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Iceland: When Too Big to Fail Becomes Too Big to Rescue

by: Felix Salmon October 04, 2008 | about stocks: MCO    
Felix Salmon

Felix Salmon

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We know that credit ratings agencies made enormous errors over the past few years when it came to rating structured products. And of course it's never easy to rate leveraged institutions, like banks, which are susceptible to runs. But what about the more conventional credits, like sovereigns?

Last year, Moody's briefly gave all of Iceland's major banks, including Glitnir, a triple-A rating, on the grounds that if they ever got into trouble, the Icelandic government would bail them out. After much ridicule, Moody's changed its mind. Clearly, it was silly to treat Iceland's banks as though they were just as creditworthy as the sovereign.

Fast-forward to today, and Iceland has indeed bailed out Glitnir. But here's the thing: Iceland's credit default swaps are now suggesting that the sovereign itself is a distressed credit.

Contracts on Iceland's debt jumped to 17.5 percent upfront and 5 percent a year to protect 10 million euros ($13.8 million) of bonds.

This is not how triple-A sovereigns behave. It's as though the analysts at Moody's (MCO) were only able to see one step ahead, and not two: They could anticipate that Iceland would bail out its banks, but they couldn't anticipate that when a tiny country bails out a bank whose assets vastly exceed the country's own GDP, then the sovereign itself loses much creditworthiness. One scary datapoint: The assets of Kaupthing Bank amount to 623% of Iceland's GDP, which is possibly why its own credit default swaps are trading somewhere over 2500bp.

How bad can things get in Iceland? Here's what one local emailed Tom Braithwaite:

They are fighting powers that they are powerless to fight. It's like tackling a storm raging in the sea with a teaspoon.

The main supermarket can't get imported goods because they have no currency. The shops are half empty. One of the store managers has advised people to start hoarding. We're running out of oil. And winter came last night - about a month early.

Received opinion has it that if Iceland backstops the Icelandic banks, then the other Nordic countries, or someone, will backstop Iceland. Which might be true: we'll find out "very soon". But there's no news yet.

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This article has 22 comments:

  •  
    Oct 04 07:14 AM
    Good news. They've lifted the restrictions on drilling for whale oil.
    Reply
  •  
    Oct 04 10:02 AM
    In this context the guarantees for unlimited amounts for depositors in Irish, and, God forfend, Greece, show themselves for what they are - desperation ploys.
    The hot money which is flowing in in a desperate attempt to find security can just as easily flow out, and when realisation dawns that the tax base of neither economy is strong enough to honour the guarantees they are blithely issuing they will indeed flow out, leaving the respective economies as wreckage.
    Reply
  •  
    Oct 04 10:03 AM
    If this "bail out" madness isn't stopped, the future of USA will be that of Iceland.
    Reply
  •  
    Oct 04 10:06 AM
    Wow, I am ecstatic that a financial crisis as Iceland’s will “never” occur in the US!!!!!
    Reply
  •  
    Oct 04 10:50 AM
    From what I'm hearing when it comes to European banks we haven't seen anything yet. One Euro analyst was recently saying that due to their huge size and extreme leverage, a number of 'too big to save' institutions will come crashing down in the not too distant future. Shorting the Euro is a no-brainer, but there are certainly a number of other ways to hedge or speculate the Euro future.
    Reply
  •  
    Oct 04 11:06 AM
    Many of us are applying the same thesis to our US speculation: long the banks, short the sovereign. As in Iceland, the credit of one is as good as the other, and the implications for the currency and the sovereign debt are extremely negative. Same story, same reasons, different scale. It's amazing that so many bright people can look at Iceland, shake their heads, and say "tsk, tsk" and then run to Treasuries for "safety." Talk about lack of introspection.
    Reply
  •  
    Oct 04 12:05 PM
    I posted in another article but here it is again - a must read - Nouriel Roubini's October 3 commentary - "Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs" (Roubini has waved subscription charges to his site - registration is free)

    www.rgemonitor.com/rou...
    Reply
  •  
    Oct 04 12:52 PM
    The first domino has fallen: will the rest spell out "USA"?
    Reply
  •  
    Oct 04 01:28 PM
    Iceland isn't in the eurozone (yet). Their currency, the krona, has been in a worse freefall than the Korean won simply due to the size of any necessary bailout.
    Reply
  •  
    Oct 04 06:40 PM
    Thank you, thank you for posting this article. Most will not grasp the significance as most are clueless here and too arogant to understand that the U.S. economy is a train wreck about to happen. Sadly for years, we assumed that the financial world revolves around us. It is true, yet so wrong. The plutocrats out of greed have gone too far. Their comeuppence is coming. Hang on, it will be a rough ride. In "God We Trust" dollars will not save us. If China gets out of Treasury's, the game is over. I am so glad I am up to my ears in gold and silver bullion.
    Reply
  •  
    Oct 04 08:15 PM
    the new motto on our momopoly money"TOO BIG TO FAIL,TOO MANY TO JAIL".
    Reply
  •  
    Oct 04 09:17 PM
    DCM, I at first read your post as a disparagement of "In Gold We Trust" and was ready with a rejoinder. Instead I see that you will be one of the survivors. After all, as the saying goes, the so-called American Triumvirate of god, gold, and guns is redundant: if you have gold and guns, what more could god do for you?

