shares and bonds. That is an intriguing point: as pointed out earlier, the bank should never have been allowed to make these investments on behalf of these clients.

In Britain, as in many European countries, the law in general stipulates that if a lender fails, loans are not to be payable right away. As far as I can see, this counts for equity release loans as well: both parts of the loan should be kept going, the loan as well as the investment. Frequently, a liquidator sells off the package at a discount, for another company to administer, in order to be able to close the books of the failed bank.

This has not been the case in Landsbanki Luxembourg equity release loans, the investments were wiped out – and yet, Luxembourg authorities have paid no attention at all to the borrowers’ claims of unfair treatment by the liquidator.

As mentioned above, Hamilius’ version of the sorry saga is that the borrowers are simply unwilling to repay the loan.

The dirty deals of the Icelandic banks in Luxembourg

The recurrent theme in so many of the criminal cases in Iceland after the banking collapse 2008 against bankers and others related to the banks is the role of the banks’ subsidiaries in Luxembourg. The dirtiest parts of the deals were done through the Luxembourg subsidiaries (particularly noticeable in the Kaupthing cases). Since Hamilius has assisted investigations into Landsbanki in Iceland, she will be perfectly well aware of the Icelandic cases related to Landsbanki.

The administrators of the Icelandic banks in Iceland were crucial in providing material for the criminal proceedings in Iceland. Yet, as far as can be seen, the administrator has allegedly not deemed it necessary to take a critical look at the Landsbanki operations in Luxembourg. Which is why no questions regarding the equity release loans have been raised by the administrator with Luxembourg authorities.

The incredibly long winding-up saga at Landsbanki Luxembourg

One interesting angle of the winding-up of Landsbanki Luxembourg saga is the time it is taking. The administrators (winding-up boards) of the three large Icelandic banks, several magnitudes larger than Landsbanki Luxembourg, more or less finished their job in 2015, after which creditors took over the administration of the assets, mostly to sell them off for the creditors to recover their funds. The winding-up proceedings of LBI ehf., the estate of Landsbanki Iceland, came to an end in December 2015, when a composition agreement between LBI ehf. and its creditor became effective.

For some years now, the LBI ehf has been the only creditor of Landsbanki Luxembourg, i.e. all funds recovered by the liquidator go to LBI ehf. Formally, LBI ehf has no authority over the Landsbanki Luxembourg estate. Yet, it is more than an awkward situation since LBI ehf is kept in the waiting position, while the liquidator continues her actions against the equity release borrowers, whose funds are the only funds yet to be recovered.

That said, Luxembourg is not unused to long winding-up sagas. The fall of the Luxembourg-registered Bank of Credit and Commerce International, BCCI, in 1991, was one of the most spectacular bankruptcies in the financial sector at the time, stretching over many countries and exposing massive money laundering and financial fraud. Famously, the winding-up took well over two decades, depending on countries. Interestingly, Yvette Hamilius was one of several administrators, in charge of the process from 2003 to 2011; the winding-up was brought to an end in 2013.

The CSSF on a mission to protect its financial sector, not investors

Recently, another case has come up in Luxembourg that throws doubt on whose interest the CSSF mostly cares for: the financial sector it should be regulating or investors and deposit holders. A pertinent question, as pointed out in an article in the Financial Times recently (23 Feb., 2020), since Luxembourg is the largest fund centre in Europe, with €4.7tn of assets under management and gaining by the day as UK fund managers shift business from Brexiting Britain to the Duchy.

The recent case seems to rotate around three investment funds – Columna Commodities, Aventor and Blackstar Commodities – domiciled in Luxembourg, sub funds of Equity Power Fund. As early as 2016, the CSSF had expressed concern about the quality of the investments: astoundingly, 4/5 of the investments were concentrated in companies related to a single group. Lo and behold, this all came crashing down in 2017.

The investors smelled rat and contacted David Mapley at Intel Suisse, a financial investigator who specialises in asset recovery. Mapley has a success to show: in 2010 he won millions of dollars from Goldman Sachs on behalf of hedge funds, which felt cheated by the bank.

In order to gain insight into the Luxembourg operations, Mapley was appointed a director of LFP I, one of the investment funds in the Equity Power Fund galaxy. (Further on this story, see Intel Suisse press release August 2018 and coverage by Expert Investor in January and October 2019.)

According to the FT, the directors of LFP I claim the CSSF has not lived up to its obligation under EU law. They have now submitted a complaint against the CSSF to European Securities and Markets Authority, Esma, which sets standards and supervises financial regulators in the EU.

In a letter to Esma, Mapley states that the CSSF’s “marketing mission to promote Luxembourg as a financial centre” has undermined its focus on protecting investors. Mapley also alleges the CSSF has attempted to quash the directors’ investigations into mismanagement and fraud by the funds’ previous managers and service providers in order to undermine the funds’ efforts “and prevent any reputational risk”. – That is, the reputational risk of Luxembourg as a financial centre.

As FT points out, investors in a Luxembourg-listed fund that invested in Bernard Madoff’s $50bn Ponzi scheme have also accused the CSSF of leniency, i.e. sheltering the fraudster and not the investors.

Luxembourg, the stain on the EU that EU is unwilling to rub off

Worryingly, the CSSF’s lenient attitude might be more prominent now than ever as Luxembourg competes with other small European jurisdictions of equally doubtful reputation such as Cyprus and Malta (where corrupt politicians set about to murder a journalist, Daphne Caruana Galizia, investigating financial fraud; brilliant Tortoise podcast on the murder inquiry) in attracting funds leaving the Brexiting UK. Esma has been given tougher intervention powers, though sadly watered down from the original intension, in order to hinder a race to the bottom. It is very worrying that the EU does not seem to be keeping an eye on this development.

As long as this is the case, corrupt money enters Europe easily, with the damaging effect on competition, businesses, politics – and ultimately on democracy.

*Foreign currency loans, FX loans, have been covered extensively on Icelog, see here. For a European Court of Justice decision in the first FX loans case, see Árpád Kásler and Hajnalka Káslerné Rábai v OTP Jelzálogbank Zrt, Case C‑26/13.

 

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The Bill passed by the Icelandic parliament in December 2008 on setting up an independent investigative commission, the Special Investigative Commission did not catch much attention at the time. The goal was nothing less than finding out the truth in order to establish events leading up to the 2008 banking collapse, analyse causes and drawing some lessons. The SIC report was an exemplary work and immensely important at the time to establish a narrative of the crisis. But in hindsight, there is yet another lesson to be learnt: its importance does not diminish with time as it helps to counteract special interests seeking to rewrite history.

There were no big headlines when on 12 December 2008 Alþingi, the Icelandic parliament, passed a Bill to set up an investigative commission “to investigate and analyse the processes leading to the collapse of the three main banks in Iceland,”which had shaken the island two months earlier. The palpable lack of enthusiasm and attention was understandable: the nation was still stunned and there was no tradition in Iceland for such commissions. No one knew what to expect, the safest bet was to not expect very much.

That all changed when the Commission presented its results in April 2010. Not only was the report long – 2600 pages in print in addition to online-only material – but it did actually tell the real story behind the collapse: the immensely rapid growth of the banks, from one GDP in 2002 to ten times the GDP in 2008, the stronghold the largest shareholders, incidentally also the largest borrowers, had on the banks’ managements, the political apathy and lax regulation by weak regulators, stemming from awe of the financial sector.

Unfortunately, the SIC report was not translated in full into English; see executive summary and some excerpts here.

With time, the report’s importance has not diminished: at the time, it clarified what had happened thus preventing those involved or others with special interest, to reshape the past according to their own interests. With time, hindering the reshaping of the past has become of major importance, also in order to draw the right lessons from the calamitous events in October 2008.

What was the SIC?

According to the December 2008 SIC Act (in Icelandic), the goal was setting up an investigative commission, that would, at the behest of Alþingi, seek “the truth about the run-up to and the causes of the collapse of the Icelandic banks in 2008 and related events. [The SIC] is to evaluate if this was caused by mistake or neglect in carrying out law and regulation of the financial sector in Iceland and its supervision and who could be held responsible for it.” – In order to fulfil its goal the SIC was inter alia to collect information on the financial sector, assess regulation or lack thereof and come up with proposals to prevent the repetition of these events.

In some countries, most notably in South Africa after apartheid, “Truth Commissions,” have played a major part in reconciliation with the past. Although the remit of the Icelandic SIC was to establish the truth, the SIC was never referred to as a “truth commission” in Iceland though that concept has been used in foreign coverage of the SIC.

The SIC had the power to make use of a vast array of sources, both by calling in people to be questioned and documents, public or private such as bank data, including data on named individuals, data from public institutions, personal documents and memos. Data, normally confidential, had to be shared with the SIC, which was obliged to operate as any other public body handling sensitive or confidential information.

Although the SIC had to follow normal procedures of discretion on personal data the SIC could “publish information, normally subject to discretion, if the SIC deems this necessary to support its conclusions. The Commission can only publish information on personal matters of named individuals, including their financial affairs, if the public interest is greater than the interest of the individuals concerned.” – In effect, this clause lift banking secrecy.

One source close to the process of setting up the SIC surmised the political intentions behind the SIC Act did not include lifting banking secrecy, indicating that the extensive powers given to the SIC were accidental. Others have claimed the SIC’s extensive powers were always part of the plan. I am in two minds about this but my feeling is that the source close to the process was right – the powers to scrutinise the main shareholders were far greater than intended to begin with.

Naming the largest borrowers, incidentally also the largest shareholders

Intentional or not, the extensive powers enabled naming the individuals who received the largest loans from the banks, incidentally their largest shareholders and their closest business partners. This was absolutely essential in order to understand how the banks had operated: essentially, as private fiefdoms of the largest shareholders.

In order to encourage those called in for questioning to speak freely, the hearings were held behind closed doors; there were no public hearings. The SIC had extensive powers to call people in for questioning: it could ask for a court order if anyone declined its invitation, with the threat of taking that person to court on grounds of contempt in case the invitation was declined.

Criminal investigation was not part of the SIC remit but its power to call for material or call in people for questioning was parallel to that of a prosecutor. As stated in the report, the SIC was obliged to inform the State Prosecutor if there was suspicion of criminal conduct:

The SIC’s assessment, pursuant to Article 1(1) of Act no. 142/2008, was mainly aimed at the activities of public bodies and those who might be responsible for mistakes or negligence within the meaning of those terms, as defined in the Act. Although the SIC was entrusted with investigating whether weaknesses in the operations of the banks and their policies had played a part in their collapse, the Commission was not expected to address possible criminal conduct of the directors of the banks in their operations.

As to suspicion of civil servants having failed to fulfil their legal duties, the SIC was supposed to inform appropriate instances. The SIC was not obliged to inform the individuals in question. As to ministers, the SIC was to follow law on ministerial responsibility.

The three members

The SIC Act stipulated it should have three members: the Alþingi Ombudsman, then as now Tryggvi Gunnarsson, an economist and, as a chairman, a Supreme Court Justice. The nominated economist was Sigríður Benediktsdóttir, then lecturer at Yale University (director of Financial Stability at CBI 2012 to 2016 when she returned to Yale). The chairman was Páll Hreinsson (since 2011 judge at the EFTA Court).

In addition to the Commission there was a Working Group on Ethics: Vilhjálmur Árnason professor of philosophy, Salvör Nordal director of the Centre for Ethics, both at the University of Iceland and Kristín Ástgeirsdóttir director of the Equal Rights Council in Iceland. Their conclusions were published in Vol. 8 of the SIC report.

In total, the SIC had a staff of around 30 people. As with the Anton Valukas report, published in March 2010, on the collapse of Lehman Brothers, organising the material, especially the data from the banks, was a major task. The SIC had access to the databases of the three collapsed banks but had only limited data from the banks’ foreign operations.

There were absolutely no leaks from the SIC, which meant it was unclear what to expect. Given its untrodden path, the voices expressing little faith were the most frequently heard. I had however heard early on, that the SIC had a firm grip on turning material into searchable databases, which would mean a wealth of material. With qualified members and staff, I was from early on hopeful that given their expertise of extracting and processing data the SIC report would most likely prove to be illuminating – though I certainly did not imagine how extensive and insightful it turned out to be.

Greed, fraud and the collapse of common sense

After the October 2008 collapse, my attention had been on some questionable practices that I heard of from talking to sources close to the failed banks.

One thing I had quickly established was how the banks, through their foreign subsidiaries, had offshorised their Icelandic clients. This counted not only for the wealthy businessmen who obviously understood the ramifications of offshorising but also people with relatively small funds. These latters had in many cases scant understanding of these services.

In the last few years, as information on offshorisation has come to the light via Offshoreleaks etc., it has become clear that Iceland was – and still is – the most offshorised country in the world (here, 2016 Icelog on this topic). Once the “art” of offshorisation is established, with all the vested interests accompanying it, it does not die easily – this might be considered one of the failed banks’ more evil legacies.

Another point of interest was how the banks had systematically lent clients, small and large, funds to buy the banks’ own shares, i.e. Kaupthing lent funds to buy Kaupthing shares etc. Cross-lending was also a practice: Bank A would lend clients to buy Bank B shares and Bank B lent clients to buy Bank A shares. This was partly used to hinder that shares were sold when buyers were few and far behind, causing fall in market value. In other words, massive market manipulation had slowly been emerging. Indeed, the managers of all three failed banks have in recent years been sentenced for market manipulation.

It had also emerged, that the banks’ largest shareholders/clients and their business partners had indeed been what I have called “favoured clients,” i.e. enjoying services far beyond normal business practices. One side of this came to light in the banks’ covenants in lending agreements: in the case of the “favoured clients,” the lending agreements tended to guarantee clients’ profit, leaving the banks with the losses. In other words, the banks took on far greater portion of the risk than these clients.

Icelog blogs I wrote in February 2010, before the publication of the SIC report, give some sense of what was known at the time. Already then, it seemed fair to conclude that greed, fraud and the collapse of common sense had been decisive factors in the event in Iceland in October 2008.

Monday morning 12 April 2010 – when time stood still in Iceland

The excitement in Iceland on Monday morning 12 April 2010 was palpable. The press conference was transmitted live. All around Iceland employers had arranged for staff to watch as the SIC presented its conclusions.

After Páll Hreinsson’s short introduction, Sigríður Benediktsdóttir gave an overview of the main findings regarding the banks, presenting “The main reasons for the collapse of the banks,” followed by Tryggvi Gunnarsson’s overview of the reactions within public institutions (here the presentations from the press conference, in Icelandic).

The main reason for the collapse of the three banks was their rapid growth and their size at the time they collapsed; the three big banks grew 20-fold in seven years, mainly 2004 and 2005; the rapid expansion into new/foreign markets was risky; administration and due diligence was not in tune with the banks’ growth; the quality of loans greatly deteriorated; the growth was not in tune with long-time interest of sound banking; there were strong incentives within the banks grow.

Easy access to short-term lending in international markets enabled the banks’ rapid growth, i.e. the banks’ main creditors were large international banks. With the rapid expansion, also abroad, the institutional framework in Iceland, inter alia the Central Bank and the FME, quickly became wholly inadequate. The under-funded FME, lacking political support, was no match for the banks, which systematically poached key staff from the FME. Given the size of the humungous size of the Icelandic financial system relative to GDP there was effectively no lender of last resort in Iceland; the Central Bank could in no way fulfil this role.

This had no doubt be clear to the banks’ management for some time. In his book, “Frozen Assets,” published in 2009, Ármann Þorvaldsson, manager of KSF, Kaupthing’s UK operation, writes that he “always believed that if Iceland ran into trouble it would be easy to get assistance from friendly nations… despite the relative size of the banking system in Iceland, the absolute size was of course very small.” (P. 194). – A breath-taking recklessness, naivety or both but might well have been the prevalent view at the highest echelons of the Icelandic financial sector at the time.

The banks’ largest shareholders and their “abnormally easy access to lending”

When it came to “Indebtedness of the banks’ largest owners” the conclusions were truly staggering: “The SIC concludes that the owners of the three largest banks and Straumur (investment bank where the main shareholders were the same as in Landsbanki, i.e. Björgólfur Thor Björgólfsson and his fater) had abnormally easy access to lending in these banks, apparently only because their ownership of these banks.”

