The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (13 page)

Yet a small band of Scandinavian economists and bankers, as well as British hedge funds, remained utterly unconvinced by the stability of Iceland’s banks. Concerns centred around over-investment in retail, leisure and property in northern Europe and the UK at the peak of a consumer boom. Icelandic tycoons and investment funds went on a spending spree, buying major UK businesses, including Hamleys, House of Fraser, West Ham United and the supermarket chain Iceland, all funded by capital provided by the Icelandic banks.

The sceptics began to circulate emails detailing the spider’s web of overlapping ownership between the Big Three – Landsbanki, Kaupthing and Glitnir – their customers and their shareholders. Little wonder, therefore, that funding streams dried up, and the credit markets indicated that Icelandic banks were the riskiest in Europe. ‘We realised that we were under attack at the end of March [2006] when Barclays and UBS brought a group of investors to Reykjavik,’ wrote Kaupthing’s London boss Armann Thorvaldsson. He described a presentation at Kaupthing’s HQ that degenerated into a shouting match between fund managers and bosses about the safety of Iceland’s financial system.

So Europe stopped funding Icelandic banks in 2006. Or at least sophisticated European money-market investors stopped funding Iceland and its banks. But the banks fought back, raising huge sums at highish interest rates from America by packaging their debt up into the notorious ‘collateralised debt obligations’ (CDOs), underpinned by the gold-standard AAA credit rating. The global flood of liquidity saved them, temporarily. Incredibly, in October 2007 Kaupthing raised 2.3 billion pesos from bond investors in Mexico, making it the first, and probably last, Nordic bank to raise pesos from Central America. The Geyser Crisis was over – for a few months.

Another wheeze to find alternative funding was to do, three years early, what banks all around the world desperately scrambled to do in 2008–9: raise money from consumer deposits – in other words, good old-fashioned retail banking. One huge problem was that Iceland’s own population of potential depositors was simply not big enough. The solution was to adopt, borrow and grab a foreign deposit base instead. Hence Icesave (the internet account from Landsbanki) and Kaupthing Edge (Kaupthing’s equivalent) sucked in billions from ordinary retail depositors in the UK and the Netherlands. Public bodies in Britain – such as the police, local councils, the geniuses at Oxford University and even the British government’s own internal auditors – also had hoards of spare cash that they willingly deposited with the Icelandic banks.

Mr Oddsson thought this strategy was a win-win. ‘I think the Icelandic banks realised from one, two years ago that they should go more in that direction [rather than]… to have to refund themselves in the market on such a large scale,’ he told me at that meeting in February 2008. ‘It was healthier to do that more by deposits – and they’ve been doing that. They’ve been doing that successfully and they’ve been doing that very honestly with an honest, successful programme. And I think we should applaud them for that, not punish them.’

Around this time, I received a call from a Scandinavian financial analyst, one of that band of sceptics who could not believe the ‘bankrupt Icelandic banks’ were being allowed to take deposits from Britain. ‘Icelandic banks have been shut out of money markets for two years, but they can ask a British housewife for a deposit?’ he asked me incredulously. ‘Why are they doing it now? They’ve been forced into doing this. But you’d never see this on the Icesave adverts.’

A significant proportion of UK savers were simply placing all their money in the savings account with the highest interest rate, as pronounced by internet comparison sites, or the misnamed ‘best buy’ tables. Icesave played this system brilliantly. It raised billions of pounds of money that it could not raise on the markets from ordinary British families. Kaupthing copied the strategy a few months later. Both banks stressed their participation in the UK’s deposit-protection schemes. The Icelandic banks were effectively free-riding on guarantees funded by UK banks and building societies – and ultimately the British taxpayer.

Iceland’s lax financial regulators should have stopped this, but the likes of Davíð Oddsson believed that the banks had ceased to be Icelandic banks per se, and were now ‘north European banks, headquartered in Reykjavik’. So the strategy of adopting a British deposit base was, as he told me six months before the crisis, ‘a very good idea, good for both the banks, and the people putting the deposits into these banks’.

The UK regulator, the Financial Services Authority, should have done more. In its defence, particularly with Icesave, the FSA was not the primary regulator. It had no access to the parent company, Landsbanki, as Icesave was operated as a branch, rather than a UK-incorporated subsidiary. European law, so-called ‘passporting rules’, obliged the UK to take at face value the Icelandic authorities’ assessment of Landsbanki’s accounts.