    The real question we must face is what becomes of the penniless billions once fiat paper collapses.
    Reply
  •  
    Oct 05 01:01 AM
    A simplified calculation ??
    75% of the Icelandic bank Glitnir got taken over by the Icelandic government at a cost of 600m EUR. Iceland has a population of 300.000.
    In the US the population is 300m people, i.e. 1.000 times the Icelandic population. The American historical financial rescue (bailout or what ever is the right terminology) is 700bn USD and target the entire financial sector.
    En similar exercise for the Icelandic financial sector would cost 700m USD (remember there are 1.000 times more Americans). Given the current foreign exchange rate of the Icelandic Kroner is roughly 2/3 of the EUR value, equates to a Icelandic bailout value of 900m USD or 900.000.000.000 USD (compared to the American case) and this is to only financially support one bank !!!! (and not even the biggest one).

    Perhaps Iceland is taking over the traditional role and history of the US that everything JUST have to be bigger ??
    Reply
  •  
    Oct 05 02:51 AM
    It's one thing to prepare for the worst, but what kind of person actively roots for their friends and neighbors to be wiped out? Some of you people need to take a long hard look inside. Think about how distasteful it is to see Iraq war opponents gloating about high casualty figures, because it proves they were "right". They're really cheering that somebody got killed and that's basically what many of you are doing too.
    Reply
  •  
    Oct 05 11:58 AM
    Very nice piece. The situation in Iceland while extreme it certainly serves as cautionary tale for all other countries including the U.S.. Clearly unless Iceland unlists subtancial help from other countries, which is unlikelly given that they have more than they can handle back at home (other than deposit guarantees on deposits held by Icelandic owned operations in their domestc markets, e.g. a Kaupthing subsidiary, the largest bank in Iceland, has about 150,000 depositors in the UK). The Country will be unable to nationalize all three largest banks and assume their liabilities without bankrupting itself. Besides what would is the point of using Iceland's tax payers money to safegard foreign creditors who should have know better? It should therefore focus on preserving deposits and assuming an interim credit provision role to the countires companies perhaps through Glitnir (whose liabilities represent perhaps about 100% of the GDP, having grown more than six fold in the last four years). It is noteworthy to point out that the fact that the government bought 75% of Glitnir does not necessarilly mean that the government is guaranteeing its debt (only implicitelly). It will be interesting (although regretful) to see how things unflod in Iceland.

    PS: Mr Bombadil, what you have here are a group of people exercising their first ammendement right to express their opinions. Besides I don't think anyone was celebrating Iceland's demise.
    Reply
  •  
    Oct 05 06:22 PM
    Iceland is indeed a good example of how overly generous the ratings agencies had been leading up to the current crisis. However, the unnamed local source is more indicative of the panic and rumors that are floating around Iceland at the moment than actual economic conditions. The owner of Iceland's largest supermarket chain was also the largest shareholder of Glitnir and is hurting financially. Financial troubles for one retailer, large at it may be, is not the same as the country's inability to import groceries.
    Reply
  •  
    Oct 05 11:17 PM
    This is ridiculous. If an entity becomes too big to fail, then either it is too big to exist or must be regulated. Otherwise, the government must not interfere with normal market forces.
    Reply
  •  
    Oct 06 04:23 AM
    Felix for the record there are many analysts who have been predicting the same for the US (marketoracle.uk is notorious since day one of predicting the enormity of the crisis(they have been right up to this point -will they continue to be remains to be seen also I find the site hard to swallow with its antiamerican overtones but none the less they have been right (more so than paulson and bernanke))- whether or not the US bailout pushes up the valuations of the credit derivatives will work for a short time but once the enormity of the problem comes to a head it might be downright unaffordable
    Reply
  •  
    Oct 06 01:33 PM
    Do you think we will ever get to the point the US govt will need a bailout... we have been discussing this on Myinvestorsplace.com..... do you think???
    Reply
  •  
    Oct 06 01:56 PM
    It is really difficult to build your economy on:

    1. The world's most beautiful women

    2. Bottled water (Fiji watch out)

    3. Geothermal power

    4. A venue for chess tournaments

    Iceland should be saved for their women... That's for sure. When the Vikings plundered countries throughout Europe, they always took the most beautiful women back to Iceland. This is a true story...
    Reply
  •  
    Oct 06 02:01 PM
    nym, nym, nym,

    Will it spell out USA? surely you jest.

    Our country has been through this and worse. Of course we currently have the marshmallow generation at the helm, but they'll get the hang of it when they go without for a few weeks. Then, nym, our country will rebuild its markets and financial system and come back stronger than before. Maybe we won't spend ourselves blind, but we will come back STRONGER than before.

    So, a word to those who would wish us ill or to take advantage of the financial fix we are in... I wouldn't do it if I were you!
    Reply
  •  
    Oct 07 02:46 PM
    So Russia might help Iceland out with 5.4 Billion:
    www.bloomberg.com/apps...

    My question is why arent the other Nordic states helping out of goodwill. Does Russia have anything that Iceland has? I thought Iceland bank had large Euro holdings. I only mention this since deals have been getting very creative lately.
    Reply
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