The largest exposures of the three large banks were to the banks’ largest shareholders. “This raises the question if the lending was solely decided on commercial terms. The banks’ operations were in many ways characterised by maximising the interest of the large shareholders who held the reins rather than running a solid bank with the interest of all shareholders in mind and showing reasonable responsibility towards shareholders.” – Creative accounting helped the banks to avoid breaking rules on large exposures.

Benediktsdóttir showed graphs to illustrate the lending to the largest shareholders in the various banks. It is worth keeping in mind that these large shareholders all had foreign assets and were all clients of foreign banks as well. In general, the Icelandic lending shot up in 2007 when international funding dried up. At this point, the Icelandic banks really showed how favoured the large shareholders were because these clients were, en masse, getting merciless margin calls from their foreign lenders.

In reality, the Icelandic banks were at the mercy of their shareholders. If the large shareholders and/or their holding companies would default, the banks themselves were clearly next in line. The banks could not make margin calls where their own shares were collateral as it would flood the markets with shares no one wanted to buy with the obvious consequence of crashing share prices.

Two of the graphs from the SIC report, shown at the press conference in April 2010, exposed the clear drift in lending at a decisive time: to Björgólfur Thor Björgólfsson, still an active investor based in London and to Fons, a holding company owned by Pálmi Haraldsson, who for years was a close business partner of Jón Ásgeir Jóhannesson, once a king on the UK high street with shops like Iceland, Karen Millen, Debenhams and House of Fraser to his name.

The lending related to Fons/Haraldsson is particularly striking since Haraldsson was part of the consortium Jóhannesson led in spring of 2007 to buy around 40% of Glitnir: after the consortium bought Glitnir, the lending to Haraldsson shot up like an unassailable rock.

Absolution of risk

The common thread in so many of the SIC stories was how favoured clients – and in some cases bank managers themselves – were time and again wholly exempt from risk. One striking example is an email (emphasis mine), sent by Ármann Þorvaldsson and Kaupthing Luxembourg manager Magnús Guðundsson, jokingly calling themselves “associations of loyal CEOs,” to Kaupthing’s chairman Sigurður Einarsson and CEO Hreiðar Sigurðsson.

“Hi Siggi and Hreidar, Armann and I have discussed this (association of loyal CEOs) and have come to the following conclusion on our shares in the bank: 1. We set up a SPV (each of us) where we place all shares and loans. 2. We get additional loans amounting to 90% LTV or ISK90 to every 100 in the company which means that we can take out some money right away. 3. We get a permission to borrow more if the bank’s shares rise, up to 1000. It means that if the shares go over 1000 we can’t borrow more. 4. The bank wouldn’t make any margin calls on us and would shoulder any theoretical loss should it occur.We would be interested in using some of this money to put into Kaupthing Capital Partners [an investment fund owned by the bank and key managers] Regards Magnus and Armann”

This set-up, where the borrower is risk-free and the bank shoulders all the risk, has lead to several cases where bankers being sentenced for breach of fiduciary duty, i.e. lending in such a way that it was from the beginning clear that losses would land with the bank. (Three of these Kaupthing bankers, Guðmundsson, Einarsson and Sigurðsson, not Þorvaldsson, have been charged and sentenced in more than one criminal case).

The “home-knitted” crisis

Due to measures taken in October 2008 in the UK against the Icelandic banks, there was a strong sense in Iceland that the Icelandic banks had collapsed because of British action. The use of anti-terrorism legislation by the British government against Landsbanki greatly contributed to these sentiments.

A small nation, far away from other countries, Icelanders have a strong sense of “us” and “the others.” This no doubt exacerbated the understanding in Iceland around the banking collapse that if it hadn’t been for evil-meaning foreigners, hell-bent on teaching Iceland a lesson, all would have been fine with the banks. Some leading bankers and large shareholders were of the opinion that Icelanders had been such brilliant bankers and businessmen that they had aroused envy abroad: British action was a punishment for being better than foreign competitors (yes, seriously; see for example Þorvaldsson’s book “Frozen Assets”).

The story told in the SIC report showed convincingly and in great detail how wrong all of this was: the banks had dug their own grave. Icelandic politicians and civil servants had tried their best to fool foreign countries and institutions how things stood in Iceland. Yes, the turmoil in international markets toppled the Icelandic banks but they were weak due to bad governance, great pressure by the largest shareholders and then weak infrastructure in Iceland, as I pointed out in a blog following the publication of the SIC report.

This understanding is at times heard in Iceland but the convincing and well-documented story told in the SIC report has slowly all but eradicated this view.

Court cases and political controversies

Some, but by far not all, of the dubious deals recounted in the SIC report have ended up in court. The SIC brought a substantial amount of cases deemed suspicious to the attention of the Office of Special Prosecutor, incidentally set up by law in December 2008. However, most if not all of these cases had also been spotted by the FME, which passed them on to the Special Prosecutors.

CEOs and managers in all three banks have been sentenced in extensive market manipulation cases – the bankers were shown to have directed staff to sell and buy shares in a pattern indicating planned market manipulation. In addition, there have been cases involving shareholders, most notably the so-called al Thani case (incidentally strikingly similar to the SFO case against four Barclays bankers) where Ólafur Ólafsson, Kaupthing’s second largest shareholder, was sentenced to 5 1/2 years in prison, together with the bank’s top management.

In total, close to thirty bankers and major shareholders have been sentenced in cases related to the old banks, the heaviest sentence being six years. The cases have in some instances thrown an interesting light on operations of international banks, such as the CLN case on Deutsche Bank.

The SIC’s remit was inter alia to point out negligence by civil servants and politicians. It concluded that the Director General of the FME Jónas Fr. Jónsson and the three Governors of the CBI, Davíð Oddsson, Eiríkur Guðnason and Ingimundur Friðriksson, had shown negligence as defined in the law “in the course of particular work during the administration of laws and rules on financial activities, and monitoring thereof.” – None of them was longer in office when the report was published in April 2010 and no action was taken against them.

The Commission was of the opinion that “Mr. Geir H. Haarde, then Prime Minister, Mr. Árni M. Mathiesen, then Minister of Finance, and Mr. Björgvin G. Sigurðsson, then Minister of Business Affairs, showed negligence… during the time leading up to the collapse of the Icelandic banks, by omitting to respond in an appropriate fashion to the impending danger for the Icelandic economy that was caused by the deteriorating situation of the banks.”

It is for Alþingi to decide on action regarding ministerial failings. After a long deliberation, Alþingi voted to bring only ex-PM Geir Haarde to court. According to Icelandic law a minister has to be tried by a specially convened court, which ruled in April 2012 that the minister was guilty of only one charge but no sentence was given (see here for some blogs on the Haarde case). Geir Haarde brought his case to the European Court of Human Rights but the judgment went against him. Haarde is now the Icelandic ambassador in Washington.

The SIC lacunae

In hindsight, the SIC was given too short a time. With some months more, the role of auditors in the collapse could for example have been covered in greater detail. It is quite clear that the auditing was far too creative and far too wishful, to say the very least. The relationship between the banks and the four large international auditors, who also operate in Iceland, was far too cosy bordering on the incestuous.

The largest gap in the SIC collapse story stems from the fact that the SIC had little access to the banks foreign operations. Greater access would not necessarily have altered the grand narrative. But court cases have shown that some of the banks’ criminal activities, were hidden abroad, notably in the case of Kaupthing Luxembourg. – As I have time and again pointed out, it is incomprehensible that authorities in Luxembourg have not done a better job of investigating the banking sector in Luxembourg. The Icelandic cases are a stern reminder of this utter failure.

As mentioned above, only excerpts of the report were translated into English. To my mind, this was a big error and extremely short-sighted. Many of the stories in the report involve foreign banks and foreign clients of the Icelandic banks. The detailed account of what happened in Iceland throws light on not only what was going on in Iceland but also in other countries where the banks operated. The excerpts are certainly better than nothing but by far not enough – publishing the whole report in English would have done this work greater justice and been extremely useful in a foreign context.

Why the SIC report’s importance has grown with time

It is now just over eight years since the publication of the SIC report. Whenever something related to the collapse is discussed the report is a constant source and the last verdict. The report established a narrative, based on extensive sources, both verbal and written.

Some of those mentioned in the report did not agree with everything in the report. When they sent in their own reports these have been published on-line. However, undocumented statements amount to little compared to the report’s findings. Its narrative and conclusions can’t be dismissed without solid and substantiated arguments to counter its well-documented conclusions.

This means the story of the 2008 banking collapse cannot easily be reshaped. This is important because changing the story would mean undermining its conclusions and lessons to be learnt. In a recent speech, Tory MP Tom Tugendhat mentioned the UK financial crisis as the “forces of globalisation.” These would be the same forces that caused the collapse of the Icelandic banks – but from the SIC report Icelanders know full well that this is far too imprecise a description: the banks, both in the UK and Iceland, collapsed due to lack of supervision and public and political scrutiny, following year of lax policies.

Lessons for other countries

In order to learn from the financial crisis, countries need to know why there was a crisis – with no thorough analysis no lessons can be learnt. Also, not only in Iceland was criminality part of the crisis. Though not a criminal investigation, many of these stories surfaced in the SIC report, another important aspect.

Greece, Cyprus, UK, Ireland, US – five countries shaken and upset by overstretched banks, which needed to be bailed out at great expense and pain to taxpayers. However, all of these countries have kept their citizens in the dark as to what happened apart from some tentative and wholly inadequate attempts. The effect of hiding how policies and actions of individuals, in politics, banking etc, caused the calamities has partly been the gnawing discontent and lack of trust, i.a. visible in Brexit and the election of Donald Trump as US president.

Although Iceland enjoyed a speedy recovery (Icelog Sept. 2015), I’m not sure there are any particular economic lessons to be learned from Iceland. There were no magic solutions in Iceland. What contributed to a relatively speedy recovery was the sound state of the economy before the crisis, classic but unavoidably painful economic measures, some prescribed by the IMF, in 2008 and the following years – and some luck. If there is however one lesson to learn it is the importance of a thorough analysis of the causes of the crisis.

The SIC was, and still is, a shiny example of thorough investigative work following a major financial crisis, also for other countries. It did not alleviate anger; anger is still lingering in Iceland. An investigative report is not a panacea, nothing is, but it is essential to establish what happened and why, with names named.

There are never any mystical “forces” or laws of nature behind financial crisis and collapse. They are caused by a combination of human actions, which can all be analysed and understood. Without analysis and investigations it is easy to tell the wrong story, ignore the causes, ignore responsibility – and ultimately, ignore the lessons.

This is the second blog in “Ten years later” – series on Iceland ten years after the 2008 financial collapse, running until the end of this year.

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During the Cold War, both the United States and the Soviet Union used various ways to influence political leaders and decision makers all over the world. Parts of the Soviet power structure, most notably of the KGB, live on in Russia. Three angles are of interest: 1) Vladimir Putin’s Russia has for years sought to influence the West via Nord Stream. 2) Admiration of Putin as the strong man thrives on the far Right in Europe and elsewhere. 3) The evolving saga of US president Donald Trump’s Russian ties might show a new side of Russian influence if it turns out that the Trump empire did receive Russian funds in its hour of need. – In addition, the Magnitsky Act proves to be an intriguing prism on Russian influence in the West.

Nord Stream and Nord Stream 2

The planning of a Russian gas pipeline from Russia to Europe started in the 1990s. It happened in an atmosphere of uncertainty following the collapse of the Soviet Union as to how the Russian relationship with the democratic West could or would develop. Some even thought Russia could join the North Atlantic Treaty Organisation, Nato.

From the beginning, Nord Stream was developed within and closely related to Gazprom, the Russian state-owned natural gas company founded in 1989 and a key factor in the Russian power structure. The first concrete step towards the pipeline was taken in 1997 but in 2005, the year the construction started, Nord Stream AG was incorporated in Zug, Switzerland. Gazprom has had various partners over the years but it still holds 51% of the shares.

In the countries affected by Nord Stream – Poland, the Baltic states, Finland, Sweden, Denmark and Germany – the effect of the pipeline in terms of environmental effect, national security, energy security and political influence has been a hotly debated topic all these years.

The pipeline was ceremoniously inaugurated in 2011 by Russian president Dmitry Medvedev, German Chancellor Angela Merkel and French Prime Minister Francois Fillon. Nord Stream 2 is now being planned.

Nordstream has always been about “Russia’s pipeline power” as Edoardo Saravelle at the Center for a New American Security wrote recently: Russia’s attempt to influence the US reaches far beyond attempting to influence the US presidential elections. “The pipeline is a naked Russian attempt to divide and conquer Europe. What makes the Kremlin so clever, and this effort so insidious, is that Gazprom has engineered an attractive business case for the project for a number of European gas importers,” writes Saravelle.

Due to the geo-political dimension of Nord Stream not only politicians and voters in the affected countries were interested in the Nord Stream development but also US politicians.

The Nord Stream effect

As German Chancellor 1998 to 2005, the social democratic leader Gerhard Schröder showed to begin with little liking for Boris Yeltsin’s Russia. That changed when Vladimir Putin, fluent in German after living there as a KGB agent, rose to power. One sign of Schröder’s strong ties to Russia was his enthusiasm for the Baltic gas pipeline and Nord Stream. One of Schröder’s last acts in office was to agree to a state guarantee of €1bn for part of the Nord Stream construction cost.

Only weeks after stepping down as Chancellor, Schröder accepted the Nord Stream offer to become head of the shareholder group of Nord Stream AG, a post he still holds. Not only Germans were shocked. Washington Post wrote an editorial on what the paper called Schröder’s “Sellout” – Democrat Congressman Tom Lantos, a holocaust survivor who died in 2008, chair of the House of Representatives foreign relations committee said that Schröder’s close ties to the Russian energy sector was “political prostitution.”

Equally, it shocked many Fins in 2008 when their social democratic Prime Minister 1995 to 2003 Paavo Lipponen became a Nord Stream consultant. A year later, Poland blocked Lipponen from being put forward as EU foreign policy chief because of his work for Nord Stream.

The new US sanctions against Russia enjoy a large bipartisan support in spite of Trump’s opposition. The new sanctions threaten to hit European companies working on the Nord Stream 2 joint venture with Russia, a major headache for the EU.

The far Right admiration for Putin

As social democrats and in spite of their ties to Putin’s Russia, both Schröder and Lipponen have been advocates of a strong and united Europe Union. But over the last decade or so, many far Right politicians in Europe and the US have shown great sympathy and even admiration for Putin.

Wholly ignoring the dismal state of the Russian economy under Putin and no matter his decidedly undemocratic and despotic tendencies many on the far Right seem to admire him as a strong leader. They have swallowed Putin’s own portrayal of himself, utterly ignoring that Putin’s iconography is unattached to reality.

The French leader of Front National Marine Le Pen and UKIP’s Nigel Farage are part of the Putin fan club. As is Republican congressman of California, Dana Rohrabacher who met with Putin in the 1990s and is known as one of Putin’s staunchest allies on Capital Hill, according to a May 2017 New York Times article.

This may well be a question of values but it can also be interpreted as flirting with an autocratic rule, characterised by “Constraints on the press, centralisation of power and various elements of nationalism” combined “with a backlash against progressive ideals and globalisation” as Olga Oliker expressed it in an article for International Institute for Strategic Studies, IISS.

Trump: more than a political admirer of Putin?

Donald Trump has shown the same admiration for Putin and autocratic rule as many on the far Right though Trump can in many ways not entirely be defined as a far Right; his vision is too rambling to show a single direction.

During his electoral campaign Donald Trump certainly flirted with ideas of autocratic rule: the idea that the president could do this and that unhampered by the House and the Senate, his many utterances against the media, his nationalistic stance and emphasis on US first, his disdain of international agreement and free trade.

Same tendencies can be found in his words and actions, or attempts to action, as president. And he does not hold back in his admiration for Putin as a person and a leader.

Last year, Republican Congressman and the House majority leader Kevin McCarthy was caught on tape saying: “There’s two people I think Putin pays: Rohrabacher and Trump.” McCarthy now says this was only a poor joke. However, indications of a much more direct Russian Trump connection than only an ideological dallying with anti-democratic ideas have now led to the investigation led by Richard Mueller.

Make Russia great again

Former National Intelligence Director James Clapper recently said that Trump’s actions were “making Russia great again.” – There is a certain irony that a US President who got voted on the slogan Make America Great Again is now being investigated for Russian ties – and one does not need Cold War glasses to understand the severity of the allegations.

