Mums go to Iceland (to get their savings back)
Readers of our blog in spring ’07 were probably a bit bemused as to why we were banging on about a little island over 1000 miles away from continental Europe, with a population the size of Sunderland/ Venezia/ Gelsenkirchen/ Cordoba/ Strasbourg/ Pittsburgh. It’s pretty clear now – Iceland is probably the world’s best example of the credit bubble, and the subsequent credit bust. Icelandic companies went on a debt fuelled binge, taking over a huge number of UK companies in particular (including, ironically, UK frozen food specialist Iceland, whose slogan forms half the title of this blog).
In February ’07, Stefan said that Moody’s decision to upgrade Iceland’s banks to AAA was “Codswallop” (see here). Moody’s thought that if any banks went under, then Iceland’s government would come to the rescue, and since Moody’s thought Iceland’s government was AAA rated then the banks were too. But as Stefan argued, it was debatable whether a country with Iceland’s population and an economy based around cod had the ability to support banks with liabilities many times the country’s GDP. Then in March ’07 (see here), Richard argued that a slowing economy would be very bad news for Iceland’s banks, and attached a chart from Merrill Lynch showing how Iceland’s deeply incestuous economy, with huge cross ownership, posed a substantial economic risk. Finally in March ’08, in “If it ain’t your cods, it pollocks” (see here) Stefan highlighted how Moody’s had backtracked and returned Iceland’s rating to A1. But even then, credit markets were already pricing Icelandic banks as junk (note that Iceland’s not the only place now closed for business – the restaurant Stefan mentioned has closed too as it smelt a bit too fishy for local residents).
What lessons should be learnt from all of this? There are too many to write about here, but on a general level, the biggest lesson needs to be taught to the ratings agencies. The fall guys from Enron’s collapse were the accountants, namely Arthur Andersen. In the aftermath of Enron, the consultancy side and the audit side were largely separated and became better regulated. Before, the big accounting firms were effectively advising companies on how to ‘interpret’ accounting regulations. They were instrumental in providing guidance on things such as off-balance sheet financing. That’s a pretty big conflict of interest.
The fall guys from this banking collapse will be the credit ratings agencies. In some ways, auditors and ratings agencies are in the same boat – the financial industry relies on their independent judgement, but independence is open to abuse when companies pay for the service themselves. With the ratings agencies (where the consulting element is still intertwined with the rating entity), ratings agencies regularly provided guidance to the banks and brokers on what bonds could or could not be included within a structured deal in order for the deal to achieve the magic AAA rating. Ratings agencies need to be more accountable, and the industry needs to be opened up to much more competition.
Talking specifically about the Iceland debacle, people need to learn that there’s no such thing as a free lunch. In the world of corporate bonds, those bonds that have the highest yield are by definition the highest risk. Similarly, those banks that offer consumers the highest interest rate on their cash deposits are probably offering high rates for a reason – they’re desperate for your money. It’s one thing for the man or woman on the street to not appreciate these risks, but there are many people who should have known a lot better, and that includes people at local councils. Forbes Fenton, the head of our risk team, was telling me yesterday morning about how the Icelandic events remind him of the early 1990s (Forbes spent time in the Cayman Islands trying to unravel BCCI’s accounts). Depositors in the cases of both BCCI and the Icelandic banks were lured by the high interest rates on offer, and parked their money in what were effectively non-UK licensed banks. Prior to BCCI going under, 30 local councils had deposits or other exposure to BCCI. In Scotland, Western Isles council alone lost £23m. Lessons weren’t learnt last time around, and in the UK, that’s cost more than 100 local councils, police authorities and fire services almost £1bn this time around.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.