Why Iceland Must Vote “No”

“The policy of collecting debts by gunboats is unrighteous, unworkable and outdated”

President Woodrow Wilson in 1919

Iceland is heading toward a referendum on a deal to refund some $5.5 billion to Britain and the Netherlands for money lost by depositors in these two countries. This puts the country on the threshold of perhaps the most important national question since its independence was formalized in 1944.

 Background

Between 2002 and 2003 three Icelandic banks Glitnir, Landsbanki, and Kaupthing, were privatized and expanded aggressively into offshore markets raising money from private citizens directly and through Internet websites. Asset footings expanded enormously, and in proportion to the Iceland economy at one point reached a ratio of more than 10 to 1. Then came the global financial crash in mid-2007 and the revelation that the asset quality of all three banks was very poor, leading to insolvency, the loss of depositors funds, a currency collapse and a severe economic contraction.

The British and Dutch Governments, under political pressure in the aftermath of the banks’ collapse, and in the midst of the crisis affecting their own domestic financial institutions, agreed to make good their depositors’ losses. For this reason the British and Dutch are of the opinion that the taxpayers of Iceland have a duty to refund this total loss to them. To force the issue, Britain froze the accounts of all its Icelandic bank branches. This prevented them from remitting funds out of the country, forcing the banks into insolvency. Britain branded Iceland as a terrorist country in order to invoke these measures because the only law at hand enabling this financial grab was emergency anti-terrorist legislation.

 A deal was subsequently hammered out with the help of the IMF whereby Iceland would get a $10 Billion rescue package (more than half of which was earmarked for repayment to the UK and the Netherlands) which included some funding to assist with the crisis and structural adjustments. When this plan was presented to Iceland’s President, Olafur Ragnar Grimsson, he chose not to ratify the legislation to repay the lost bank deposits to Britain and the Netherlands. Under the parliamentary procedure a national referendum on this issue must now be held and will take place on March 6^th.

Britain and the Netherlands have railed against Grimsson’s  intervention and issued thinly veiled threats that collapse of the deal would throw into doubt Iceland’s bid to join the European Union and its eligibility to qulaify for a $10bn economic rescue program that has had the participation of the International Monetary Fund.

Do the Math

We have set out a table which list some of the key variables to consider is assessing the relative merits of a “Yes” or “No” vote in relation to the bailout package that is being pushed onto the country by the UK and the Netherlands. In the discussion following we look at each of the considerations in more detail. 

*Recovery Partners’ estimates. Wide ranges due to uncertainty owing to steep GDP decline and currency depreciation

 Historical Precedent

 If the bailout plan goes ahead it would be the first peacetime circumstance where a borrower’s debt burden has actually been adjusted significantly higher following a crisis and the subsequent restructuring. The proposal, as rejected by President Grimmson does not make any sense in the historical context whatsoever. He was right to refuse to aquiesce on this basis alone.

Legal Precedent

We operate in a limited liability legal system.

There is absolutely no legal (or moral) obligation to pay off the claims lodged by the UK and the Netherlands. Insolvency law states that recourse can only be made to the estate of the bankrupt and not to unrelated parties. If the Deposit Insurance Fund set up to guard the claims of the depositors is bankrupt, there is no case law that states recourse to the taxpayers is a legitimate avenue for resolving unsatisfied claims in the absence of explicit sovereign guarantees. We are not aware of any such guarantees. As a case in point, do we have any evidence of US depositors seeking redress for their claims against failed UK financial institutions from the UK Government? Have International creditors of Lehman Brothers or Bear Stearns approached the US Government for restitution? It is not hard to imagine how far Europe’s leaders would have gotten in their discussions with the US Treasury if they had dared to make this approach.

Hello Iceland, Meet your new EU Neighbors

The currency crisis, collapse of the financial system, and pressure from Britain and the Netherlands has led to a major shift in opinion within Iceland in favor of joining the EU and adopting the euro. Despite this, there is significant confusion within Iceland as to what “joining Europe” would mean in practice. Moreover there appears to be only minimal understanding of how the EU is now being torn apart by unstable, heavily indebted post-Soviet economies and other states (e.g. Greece) that have no clear means of financing ballooning structural deficits.

Central and Eastern European members of the former Soviet Union voted to join the EU in the 1990s under the impression that the EU would help them put in place a modernized Western-style industrial capitalism that would lead to rising living standards. Instead, the EU leadership looked at these post- Soviet economies as outlets for their exports, and greenfield opportunities for its banks. The EU looked the other way when the privatization process in these countries became corrupted; and again looked the other way when locals mortgaged their properties with FX loans which fueled an unstable real estate bubble. Crises in a variety of these economies is presently severely undermining the EU and the European Monetary Union and could lead to its demise.