But in many ways, Trump is only the icing on a Russian pie, rich of intriguing Russian ties to Washington DC. There is Rohrabacher, as mentioned earlier. Unconnected to Trump and not under investigation as far as is known, Trump’s Commerce Secretary Wilbur Ross has a particular interesting history of Russian relations. Ross led a group of investors recapitalising Bank of Cyprus in 2014, a year after a financial crisis shook the island, a safe haven for Russian money. Ross ousted some Russians from the board, leading to speculations he was not at all a friend of Russia.

However, Viktor Vekselberg, seen as central part of Putin’s financial empire, is now the largest single shareholder in Bank of Cyprus with a representative on the board. Ross appointed Joseph Ackerman, CEO of Deutsche Bank 2002 to 2012, as a chairman of the board of Bank of Cyprus. Deutsche Bank was so active in Russia in the 1990s that one source told me the bank should have been called Russische Bank. In January 2017 Deutsche was fined $630m for having laundered $10bn on behalf of Russians.

As sources indicate that Attorney General Jeff Sessions met Russian officials during the Trump campaign in spite of his earlier categorical denials Sessions is now under renewed pressure to testify again. Then there are the contacts Trump’s son-in-law and advisor Jared Kushner and Trump’s son Donald Junior had with Russians. Paul Manafort and Michael Flynn lost their jobs due to Russian ties. (See here a Washington Post overview over Team Trump and its Russian connections.)

Burt and his network

Richard Burt, a former journalist, US Ambassador in Federal Republic of Germany 1985 to 1989 during the Reagan administration and a known lobbyist for Russian interests, is one of those who have suddenly been swept into the limelight because of the investigation into Trump’s Russian connections.

Burt has confirmed that he was present at two dinners hosted by Jeff Sessions during the 2016 campaign. Sessions had explicitly denied having met any lobbyists working on behalf of the Russians. Burt said to the Guardian that Sessions possibly did not know of his activities though they are widely known in Washington.

It now seems certain that Sessions met Sergey Kislyak, who until recently was the Russian Ambassador to the US, at an event in April 2016 at the Mayflower Hotel, hosted by the magazine The National Interest in Washington. At this event Trump delivered his first major speech on foreign affairs. Burt was an adviser on that speech but has said little from his notes was taken up in the speech.

An article in April this year in The National Interest, published by the think tank Center for the National Interest where Burt is on the board, gives an idea of Burt’s view on Russia. In “A Grand Strategy for Trump” Burt advocates that a US military build-up could incentivise Russia “to seek a more productive relationship with the West.” Other steps would be “finding a settlement in Ukraine, examining ways to cooperate in fighting ISIS, and addressing a new agenda of military threats and non-proliferation.”

The problem, according to Burt, is the “current Russiagate mania” “a partisan and increasingly hysterical debate in Washington over what, if anything, the Trump campaign did to assist Russian hackers in intervening in the 2016 elections.” Quoting Henry Kissinger that “demonizing Putin is not a strategy” Burt then asks: “if the United States gave up, at least for now, its twenty-five-year-old policy of turning Russia into a Western-style democracy, but instead focused on the external threats it poses, would a more politically secure Kremlin be prepared to respond positively?”

Burt is a managing director at McLarty Associates, previously part of Kissinger McLarty Associates. In his role at McLarty he has been a lobbyist for Nord Stream II. In addition he is on the board of Deutsche Bank closed-end funds. He has also been an adviser for Alfa Capital Partners, the investment arm of Alfa Bank, operating in Russia, the Netherlands, UK, Belarus, Ukraine and Kazakhstan.

The Group’s largest investor, holding 32.8%, is Mikhail Fridman, the Ukrainian oligarch who over the years has managed to distance himself from Russia and Kremlin with his wealth intact in spite of some skirmishes: Fridman was forced to sell his stake in the oil company TNK-BP, the Russian joint venture with the BP, to the Kremlin controlled Rosneft but he apparently got a full price in cash at the top of the cycle, according to a Forbes in November 2016, written when Alfa had become part of … yes, the Trump story.

Incidentally, Gerhard Schröder sat for a while on the board of the TNK-BP. And Deutsche Bank has over the years been the largest lender to the Trump empire.

The Magnitsky prism: what does it mean talking about adoption?

“It was not a long conversation, but it was, you know, could be 15 minutes. Just talked about — things. Actually, it was very interesting, we talked about adoption… We talked about Russian adoption. Yeah. I always found that interesting. Because, you know, he (Putin) ended that years ago. And I actually talked about Russian adoption with him, which is interesting because it was a part of the conversation that Don [Jr., Mr. Trump’s son] had in that meeting.” – This is how Trump described his tête-à-tête with Putin at the G20 dinner in July in a New York Times interview.

Talking about adoption sounds very innocent – except the context is less so: Putin put an end to Americans adopting Russian children in retaliation to the Sergei Magnitsky Rule of Law Accountability Act, passed in the US in 2012. Only now is a similar act finding its way into UK law in the Criminal Finance Bill. Similar law is being passed in Canada, Estonia has already its Magnitsky Act and it has been discussed in the EU.

The hedge fund manager Bill Browder hired Magnitsky as his lawyer but after exposing $230m tax fraud enriching Putin and his cohort, Magnitsky was imprisoned in Moscow in autumn 2008 and died from torture in prison a year later. Browder’s book “Red Notice” (2015) is a horrifying exposé of the whole fraud saga leading to Magnitsky’s death.

As Browder explained in a recent interview, Kremlin pays the lawyer Natalia Veselnitskaya and others millions to lobby against the Magnitsky Act. In addition to being Browder’s nemesis in fighting the Magnitsky Act she has represented Russians, with ties to Kremlin, who had their assets frozen by the US Department of Justice frozen due to the Act.

In general, corrupt politicians and officials need to get their funds abroad in order to be able to make use of these funds to pay bribes, invest etc. An essential part of corruption is of course that it is hidden and those who operate by corrupt means operate through others. With funds abroad they can promise the helpers impunity and payment abroad.

Putin, often estimated to be the richest man in the world, is no exception: if the flow of funds abroad is hindered his power is seriously diminished. The Magnitsky Act hits this flow and has exposed Putin’s Achilles heal.

Trump’s interest in adoption relates directly to the campaign against the Magnitsky Act, exposes the Russian enablers and the extensive Russian attempts to influence US politics, ultimately a serious threat to the security of the West and rule of law and democracy.

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Contacts between Iceland and Russia have for almost two decades been a source of speculations, some more fancifully than others. The speculations have now again surfaced in the international media following the focus on US president Donald Trump and his Russian ties: part of that story involves his connections with Bayrock where two Icelandic companies, FL Group and Novator, are mentioned. Contrary to the rumours at the time, Icelandic expansion abroad up to the banking collapse in 2008 can be explained by less sensational sources than Russian money – but there are some Russian ties to Iceland.

“We have never seen businessmen who operate like the Icelandic ones, throwing money around as if funding was never a problem,” an experienced Danish business journalist said to me in 2004. From around 2002 to the Icelandic banking collapse in October 2008, the Icelandic banks and their largest shareholders attracted attention abroad for audacious deals.

The rumours of Russian links to the Icelandic boom quickly surfaced as journalists and others sought to explain how a tiny country of around 320.000 people could finance large business deals by Icelandic businesses abroad. The owners of one of Iceland’s largest banks, Landsbanki, father and son Björgólfur Guðmundsson and Björgólfur Thor Björgólfsson, had indeed become rich in Saint Petersburg in the 1990s.

The unequivocal answer on how the foreign expansion of Icelandic banks and businesses was funded came in the Special Investigative Commission Report, SICR, in 2010: the funding came from Icelandic and international banks; the Icelandic banks found easy funding on international markets, the protagonist were at the same time the banks’ largest shareholders and their largest borrowers.

The rumours of Russian connections have surfaced again due to the Bayrock saga involving US president Donald Trump and his relations to Russia and Russian mobsters. Time to look at the Icelandic chapter in the Bayrock saga and Russian Icelandic links.

The Bayrock saga

By now, there is hardly a media company in the world that has not paid some attention to Donald Trump and Bayrock, with a mention of the Icelandic FL Group and the Russian money in Icelandic banks and businesses. The short version of that saga is the following:

Tevfik Arif, born in Kazakhstan during the Soviet era, was a state-employed economist who turned to hotel development in Turkey in the 1990s before moving into New York property development where he founded Bayrock in 2001. As with many real estate companies Bayrock’s structure was highly complex with myriad companies and shell companies, on- and offshore.

Arif hired a Russian to run Bayrock. Felix Sater or Satter was born in Russia in but moved to New York as youngster with his family. In 1991 Sater was sentenced to prison for a bar brawl cutting up the face of his adversary with a broken glass. Having admitted to security fraud in cohort with some New York Mafia families in 1998 he was eventually found guilty but apparently got a lenient sentence in return for becoming an informant for the law enforcement.

In 2003, Arif and Sater were introduced to a flamboyant property developer by the name of Donald Trump, already a hot name in New York. One of their joint projects was the Trump Soho. The Trump connection did attract media attention. Apparently following a New York Times profile of Sater in December 2007, unearthing his criminal records, Arif dismissed Sater in 2008.

Bayrock and FL Group

By then, another scheme was brewing and that is where the Icelandic FL Group enters the Bayrock and Trump story. This part of the story has surfaced in court cases, still ongoing, where two ex-Bayrock employees, Jody Kriss and Michael Ejekam, are suing Bayrock for cheating them of profit inter alia from the Trump SoHo deal.

Their story details complicated hidden agreements whereby Arif and Sater, according to Kriss and Ejekam, essentially conspired to skim off profit from Bayrock, cheating everyone who entered an agreement with them. According to the story told in the court documents (see inter alia here) Bayrock entered an agreement with FL Group in May 2007: for providing a loan of $50m FL Group would get 62% of the total profits from four Bayrock entities, expected to generate a profit of around $227.5m.

The loan arrangement with FL Group did not make a great financial sense for Bayrock, again according to Kriss and Ejekam, but it was part of Arif and Sater’s scheme to cheat investors as well the US tax authorities. When Kriss complained to Sater that the $50m loan from FL Group was not distributed as agreed, Sater “made him (Kriss) an offer he couldn’t refuse: either take $500,000, keep quiet and leave all the rest of his money behind, or make trouble and be killed.” – Given Sater’s criminal record and threats he had made to another Bayrock partner Kriss left Bayrock.

The short and intense FL saga and its record losses

FL Group was one of the companies that formed the Icelandic boom. Out of many financial follies in pre-crash Iceland the FL Group saga was one of the most headline-creating. In 2002 Jón Ásgeir Jóhannesson, of Baugur fame, bought 20% in the listed air carrier Flugleiðir. In 2004 he teamed up with Hannes Smárason who with a degree from the MIT and four years at McKinsey in Boston had a stellar CV.

Smárason was first on the board until he became a CEO in October 2005. The duo oversaw the take-over of Flugleiðir, sold off assets and turned the company into an investment company, FL Group; inter alia FL Group was for a short while the largest shareholder in EasyJet.

In spring 2007, a group of investors led by Jóhannesson became the largest shareholder in Iceland’s third largest bank, Glitnir. Their Glitnir holding was through FL Group, consequently the bank’s largest shareholder.

At the beginning of 2007, the FL Group debt with the Icelandic banks amounted to almost €600m but had risen to €1.1bn in October 2008. Interestingly, its debt to Glitnir rose by almost 800%. As mentioned above, Jóhannesson and his business partners, among them FL Group, became Glitnir’s largest shareholder in spring 2007, following the pattern that the banks’ largest shareholders were also their largest borrowers.

FL Group – folly or a classic “pump and dump”?

By the end of 2007, 26 months after Hannes Smárason became CEO, FL Group had set an Icelandic record in losses: ISK63bn, now €660m, ten times the previous record, from 2006, incidentally set by a media company controlled by Jóhannesson.

Facing these stunning losses Smárason left FL Group in December 2007. The story goes that at the shareholders’ meeting where his departure was announced he left the room waving, saying “See you in the next war, guys” (In Icelandic: “Sjáumst í næsta stríði, strákar).

There are endless stories of staggering cost and insane spending related to the FL Group boom and bust. Interestingly, a large part of the losses stemmed from consultancy cost for projects that never materialised. Smaller investors lost heavily and in hindsight the question arises if the FL saga was a folly or some version of a “pump and dump.” Smárason was charged with embezzlement in 2013, acquitted in Reykjavík District Court but the State Prosecutor’s appeal was thrown out of the Supreme Court due to the Prosecutor’s mistakes.

FL Group never recovered from the losses and was delisted in the spring of 2008 and its name changed to Stoðir. FL Group never went into bankruptcy but its debt was written off. A group of earlier FL Group managers (Smárason is not one of them) now owns over 50% of Stoðir.

FL Group and the Icelandic Bayrock

Part of FL Group’s eye-watering losses was the Bayrock adventure. FL Group set up a company in Iceland, FL Bayrock Holdco, financed by the Icelandic mother company. Already in 2008 the FL Group Bayrock was a loss-making enterprise, its three FL Bayrock US companies were written off with losses amounting to ISK17.6bn, now €157m. When the Icelandic FL Bayrock finally failed in January 2014 Stoðir (earlier FL Group) was more or less the only creditor, its claims amounting to ISK13bn; no assets were found.

According to the Kriss-Ejekam story, FL Group willingly and knowingly took part in a scam. When I approached a person close to FL Group, he maintained the investment had not been a scam but just one of many loss-making investments, not even a major investment, compared to what FL Group was doing at the time.

An FL Group investor told me that he had never even heard of the Bayrock investment until the Trump-related Bayrock stories surfaced. He expressed surprise that such a large investment could have been made without the knowledge of anyone except the CEO and managers. He added however that this was perhaps indicative of the problems in FL Group: managers making utterly insane and ill-informed decisions leading to the record losses.

Bayrock and Novator

Another Icelandic company, mentioned in the Kriss-Ejekam case is Novator, which was offered to participate in Bayrock. There is a whole galaxy of Novator companies, inter alia 19 in Luxembourg, encompassing assets and businesses of Björgólfur Thor Björgólfsson.

This, according to court documents (emphasis mine):

During the early FL negotiations, Bayrock was approached by Novator, an Icelandic competitor of FL’s, which promised to go into the same partnership with Bayrock as FL was contemplating, and at better terms. Arif and Satter told Kriss that this would not be possible, because the money behind these companies was mostly Russian and the Russians behind FL were in favor with Putin, but the Russians behind Novator were not, and so they had to deal with FL. Whether or not this was true and what further Russian involvement existed must await disclosure.

This is the clause that has yet again fuelled speculations of Russian dirty money in the Icelandic banks and Icelandic companies. As stated in the last sentence this is however all pure speculation.

The story from the Novator side is a different one. In an email answer to my query, the spokeswoman for Björgólfsson wrote that Bayrock approached Novator Properties, which considered the project far from attractive. Following some due diligence Novator concluded that the people involved were not appealing partners, which led Novator to decline the invitation to participate.

The origin of rumours of corrupt Russian connections to Iceland

Towards the end of 2002 the largest Icelandic banks and their main shareholders were already attracting foreign media attention. Euromoney (paywall) raised “Questions over Landsbanki’s new shareholder” in November 2002 focusing on the story of the father and son Björgólfur Guðmundsson and Björgólfur Thor Björgólfsson, who with their business partner Magnús Þorsteinsson struck gold in Saint Petersburg in the 1990s and were now set to buy over 40% of privatised Landsbanki.

The two businessmen, the Brit Bernard Lardner and his Icelandic partner Ingimar Ingimarsson, who in the mid 1990s had hired the three Icelanders to run their joint Saint Petersburg venture, were less lucky. In 2011 Ingimarsson published a book in Iceland, The Story that Had to be Told, (Sagan sem varð að segja), where he tells his side of the story: how father and son through tricks and bullying took over the Lardner and Ingimarsson venture, essentially the story told in Euromoney in 2002 (see earlier Icelog).

In June 2005, Guardian’s Ian Griffith wrote an article on the Icelandic businessmen Björgólfsson and Jón Ásgeir Jóhannesson, ever more visible in the London business community, asking where the Icelandic “Viking raiders” as they were commonly called got their money from, hinting at Russian mafia money. The quick rise to riches, wrote Griffith, exposed the Icelanders to “the persistent but unsubstantiated whispering that the country’s economic miracle has been funded by Russian mafia money rather than growth and liberalisation.”