So the FSA can make a reasonable argument that it had no good reason or no legal basis to prevent Landsbanki from opening up Icesave in the UK. However, when it became apparent that the banks had unexpectedly attracted billions of pounds of internet savings, alarm bells should have rung louder. The FSA did retain powers and tools even under the passporting arrangements. The FSA gently suggested to banks in its 2008 Financial Risk Outlook that internet savings were proving more fickle and less ‘sticky’ than conventional savings. It was talking about Icesave, but could not say so too clearly. When prodded by me, the FSA also advised savers to ‘talk to their providers’ to check if they were comfortable with different deposit-protection schemes offered by foreign banks. In Icesave’s case, the first £18,000 of a depositor’s saving was guaranteed by an Icelandic fund. It was never paid, and this is what forms the Icesave debt. It amounted to about 40 per cent of Iceland’s entire national income.

However, by the time the FSA issued this warning – in March 2008 – the train crash was unavoidable. A round of increasingly frenzied crisis talks between the Treasury, the Bank of England, the FSA and the Icelandics began, and the details were subsequently divulged by sources in Reykjavik. Icesave began its transition from high finance to high diplomacy.

Yet there is a fundamental unanswered question about this fiasco, a question with important implications for the future. How did Icesave amass so much cash from UK depositors so quickly? As much as £3 billion flowed into Icesave in the first three months following its launch, with total balances peaking above £6 billion. A remarkable proportion of these deposits was transferred directly from the then market-leading internet savings account ING Direct, which had cut the rates it offered just as Icesave launched.

In the UK especially, Icesave’s strategy would not have been possible were it not for the evangelical zeal of a populist personal-finance media. The money pundits portrayed Iceland as northern Europe’s new piggy bank, a much better prospect than the bad guys at ING Direct or the stingy British high street banks, who had refused to pass on rises in Bank of England interest rates. But the buys in the ‘best buy’ league tables were by no means the best buys. The offer of a high interest rate was portrayed as an altruistic Viking attempt to shake up the staid British savings market, rather than a reflection of the banks’ desperate requirement for funding. Icesave’s marketing pitch was unquestioningly and enthusiastically lapped up in the specialist press, which plays such a key role in the savings market. The Icesave public relations team sent an ‘Ice Bar’ around Fleet Street’s personal-finance journalists, offering drinks on the house. Some were flown to Iceland. The high rates were hailed by the media in a series of nonsensical and unquestioning headlines. ‘Viking invaders return un- defeated to Britain’s financial territory… Time for savers to get their skates on… The iceman cometh and savers swoon… A crystal clear savings account from Iceland… Icesave looks a hot deal’ – and my favourite, from the
Scotsman
: ‘Foreign financial invaders are such progressive geysers.’

Iceland’s banks had pulled off a remarkable and perfectly legal heist. At this point it was too late for the UK government or regulators to get the money back.

One issue was that Mr Oddsson of Iceland’s Central Bank was in a pickle trying to defend Kaupthing’s financial honour. As prime minister a few years earlier, Oddsson had withdrawn all of his £3,000 worth of savings from Kaupthing in protest at their eye-watering bonuses to senior management and their control of important Icelandic media. It was noticeable that he did not do much to defend Kaupthing, when in February 2008 I asked him questions about bank safety. He preferred to talk about Landsbanki. ‘Deposits are mainly in Landsbanki,’ he told me, reassuring me that they had ‘been put in a very safe place’. ‘Landsbanki has been around 120 years,’ he continued, ‘quite respected, doing well, here and elsewhere. I wouldn’t say anything else than it was a good decision to utilise possibilities of saving with Landsbanki.’

The end result was that Iceland was sitting on £10 billion of deposits from UK savers. To put this in context, in 2007 the foreign-currency liabilities of foreign branches of Iceland’s banks was more than the country’s GDP. It was over three times its annual state budget, and four times the government of Iceland’s foreign-exchange reserves. Neither the banks, nor the deposit bailout fund, nor the government of Iceland had enough money, and in particular enough pounds or euros, to pay out in the event of a crisis.