The foregoing describes the exact the situation that Iceland finds itself in today. The added danger is that Iceland might surrender to the pressure to join the EU, when this will likely result in outside interests appropriating its fishing rights, energy resources, obtain unfettered access to the banking markets, and maintain the program of keeping the Government in thrall by lending to it in order to bail out their citizens and companies who speculated and lost with the now-defunct Icelandic banks. The EU entry would also take place at an extremely disadvantageous exchange rate, effectively undervaluing the entire country in euro terms.

We say leave the EU to itself, entry now creates problems for Iceland and does not solve anything.

Debt Paralysis

If the package were to be adopted the share of debt servicing out of total government revenues would top 16%. At those levels this statistic is more usually associated with extreme sovereign default risk.  Iceland’s current Debt to GDP ratio stands between 80 and 100%. This is already very dangerous territory. However, if the USD 10 Bn. package were adopted this ratio would soar to around 140-160%, an extreme danger zone as regard defualt risk. In that case the Debt to Government Revenue ratio would rise from around 160% to almost 300%. The World Bank defines Heavily Indebted Poor Countries (HIPC) as those where this ratio exceeds 280%. The HIPC’s are all basket cases where social dislocation, starvation and corruption are a daily fact of life.

Why “restructure” in order to inevitably slide into that state of affairs?

Credit Ratings

Fitch, the credit ratings agency, downgraded Iceland’s main sovereign rating to “junk” status recently. This is not surprising. What is also not in question is that it would be extremely unlikely that Iceland’s rating would move higher if it adopted the bailout proposals. The country would likely remain a basket case for the foreseeable future.

Alternatively, if Iceland were to embark on a comprehensive reform program, retrenching and relying on its natural resource base and strong exporter status to backstop fresh money from different sources, a move upwards in the credit rankings can become a reality within a relatively short period of time.  

 Structural Reform

Iceland must free up parts of its economy and make increased revenues available to the Government as part of the attempt to did itself out of this hole. For example Iceland’s Treasury currently receives no recurring revenue from the domestic fishery. Fishing Licenses have become a “rentier” instrument whose benefits accrue to a narrow slice of the populace This needs to be changed to the benefit of the entire country rather than the few insiders who now control the licenses.

Among the other issues to address is the free lunch given to financial firms through debt indexation which places the burden of adjustment primarily on households and has led to a rash of mortgage defaults.

International Pariah?

The UK has warned that Iceland faces economic isolation if they do not approve the package as negotiated. The sub text here is: “If you do not do as we say we will try and make this happen to you.” The reality is that the UK has massive problems of its own, is effectively bankrupt and in need of outside assistance itself. Iceland has abundant natural endowments, exports that the world wants and earns significant revenues from the tourism business. Are the Brits going to interdict fly fisherman and nature lovers when they try to visit Iceland? Are they going to stop shipments of fish from landing in the local  supermarket in Oslo? We think not. Iceland is perhaps the best placed economy to push ahead on its own. It can feed itself, build and heat its own homes and earns enough net export revenues to buy the little fossil fuels that it needs.

Durability of the Fix

Public-sector borrowing to bail out bad private-sector debts involves expropriating money from the workforce through higher taxation ultimately rendering the economy uncompetitive. This leads to a self reinforcing death spiral in which the liability grows and debt servicing costs eventually cannot be met resulting another bust. This is exactly what the UK and Netherlands sponsored bailout package will deliver. (It is of note that the Latvian bailout stipulates that the Government there only use the bailout money to pay off foreign creditors and not for structural adjustment or job creation. Nothing good is coming from that situation as we are seeing.)

Vote “NO” on March 6th!!

In reviewing the forgoing it is hard to identify any upside in the ”Yes” scenario..

The facts reveal the bailout plan cobbled together under significant UK and Dutch pressure to be nothing more than a 21st Century version of Gunboat Diplomacy and should be rejected by the population of Iceland out of hand. It would consign the population to de facto slavery and remove whatever degrees of freedom are left regarding the country’s flexibility to dig itself out of this hole and to chart its own course as an independent nation.

The “No” vote has history, the law and economic reality on its side. Icelanders should vote “No” in favor of a better future for themselves and their countryfolk and not allow themselves to be bullied into a bad deal by other countries whose disingenious politicians are following the “Somebody Else Must Pay” maxim.

 It is important to note that voting “No” means that Iceland needs to negotiate shrewdly and launch a comprehensive restructuring that targets key areas of its economy, its financial management and its regulatory oversight practices. Properly managed, a restructuring backed by the natural resource and export earning potential of Iceland could restore incomes and economic activity to pre-crisis levels within 3 to 7 years.