As Griffith points out, Björgólfsson and his partners were operating in Saint Petersburg, “the city regarded as the Russian mafia capital. That investment was being made in the drinks sector, seen by the mafia as the industry of choice. 

Yet against all the odds, Bravo went from strength to strength. 

Other St Petersburg brewing executives were not so fortunate. One was shot dead in his kitchen from the ledge of a fifth-floor window. Another perished in a hail of bullets as he stepped from his Mercedes. And one St Petersburg brewery burned to the ground after a mishap with a welding torch. 

But the Bravo business, run by three self-confessed naives, suddenly found itself to be one of Russia’s leading brewers. In under three years it became the fastest-growing brewer in the country. It secured a 17% market share in the St Petersburg region and 7% in the Moscow area. It was selling 2.5m hectolitres of beer a year in 2001 and heading for 4m when Heineken of the Netherlands stepped in to buy it for $400m in 2002. Heineken said one of the reasons for the Bravo purchase was the absence of any corruption.”

Björgólfsson has always vehemently denied stories of his alleged links to the Russian dark forces and Ingimarsson’s story. Billions to Bust and Back, published in 2014, is Björgólfsson’s own story of his life. The book has not been published in Iceland.

The Icelandic miracle exposed: international banks and “favoured clients”

During the Icelandic boom years Griffith was not the only one to question how the tiny economy of tiny Iceland could fund the enormous expansion of Icelandic banks and businesses abroad. The Russian rumours were persistent, some of them originating in the murky London underworld, all to explain this apparently miraculous growth. Most of this coverage was however more fiction than facts (the echo of this is found in my financial thriller, Samhengi hlutanna, which takes place in London and Iceland after the collapse, published in Iceland in 2011; English synopsis.)

The Icelandic Special Investigative Commission Report, SICR, published in April 2010, convincingly answered the question where the money came from: “Access to international financial markets was, for the banks, the principal premise for their big growth,” facilitated by their high credit ratings and Iceland’s membership of the European Economic Area, EEA. As to the largest shareholders the SICR concluded: “The largest owners of all the big banks had abnormally easy access to credit at the banks they owned, apparently in their capacity as owners… in all of the banks, their principal owners were among the largest borrowers.”

The story told in the SICR is how the Icelandic banks essentially ran a double banking system: one for normal bank clients who got loans against sound collaterals and loan contracts with normal covenants – and then another system for what I have called the “favoured clients,” i.e. the largest shareholders and their business partners.

The loans to the “favoured clients” were on very favourable terms, mostly bullet loans extended as needed, often with little or no collateral and light covenants. The consequence was that systematically, these clients profitted but if things went wrong the banks shouldered the losses. – In recent years, some of these abnormally favourable loans have sent around twenty bankers to prison.

The real Russian connections in Iceland

Although the Icelandic expansion abroad can be explained with less exciting facts than Russian Mafia and money laundering, there are a few tangible Russian contacts to Iceland: Vladimir Putin and the Kremlin did show an interest in Iceland at a crucial time, just as in Cyprus in 2013; Alisher Usmanov had ties to Kaupthing; the Danish lawyer Jens Peter Galmond, famous for his Leonid Reiman connections, and his partner Claus Abildstrøm did have Icelandic clients and Mikhail Fridman gets a mention.

At 4pm Monday 6 October 2008 prime minister and leader of the Independence party (conservative) Geir Haarde addressed Icelanders via the media: the government was introducing emergency measures to deal with the banks in an orderly manner. Icelanders sat glued to their tv sets struggling to understand the meaning of it all.

Haarde’s last words, “God bless Iceland,” brought home the severity of the situation. Icelanders had never heard head of government bless the country and never heard of measures like the ones introduced. The speech and the emergency Act it introduced came to be seen as the collapse moment – the three banks were expected to fail and by Wednesday 8 October they had all failed indeed.

An elusive Russian loan offer

The next morning, 7 October 2008 as Icelanders woke up to a failing financial system, the then governor of the Icelandic Central Bank, CBI, Davíð Oddsson, an earlier leader of the Independence Party and prime minister, told the still shocked Icelanders that all would be well: around 7am Victor I. Tatarintsev the Russian ambassador in Iceland had called Oddsson to inform him that the Russian government was willing to lend €4bn to Iceland, bolstering the Icelandic foreign reserves.

According to the CBI press release the loan would be at 30-50bp above Libor and have a maturity of three to four years. Later that day another press release just stated that representatives of the two countries would meet in the coming days to negotiate on “financial issues” – no mention of a loan.

According to Icelog sources, the morning news was hardly out when the CBI heard from news agencies that Russian minister of finance Alexei Kudrin had denied the story of a Russian loan to Iceland; indeed the loan never materialised though some CBI officials did fly out to Moscow a week later.

There have of course been wild speculations as to if the offer was real, why Kremlin was ready to offer the loan and then why Kremlin did, in the end, not stand by that offer.

Judging from Icelog sources it seems no misunderstanding that Tatarintsev mentioned a loan to Oddsson. As to why Kremlin – because that is where the offer did come from – wanted to lend or at least to tease with the offer is less clear though there is no lack of undocumented stories.

One story is that some Russian oligarchs did have money invested in Iceland. Fearing their funds would be inaccessible they pulled some strings but when they realised their funds were not in danger they lost interest in helping Iceland and so did Kremlin. Another explanation is that Kremlin just wanted to tease the West a bit, make as if it was stretching its sphere of interest further west. Yet another story is that a European minister of finance called his Russian counterpart telling him to stay away from Iceland; the European Union, EU would take care of the country.

Iceland found in the end a more conventional source of emergency funding: by 19 November 2008 it had secured $2.1bn loan from the International Monetary Fund, IMF.

Russia, Iceland and Cyprus

In 2013, Russia played the same game with Cyprus: it teased Cyprus with a loan. The difference was however that the Russian offer to Cyprus did not come as a surprise: Russia had long-standing and close political ties to the island. Russian oligarchs and smaller fries had for years made use of Cyprus as a first stop for Russian money out of Russia. At the end of 2011, Russia had lent €2.5bn to Cyprus. However, the crisis lending did not materialise, any more than it had in Iceland (see my Cyprus story).

The international media reported frequently that the EU and the IMF were reluctant to assist Cyprus because these organisations were irritated by the easy access of Russian funds to and through the island’s banks. A classified German report was said to show how Cyprus had been a haven for money laundering (if that report did indeed exist Germans could and should have used the same diligence to check their own Deutsche Bank!)

After the 2008 collapse in Iceland a credible source told me he had seen a US Department of Justice classified report on money laundering stating that Icelandic banks were mentioned as open to such flows. Given the credibility of the source I have no doubt that the report exists (though all my efforts to trace it have failed). I have however no idea if that report was thoroughly researched or not nor in what context the Icelandic banks were mentioned.

Kaupthing and Usmanov

Some Icelandic banks did have clients from Russia and the former Soviet Union. The only one mentioned in the SICR, is the Uzbek Alisher Usmanov. He turned to Kaupthing in summer of 2008 when he was seeking to buy shares in Mmc Norilsk Adr. According to the SICR the bank also sold Usmanov shares in Kaupthing – by the end of September 2008 he owned 1.48% in the bank.

I am told that Usmanov was not Kaupthing client until in the summer of 2008 (earlier Icelog). Funding was generally drying up but Kaupthing was keen on the connection as it was planning to branch out to Russia and consequently looking for Russian connections.

If Usmanov’s shareholding in Kaupthing comes as surprise it is important to keep in mind that part of Kaupthing’s business model was to lend money to clients to buy Kaupthing shares. This was no last minute panic plan but something Kaupthing had been doing for years.

This model, which looks like a share-parking scheme, is a likelier explanation for Usmanov’s stake in Kaupthing rather than a sign of Usmanov’s interest in Kaupthing. A Kauphting credit committee minute from late September 2008, leaked after the collapse, shows that Kaupthing had agreed to lend Usmanov respectively €1,1bn and $1.2bn. According to Icelog sources the bank failed before the loans were issued.

Fridman, Exista and Baugur/Gaumur

There are two Icelandic links to Mikhail Fridman, through Kaupthing and the investment bank Straumur. Its chairman, largest investor and eventually largest borrower was Björgólfur Thor Björgólfsson.

By 1998, Kaupthing was operating in Luxembourg. In June that year, a Luxembourg lawyer, Francis Kass, appeared twice on the same day as a representative of two BVI companies, Quenon Investments Ltd and Shapburg Ltd, both registered at the same post box address in Tortola. His mission was to set up two companies, both with names linked to the North: Compagnie Financiere Scandinave Holding S.A. and Compagnie Financiere Pour L’Atlantique du Nord Holding S.A. The directors were offshore service companies, owned by Kaupthing or used in other Kaupthing offshore schemes.

These two French-named companies, founded on the same day by the same lawyer, came to play major roles in the Icelandic boom until the bust in October 2008. The former was for some years controlled by Kaupthing top managers until it changed name in 2004 to Meiður and to Exista the following year. By then it was the holding company for Lýður and Ágúst Guðmundsson who became Kaupthing’s largest shareholders, owning 25%. In 2000, the latter company’s name changed to Gaumur. Gaumur was part of the Baugur sphere, controlled by Jón Ásgeir Jóhannesson.

The owners of Exista and Baugur were dominating forces in the years when Icelandic banks and businesses were on their Ikarus flight.

Apart from the UK, the Icelandic business expansion abroad was most noticeable in Denmark. Danish journalists watched with perplexed scepticism as swaggering Icelanders bought some of their largest and most eye-catching businesses. In Iceland, politicians and business leaders talked of Danish envy and hostility, claiming the old overlords of Iceland were unable to tolerate the Icelandic success. They were much happier with the UK press that followed the Icelandic rise rather breathlessly.

In 2006 the Danish tabloid Ekstra bladet wrote a series of articles again bringing up Russian ties. Part of the coverage related to the two Krass companies: Quenon and Shapburg have also set up Alfa companies, part of Mikhail Fridman’s galaxy of on- and offshore companies.

The Danish articles were translated into English and posted on the internet. Kaupthing sued the Danish tabloid, which was forced to retract the articles in order to avoid the crippling costs of a libel case in an English court.

JP Galmond – the fixer who lost his firm

An adversary of Fridman, with Icelandic ties, figures in a long saga where also Usmanov plays a role: the Danish lawyer, Jeffrey Peter Galmond. – Some of the foreign fixers who have worked for ex-Soviet oligarchs have in some cases lost their lives under mysterious circumstance. JP Galmond lost his law firm. His story has been told in the international media over many years (my short overview of the Galmond saga).

Galmond was one of the foreign pioneers in St Petersburg in the early 1990s where he soon met Leonid Reiman, manager at the city’s telephone company. By the end of 1990s many foreign businessmen had learnt there was not a problem Galmond could not fix. Reiman went on to become a state secretary in 1999 when Boris Jeltsin made his Saint Petersburg friend Vladimir Putin prime minister.

By 2000 the Danish lawyer had turned to investment via IPOC, his Bermuda-registered investment fund. The following year he bought a stake in the Russian mobile company Megafon. Soon after the purchase Mikhail Fridman claimed the shares were his. This turned into a titanic legal battle fought for years in courts in the Netherlands, Sweden, Britain, Switzerland, the British Virgin Islands and Bermuda.

In 2004 Galmond’s IPOC had to issue a guarantee of $40m to a Swiss court in one of the innumerable Megafon court cases. The court could not accept the money without checking its origin. An independent accountant working for the court concluded that the intricate web of IPOC companies sheltered a money-laundering scheme. In spring of 2008 IPOC was part of a criminal case in the BVI. That same spring, the Megafon battle ended when Alisher Usmanov bought IPOC’s Megafon shares.

The Megafon battle exposed Galmond as a straw-man for Leonid Reiman who was forced to resign as a minister in 2009 due to the IPOC cases. In 2007, Galmond was forced to leave his law firm due to the Megafon battle; his younger partner Claus Abildstrøm took over and set up his own firm, Danders & More, in 2008.

Galmond’s Icelandic ties

In spite of the international media focus on Galmond, he and his partner Claus Abildstrøm enjoyed popularity among Icelandic businessmen setting up business in Copenhagen. An Icelandic businessman operating in Denmark told me he did not care about Galmond’s reputation; what mattered was that both Galmond and Abildstrøm understood the Icelandic mentality and the need to move quickly.

Already in 2002, Abildstrøm had an Icelandic client, Birgir Bieltvedt, a friend and business partner of both Björgólfur Thor Björgólfsson and Jón Ásgeir Jóhannesson. In 2004 Abildstrøm assisted Bieltvedt, Jón Ásgeir Jóhannesson and Straumur investment bank, where Björgólfsson was the largest shareholder, to buy the department store Magasin du Nord, where Abildstrøm then became a board member.

In 2007, when the IPOC court cases were driving Galmond to withdraw from his legal firm, the Danish newspaper Børsen reported that among Galmond’s clients were some of the wealthiest Icelanders operating in Denmark, such as Björgólfur Thor Björgólfsson and Jón Ásgeir Jóhannesson.

In his book, Ingimar Ingimarsson claimed that Galmond acted as an advisor to Björgólfsson. According to an Icelog source Galmond represented a consortium led by Björgólfsson’s father Björgólfur Guðmundsson when they bought a printing press in Saint Petersburg in 2004. Björgólfsson has denied any ties to Galmond and to Reiman but has confirmed that Abildstrøm has earlier worked for him.

Alfa, Pamplona Capital Management and Straumur/Björgólfsson

Pamplona Capital Management is a London-based investment fund, which in late 2007 entered a joint venture, according to the SICR, with Straumur, an investment bank where Björgólfur Thor Björgólfsson was the largest shareholder, chairman of the board and Björgólfsson-related companies were eventually the largest borrower (SICR).

In 2005 Pamplona had bought a logistics company, ADR-HAANPAA, operating in the Nordic countries, the Baltics, Poland and Russia. In 2007 Straumur provided a loan of €100m to refinance ADR in a structure where Pamplona owned 80.8%, Straumur 7.7% and ADR managers the rest.

Pamplona was set up in 2004 by the Russian Alexander Knaster, who as a teenager had immigrated to the US with his parents. Knaster was the CEO of Fridman’s Alfa Bank from 1998 until 2004 when he founded Pamplona, partly with capital from Fridman. Knaster has been a British citizen since 2009 and has, as several other Russian billionaires living in the UK, donated money, £400.000, to the Conservatives.

Incidentally, Pamplona shares the same London address as Novator, Björgólfsson’s investment fund, according to Companies House data: 25 Park Lane is one of London’s most attractive business addresses.

The Icelandic business model: corrupt patterns v “time is money”

Big banks such as Wachovia and Citigroup have been fined for facilitating money laundering for Mexican gangs. Deutsche Bank as been fined recently for doing the same for Russians with ties to president Trump. All of this involves violating anti-money laundering rules and regulations and this criminal activity has almost invariably only been discovered through whistle-blowers. Since large international banks could get away with laundering money, could something similar have been going on in the Icelandic banks?

The Icelandic Financial Supervisor, FME, was famously lax during the years of the banks’ stratospheric growth and expansion abroad. One anecdotal evidence does not inspire confidence: during the boom years an Icelandic accountant drew the attention of the police to what he thought might be a case of money laundering in a small company operating in Iceland and offshore. The police seemed to have a very limited understanding of money laundering other than crumpled notes literally laundered.

However, the banking collapse set many things in motion. The failed banks’ administrators, foreign consultants and later experts at the Office of the Special Prosecutor have scrutinised the accounts of the failed banks landing some bankers and large shareholders in prison. I have never heard anyone with plausible insight and authority mention money laundering and/or hidden Russian connections.

I do not know if it was systematically investigated but some of those familiar with the failed banks would know that money laundering, though of course hidden, leaves a certain patterns of transactions etc. But most importantly, the banks’ operation in Luxembourg, where in the Kaupthing criminal cases the dirty deals were done, have not been scrutinised at all by Luxembourg authorities.

The Icelandic businessmen most active in Iceland and abroad were famous for two things: complex structures, not an Icelandic invention – and buying assets at 10-20% higher prices than others were willing to offer.

As one Danish journalist asked me in 2004: “Why are Icelanders always willing to pay more than the asking price?” The Icelandic businessmen explained this by “time is money” – instead of wasting time to negotiate pennies or cents it paid off to close the deals quickly, they claimed.

