Iceland: The country that became a hedge fund
????It was a dangerous game to play, and it quickly went wrong. In April 2006 the rating agency Fitch abruptly downgraded its outlook for Iceland, citing concerns about the banks. Investors panicked, and the currency and the stock market both plunged 25% in a matter of days.
????Now infamous credit default swaps - a type of speculative insurance - on Iceland's banks soared. The incident prompted stern warnings from some international experts, including American economist Robert Aliber, who gave a lecture in Reykjavík in May 2008 urging the banks to split off their Icelandic commercial-banking operations from their volatile investment-banking activities.
????The banks did unwind some of their opaque cross-shareholdings and move to strengthen their balance sheets. Landsbanki and Kaupthing started up Internet banks that offered very attractive rates targeted at British and Dutch retail customers.
????But the central bank did little to guard against tougher times. It increased its foreign-currency reserves - but to less than $4 billion. And other than a swap agreement with Scandinavian central banks in May 2008, it failed to secure credit lines from others around the world.
????Oddsson declined to comment for this article. In a statement, the central bank said that its international peers declined to help "largely on the grounds that the Icelandic banking system was far too large and that swap agreements would not make any difference."
????That's only half the story. Officials in Iceland and at central banks elsewhere say that Oddsson's approach was deeply flawed: He penned short notes to other central banks that barely struck them as serious requests for help.
????Officially the Bank of England, the U.S. Treasury, and the European Central Bank won't comment. But, says a senior official at the ECB in Frankfurt, "if you want to put in place a swap agreement with us, you call [ECB president Jean-Claude] Trichet and make an appointment to come to see him. Then you fly to Frankfurt to discuss your request and explain how it is supposed to work. You need to win him over. Oddsson didn't even try."
????On Aug. 14, Iceland's banking regulator, Jónas Jónsson, announced that he had put the three banks through a "stress test" to see how they would perform if their assets or the krona dropped in value. The conclusion: "The banks are solid and can withstand considerable financial shocks," Jónsson noted enthusiastically. Less than six weeks later all three banks were defunct.
????Lehman's collapse on Sept. 15 played a critical role because it led to the drying-up of interbank lending around the world. The Icelandic banks were highly vulnerable because deposits covered only a fraction of their loans, despite the success of their new Internet-banking operations.
????Glitnir, named after the Norse god of justice, was the most exposed. On Friday, Sept. 26, its senior executives met with Oddsson seeking a liquidity infusion of up to $900 million. Earlier that week, they told Oddsson, one of Glitnir's biggest creditors, Germany's Bayerische Landesbank, had canceled a previously promised $200 million credit line. The reason: The Germans had just taken part in a $400 million loan to the Icelandic state, and because of the turmoil in banking markets, they told Glitnir executives, their bank had hit the limit of its exposure to Iceland. The German bank won't comment on individual client relationships but says it is writing off about $1 billion of its $1.8 billion exposure to Iceland.
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