 [If you would like additional detail about any aspect of the forgoing, then please do not hesitate to give us a call here at Recovery Partners.]

 

 

Posted in Bankruptcy, Banks, EU, IMF, Restructuring, Sovereign Debt | No Comments »

Bread and Circuses

A nation ignorant of the equal benefits of liberty and law must be awed by the flashes of arbitrary power: the cruelty of a despot will assume the character of justice; his profusion, of liberality; his obstinacy, of firmness. 

Edward Gibbon, The Decline and Fall of the Roman Empire

 Yesterday, the markets learned that the rumors of a new tax on US financial institutions imposed to “pay” for the bailout were in fact about to be realized. The White House issued a press release concurrent with the announcement of the tax by President Obama while flanked by his economic advisors. In making this announcement, the Obam-ites appear to have stolen a march on George Washington Plunkett and his devious vote-getting practices.

 The US public is being led to believe that the impact of the financial crisis on household finances will be lessened by this new levy on the big, bad financial institutions. Interviewed after the President’s announcement, the venerable ex-Fed Chairman, Paul Volcker did nothing to dispel this impression even if he believed otherwise. Nothing, in fact, could be further from the truth.

 According to the White House press statement the parameters of the “Financial Crisis Responsibility Fee” are designed to “require the largest and most highly levered Wall Street firms to pay back taxpayers for the extraordinary assistance provided so that the TARP program does not add to the deficit”. It is expected to stay in place for 10 years or longer. By imposing this tax on the banks (at the same time that the US Congress was grilling the heads of the largest US financial institutions in front of the Financial Crisis Inquiry Committee) the Obama administration is seeking to deflect responsibility for the financial crisis from the Democrats and Government agencies that supported various risky schemes to expand homeownership, to rest squarely onto the shoulders of the banks. In a  month which features a critical Senate race, and a year where it looks like the Democratic Party is on the back foot heading into mid-term elections following a variety of gaffes and mistakes that has sent the President’s and the party’s popularity plummeting, this amounts to blatant pandering to the electorate.

In fact Mr. Volcker was probably privately shaking his head with dismay, but clinging to the party line as the better of two very bad alternatives – the other one being to resign in the face of this populist fakery. We are sure that the respected ex-Chairman felt it better to stay inside the tent and remain in a position to counsel against the next mis-step rather than to quit.

 Anyone remotely familiar with the nature of banking will recognize that the ones paying for the tax will be bank customers i.e. businesses and individual taxpayers. Banks are simply intermediators of risk. In order to function efficiently they must earn an after-tax, after-cost return on capital that is commensurate with the risk they are taking. This means that in the absence of any changes to the risk profile of their balance sheets, that the tax will be paid for by a rise in lending spreads and bank fees to customers in order to preserve the banks’ required risk adjusted returns. This is no different to a utility that will pass on increases in input costs to its installed base of customers in order to ensure that it maintain a return on capital sufficient to maintain services, replace depreciated equipment and expand capacity to meet future demand growth.

 As such, the new tax promises to be a drag on growth, because it will reduce incomes and profits of consumers and businesses that do business with the banks. The fact that smaller banks are exempt and that ten of the largest banks are expected to have to pay around two-thirds of the expected receipts does not change this fact. US growth prospects are reduced because of it and households will retain less spending power.

 The bottom line is that the Administration is betting that the electorate is stupid and does not realize the fact that they will be the ones largely funding the new tax. The measure is thus a cynical ploy to appear righteous and strong in championing the cause of the “little guy” against the big evil banks when in fact the “little guy” is being soaked for new cash and the only real objective of value for the Obama Administration is to gain his vote by whatever means.

Posted in Bank Loans, Bankruptcy, Crisis, Fed Policy, Restructuring, Sovereign Debt | No Comments »

Non-Farm Payrolls Drop Again: Is the US checking in to the Roach Motel?

 “The recession isn’t over”

Martin Feldstein interviewed on Bloomberg Radio 17/12/2009

In our opinion, there was nothing in today’s US Labor Department statistical release to cause the esteemed Harvard Professor to change his views. Moreover, the statistics offered little cheer to those pundits in the recovery camp who have been predicting a swift V-shaped upturn in response to the Fed and Treasury’s unprecedented Monetary and Fiscal stimulus. Indeed, the drop in  payrolls of 85,000 and the record-setting decline in consumer credit also reported today, only served to reinforce the calls of unrepentant Keynesians such as Paul Krugman who have been calling for another vast round of fiscal stimulus. Does this advice make any sense when there is no evidence whatsoever that monetary expansion and government spending programs can cure the ill effects of past financial excesses?