Paying more than the asking price, exorbitant consultancy fees, sales at inexplicable prices to related parties and complicated on- and offshore structures are all known characteristics of systematic looting, control fraud and money laundering – and there are many examples of all of this from the Icelandic boom years. But these features can also be the sign of abysmally bad management.

Follow me on Twitter for running updates.

Icelandic authorities ignored warnings before October 2008 on the expanded banking system threatening financial stability but the shock of 90% of the financial system collapsing focused minds. Disciplined by an International Monetary Fund program, Iceland applied classic crisis measures such as write-down of debt and capital controls. But in times of shock economic measures are not enough: Special Prosecutor and a Special Investigative Committee helped to counteract widespread distrust. Perhaps most importantly, Iceland enjoys sound public institutions and entered the crisis with stellar public finances. Pure luck, i.e. low oil prices and a flow of spending-happy tourists, helped. Iceland is a small economy and all in all lessons for bigger countries may be limited except that even in a small economy recovery does not depend on a one-trick wonder.

“The medium-term prospects for the Icelandic economy remain enviable,” the International Monetary Fund, IMF, wrote in its 2007 Article IV Consultation
Concluding Statement, though pointing out there were however things to worry about: the banking system with its foreign operations looked ominous, having grown from one gross domestic product, GDP, in 2003 to ten fold the GDP by 2008. In early October 2008 the enviable medium-term prospect were clouded by an unenviable banking collapse.

All through 2008, as thunderclouds gathered on the horizon, the Central Bank of Iceland, CBI, and the coalition government of social democrats led by the Independence party (conservative) staunchly and with arrogance ignored foreign advice and warnings. Yet, when finally forced to act on October 6 2008, Icelandic authorities did so sensibly by passing an Emergency Act (Act no. 125/2008; see here an overview of legislation related to the restructuring of the banks and here more broadly on economic measures).

Iceland entered an IMF program in November 2008, aimed at restoring confidence and stabilising the economy, in addition to a loan of $2.1bn. In total, assistance from the IMF and several countries amounted to ca. $10bn, roughly the GDP of Iceland that year.

In spite of mostly sensible measures political turmoil and demonstrations forced the “collapse government” from power: it was replaced on February 1 2009 by a left coalition of the Left Green party, led by the social democrats, which won the elections in spring that year. In spite of relentless criticism at the time, both governments progressed in dragging Iceland out of the banking mess.

After the GDP contracted by 4% in the first three years the Icelandic economy was already back to growth summer 2011 and is now in its fifth year of economic growth. In 2015, Iceland became the first European country, hit by crisis in 2008-2010, to surpass its pre-crisis peak of economic output.

Iceland is now doing well in economic terms and yet the soul is lagging behind. Trust in the established political parties has collapsed: instead, the Pirate party, which has never been in government, enjoys over 30% following in opinion polls.

Compared to Ireland and Greece, Iceland’s recovery has been speedy, giving rise to questions as to why so quick and could this apparent Icelandic success story be applied elsewhere. Interestingly, much of the focus of that debate is very narrow and in reality not aimed at clarifying the Icelandic recovery but at proving or disproving aspects of austerity, the euro or both.

Unfortunately, much of this debate is misleading because it is based on three persistent myths of the Icelandic recovery: that Iceland avoided austerity, did not save its banks and that the country defaulted. All three statements are wrong: Iceland has not avoided austerity, it did save some banks though not the three largest ones and did not default.

Indeed, the high cost of the Icelandic collapse is often ignored, amounting to 20-25% of GDP. Yet, not as high as feared to begin with: the IMF estimated it could be as much as 40%. The net fiscal cost of supporting and restructuring the banks is, according to the IMF 19.2% of GDP.

Costliest banking crisis since 1970; Luc Laeven and Fabián Valencia.

As to lessons to avoid the kind of shock Iceland suffered nothing can be learnt without a thorough investigation as to what happened, which is why I believe the report, a lesson in itself, by the Special Investigative Commission, SIC, in 2010 was fundamental. Tackling eventual crime, as by setting up the Office of the Special Prosecutor, is important to restore trust. Recovering from a collapse of this magnitude is not only about economic measures and there certainly is no one-trick fix.

On specific issues of the economy it is doubtful that Iceland, a micro economy, can be a lesson to other countries but in general, the lessons are simple: sound public finances and sound public institutions are always essential but especially so in times of crisis.

In general: small economies fall and bounce fast(er than big ones)

The path of the Icelandic economy over the past fifty years has been a path up mountains and down deep valleys. Admittedly, the banking collapse was a major shock, entirely man-made in a country used to swings according to whims of fishing stocks, the last one being in the last years of the 1990s.

(Statistics, Iceland)

 

Sound public finances, sound institutions

What matters most in a crisis country? Cleary a myriad of things but in hindsight, if a country is heading for a major crisis make sure the public finances are in a sound state and public authorities and institutions staffed with competent people, working for the general good of society and not special interests – admittedly not a trivial thing.

Since 1980 Icelandic sovereign debt to GDP was on average 48.67%, topped at almost 60% around the crisis in late 1990s and had been going down after that. Compare with Greece.

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Same with the public budget: there was a surplus of 5-6% in the years up to 2008, against an average of -1.15% of GDP from 1998 to 2014. With a shocking deficit of 13.5% in 2009 it has since steadily improved, pointing to a balanced budget this year and a tiny surplus forecasted for next year. Again, compare with Greece.

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As to institutions, the CBI has been crucial in prodding the necessary recovery policies; much more so after change of board of governors in early 2009. Sound institutions and low corruption is the opposite of Greece, where national statistics were faulty for more than a decade (see my Elstat saga here).

Events in 2008

In early 2007, with sound state finances and fiscal strength the situation in Iceland seemed good. The banks felt invincible after narrowly surviving the mini crisis on 2006 following scrutiny from banks and rating agencies (the most famous paper at the time was by Danske Bank’s Lars Christensen).

Icelanders were keen on convincing the world that everything was fine. The Icelandic Chamber of Commerce hired Frederic Mishkin, then professor at Columbia, and Icelandic economist Tryggvi Þór Herbertsson to write a report, Financial Stability in Iceland, published in May 2006. Although not oblivious to certain risks, such as a weak financial regulator, they were beating the drum for the soundness of the Icelandic economy.

But like in fairy tales there was one major weakness in the economy: a banking system with assets, which by 2008 amounted to ten times the country’s GDP. Among economists it is common knowledge that rapidly growing financial sector leads to deterioration in lending. In Iceland, this was blissfully ignored (and in hindsight, not only in Iceland: Royal Bank of Scotland is an example).

Instead, the banking system was perceived to be the glory of Icelandic policies in a country that had only ever known wealth from the sea. Finance was the new oceans in which to cast nets and there seemed to be plenty to catch.

In early 2008 things had however taken a worrying turn: the value of the króna was declining rapidly, posing problems for highly indebted households – 15% of their loans were in foreign currency, i.a. practically all car loans. The country as a whole is dependent on imports and with prices going up, inflation rose, which hit borrowers; consumer-price indexed, CPI, loans (due to chronic inflation for decades) are the most common loans.

Iceland had been flush with foreign currency, mainly from three sources: the Icelandic banks sought funding on international markets; they offered high interest rates accounts abroad – most of these funds came to Iceland or flowed through the banks there (often en route to Luxembourg) – and then there was a hefty carry trade as high interest rates in Iceland attracted short- and long-term investors.

“How safe are your savings?” Channel 4 (very informative to watch) asked when its economic editor Faisal Islam visited Iceland in early March 2008. CBI governor Davíð Oddsson informed him the banks were sound and the state debtless. Helping the banks would not be “too much for the state to swallow (and here Oddsson hesitated) if it wanted to swallow it.” – Yet, timidly the UK Financial Services Authority, FSA, warned savers to pay attention not only to the interest rates but where the deposits were insured the point being that Landsbanki’s Icesave accounts, a UK branch of the Icelandic bank, were insured under the Icelandic insurance scheme.

The 2010 SIC report recounts in detail how Icelandic authorities ignored or refused advise all through 2008, refused to admit the threat of a teetering banking system, blamed it all on hedge funds and soldiered on with no plan.

The first crisis measure: Emergency Act Oct. 6 2008

Facing a collapsing banking system did focus the minds of politicians and key public servants who over the weekend of October 4 to 5 finally realised that the banks were beyond salvation. The Emergency Act, passed on October 6 2008 laid the foundation for splitting up the banks. Not into classic good and bad bank but into domestic and foreign operations, well adapted to alleviating the risk for Iceland due to the foreign operations of the over-extended banks.

The three old banks – Kaupthing, Glitnir and Landsbanki – kept their old names as estates whereas the new banks eventually got new names, first with the adjective “Nýi,” “new,” later respectively called Arion bank, Íslandsbanki and Landsbankinn. Following the split, creditors of the three banks own 87% of Arion and 95% of Íslandsbanki, with the state owning the remaining share. Due to Icesave Landsbanki was a different case, where the state first owned 81.33%, now 97.9%.

In addition to laying the foundation for the new banks, one paragraph of the Emergency Act showed a fundamental foresight:

In dividing the estate of a bankrupt financial undertaking, claims for deposits, pursuant to the Act on on (sic) Deposit Guarantees and an Investor Compensation Scheme, shall have priority as provided for in Article 112, Paragraph 1 of the Act on Bankruptcy etc.

By making deposits a priority claim in the collapsed banks interests of depositors were better secured than had been previously (and normally is elsewhere).

When 90% of a financial system is swept away keeping payment systems functioning is a major challenge. As one participant in these operations later told me the systems were down for no more than ca. five or ten minutes during these fateful days. All main institutions, except of course the three banks, withstood the severe test of unprecedented turmoil, no mean feat.

The coming months and years saw the continuation of these first crisis measures.

It is frequently stated that Iceland, the sovereign, was bankrupted by the collapse or defaulted on its debt. That is not correct though sovereign debt jumped from ca. 30% of GDP in 2008 until it peaked at 101% in 2012.

IMF and international assistance of $10bn

That fateful first weekend of October 2008 it so happened that there were people from the IMF visiting Iceland and they followed the course of events. Already then seeking IMF assistance was discussed but strong political forces, mainly around CBI governor Davíð Oddsson, former prime minister and leader of the Independence party, were vehemently against.

One of the more surreal events of these days was when governor Oddsson announced early morning on October 7 that Russia would lend Iceland €4bn, with maturity of three to four years, the terms 30 to 50 basis points over Libor. According to the CBI statement “Prime Minister Putin has confirmed this decision.” – It has never been clarified who offered the loan or if Oddsson had turned to the Russians but as the Cypriot and Greek government were to find out later this loan was never granted. If Oddsson had hoped that a Russian loan would help Iceland avoid an IMF program that wish did not come true.

On November 17, 2008 the Prime Minister’s Office published an outline of an Icelandic IMF program: Iceland was “facing a banking crisis of extraordinary proportions. The economy is heading for a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in public sector debt – by about 80%.”

The program’s three main objectives were: 1) restoring confidence in the króna, i.a. by using capital controls; 2) “putting public finances on a sustainable path”; 3) “rebuilding the banking system… and implementing private debt restructuring, while limiting the absorption of banking crisis costs by the public sector.”

An alarming government deficit of 13.5% was now forecasted for 2009 with public debt projected to rise from 29% to 109% of GDP. “The intention is to reduce the structural primary deficit by 2–3 percent annually over the medium-term, with the aim of achieving a small structural primary surplus by 2011 and a structural primary surplus of 3½-4 percent of GDP by 2012.” – This was never going to be austerity-free.

By November 20 2008 IMF funds had been secured, in total $2.1bn with $827m immediately available and the remaining sum paid in instalments of $155m, subject to reviews. The program was scheduled for two years and the loan would be repaid 2012 to 2015.

Earlier in November Iceland had secured loans of $3bn from the other Nordic countries together with Russia and Poland (acknowledging the large Polish community in Iceland). Even the tiny Faroe Islands chipped in with $50m. In addition, governments in the UK, the Netherlands and Germany reimbursed depositors in Icelandic banks, in all ca. $5bn. Thus, Iceland got financial assistance of around $10bn, at the time equivalent of one GDP, to see it through the worst.

In spite of a lingering suspicion against the IMF, both on the political left and right, there was never the defiance à la greque. Both the “collapse coalition” and then the left government swallowed the bitter pill of an IMF program and tried to make the best of it. Many officials have mentioned to me that the discipline of being in a program helped to prioritise and structure the necessary measures.

Recently, an Icelandic civil servant who worked closely with the IMF staff, told me that this relationship had been beneficial on many levels, i.a. had the approach of the IMF staff to problem solving been an inspiration. Here was a country willing to learn.

Part of the answer to why Iceland did so well is that the two governments more or less followed the course set out in he IMF program. This turned into a success saga for Iceland and the IMF. One major reason for success was Iceland’s ownership of the program: politicians and leading civil servants made great effort to reach the goals set in the program. – An aside to the IMF: if you want a successful program find a country like Iceland to carry it out.

Capital controls: a classic but much maligned measure

For those at work on crisis measures at the CBI and the various ministries there was little breathing space these autumn weeks in 2008. No sooner was the Emergency Act in place and the job of establishing the new banks over (in reality it took over a year to finalise) when a new challenge appeared: the rapidly increasing outflow of foreign funds threatened to sink the króna below sea level and empty the foreign currency reserves of the CBI.

On November 28 the CBI announced that following the approval of the IMF, capital flows were now restricted but would be lifted “as soon as circumstances allow.” De facto, Iceland was now exempt from the principle of freedom of capital movement as this applies in the European Economic Area, EEA. The controls were on capital only, not on goods and services, affected businesses but not households.

At the time they were set, the capital controls kept in place foreign-owned ISK650bn, or 44% of Icelandic GDP, mostly harvest from carry trades. Following auctions and other measures these funds had dwindled down to ISK291bn by the end of February 2015, just short of 15% of GDP. However, other funds have grown, i.e. foreign-owned ISK assets in the estates of the failed banks, now ca. ISK500bn or 25% of GDP.

In addition, there is no doubt certain pressure from Icelandic entities, i.e. pension funds, to invest abroad. The Icelandic Pension Funds Association estimates the funds need to invest annually ISK10bn abroad. Greater financial and political stability in Iceland will help to ease the pressure. (Further to the numbers behind the capital controls and plan to ease them, see my blog here).

With capital controls to alleviate pressure politicians in general have the tendency to postpone solving the problems kept at bay by the controls; this has also been the case in Iceland. The left government made various changes to the Foreign Exchange Act but in the end lacked the political stamina to take the first steps towards lifting them. With up-coming elections in spring 2013 it was clear by late 2012 that the government did not have the mandate to embark on such a politically sensitive plan so close to elections.

In spring 2015, after much toing and froing, the coalition of Independence party led by the Progressive party presented a plan to lift the controls. The most drastic steps will be taken this winter, first to bind what remains from the carry trades and second to deal with the estates, where ca. 80% of their foreign-owned ISK assets will be paid as a “stability contribution” to the state. (I have written extensively on the capital controls, see here). The IMF estimates it might take up to eight years to fully lift the controls.

It is notoriously difficult to measure the effects of capital controls. It is however a well-known fact that with time capital controls have a detrimental effect on the economy, as the CBI has incessantly pointed out in its Financial Stability reports.

In its 2012 overview over the Icelandic program the IMF summed up the benefits of controls:

“… as capital controls restricted investment opportunity abroad, both foreign and local holders of offshore króna found it profitable to invest in government bonds, which facilitated the financing of budget deficit and helped avoid a sovereign financing crisis.” – Considering the direct influence of inflation, due to CPI-indexation of household debt, the benefits also count for households.

Again, measuring is difficult but the stability brought by the controls seems to have helped though the plan to lift them came none too soon. Some economists claim the controls were unnecessary and have only done harm. None of their arguments convince me.

Measures for household and companies

Icelandic households have for decades happily lived beyond their means, i.e. household debt has been high in Iceland. The debt peaked in 2009 but has been going down rapidly since then.

CBI

Already in early 2008, the króna started to depreciate versus other currencies. From October 2007 to October 2008 the changes were dramatic: €1 stood at ISK85 at the beginning of this period but at ISK150 in the end; by October 2009 the €1 stood at ISK185.

