The Isle That Rattled the World

[frigidmagi]

WSJ

[quote]A boy charged to the front of an angry crowd here recently and tossed a carton of skyr, a popular local yogurt-like snack, at the Parliament building. It splattered on the rough-hewn stone.

He and thousands of Icelanders were protesting one of the strangest economic failures of the global financial crisis. This past fall, every bank that matters in this tiny nation -- that is, all three of them -- failed. Iceland's currency, the krona, became worthless beyond its shores. The country's financial system stopped working.

"We are pissed off at the government," said one young man, pausing between fusillades of eggs. A roll of toilet paper arced across the Nordic sky.
Voices of Anger, Shame in Iceland

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In the whipping wind, a woman held a cardboard with a screaming mouth on Nov. 21.

Iceland is an extreme casualty of an era in which it became extraordinarily easy to borrow money. But it was more than that: An examination of the nation's banking system, which collapsed over about 10 days this autumn, reveals the degree to which Iceland was one of the international financial bubble's most enthusiastic players. Home to fewer people than Wichita, Kan., Iceland became so leveraged and so deeply intertwined with the global financial infrastructure that its collapse has rattled the world from Tokyo to California to the Middle East.

In Japan and Hong Kong, bond buyers got stuck holding all-but-worthless debt. In Beverly Hills, a real-estate developer was forced to default after teaming up with an Icelandic bank to build condos near Wilshire Boulevard. A German regional lender, Bayerische Landesbank, suffered big losses on its Icelandic investments contributing to its need for a €30 billion ($42 billion) bailout package.

And in recent weeks, Naomi House, a hospice in southern England, had to cancel a service in which aides made house calls to give the parents of dying children a helping hand. Some £5.7 million ($8.7 million) -- two-thirds of its available cash -- is frozen and may never be fully returned. It was deposited in an Icelandic bank.

Khalid Aziz, chairman of the hospice trust, says he didn't think twice back in 2005 when Icelanders bought the local bank. "With the globalization of markets," he says, "everybody owns everything these days, don't they?"
Reindeer, Gooseberries
video
How Iceland Collapsed
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WSJ's Andy Jordan examines how Iceland's economic miracle came to an abrupt end and explains why the world should care about the collapse of the small country's financial system.

Until very recently, the 21st century had smiled on Iceland. Last year, it boasted the highest standard of living of any country, according to the United Nations -- outranking the U.S., for all its McMansions and drive-through coffee shops, and Sweden with its government-paid parental leave and other generous social benefits.

High interest rates set by the central bank kept foreign money flowing onto the island, strengthening the krona and making imported goods easily affordable. Iceland's ports unloaded ships full of swank Scandinavian furniture, building materials for new houses and sport-utility vehicles. Imports were boundless: Recently, cape gooseberries were a common adornment on the plates of Reykjavik's chic restaurants.

Iceland has long had many valuable natural assets. It sits amid some of the world's best fishing grounds, and that industry sustained the local economy for centuries. It is a wild, beautiful place where some people still believe in alfar, or elves.

The cinematic landscape of fjords, glaciers and reindeer attracts adventurous tourists and their dollars. The earth's innards bubble to the surface in volcanoes and geysers -- a product of Iceland's location atop the violent meeting point of the North American and Eurasian tectonic plates.

But in the early 1990s, some people felt Iceland could be more than a showcase for nature and producer of salt cod.

Leading the charge was David Oddsson. A shaggy-haired former mayor of Reykjavik, Mr. Oddsson was an Icelandic character: a writer of short stories and religious hymns, the one-time host of a comic radio program and, as a youth, an aspiring actor who dressed as Santa Claus to earn pocket money at Christmas.

He was known for his wit, says Hannes Gissurarson, a member of Mr. Oddsson's inner circle at the time. When Shimon Peres, the Israeli politician, visited Iceland, Mr. Oddsson jokingly said to him: "You are the chosen people, we are the frozen people," according to Mr. Gissurarson.

Mr. Oddsson became prime minister in 1991 promising to bring an end to the country's boom-and-bust cycles tied to the fish catch. He blamed the trouble on the state-controlled economy, which put bureaucrats in charge of fishing, the media, even a travel agency.

Within a few years, Iceland had sold off companies worth a combined $2 billion, a big sum for the small economy, says Mr. Gissurarson.

For Mr. Oddsson, what most held Iceland back was government control of banking, which put politicians in the position of determining how capital should be allocated. "The crucial factor," he said in a 2004 speech, "was the iron grip that the Icelandic state had on all business activity through its ownership of the commercial banks."

He sold them all.
From Fish to Finance

Icelanders embraced change. The highly educated populace launched biotechnology and software companies. Ossur hf, an Icelandic maker of artificial limbs, grew into a global supplier of high-tech prosthetics. At this year's Beijing Paralympic Games, the South African sprinter Oscar Pistorius won three gold medals wearing Ossur's "Cheetah" brand legs, running the 100-meter dash in 11.17 seconds.

