house of cards?

Another temblor shook Iceland yesterday, this time in the opaque world of Icelandic banking. Analysts at Merrill Lynch in London released a scathing report on the health or lack thereof of the big three Icelandic banks: Kaupþing, Landsbankinn, and Íslandsbanki. They recommend against holding debt issued by these banks, but in justifying this recommendation they paint a well-researched picture of systemic weaknesses in Icelandic finance and the possibly shaky underpinnings of the Icelandic economy as a whole.

I couldn't put the report down last night; it read a bit like the bestselling "The Smartest Guys in the Room" (about the rise and fall of Enron). Here are some of the interesting facts I gleaned from reading:

• Icelandic banks operate in a market that is more like the "emerging" markets (Brazil, Russia, etc) than the mature markets of Western Europe. The systemic risks associated with the Icelandic market are similar to the risks in "emerging" economies.
• Icelanders are borrowing heavily from the future to finance the good times today. There have been huge expansions in credit (people and businesses taking loans) in Iceland in recent years, "significantly in excess of the productive capacity of the economy". Household debt in 2004 was 192% of household disposable income. Credit to the private sector amounted to 218% of GDP at the end of last year, doubling in the last 3 years.
• Business deals in Iceland tend to be "skuggalegt" (shadowy), in the words of some old guys I overheard in the sauna. The report uses the financespeak "highly leveraged", meaning financed heavily on loans and less on up-front cash, or roughly the same thing. The report relays the story of Íslandsbanki selling part of its Sjóvá insurance arm to Þáttur, but then loaning the money to Þáttur to pay for much or all of the sale. The loan has never been repaid. Þáttur in turn owns Milestone which is a major shareholder in the bank that originated the deal. "Such arrangements do not at all appear to be unusual in the world of Icelandic finance." And, sadly, they are not.
• The presence of HFF, the government's Housing Finance Fund, in the mortgage market means that Icelandic banks must compete with this behemoth when making mortgage loans, a business they entered in August 2004 in an attempt to shut down HFF. But since HFF is government-backed, it can offer loans on terms that the banks can't match and be profitable. So the Icelandic banks are breaking even at best, and in general losing money on their mortgage businesses while they wait for HFF to depart the market. In the rest of Europe, mortgages are a steady source of solid income for banks. In Europe, "Iceland is alone in having banks that have entered the [mortgage] market without really being able to make money from it."
• Icelandic banks have huge stakes in the local equity (stock) market and do not disclose those stakes in a very transparent way. So their health is dependent on the health of the stock market to a much larger degree than elsewhere in Europe. "We cannot recall of a single other instance in Europe of where banks hold such substantial stakes in the local market."
• Speaking of the stock market, Icelandic banks account for 66% of the market value of the benchmark ICEX-15 stock index, so troubles with them would effectively drag down the entire stock market.
• Icelandic banks' "spread over sovereign" (amount of extra yield that must be paid on their debt relative to government debt) is significantly higher than European banks, so the market is already saying now that Icelandic banks are riskier than their European cousins. The authors of the report believe that the Icelandic market is in actuality even riskier than this, however, because of systemic factors such as the structure of the Icelandic mortgage market.
• Icelandic banks rely increasingly on "external funding", that is raising of capital outside of savings account deposits, for example through debt and equity issues. This is risky since this funding can dry up almost overnight if investors decide the banks are too risky, leaving the banks high and dry. All three banks have a loan-to-deposit ratio of around or over 300%. That means they are lending out 3 times more than they have available as deposits, and using outside financing to make up the difference.
• Icelandic banks issued so much commercial paper (short-term unsecured loans) at the end of 2005 that the European debt markets are effectively now closed to them. They are planning to issue future debt elsewhere: the U.S., Japan, Switzerland, et cetera. But it will be impossible for them to raise funds at the easy rates of the recent past, if at all.
• A majority of outstanding debt comes due for all 3 Icelandic banks in 2006-2008. Kaupþing alone needs to refinance about US$8.6 Billion in debt in 2006-2007, a number on the same order as the GDP of all of Iceland. Having the debt structure so "front loaded", rather than evenly distributed across future years, is very risky, because it relies on favorable circumstances to roll over the majority of debt all at one go.
• Icelandic finance is a complex arrangement of cross shareholdings. The report has an amazing diagram of these arrangements. The spiderweb of interdependent ownership is unhealthy, as it makes the true risks held by the banks (and the other parties) difficult to quanitify. This picture alone made me very nervous about the true health of the Icelandic economy. Skuggalegt, indeed.
  

From what I have heard, the Icelandic media, taking their lead from bank spokespeople, are downplaying the Merrill analysis, saying, in effect, "Iceland is special." or "This is based on outdated data." or "They're just jealous of our success." They shouldn't downplay this one. This is a wakeup call that the Icelandic miracle may be about to reverse dramatically.