Even before the collapse it was clear that households would be badly hit in various ways by the depreciating króna, i.a. due to the CPI-indexation of loans as mentioned above. In addition, banks loaded with foreign currency from the carry trades had for some years been offering foreign currency loans, in reality loans indexed against foreign currencies. With the króna diving instalments shot up for those borrowing in foreign currency; as pointed out earlier, 15% of household debt was in foreign currency.

The left government’s main stated mission was to shield poorer households and defend the welfare system during unavoidable times of austerity following the collapse. In addition, there was also the point that in a contracting economy private spending needed to be strengthened.

The first measure aimed directly at households was in November 2008 when the government announced that people could use private pension funds to pay down debt.

Soon after the banking collapse borrowers with loans in foreign currency turned to the courts to test the validity of these loans. As the courts supported their claims the government stepped in to push the banks to recalculate these loans.

In total, at the end of January 2012 write-downs for households amounted to ISK202bn. For non-financial companies the write-downs totalled ISK1108bn by the end of 2011 (based on numbers from Icelandic Financial Services Association). In general, Icelandic households have been deleveraging rapidly since the crisis.

CBI

Governments in other crisis countries have been reluctant to burden banks with the cost of write-downs and non-performing loans. In Iceland, there was a much greater political willingness to orchestrate write-downs. The fact that foreign creditors owned two of the three banks may also have made it less painful to Icelandic politicians to subject the banks to the unavoidable losses stemming from these measures.

Changes in bankruptcy law

In 2010 the Icelandic Bankruptcy Act was changed. Most importantly, the time of bankruptcy was shortened to two years. The period to take legal action was shortened to six months.

There are exemptions from this in case of big companies and bankruptcy procedures for financial companies are different. However, the changes profited individuals and small companies. In crisis countries such as Greece, Ireland and Spain bankruptcy laws has been a big hurdle in restructuring household finances, only belatedly attended to.

… and then, 21 months later, Iceland was back to growth

It was indicative of the political climate in Iceland that when the minister of finance, trade and economy Steingrímur Sigfússon, leader of the Left Green party, announced in summer 2011 that the economy was now growing again his tone was that of an undertaker. After all, the growth was “only” forecasted to be around 2%, much less than what Iceland had enjoyed earlier. Yet, this was a growth figure most of his European colleagues would have shouted from the rooftops.

Abroad, Sigfússon was applauded for turning the economy around but he enjoyed no such appreciation in Iceland.

As inequality diminished during the first years of the crisis the government could to a certain degree have claimed success (see on austerity below). However, the left government did poorly in managing expectations. Torn by infighting, its political opponents, both in opposition and within the coalition parties never tired of emphasising that no measures were ever enough. That was also the popular mood.

The króna: help or hindrance?

Much of what has been written on the Icelandic recovery has understandably been focused on the króna – if beneficial and/or essential to the recovery or curse – often linked to arguments for or against the EU and the euro.

A Delphic verdict on the króna came from Benedikt Gíslason, member of the capital controls taskforce and adviser to minister of finance Bjarni Benediktsson. In an interview to the Icelandic Viðskiptablaðið in June 2015 Gíslason claimed the króna had had a positive effect on the situation Iceland found itself in. “Even though it (the króna) was the root of the problem it is also a big part of the solution.”

Those who believe in the benefits of own independent currency often claim that Iceland did devalue, as if that had been part of a premeditated strategy. That however was not the case: the króna has been kept floating, depreciating sharply when funds flowed out in 2008. The capital controls slammed the break on, stabilising and slowly strengthening the króna.

Lately, with foreign currency inflows, i.a. from tourism, the króna has further appreciated but not as much as the inflows might indicate: the CBI buys up foreign currency, both to bolster its reserve and to hinder too strong a króna. Thus, it is appropriate to say that the króna float is steered but devaluation, as a practiced in Iceland earlier (up to the 1990s) and elsewhere, has not been a proper crisis tool.

Had Iceland joined the EU in 1995 together with Finland and Sweden, would it have taken up the euro like Finland or stayed outside as Sweden did? There is no answer to this question but had Iceland been in the euro capital controls would have been unnecessary (my take on Icelandic v Greek controls, see here). Would the euro group and the European Central Bank, ECB, have forced Iceland, as Ireland, to save its banks if Iceland had been in the euro zone? Again, another question impossible to answer. After all, tiny Cyprus did a bail-in (see my Cyprus saga here).

On average, fisheries have contributed around 10% to the Icelandic GDP, 11% in 2013 and the industry provided 15-20% of jobs. Fish is a limited resource with many restrictions, meaning that no matter markets or currency fishing more is not an option.

Tourism has now surpassed the fishing industry as a share of GDP. Again, depreciating króna could in theory help here but Iceland is not catering to cheap mass tourism but to a more exclusive kind of tourism where price matters less. Attracting over a million tourists a year is a big chunk for a population of 330.000 but my hunch is that the value of the króna only has a marginal effect, much like on the fishing industry: the country’s capacity to receive tourists is limited.

Currency is a barometer of financial soundness. One of the problems with the króna is simply the underlying economy and the soundness of the governments’ economic policies or lack of it, at any given time. Sound policies have often been lacking in Iceland, the soundness normally not lasting but swinging. Older Icelanders remember full well when the interests of the fishing industry in reality steered the króna, much like the soya bean industry in Argentina.

The króna is no better or worse than the underlying fundamentals of the economy. In addition, in an interconnected world, the ability of a government to steer its currency is greatly limited, interestingly even for a major currency like the British pound. What counts for a micro economy like Iceland is not necessarily applicable for a reserve currency.

Needless to say, the króna did of course have an effect on how Iceland fared after the collapse but judging exactly what that effect has been is not easy and much of what has been written is plainly wrong. (I have earlier written about the right to be wrong about Iceland; more recent example here). In addition, much of what has been written on Iceland and the króna is part of polemics on the EU and the euro and does little to throw light on what happened in Iceland.

Iceland: no bailouts, no austerity?

There have been two remarkably persisting stories told about the Icelandic crisis: 1) it didn’t save its banks and consequently no funds were used on the banks 2) Iceland did not undergo any austerity. – Both these stories are only myths, which have figured widely in the international debate on austerity-or-not, i.a. by Paul Krugman (see also the above examples on the right to be wrong about Iceland) who has widely touted the Icelandic success as an example to follow. Others, like Tyler Cowen, have been more sceptical.

True, Iceland did not save its three largest banks. Not for lack of trying though but simply because that task was too gigantic: the CBI could not possibly be the lender of last resort for a banking system ten times the GDP, spread over many countries.

When Glitnir, the first bank to admit it had run out of funds, turned to the CBI for help on September 29 2008, the CBI offered to take over 75% of the bank and refinance it. It only took a few days to prove that this was an insane plan. The CBI lent €500m to Kaupthing on the day the Alþingi passed the Emergency Act, October 6 2008, half of which was later lost due to inappropriate collaterals. This loan is the only major unexplained collapse story.

The left government later tried to save two smaller banks – a futile exercise, which only caused losses to the state – and did save some building societies. The worrying aspect of these endeavours was the lack of clear policy; it smacked of political manoeuvring and clientilismo and only added to the high cost of the collapse, in international context.

As to austerity, every Icelander has stories to tell about various spending cuts following the shock in October 2008. Public institutions cut salaries by 15-20%, there were cuts in spending on health and education. (Further on cuts see IMF overview 2012).

With the left government focused on the poorer households it wowed to defend benefit spending and interest rebates on mortgages. These contributions are means-tested at a relatively low income-level but helped no doubt fending off widening inequality. Indeed, the Gini coefficients have been falling in Iceland, from 43 in 2007 to 24 in 2012, then against EU average of 30.5. (See here for an overview of the social aspects of the collapse from October 2011, by Stefán Ólafsson).

In addition, it is however worth observing that although inequality in general has not increased, there are indications that inter-generational inequality has increased, as pointed out in the CBI Financial Stability Report nr. 1, 2015: at end of 2013 real estate accounted for 82% of total assets for the 30 to 40 years age group, compared to 65% among the 65 to 70 years old. The younger ones, being more indebted than the older ones are much more vulnerable to external shocks, such as changes in property prices and interest rates. Renters and low-income families with children, again more likely to be young than older people, are still vulnerable groups.

In the years following the crisis the unemployment jumped from 2.4% in 2008 to peak of 7.6% in 2011, now at 4.4%. Even 7.6% is an enviable number in European perspective – the EU-28 unemployment was 9.5% in July 2015 and 10.9.% for the euro zone – but alarming for Iceland that has enjoyed more or less full employment and high labour market participation.

Many Icelanders felt pushed to seek work abroad, mostly in Norway, either only one spouse or the whole family. Poles, who had sought work in Iceland, moved back home. Both these trends helped mitigate cost of unemployment benefits.

Austerity was not the only crisis tool in Iceland but the country did not escape it. And as elsewhere, some have lamented that the crisis was not used better to implement structural changes, i.a. to increase competition.

The pure luck: low oil prices, tourism and mackerel

Iceland is entirely dependent on oil for transport and the fishing fleet is a large consumer of oil. Iceland is also dependent on imports, much of which reflect the price of oil, as does the cost of transport to and from the country. It is pure luck that oil prices have been low the years following the collapse, manna from heaven for Iceland.

The increase in tourism has been crucial after the crisis. Tourism certainly is a blessing but the jobs created are notoriously low-paying jobs. As anyone who has travelled around in Iceland can attest to, much of these jobs are filled not by Icelanders but by foreigners.

Until 2008, mackerel had never been caught in any substantial amount in Icelandic fishing waters: the catch was 4.200 ton in 2006, 152.000 ton in 2012. Iceland risked a new fishing war by unilaterally setting its mackerel quota. Fishing stocks are notoriously difficult to predict and the fact that the mackerel migrated north during these difficult years certainly was a stroke of luck.

The non-measureables: Special Prosecutor and the SIC report

As Icelanders caught their breath after the events around October 6 2008 the country was rife with speculations as to what had indeed happened and who was to blame. There were those who blamed it all squarely on foreigners, especially the British. But the collapse also changed the perception of Icelanders of corruption and this perception has lingered in spite of action taken against individuals. This seems to be changing, yet slowly.

When Vilhjálmur Bjarnason, then lecturer at the University of Iceland, now MP for the Independence party, said following the collape that around thirty men (yes, all males) had caused the collapse, many nodded.

Everyone roughly knew who they were: senior bankers, the main shareholders of the banks and the largest holding companies, all prominent during the boom years until the bitter end in October 2008. Many of these thirty have now been charged, some are already in prison and other fighting their case in courtrooms.

Alþingi responded swiftly to these speculations, by passing two Acts in December: setting up an Office of a Special Prosecutor, OSP and a Special Investigative Committee, SIC to clarify the collapse of the financial sector. These two Acts proved important steps for clearing the air and setting the records straight.

After a bumpy start – no one applied for the position of a Special Prosecutor – Ólafur Hauksson a sheriff from Reykjavík’s neighbouring town Akranes was appointed in January 2009. Out of 147 cases in the process of being investigated at the beginning of 2015, 43 are related to the collapse (the OSP now deals with all serious cases of financial fraud).

The Supreme Court has ruled in seven cases related to the collapse and sentenced in all but one case; Kaupthing’s second largest shareholder and three of the bank’s senior managers are now in prison after a ruling in the so-called al Thani case. – Gallup Iceland regularly measures trust in institutions. Since the OSP was included, in 2010, it has regularly come out on top as the institution enjoying the highest trust.

As to the SIC its report, published on 12 April 2010, counts a 2600 page print version, which sold out the day it was published, with additional material online; an exemplary work in its thoroughness and clarity.

The trio who oversaw the work – its chairman then Supreme Court judge Páll Hreinsson (now judge at the EFTA Court), Alþingi’s Ombudsman Tryggvi Gunnarsson and Sigríður Benediktsdóttir then lecturer in economics at Yale (now head of Financial Stability at the CBI) – presented a convincing saga: politicians had not understood the implication of the fast growing banking sector and its expansion abroad, regulators were too weak and incompetent, the CBI not alert enough and the banks egged on by over-ambitious managers and large shareholders who in some cases committed criminality.

How have these two undertakings – the OSP and the SIC – contributed to the Icelandic recovery? I fully accept that the effect, as I interpret it, is subjective but as said earlier: recovery after such a major shock is not only about direct economic measures.

Setting up the OSP has strengthened the sense that the law is blind to position and circumstances; no alleged crime is too complicated to investigate, be it a bank-robbery with a crowbar or excel documents from within a bank. The OSP calmed the minds of a nation highly suspicious of bankers, banks and their owners.

The benefit of the SIC report is i.a. that neither politicians nor special interests can hi-jack the collapse saga and shape it according to their interests. The report most importantly eradicated the myth that foreigners were only to blame – that Iceland had been under siege or attack from abroad – but squarely placed the reasons for the collapse inside the country.

The SIC had a wide access to documents, also from the banks. The report lists loans to the largest shareholders and other major borrowers. This clarified who and how these people profited from the banks, listed companies they owned together with thousands of Icelandic shareholders.

The SIC’s thorough and well-documented saga may have focused the political energy on sensible action rather than wasting it on the blame game. Interestingly, this effect is no less relevant as time goes by. To my mind, the atmosphere both in Ireland and Greece, two countries with no documented overview of what happened and why, testifies to this.

In addition, the report diligently focuses on specific lessons to be learnt by the various institutions affected. Time will show how well the lessons were learnt but at least heads of some of these institutions took the time and effort, with their staff, to study the outcome.

A country rife with distrust and suspicion is not a good place to be and not a good place for business. Both these undertakings cleared the air in Iceland – immensely important for a recovery after such a shock, which though in its essence an economic shock is in reality a profound social shock as well.

I mentioned sound institutions above. Their effect is not easily measureable but certainly well functioning key institutions such as ministries, National Statistics and the CBI have all been important for the recovery.

Lessons?

In its April 2012 Ex Post Evaluation of Exceptional Access Under the 2008 Stand-by Arrangement the IMF came up with four key lessons from Iceland’s recovery:

(i) strong ownership of the program … (ii) the social impact can be eased in the face of fiscal consolidation following a severe crisis by cutting expenditures without compromising welfare benefits, while introducing a more progressive tax system and improving efficiency; (iii) bank restructuring approach allowing creditors to take upside gains but also bear part of the initial costs helped limit the absorption of private sector losses by public sector; and (iv) after all other policy options are exhausted, capital controls could be used on a temporary basis in crisis cases such as Iceland, where capital controls have helped prevent disorderly deleveraging and stabilize the economy.

The above understandably refers to the economic recovery but recovering from a shock like the Icelandic one – or as in Ireland, Greece and Cyprus – is not only about finding the best economic measures, though obviously important. It is also about understanding and coming to terms with what happened.

As mentioned above, I firmly believe that apart from classic measures regarding insolvent banks and debt, both sovereign and private, the need to clarify what happened, as was done by the SIC and to investigate alleged criminality, as done by the OSP, is of crucial importance – something that Ireland (with a late and rambling parliamentary investigation), Greece, Cyprus and Spain could ponder on. All of this in addition to sound institutions and sound public finances before a crisis.

The soul lagging behind

In the olden days it was said that by traveling as fast as one did in a horse-drawn carriage the soul, unable to travel as fast, lagged behind (and became prone to melancholia). Same with a nation’s mood following an economic depression: the soul lags behind. After growth returns and employment increases it takes time until the national mood moves into the good times shown by statistics.

Iceland is a case in point. Although the country returned to growth, with falling unemployment, in 2011 the debate was much focused on various measures to ease the pain of households and nothing seemed ever enough.

The Gallup Expectations monitor turned upwards in late 2009, after a steep fall from its peak in late 2007, and has been rising slowly since. Yet it is now only at the 2004 level; the Icelandic inclination to spending has been sig-sawing upwards. – Here two graphs, which indicate the mood:

With plan in place to lift capital controls, the last obvious sign of the 2008 collapse will be out of the way. Implementation will take some years; a steady and secure execution this coming winter will hopefully lift spirits in the business community.

Living intimately with forces of nature, volcanoes and migrating fish stocks, and now tourists, as fickle as the fish in the ocean, Icelanders have a certain sangue-froid in times of uncertainty. Actions by the three governments since the collapse have at times been rambling but on the whole they have sustained recovery.

A sign of the lagging soul is that growth has not brought back trust in politics. Politicians score low: the most popular party now enjoying ca. 35% in opinion polls, almost seven years after the collapse and four years since turning to growth, is the Pirate party, which has never been in government.

