The Magazine

Iceland Melts Down

A subprime borrower defaults in Orlando, and a Pole buys a used car in Reykjavik.

Nov 3, 2008, Vol. 14, No. 08 • By JONATHAN V. LAST
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On October 6, Iceland's prime minister, Geir Haarde, claimed his country was on the verge of "national bankruptcy." Over the following days, the government was forced to nationalize the three big Icelandic banks. The stock market crashed, and the krona became so devalued that trading was halted. Members of the Icelandic government were placed under police protection for the first time in the nation's history. Various English-language press reports suggested that food shortages were days away. The Icelandic government undertook formal negotiations for a bailout with Russia, speculation being that the Russians would want the abandoned U.S. airbase at Keflavik in return. Iceland, it seemed, was on its way to becoming a frozen banana republic.

The reality is somewhat less hysterical. Icelanders continue to work and drive and, to a lesser degree, shop. The grocery stores are fully stocked. Offering greenbacks to merchants doesn't trigger any under-the-table discounts. The Icelandic government, having previously said it had secured a loan from Russia (it hadn't), last Monday leaked word that it had coordinated a $6 billion loan with the IMF, Norway, Sweden, and Japan. That loan never materialized and on Friday, Haarde announced that the government would begin negotiations with the IMF for $2 billion in immediate aid--leaving Russia's generosity blessedly untouched.

The fact that Iceland has not gone literally bankrupt, however, is the end of the good news. The financial crisis that began with mortgage defaults in California and Florida has wreaked havoc in the North Atlantic. And the worst is yet to come.

Before October, Iceland was an economic Cinderella story with sustained annual growth of 4 percent and the fifth highest per capita GDP in the world. The OMX Iceland 15, their version of the Dow, stood slightly off its historic highs of 2007. The engine of this success was the country's banks, whose privatization was completed in 2000. The three banks--Glitnir, Landsbanki, and Kaupthing--embarked on a course of aggressive foreign expansion, gathering overseas investors attracted by Iceland's high interest rates. The combination of the krona's strength (in 2007, the Economist estimated that the krona was the most overvalued currency in the world--by 131 percent) and the Icelandic central bank's high interest rates (which peaked at 15.5 percent) made saving in Internet accounts, such as Landsbanki's "Icesave" program, particularly attractive to Europeans. Three-hundred thousand Britons socked away £4.6 billion ($7.8 billion) in Icesave alone. For a sense of scale, Iceland has a population of 304,000 and a total annual GDP of $20 billion.

Iceland's banks were not particularly risky constructions. They were not weighted down by the subprime-debt packages--excuse me, structured investment vehicles--which caused so much trouble in America. But their reliance on foreign investment left them dangerously exposed to disruptions in the credit markets. When the markets seized up in late September, Iceland's banks were unable to secure loans to meet their short-term debts. It was a difficult and perilous moment. Iceland's leaders made the situation worse.

When Glitnir faltered first, in late September, it approached the Sedlabanki, Iceland's central bank, for a short-term loan. The head of the central bank, David Oddsson, is a politician with no background in economics. He was mayor of Reykjavik and then prime minister from 1991-2004. Oddsson reacted to the situation like a politician: He declined to bail out Glitnir and pushed for aggressive nationalization.

As Richard Porkes explained in the Financial Times, "This triggered a sovereign debt downgrade and a sharp further fall in the already depreciated krona. Short-run funding for Glitnir and Landsbanki evaporated, margin calls came from the European Central Bank, loan covenants kicked in."

Because of all this, Landsbanki failed a week later. The government nationalized it, too. But Oddsson wasn't finished. In another political maneuver, he intimated that the Icelandic banks might not be able to pay their U.K. investors. This prompted Gordon Brown to lockdown Icelandic assets in the U.K.--using a provision originally crafted as part of a post-9/11 anti-terror statute. Brown wasn't about to abandon constituents who were losing their savings. The seizure killed Kaupthing, the one bank which still had life in it. The government took it over the next day. Suddenly, the Icelandic government was holding $61 billion of bank debt--roughly 8 times the national budget.