Bankruptcy

Debt and the People, Part I: The Cold

By Anna Gelpern

In earlier posts, I considered two trends:  first, the eroding boundary between chronically defaulting sovereign and risk-free government debt; and second, the comfy symbiosis among feckless rules, fudged government accounts and basic financial engineering.  I also considered the politics of erosion and symbiosis.  In this post and the next, I move to a third trend, perhaps the most overtly political of the lot: the resurgence of popular input in national debt matters.  The latest exhibit in this trend is Iceland, whose money troubles gave Michael Lewis the opening to set Beverly Hillbillies in Lake Wobegon.  The immediate predicate for this post is last weekend's referendum, where over 93% of the voters rejected a plan for Iceland?s government to guarantee payments to the United Kingdom and the Netherlands, compensating them for compensating their nationals who lost money in Icelandic internet bank accounts.  Curious referendum factoids include that (a) the deal voted on had long been superseded, and (b) ?yes? votes came in third after empty ballots.  But the back-story is serious, complicated and revealing.

[The following background is mostly a lite retelling of the material in these two IMF staff reports, with my editorial asides.]

Over the bubble decade just past, Iceland?s banks borrowed money from all over the world and invested it in overpriced, increasingly loopy assets.  Reasonable readers might ask why anyone put money in, say, an internet banking outfit called Icesave.  There are two answers:  (a) why not (it was a branch of Iceland's top bank), and (b) it paid.  When Japan kept its interest rates low to grow its economy, you could borrow yen for free and invest the proceeds in Iceland at over 15%.  This was the über-bubbly ?carry trade? (where ?carry? is the return on holding the asset, not the act of carrying yen to Iceland).  And it was not just for prop traders with fancy screens; scores of regular citizens, with the Brits and the Dutch in the lead, carry-traded away ? until the music stopped in October 2008.  When it did, Iceland?s banking sector was nine times the size of its economy, with huge domestic and foreign deposit liabilities.  The rest of the private sector was similarly massively over-indebted, notably including FX-denominated mortgage liabilities in the household sector.  Oh, and the Icelandic currency tanked, which made already unrealistic foreign currency debts unfathomable.

The government quickly intervened in the top three private banks, which represented about 85% of all banking assets going into the crisis and imposed capital controls, along with moratoria on foreclosures and FX mortgage repayments, among other measures.  But there was not nearly enough money in Iceland?s deposit insurance fund, and not enough cod in the sea to make good on all those deposits, not to mention other creditors, who normally take after the depositors.

And so Iceland did what most governments do, but rarely admit to doing:  it split up the banks into domestic (new) and foreign (old); put the old in liquidation proceedings, and proceeded to recapitalize the new.  This meant that foreign creditors, notably depositors, felt ill-used.  The British government first responded with Duck-Soup-worthy diplomacy, invoking anti-terrorism laws to freeze Icelandic assets, and prompting this early episode of video-democracy, which has since grown into an impressive movement culminating in the referendum.  In the end, the British and Dutch authorities could not afford to see their voters stiffed (so much for market discipline for retail deposits), and paid them off out of their own coffers, acquiring something of a claim against Iceland.  This is where it gets complicated.

Under EU law, members of the European Economic Area are responsible for supervising and insuring European branches of their deposit-taking institutions.  I have no view on matters of EU law, but Michael Waibel points out that it is far from clear that EEA member responsibility goes beyond establishing a deposit-guarantee scheme.  Funding the scheme, especially funding it to absorb losses of systemic proportions, is another matter.  So from one angle, the U.K. and the Netherlands might be holding claims against an unfunded shell, and negotiating for mercy with an already over-indebted government determined not to assume private liabilities.  At best, they might get a government guarantee to backstop what would become a long-term loan to the still-bankrupt deposit insurance fund.

But there is another angle.  Iceland has a stand-by program with the IMF, which?as all IMF programs?requires ?financing assurances?.  This means that before the program is approved and the money is disbursed, the numbers must add up.  And for Iceland?s program to add up, they need to get funding from certain Nordic creditors, whose disbursements are in turn contingent on the resolution of the Icesave dispute with the Brits and the Dutch, which gives the latter quite a bit more leverage ? unless Iceland or the Fund can come up with alternative funding sources.  (I will not go into the additional Euro accession angle, which is further complicated by the ongoing Euroworld mess.)

For now, domestic politics seems to dominate on all sides.  Iceland?s President vetoed the law approving the terms reached at the end of last year, and put the deal to a referendum, where it died ? except that the negotiators had already agreed on more favorable terms for Iceland, including a lower interest rate and seven years? grace.  Nevertheless, the talks have broken down.  On the other hand, the economy is sort of picking up, and private debt negotiating is going on here and there, complete with tensions over payment priority between depositors (and their successors) and non-depositor creditors.  Meanwhile, two out of the three ?old? banks now in resolution proceedings have managed to buy the new banks.  (Don?t ask.)

Taking a step back, the Icelandic saga is worth watching for at least two reasons.  First, it highlights the way in which apparently private liabilities are really contingent fiscal liabilities, especially in banking, and especially in crisis.  (Dubai, which I may not have time to cover in the series, offers another twist with the debts of a state-owned enterprise that benefits from the presumption of separateness from general government operations.)  Second, the referendum is marks a new inflection in international debt politics.  It is different from our own debt clock and its permutations, which express generalized discontent with the level of public debt, not objections to the terms of a particular debt deal.  It is also different from the familiar IMF riots (a rather lurid take here), and today's Greek demonstrations, which go to economic policy conditionality, not debt terms as such.  And it is different from popular participation in the debt relief movement on the Jubilee model and those that came before, because it is primarily trying to block the government from incurring particular debt obligations to begin with, not seeking their reduction after the fact.

This move to specific, ex-ante direct popular approval?perhaps only possible in a country half the size of Washington, DC?adds a fascinating twist to the debate about legitimacy and responsibility in sovereign borrowing, to which I will return in the next post.

Full post as published by Credit Slips on March 11, 2010 (boomark / email).