Recovery (probably) secured – but not the future

As pointed out in a recent OECD report on Iceland the prospect is good and progress made on many fronts, the latest being the plan to lift capital controls: “inflation has come down, external imbalances have narrowed, public debt is falling, full employment has been restored and fewer families are facing financial distress. “

However, the worrying aspect is that in addition to fisheries partly based on cheap foreign labour the new big sector, tourism, is the same. Notoriously low productivity – a chronic Icelandic ill – will not be improved by low-paid foreign labour. Well-educated and skilled Icelanders are moving abroad whereas foreigners moving to the country have fewer skills. Worryingly, there is little political focus on this.

As the OECD points out “unemployment amongst university graduates is rising, suggesting mismatch. As such, and despite the economic recovery, Iceland remains in transition away from a largely resource-dependent development model, but a new growth model that also draws on the strong human capital stock in Iceland has yet to emerge.”

Iceland does not have time to rest on its recovery laurels. Moving out of the shadow of the crisis the country is now faced with the old but familiar problems of navigating a tiny economy in the rough Atlantic Ocean.

This post is cross-posted with A Fistful of Euros.

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Now that Greece has controls on outtake from banks, capital controls, many commentators are comparing Greece to Iceland. There is little to compare regarding the nature of capital controls in these two countries. The controls are different in every respect except in the name. Iceland had, what I would call, real capital controls – Greece has control on outtake from banks. With the names changed, the difference is clear.

Iceland – capital controls

The controls in Iceland stem from the fact that with its own currency and a huge inflow of foreign funds seeking the high interest rates in Iceland in the years up to the collapse in October 2008, Iceland enjoyed – and then suffered – the consequences, as had emerging markets in Asia in the 1980s and 1990s.

Enjoyed, because these inflows kept the value of the króna, ISK, very high and the whole of the 300.000 inhabitants lived for a few years with a very high-valued króna, creating the illusion that the country was better off then it really was. After all, this was a sort of windfall, not a sustainable gain or growth in anything except these fickle inflows.

Suffered, because when uncertainty hit the flows predictably flowed out and Iceland’s foreign currency reserve suffered. As did the whole of the country, very dependent on imports, as the rate of the ISK fell rapidly.

During the boom, Icelandic regulators were unable and to some degree unwilling to rein in the insane foreign expansion of the Icelandic banks. On the whole, there was little understanding of the danger and challenge to financial stability that was gathering. It was as if the Asia crisis had never happened.

As the banks fell October 6-9 2008, these inflows amounted to ISK625bn, now $4.6bn, or 44% of GDP – these were the circumstances when the controls were put on in Iceland due to lack of foreign currency for all these foreign-owned ISK. The controls were put on November 29 2008, after Iceland had entered an IMF programme, supported by an IMF loan of $2.1bn. (Ironically, Poul Thomsen who successfully oversaw the Icelandic programme is now much maligned for overseeing the Greek IMF programme – but then, Iceland is not Greece and vice versa.)

With time, these foreign-owned ISK has dwindled, is now at 15% of GDP but another pool of foreign-owned ISK has come into being in the estates of the failed bank, amounting to ca. ISK500bn, $3.7bn, or 25% of GDP.

In early June this year, the government announced a plan to lift capital controls – it will take some years, partly depending on how well this plan will be executed (see more here, toungue-in-cheek and, more seriously, here).

Greece – bank-outtake controls

The European Central Bank, ECB, has kept Greek banks liquid over the past many months with its Emergency Liquid Assistance, ELA. With the Greek government’s decision to buy time with a referendum on the Troika programme and the ensuing uncertainty this assistance is now severely tested. The logical (and long-expected) step to stem the outflows from banks is limit funds taken out of the banks.

This means that the Greek controls are only on outtake from banks. The Greek controls, as the Cypriot, earlier, have nothing to do with the value or convertibility of the euro in Greece. The value of the Greek euro is the same as the euro in all other countries. All speculation to the contrary seems to be entirely based on either wishful thinking or misunderstanding of the controls.

However, it seems that ELA is hovering close to its limits. If correct that Greek ELA-suitable collaterals are €95bn and the ELA is already hovering around €90bn the situation, also in respect, is precarious.

How quickly to lift – depends on type of controls

The Icelandic type of capital controls is typically difficult to lift because either the country has to make an exorbitant amount of foreign currency, not likely, a write-down on the foreign-owned ISK or binding outflows over a certain time. The Icelandic plan makes use of the two latter options.

Lifting controls on outtake from banks takes less time, as shown in Cyprus, because the lifting then depends on stabilising the banks and to a certain degree the trust in the banks.

This certainly is a severe problem in Greece where the banks are only kept alive with ELA – funding coming from a source outside of Greece. This source, ECB, is clearly unwilling to play a political role; it will want to focus on its role of maintaining financial stability in the Eurozone. (I very much understand the June 26 press release from the ECB as a declaration that it will stick with the Greek banks as long as it possibly can; ECB is not only a fair-weather friend…)

Without the IMF it would have been difficult for Iceland to gather trust abroad in its crisis actions – but Greece is not only dependent on the Eurozone for trust but on the ECB for liquidity. Without ELA there are no functioning Greek banks. If the measures to stabilise the banks are to be successful the controls are only the first step.

*Together with professor Þórólfur Matthíasson I have earlier written on what Icelandic lessons could be used to deal with the Greek banks. – Cross-posted at Fistful of euros.

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There are many misconceptions floating around regarding Iceland and capital controls. Here are the barest essentials:

Iceland introduced capital controls on November 29, seven weeks after the official collapse date October 2008. The reason was not money flowing out of banks, as in Cyprus but because foreigners, mostly those who had invested in Icelandic bonds, so called “Glacier bonds”, were converting their Icelandic funds into foreign currency, rapidly draining the none-too large currency reserves. At the time, these holdings amounted to 44% of GDP.

Over time, this original overhang of 44% of GDP has been reduced and now amounts to 16%. This is a process overseen by the Central Bank of Iceland, CBI, which has held auctions to match in- and outflows. The original overhang is further being worked on; the Central Bank of Iceland recently announced measures and more will come as part of a plan to lift capital controls.

The controls are on CAPITAL, meaning that capital, i.a. for investment can not be moved in our out of the country. This means that Iceland no longer adheres to the four freedoms of European Economic Area, EEA, i.e. freedom on goods, services, people and capital.

However, the controls are NOT on goods and services, meaning that money to pay for goods and services can move freely.

With time however another reserve of foreign-owned ISK has formed, i.e. ISK in the estates of the three failed banks. Since foreign creditors hold ca. 95% of the claims to these three estates the ISK assets of the estates are another pool of foreign-owned ISK, now ca. 25% of GDP. FX assets of Glitnir amount to 63% but the FX ratio in Kaupthing is 72%.**

These two pools of foreign-owned ISK holds the controls in place, which is why a plan needs to tackle both of them. As said earlier, the old overhang is already part of a process. What now needs to be tackled is the ISK pool within the estates of the three banks.

The simple and classic way to solve this kind of a problem (Iceland certainly is not the first country to face this problem) would be to negotiate with creditors on a haircut of the ISK assets in the estates. This is what the creditors have been hoping for and this is what the Icelandic government has not been willing to do.

The government’s reasoning has been that engaging with creditors was none of their business and could expose the government to legal risk. After all, the estates are of private companies, no relation to the state. However, the estates cannot be resolved unless it is clear how to deal with their ISK assets and since they cannot be taken out of the country the creditors cannot be paid out, i.e. the estates cannot be resolved. Which means that really, the government holds the threads, i.e. because it has put legislation in place regarding the estates and so, the government is already part of this equation.

Now it seems that the creditors will get some sort of an offer – maybe with a scope to negotiate, maybe only a take-it-or-leave-it offer. Remains to be seen until all the government’s cards are on the table, probably Monday afternoon.

What complicates matters is that the government seems to want not only to get a cut of the ISK assets but of the foreign assets as well. There is no balance-of-payment reason for taking foreign funds though the government refers to “stability tax.”

Further, the Icelandic capital controls are NOT a sovereign debt problem, such as lie at the core of the Argentinian dispute with creditors nor is it parallel to the Greek situation, another sovereign debt problem. And the Icelandic capital controls are not comparable to the Cypriot controls, which were put in place to keep money in the banks and prevent them from collapsing as funds flowed out.

*For data regarding the estates and capital controls see the latest CBI Financial Stability report.

**UPDATE: sorry, I wrote earlier that this was the ISK ratio – it is of course the FX ratio!

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The Swiss Franc unpegging from the euro 15 January this year brought the risk of foreign currency borrowing for unhedged borrowers yet again to the fore. In Central, Eastern and South-Eastern Europe lending in Swiss Franc and other foreign currency, most notably in euros, has been common since the early 2000s, often amounting to more than half of loans issued to households. The 2008 crisis put some damper on this lending, did not stop it though and in addition legacy issues remain. Now, actions by foreign currency borrowers in various countries are also unveiling a less glorious aspect: mis-selling and breach of European Directives on consumer protection. Senior bankers involved in foreign currency lending invariably claim that banks could not possibly foresee FX fluctuation. Yet, all of this has happened earlier in different parts of the world, most notably in Australia in the 1980s.

“The 2008-09 financial crisis has highlighted the problems associated with currency mismatches in the balance sheets of emerging market borrowers, particularly in Emerging Europe,” economists at the European Bank of Reconstruction and Development, EBRD, Jeromin Zettelmeyer, Piroska Nagy and Stephen Jeffrey wrote in the summer of 2009.*

In the grand scheme of Western and Northern European countries this mismatch was a little-noticed side-effect of the 2008 crisis. But at the EBRD, focused on Central, Eastern, South East European, CESEE, countries, its chief economist Erik Berglöf and his colleagues worried since foreign currency, FX, lending was common in this part of Europe. FX lending per se was not the problem but the fact that these loans were to a great extent issued to unhedged borrowers, i.e. borrowers who have neither assets nor income in FX. This lending was also partly the focus of the Vienna Initiative, launched in January 2009 by the EBRD, European and international organisations and banks to help resolve problems arising from CESEE countries mainly being served by foreign banks.

In Iceland FX lending took off from 2003 following the privatisation of the banks: with the banks growing far beyond the funding capacity of Icelandic depositors, foreign funding poured in to finance the banks’ expansion abroad. Icelandic interest rates were high and the rates of euro, Swiss Franc, CHF and yen attractive. Less so in October 2008 when the banks had collapsed: at the end of October 2007 1 euro stood at ISK85, a year later at ISK150 and by October 2009 at ISK185.

After Icelandic borrowers sued one of the banks, the Supreme Court ruled in a 2010 judgement that FX loans were indeed legal but not FX indexed loans, which most of household loans were. It took further time and several judgements to determine the course of action: household loans were recalculated in ISK at the very favourable foreign interest rates. Court cases are still on-going, now to test FX lending against European directives on consumer-protection.

In all these stories of FX loans turning into a millstone around the neck of borrowers in various European countries senior bankers invariably say the same thing: “we couldn’t possibly foresee the currency fluctuations!” In a narrow sense this is true: it is not easy to foresee when exactly a currency fluctuation will happen. Yet, these fluctuation are frequent; consequently, if a loan has a maturity of more than just a few years it is as sure as the earth revolving around the sun that a fluctuation of ca. 20%, often considerably more, will happen.

Interestingly, many of the banks issuing FX loans in emerging Europe did indeed make provisions for the risk, only not on behalf of their clients. According to economist at the Swiss National Bank, SNB, Pinar Yeşin “banks in Europe have continuously held more foreign-currency-denominated assets than liabilities, indicating their awareness of the exchange-rate-induced credit risk they face.”

Indeed, many of the banks lending to unhedged borrowers took measures to hedge themselves. Understandably so since it has all happened before. Recent stories of FX lending misery in various European countries are nothing but a rerun of what happened in many countries all over the world in earlier decades: i.a., events in Australia in the 1980s are like a blueprint of the European events. In Australia leaked documents unveiled that senior bankers knew full well of the risk to unhedged borrowers but they kept it to themselves.

It can also be argued that given certain conditions FX lending led to systematic lending to CESEE clients borrowing more than they would have coped with in domestic currency making FX lending a type of sub-prime lending. What now seems clear is that cases of mis-selling, unclear fees and insufficient documentation now seem to be emerging, albeit slowly, in European FX lending to unhedged borrowers.

FX lending in CESEE: to what extent and why

A striking snapshot of lending in Emerging Europe is that “local currency finance comes second,” with the exception of the Czech Republic and Poland, as Piroska Nagy pointed out in October 2010, referring to EBRD research. With under-developed financial markets in these countries banking systems there are largely dominated by foreign banks or subsidiaries of foreign banks.

This also means, as Nagy underlined, that there is an urgent need to reduce “systemic risks associated with FX lending to unhedged borrowers” as this would remove key vulnerabilities and “enhance monetary policy effectiveness.”

Although action has been taken in some of the European countries hit by FX lending, “legacy” issues remain, i.e. problems stemming from prolific FX lending in the years up to 2008 and even later. In short, FX lending is still a problem to many households and a threat to European banks, in addition to non-performing loans, i.e. loans in arrears, arising from unhedged FX lending.

The most striking mismatch in terms of banks’ behaviour is evident in the operations of the Austrian banks that have been lending in FX at home in Austria the euro country, but also abroad in the neighbouring CESEE countries. In Austria, FX loans were available to wealthy individuals who mostly hedged their FX balloon loans (i.e. a type of “interest only” loans) with insurance of some sort. Abroad however, “these loans in most cases had not been granted mostly to relatively high income households,” as somewhat euphemistically stated in the Financial Stability report by the Austrian Central Bank, OeNB in 2009.

There is plenty of anecdotal evidence to conclude that during the boom years banks were pushing FX loans to borrowers, rather than the other way around. Thus, it can be concluded that the FX lending in CESEE countries was a form of sub-prime lending, that is people who did not meet the requirements for borrowing in the domestic currency could borrow, or borrow more, in FX. This would then also explain why FX loans to unhedged borrowers did become such a major problem in these countries.

Where these loans have become a political issue FX borrowers have often been met with allegations of greed; that they were trying to gain by gambling on the FX market. In 2010 Martin Brown, economist at the SNB and two other economists published a study on “Foreign Currency Loans – Demand or Supply Driven?” They attempted to answer the question by studying loans to Bulgarian companies 2003-2007. What they discovered was i.a. that for 32% of the FX business loans issued in their sample the companies had indeed asked for local currency loan.

“Our analysis suggests that the bank lends in foreign currency, not only to less risky firms, but also when the firm requests a long-term loan and when the bank itself has more funding in euro. These results imply that foreign currency borrowing in Eastern Europe is not only driven by borrowers who try to benefit from lower interest rates but also by banks hesitant to lend long-term in local currency and eager to match the currency structure of their assets and liabilities.”

In other words, the banks had more funding in euro than in the local currency and consequently, by lending in FX (here, euro), the banks were hedging themselves in addition to distancing themselves from instable domestic conditions. A further support for this theory is FX lending in Iceland, which took off when the banks started to seek funding on international markets. (The effect on banks’ FX funding is not uncontested: further on reasons for FX lending in Europe see EBRD’s “Transition Report” 2010, Ch. 3, esp. Box 3.2.)

The Australian lesson: with clear information “…nobody in their right mind… would have gone ahead with it”

Financial deregulation began in Australia in the early 1970s. Against that background, the Australian dollar was floated in December 1983. In the years up to 1985 banks in Australia had been lending in FX, often to farmers who previously had little recourse to bank credit. However, the Australian dollar started falling in early 1985; from end of 1984 to the lowest point in July 1986 the trade-weighted index depreciated by more then a third. Consequently, the FX loans became too heavy a burden for many of the burrowers, with the usual ensuing misery: bankruptcy, loss of homes, breaking up of marriages and, in the most tragic cases, suicide.

The Australian bankers shrugged their shoulders; it had all been unforeseeable. FX borrowers who tried suing the banks lost miserably in court, unable to prove that bankers had told them the currency fluctuations would never be that severe and if it did the bank would intervene. As one judge put it: “A foreign borrowing is not itself dangerous merely because opportunities for profit, or loss, may exist.” The prevailing understanding in the justice system was that those borrowing in FX had willingly taken on a gamble where some lose, some win.