I asked Davíð Oddsson how on earth Iceland could stand behind the British depositors’ cash. ‘The economy of this country is quite extraordinarily good – the country itself, the state, is net debt-free – with good resources and a good situation,’ he reassured me. ‘The state could relatively easily do it, and afterwards, it would be one of the most debt-free economies in Europe. Afterwards,’ he said. ‘This would not be too much for the state to swallow, if it would like to swallow it.’

I did not believe him. And it emerged that before my interview Mr Oddsson had already been expressing concerns in Iceland about the health of the same banks I had asked about. Moody’s, the international credit-ratings agency, had warned in early February that the Central Bank of Iceland needed access to sterling and euro liquidity, so-called ‘swap agreements’. Coincidentally, on the day my interview aired on
Channel 4 News
, Davíð Oddsson was in London, meeting with the Bank of England governor Mervyn King to begin the process of asking for a swap agreement. I did not know this at the time, but it might explain the strange, irate phone call from the Icelandic ambassador demanding a DVD of my report, immediately after the show ended.

That same month, a rather desperate negotiation ensued between the Icelandic and UK central banks over a £1–2 billion currency swap. King was never convinced. The previous year, an IMF board member had remarked
at its Article IV economic review that ‘Iceland essentially was functioning like a hedge fund, borrowing abroad to acquire foreign assets.’ The IMF did not act on these concerns, however, and in fact there was no IMF mission chief for six months as the storm clouds gathered.

The formal request to the Bank of England by Mr Oddsson began diplomatically enough, but then veered off into warnings about ‘unscrupulous forces’ that needed to be deterred. And then came the darker negotiation gambit: King should cough up, Oddsson suggested, because an Icelandic crisis would imperil the world financial system through exposures hidden in derivatives. ‘Icelandic bank paper is believed to be included in more than half of all CDO structures created in recent years,’ Mr Oddsson wrote to Mr King. ‘Our international banking contacts have underlined that a credit event stemming from a large-scale liquidation of Icelandic bank obligations would have a serious impact on global asset markets.’ It was desperate stuff, from a man who days previously had told me his banks were ‘very sound’ and that his economy was ‘extraordinarily good’.

Mervyn King was unimpressed. He turned down Mr Oddsson’s request, saying that Iceland needed to reduce the size of its banking sector by selling off at least one of the major banks. He also said it was ‘extremely difficult’ for Iceland to provide lender-of-last-resort facilities to its banks, and that the markets knew this. ‘The swap might look like a political gesture rather than a credible financial strategy,’ he wrote to Mr Oddsson. ‘I know you will be disappointed. But among friends it is sometimes necessary to be clear about what we think.’ Governor Oddsson replied the same day, simply restating the need for a currency arrangement, and upping the ante on the global damage an Icelandic crisis could inflict. ‘The absence of a swap arrangement in the current circumstances could have very severe consequences,’ he wrote to King. ‘I must emphasise my belief that this is not an isolated Icelandic concern. Difficulties in Iceland could have serious contagious effects in other countries.’ He received no reply. The letter almost sounded threatening. Was he talking about the UK depositors’ money? The US Federal Reserve also politely declined Iceland’s request for a swap.

Extraordinarily enough, despite the UK authorities refusing support facilities and knowing their own government could not support them, Icelandic banks were permitted to continue taking British deposits for six months. And they did. Icelandic bankers in London put King’s refusal down to the British banks’ jealousy of their cunning in grabbing deposits.

An intriguing army of Icelandic bank loyalists descended upon the British blogosphere and internet personal-finance forums to reassure those savers expressing concerns, and to rubbish my report, and others like it. Some smart Conservative councils reviewed their massive deposits in Icelandic banks. In general, though, there was no way for British savers to get their deposits back quickly.

At this point Iceland’s fate was sealed. It was only a matter of time before the collapse. Iceland’s banks did try to shrink their balance sheets by selling off loans and businesses. Kaupthing Edge, Kaupthing’s version of Icesave, which only opened in the UK in 2008, sucked in the equivalent of a billion euros a month in retail deposits even as the Icelandic authorities knew that the nation could not possibly support its liabilities. British regulators did not step in to stop this. In Britain, 170,000 savers placed £2.7 billion in deposits with Kaupthing Edge. The FSA required that Kaupthing Singer & Friedlander (Kaupthing’s UK branch) hold 90–95% of the value of deposits.