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Demonstrators crowd into a city square in Reykjavik on Dec. 1. The global credit crunch has brought down Iceland's three main banks, many businesses have failed, unemployment has risen, prices have shot up and the value of the country's currency, the krona, has plummeted.
Associated Press

Demonstrators crowd into a city square in Reykjavik on Dec. 1. The global credit crunch has brought down Iceland's three main banks, many businesses have failed, unemployment has risen, prices have shot up and the value of the country's currency, the krona, has plummeted.
Demonstrators crowd into a city square in Reykjavik on Dec. 1. The global credit crunch has brought down Iceland's three main banks, many businesses have failed, unemployment has risen, prices have shot up and the value of the country's currency, the krona, has plummeted.
Demonstrators crowd into a city square in Reykjavik on Dec. 1. The global credit crunch has brought down Iceland's three main banks, many businesses have failed, unemployment has risen, prices have shot up and the value of the country's currency, the krona, has plummeted.

Industrialists harnessed the energy of volcanoes and waterfalls to power aluminum smelters. Alcoa Inc. built a giant smelter among Iceland's eastern fjords.

But Iceland's biggest foray was into banking. Almost immediately, the newly privatized banks started looking overseas for growth. There was a simple reason: The local economy is small. With only 300,000 citizens, there aren't enough Icelanders to open new accounts.

In 2000, Kaupthing Bank, Iceland's biggest, had assets of just 208 billion kronur. By June 30 of this year, its assets had ballooned some 30 times, to 6.6 trillion kronur.

By earlier this year, the three main banks had grown so much that they accounted for around three-quarters of Iceland's stock-market value. Their loans and other assets totaled about 10 times Iceland's gross domestic product.

Central Reykjavik has a small-city feel -- rows of gabled houses and lamplit streets. But driven by banking, it became a mini financial capital.

Icelandic tycoons held court at hotel bars and hip eateries that overshadowed the port city's seafood shacks. At one, Sjávarkjallarinn, or Seafood Cellar, chefs put Icelandic fish in outré combinations with exotic ingredients. Its signature appetizer: a Mason jar of lobster, cauliflower and a truffle-flecked foie gras sauce.

Universities lured the children of fishermen and trained them in finance. In 2005, Silja Sigurdardottir, 26 years old, was an engineering student, then switched to financial math. "The banks were really big, and everything was going up," she says.

Ms. Sigurdardottir got her masters in 2007, and worked for Kaupthing for one year. During that time, "I didn't really worry about money," she says.
A Global Saga: Players in Iceland's Collapse
[David Oddsson]

[Silja ]
David Oddsson: The central-bank chief and former prime minister, he was a driving force behind Reykjavik's transformation into a financial hub. Silja Sigurdardottir: With a math degree, she landed a lucrative banking job in Reykjavik last year. This October, she was laid off.
[Jon Asgeir Johannesson]

[Geir Haarde]
Jón Asgeir Jóhannesson: Icelandic mogul who built a retail empire on his discount-grocery business. Geir Haarde: The country's prime minister, he jetted back to Iceland from New York to try to save the financial system.
[Larus Welding]

[Daniel Herzberg]
Larus Welding: CEO of Glitnir bank, which got trouble when euro-denominated bonds came due just as the krona was falling off a cliff. Daniel Herzberg: An expat Briton who runs bike tours in Spain, he'll likely lose most of the money he had in a high-yielding Iceland-affiliated account.

Those days are over. She was laid off in October. Next year she plans to begin studying for a new degree, in sustainable development. "Now I have to go back to being a poor student," she says.

Much of Iceland is on a similar trajectory. After years of growth, Iceland's GDP is forecast to shrink by 8% next year. Inflation, at 18% and expected to rise, is gutting the value of regular Icelanders' assets and crimping their once-flush household budgets.

"We have a major macroeconomic problem on our hands," says Geir Haarde, the country's prime minister.

To a degree, the wealth Iceland enjoyed during the boom years was a mirage. It was conjured by high interest rates, which attracted vast sums of foreign money.
Paradise of Returns

Iceland became a paradise of high returns, even for individual foreigners simply looking for a bank account. For instance, in July, Kaupthing's Isle of Man subsidiary offered 7.15% on one-year deposits.

High interest rates kept the currency, the krona, strong. The strong krona, in turn, made the prices of imported goods -- flat-screen television sets, SUVs -- low. So Icelanders went on an epic shopping spree. They dodged the expense of borrowing at those rates, though, by instead borrowing at lower interest rates in foreign currencies (Japanese yen, Swiss francs) to finance homes and other big purchases.

Like Americans who rode a housing bubble thanks to the U.S. Federal Reserve's maintaining low interest rates for years, Icelanders had found a cheap source of borrowing to finance their consumption.

As long as foreign money kept flowing into Iceland, everything remained fine. But an outflow would dangerously reverse the equation, and set the stage for calamity.

Iceland isn't the only small country to be whipsawed by foreign money flooding in, then gushing out. Hungary and Latvia were similarly hit.

What makes Iceland different: It tried to build a global banking center on top of a tiny currency. So when foreign investors tried to pull out -- converting kronur back into dollars or euros en masse -- its currency fell like a rock, spurring more withdrawals.

Amid Iceland's euphoria, there were warnings. In 2006, analysts at Danske Bank wrote a paper titled "Geyser Crisis" saying that Iceland's banks had grown too much, and the country was dangerously reliant on the willingness of foreigners to keep sending money.

Hedge funds attacked the Icelandic krona. The banks weathered the assault, and the krona bounced back. Fatally, Iceland viewed its successful defense as proof of the banks' resilience.

But the Danske Bank team wasn't wrong, just early.

Meantime, Iceland's new breed of tycoons was living large.
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