Instead, we have to ask ourselves is whether, by applying massive stimulus, the Fed and Treasury have built a “Roach Motel” (i.e. you can get in, but you cannot get out!) for themselves in terms of the vulnerability of the US economy to new shocks and their future policy flexibility; rather than setting the stage for a durable and reasonably robust recovery.

 Chief among our concerns is that the vast increase in the Fed’s balance sheet has seriously compromised the independence of the central bank. In this regard we note that every hyperinflation in history has featured situations where (a) the central bank has meddled with private sector financing decisions (beyond the setting of the policy rate) and (b) the government ran budget deficits that the political system could not remediate. We note that the entire raison d’ètre of the Fed’s new lending facilities is to redirect capital to specific perceived priorities under the general suggestion that unelected Fed officials are better able to make such decisions than the private sector. This does not square with the generally accepted view of how the world should work (unless you are living in the USSR of 1955). We also observe that  in the U.S. today, with over 100 million voters dependant on handouts from the government (food stamps, welfare, unemployment benefits and the like) there is little question that repaying the projected deficits with tax increases or spending cuts will be extremely difficult, if not impossible, politically.

 The “Super-sized” Fed balance sheet has also handicapped the Fed’s ability to fulfill its primary mission, which is promoting a stable and predictable low rate of inflation. It is easy to foresee that special interests and political pressures may make it harder to terminate the ad hoc programs in a timely manner, thus making it difficult to shrink the Fed’s balance sheet and avoid policy error.

We note further that despite the well known solvency issues at the aggregate level, in the US, banks there have been keen to pay off TARP liabilities. What seems to have escaped the attention of the mainstream media is that many of these banks are still far from having marked all of their crappy assets to market and that in the event of another shock to the system, that they may be ultimately forced to reveal the illiquid and insolvent state of their balance sheets and then turn to Fed for help yet again. We note in addition that there is now no further room to cut rates, only to inflate the money supply more.

 Back when the Fed held $900 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury’s liability would never cost taxpayers a cent. In the present situation, the Fed has taken on significant private sector risk for which the taxpayers are potentially on the line,  distracts the Fed from its primary mission and subjects it to even more political pressures than it usually has to bear.

 Moreover, should the markets begin to suspect that because of the policy gridlock as relates to the unwinding of fiscal stimulus and the needed shrinkage of the Fed’s balance sheet, that the US will attempt to inflate itself of its debt and deficit problems, then term rates will rise very fast and very sharply. This would further complicate debt management generally for households, businesses and governments.

 Typically Sovereign debt crises are triggered when debt servicing costs as a proportion of total budget expenditures reach levels around 15-25%. By this measure the US appears OK, but that is only if one ignores the Off Balance Sheet obligations of the US Government, as the markets have been doing for some years. However numerous other nations are not currently so fortunate. We are already seeing the effects of the raids by bond vigilantes in the Baltics, the PIIGS, and central Asian countries. In these economies the “going-in” position to the GFC was far weaker than that of the more developed economies, China and the Asian Tigers. Multiple debt crises are looming, accompanied by social dislocation and political strife.

 The risks associated with Chairman Bernanke’s strategy are thus significant. Should Bernanke’s bet go wrong, the nexus of finance and politics suggests that preeminence of the US and the role of the dollar as the key international reserve currency could unravel far more quickly than anyone in the mainstream currently thinks possible. In this scenario the US could end up facing significant and more immediate challenges to its hegemony from China and its rapidly growing roster of client states as well as others. Volatility and carnage would likely follow in many investment markets throwing the Global Economy into another severe down-leg. This outcome might also very well be accompanied by military adventurism in a variety of places and an emboldened array of terrorist plotters for the US Globo-Cop to contend with simultaneously.

 In the meantime, we expect the unfolding Sovereign Debt Crisis story to remain prominent in the headlines for 2010 and beyond. PIMCO and other large scale investors recently announced that they are trimming bond exposures to the US Treasury and other government bond markets. We expect this trend to continue, pressuring rates in the belly of the US Treasury curve and beyond. For this reason we expect equity markets in most economies to experience a downward adjustment in 2010. Equities will also be pressured generally in response to downwardly revised expectations for economic growth,  top-line revenues and profits. Finally, the continuing weak economic profile and rising term rate environment will not allow banks to recapture, or begin to limit, loan loss provisions as many of them have been expecting. Our view is that most banks will likely experience even greater distress ratios in their asset portfolios and pressure on their capital cushions and efficiency ratios.

Posted in Banks, Crisis, Economy, Fed Policy | No Comments »