But gambling turned out to be a mistaken parallel: a gambler knows he is gambling; the FX borrowers did not know they were involved in FX gambling. The borrowers got organised, by 1989 they had formed the Foreign Currency Borrowers Association and assisted in suing the banks. The tide finally turned in favour of the borrowers and against the banks; the courts realised that unlike gamblers the borrowers had been wholly unaware of the risk because the banks had not done their duty in properly informing the FX borrowers of the risk. But by this time FX borrowers had already been suffering pain and misery for four to five years.

What changed the situation were internal documents, two letters, tabled on the first day of a case against one of the banks, Westpac. The letters, provided by a Westpac whistle-blower, John McLennan, showed that when the loan in question was issued in March 1985 the Westpac management was already well aware of the risk but said nothing to clients. Staff dealing with clients was often ignorant of the risks and did not fully understand the products they were welling. When it transpired who had provided the documents Westpac sued McLennan – a classic example of harassment whistle-blowers almost invariably suffer – but later settled with McLennan.

As a former senior manager summed it up in 1991: “Let us face it – nobody in their right mind, if they had done a proper analysis of what could happen, would have gone ahead with it.” (See here for an overview of some Australian court cases regarding FX loans).

FX borrowers of all lands, unify!

“Probably like a lot of other people (.) I felt that the banks knew what they were doing, and you know, that they could be trusted in giving you the right advice,” is how one Westpac borrower summed it up in a 1989 documentary on the Australian FX lending saga.

This misplaced trust in banks delayed action against the banks in Australia in the 1980s and in all similar sagas. However, at some point bank clients realise the banks take their care of duty towards clients lightly but are better at safeguarding own interests. As in Australia, the most effective way is setting up an association to fight the banks in a more targeted cost-efficient way.

This has now happened in many European countries hit by FX loans and devaluation. At a conference in Cyprus in early December, organised by a Cypriot solicitor Katherine Alexander-Theodotou, representatives from fifteen countries gathered to share experience and inform of state of affairs and actions taken in their countries regarding FX loans. This group is now working as an umbrella organization at a European level, has a website and aims i.a. at influencing consumer protection at European level.

Spain is part of the euro zone and yet banks in Spain have been selling FX loans. Patricia Suárez Ramírez is the president of Asuapedefin, a Spanish association of FX borrowers set up in 2009. She says that since the Swiss unpegging in January the number of Asuapedefin members has doubled. “There is an information mismatch between the banks and their clients. Given the full information, nobody in their right mind would invest all their assets in foreign currency and guarantee with their home. Banks have access to forecasts like Bloomberg and knew from early 2007 that the euro would devalue against the Swiss Franc and Japanese Yen.”

As in Australia, the first cases in most of the European countries have in general and for various reasons not been successful: judges have often not been experienced enough in financial matters; as in Australia clients lack evidence; there tends to be a bias favouring the banks and so far, only few cases have reached higher instances of the courts. However, in Europe the tide might be turning in favour of FX borrowers, thanks to an fervent Hungarian FX borrower.

The case of Árpád Kásler and the European Court of Justice

In April 2014 the European Court of Justice, ECJ, ruled on a Hungarian case, referred to it by a Hungarian Court: Árpád Kásler and his wife v OTP Jelzálogbank, ECJ C‑26/13. The Káslers had contested the bank’s charging structure, which they claimed unduly favoured the bank and also claimed the loan contract had not been clear: the contract authorised the bank to calculate the monthly instalment on the basis of the selling rate of the CHF, on which the loan was based, whereas the amount of the loan advanced was determined by the bank on the basis of the buying rate of the CHF.

After winning their case the bank appealed the judgement after which the Hungarian Court requested a preliminary ruling from the ECJ, concerning “the interpretation of Articles 4(2) and 6(1) of Council Directive 93/13/EEC of 5 April 1993 on unfair terms in consumer contracts (OJ 1993 L 95, p. 29, ‘the Directive’ or ‘Directive 93/13’).”

In its judgment the ECJ partly sided with the Káslers. It ruled that the fee structure was unjust: the bank did not, as it claimed, incur any service costs as the loan was indeed only indexed to CHF; the bank did not actually go into the market to buy CHF. The Court also ruled that it was not enough that the contract was “grammatically intelligible to the consumer” but should also be set out in such a way “that consumer is in a position to evaluate… the economic consequences” of the contract for him. Regarding the third question – what should substitute the contract if it was deemed unfair – the ECJ left it to the national court to decide on the substitute.

Following the ECJ judgement in April 2014, the Hungarian Supreme Court ruled in favour of the Káslers: the fee structure had indeed favoured the bank and was not fair, the contract was not clear enough and the loan should be linked to interest rates set by the Hungarian Central Bank. – As in the Australian cases Kásler’s fight had taken years and come at immense personal pain and pecuniary cost.

Hungarian law are not precedent-based, which meant that the effect on other similar loan contracts was not evident. In July 2014 the Hungarian Parliament decided that banks lending in FX should return the fee that the Kásler judgement had deemed unfair.

The European Banking Authority, EBS is the new European regulator. The ECJ ruling in many ways reflects what the EBA has been pointing from the time it was set up in 2011. In its advice in 2013 on good practice for responsible mortgage lending it emphasises “a comprehensive disclosure approach in foreign currency lending, for example using scenarios to illustrate the effect of interest and exchange rate movements.”

Calculated gamble v being blind-folded at the gambling table

“Since the ECJ judgment in the Kásler case, judges in Spain have started to agree with consumers from banks,” says Patricia Suárez Ramírez. So far, anecdotal evidence supports her view that the ECJ judgment in the Kásler case is, albeit slowly, determining the course of other similar cases in other EU countries.

The FX loans were clearly a risk to unhedged borrowers in the countries where these loans were prevalent. If judgements to come will be in favour of borrowers, as in ECJ C‑26/13, the banks clearly face losses: in some cases even considerable losses if the FX loans will have to be recalculated on an extensive scale, as did indeed happen in Iceland.

Voices from the financial sector are already pointing out the unfairness of demands that the banks recalculate FX loans or compensate unhedged FX borrowers. However, it seems clear that banks took a calculated gamble on FX lending to unhedged borrowers. In the best spirit of capitalism, you win some you lose some. The unfairness here does not apply to the banks but to their unhedged clients, who believed in the banks’ duty of care and who, instead of being sold a sound product, were led blind-folded to the gambling table.

*The first draft was written in July 2009; published 2010 as EBRD Working Paper.

This is the first article in a series on FX lending in Europe: the unobserved threat to FX unhedged borrowers – and European banks.The next article will be on Austrian banks, prolific FX lenders both at home and abroad, though with an intriguing difference. The series is cross-posted on Fistful of Euros.

See here an earlier article of mine on FX lending, cross-posted on Fistful of Euros and my own blog, Icelog.

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Back in the 1980s Australians, many of them farmers, were offered low-interest loans, appealing in a high-interest environment. With changes in currency rates the loans in Swiss francs and Japanese yen quickly became much beyond the means of the borrowers to service with ensuing pain and suffering. The same story has since played out in country after country with the obvious lesson reiterated: for people with income only in their domestic currency FX borrowing is too high-risk to be wise. Icelanders felt the FX loans’ pain as the Icelandic króna depreciated 2008 as did many Eastern-European countries. – All these loans, often the result of predatory lending, follow the same pattern and it is no coincidence where they hit. There is now ample case for countries to take action: banks should be forbidden to lend in FX to private individuals with all their income in the domestic currency.

Australia in the 1980s, New Zealand in the 1990s, Iceland and a whole raft of other European countries in the 2000s saw liberalised markets but inflation was high and so were interest rates. By taking an FX loan or even just a loan pegged to FX the high domestic interest rates could be avoided – it seemed too good to be true.

Sadly it was indeed too good to be true: currency fluctuations changed the circumstances and servicing FX loans for those with income in the domestic currency became unsustainable. For loans running over many years this was, statistically seen, almost unavoidable. FX loans have turned into a huge problem in countries such Croatia, Bosnia, Bulgaria, Montenegro, Poland and Ukraine but politicians and banks have ignored the problem. These cases were spelled out at a conference on CHF/FX loans in Cyprus in December. Organised by Katherine Alexander-Theodotou president of the UK Anglo-Hellenic and Cypriot Law Association and various representatives of organisations fighting FX loans, the organisers have recently set up European Legal Committee for Consumer Rights to co-ordinate their work in the various countries marred by FX loans.

The recent shock of the CHF appreciation is now forcing the problem into the foreground in these countries. But more should be done: this problem should be solved once and for all because as long as banks and investors see profits in these loans this sorry saga will continue in new countries.

Australia in the 1980s

In Australia banks started offering customers, many of them farmers, yen and CHF loans in the 1980s. With Australian interest rates at around 10-16% the 7% rates of the yen and the CHF was attractive. When the Australian dollar started depreciating in 1986 the difference in interest rates was by far not enough to compensate for the new ratio between the Aussie dollar and other currencies.

As always, the borrowers first tried to keep on paying, then to negotiate new terms with the banks followed by court cases, mostly based on the banks’ negligence of warning the borrowers of the inherent risk of FX loans. To begin with, the borrowers were fighting on their own, not realising that there were so many others in the same situation.

The banks had the upper hand in court: people should have understood the risk and it was neigh impossible for the borrowers to prove what the bankers had said or not said, promised or not several years earlier. The banks claimed the loans had been issued in good faith and foreseeing the Aussie dollar depreciation had been impossible.

Westpac had been particularly successful in the FX loan market. In 1991 a former Westpac executive, John McLennan, leaked two letters from 1986 showing that the bank was well aware of the risk. What ensued was an investigation, which exposed that not only had Westpac been aware of the risk but a law firm had helped it covering its track. This turned into a classic whistle-blower case: Westpac sued McLennan but later settled.

The letters set the story straight, politicians finally turned against the banks and thus the borrowers got the upper hand and some compensation. But all of this only happened five years after the depreciation, leaving many borrowers bankrupt with all the tragedies such events bring on.

The Australian saga entails the same elements later seen in country after country: banks lend in FX to people who neither have an FX income nor are particularly well-placed to gauge the risk; politicians side with the banks – and only after much struggle and long time are borrowers able to get a write-down or other assistance. But by then, tragedies such as divorce or homes lost have already happened and things can never be the same or compensated.

Iceland: where politicians sided with borrowers

High inflation and consequently high interest rates characterised booming Iceland after the privatisation of the financial system in 2003. Banks were eager to grow by issuing loans and lend funds they borrowed internationally. With credit boom in Iceland savings were insufficient to satisfy the credit demand. Icelandic borrowers were offered so called “currency basket loans”: FX indexed loans usually based on a mixture of currency, usually US$, euro, CHF and yen.

As in Australia, things changed and fairly quickly. From October 2007 to October 2008 the króna had been depreciating drastically: €1 cost ISK85 at the beginning of this period but ISK150 in the end; by October 2009 the €1 stood at ISK185.

Borrowers complained, turned to their banks and some individual solutions were found. However, quickly borrowers were not only turning to the banks but to courts. There were no class actions but individuals sought to court, the cases were well publicised and others in the same situation followed them intently.

Already in June 2010 the first Supreme Court judgment fell regarding two such cases. According to the ruling it was against Icelandic law to tie interest rates on Icelandic loans, loans in Icelandic króna, to foreign currency but perfectly legal to lend in FX.

The result was huge uncertainty: first of all, which loans were legal and which were not, i.e. which loans were real FX loans and which were only FX indexed loans – and if some of these loans were illegal what should the interest rates be?

The banks distinguished between loans to private individuals and to companies where company loans have mostly been regarded as legal FX loans, i.e. the companies did indeed receive FX whereas loans to individuals have all been treated as illegal, i.e. not proper FX loans but only with interest rates tied to FX, no matter the form. The Supreme Court ruled that instead of the FX currency interest rates the lowest CBI rates should be used causing substantial losses to the banks.

The Supreme Court has by now ruled in around thirty FX loans’ cases. There are however still on-going FX loan cases in the courts, some of them related to consumer information such as Directive 87/102/EEC The Consumer Credit Directive, Directive 93/13/EEC The Unfair Terms Directive and Directive 2005/29/EC The Unfair Commercial Practices Directive

The peculiarity of the Icelandic FX loans saga is that from the first borrowers had political support, very much contrary to other countries where FX loans have been common. This is partly due to the fact the Icelandic households have long been highly indebted, which has to a certain degree tilted sympathy towards debtors rather than towards those who are trying to save money.

Croatia, Hungary and Poland

The fight of Croatian FX borrowers have their own organisation, the Franc Association but their fight has been arduous, as covered earlier on Icelog. Already last year, Franc won a case against eight banks, all foreign or foreign-owned subsidiaries: UniCredit – Zagrebačka Banka, Intesa SanPaolo – Privredna Banka Zagreb, Erste & Steiermärkische Bank, Raiffeisenbank Austria, Hypo Alpe-Adria-Bank, OTP Bank, Société Générale – Splitska banka and Sberbenk.

The banks were found to have violated customer protection law by not informing clients properly. Further, the Croatian government has now decided to freeze interest rates for one year while further solutions will be sought, with banks forced to take a write-down on these loans.

In Hungary, where FX loans were among the most widespread in Eastern Europe before the 2008 crash, the government ordered banks last year to fix conversion of euro and CHF loans into Hungarian florints to a rate well below market levels. Following the recent CHF deprivation the government has said that no further action will be taken.

Polish FX loans have not been issued since the financial crisis of 2008 but the number of loans before that had been high, which means that many are still suffering their effect. Last year, governor of the Polish Central Bank Marek Belka said these loans were a ticking time-bomb. It certainly has blown up now with the CHF appreciation. The Polish government is now seeking a solution and regulators are investigating collusion on lending terms among the banks issuing the FX loans.

The underlying mechanism of FX loans

Although FX loan sagas vary in details from country to country the general mechanism is everywhere the same, always with four actors involved: international financial institutions looking for interest margins; investors, often called “Belgian dentists,” i.e. wealthy individuals looking for moderate-risk long-term investments; domestic financial institutions (often foreign subsidiaries) selling domestic currency, looking to lend in FX; domestic borrowers looking for low-interest loans.

The FX loans are normally marketed to middle or low-income earners in small or transition economies, recently been liberalised, with unstable currency or where the currency lacks credibility – and/or where interest rates are high. The banks issuing the loans are often, but not always, foreign banks, operating in a weak legal environment with weak or no customer protection.

There are certainly FX loans in other countries, such as the UK but there they have mostly been issued to wealthy borrowers often financing property deals abroad. The situation can certainly be painful for those individuals but these loans are anomalous, hitting only a very limited part of borrowers. In France, many local councils are struggling with CHF loans and fighting financial institutions in court, again clearly a major problem for the councils but now following the general pattern of FX loans listed above.

The general description above fits Australia, New Zealand, Iceland – and the countries where many borrowers have been sorely struggling with FX/CHF loans since 2008, i.a. Poland, Croatia, Hungary and other countries. With the exception of Iceland these countries have been fighting the banks for years, often with limited or only very late success. Only the recent CHF appreciation has finally managed to clearly demonstrate the calamity these loans are for normal borrowers with income only in their domestic currency.

The only sensible solution to FX (predatory) lending

For more than thirty years FX loans have periodically been causing huge harm and personal tragedy in country after country. The pattern is always the same. Banks continue this type of lending, every time minimising or ignoring the risk to unenlightened borrowers. The only new elements are a new country and new people to suffer the consequences.

Since this story has been repeating itself for decades, bankers issuing these loans cannot reasonably claim to be unaware of the risk. Instead, FX lending to private individuals with no FX hedge increasingly looks like predatory lending: the banks must have been aware of the risk and known that the risk had indeed materialised earlier in other countries.

Bankers have so far shown little aptitude of learning anything at all from the past few decades. National and international organisations working in the field of financial regulation and consumer protection should work towards making FX lending to private individuals with no FX hedge illegal. Until that happens the FX loans will continue to find new countries to wreck havoc in.

*Another side to the FX lending is whether the banks issuing the loans have properly hedged their FX exposure of their liabilities. There is indication that banks in i.a. Austria, Croatia and Hungary have held more CHF assets than liabilities. This is another interesting aspect, which I hope to cover later.

If any Icelog reader has documents showing that banks were aware of the risk of FX borrowing to clients but did wilfully not inform them I would be interested in hearing from them.

Update 15.11.22 – obs: some of the links are now out of date. 

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