With all of the focus in the United States on the collapse of Bear Stearns, AIG, Lehman Brothers, and Merril Lynch, we may be a bit myopic in not noticing other issues around the world. Iceland stands out as a country that has really run into trouble. As Michael Lewis wrote in Wall Street on the Tundra: “Iceland instantly became the only nation on earth that Americans could point to and say, ‘Well, at least we didn’t do that.’”
The collapse has been so big that Iceland is abandoning its own currency to join the European Union. Until the collapse, Iceland had little interest in joining the EU. They do want the bureaucrats in Brussels messing with their fishing. Iceland put some excellent regulatory controls on fishing that have lead to stable fish populations and rich fishermen.
They failed to do the same with their financial system. They ended up having fisherman quitting the sea to engage in currency trading.
There are lots of lessons to be learned from a compliance and risk management perspective.
Legend has it that Joe Kennedy cashed out of the stock market when his shoeshine boy gave him stock tips. Maybe a warning sign should be fishermen engaging in currency trading. We saw similar events in the U.S. as people quit their jobs to be real estate entrepreneurs. I heard a success story from an acquaintance who told of buying a house for 100, putting in 10 and selling it for 120. I didn’t have the heart to tell him that house prices has risen by 15% during that same time frame. A rising market makes everyone look like a genius.
As Michael Lewis points out “One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.” You saw that with Iceland’s collapse and you saw that with the collapse in the United States. The most publicity shined on Goldman Sachs for its profits in September 2007 made from shorting mortgage positions. I am sure that there were quite a few mortgage originators who knew they were peddling garbage. But they had no incentive to stop the income coming from origination fees.
The three biggest banks in Iceland, a country of only 310,000, made loans totaling over 850% of Iceland’s Gross Domestic Product. Only 1/5 of the loans were in Iceland’s currency. They instead borrowed from their banks in cheaper currencies such as yen and Swiss francs. To compare, the balance sheet of Britain’s banking system was at 450% of GDP and the US at 350%. Clearly, carrying too much debt is a problem. Especially when their are few alternative sources of capital besides more debt.
Iceland’s debt load increased from 200% of GDP in 2003 to almost 1000% in 2008. That is an enormous growth curve. Even steeper than the rise of housing prices in the United States.
Economic cycles are part of human nature. We overbuy into good times and oversell in bad times. It easy enough to look back a few years to the Dot-Com bubble focusing on market share and eyeballs at the expense of the bottom line.
See:
- Wall Street on the Tundra by Michael Lewis in Vanity Fair
- Cracks in the Crust published in The Economist
- Iceland Hunts the Euro published in The Economist
- Iceland Faces the Worst of Times published by The Economist Intelligence Unit Briefing
- An Icelandic Success: A model way to catch and keep fish published by The Economist
- The Fitzgeralds and the Kennedys : An American Saga
by Doris Kearns Goodwin
- Goldman Sachs Net Rises 79% on Mortgage Trading
- Real Estate Price Rollercoaster by speculativebubble on You Tube
- Dot Com Bubble -from Wikipedia
Doug, heard this joke somewhere recently–
Q: What’s the capital of Iceland?
A: About $1.50.
Bruce –
Thanks for sharing the joke!
The kreppa jokes keep coming. (Kreppa is the Icelandic word for recession and also the verb ‘to clench’, like a fist). [From Ice news]
How do you get rid of the stockbroker at your front door?
Just pay him for the pizza!
Do you know how to save a risk investor (probably best translated into English as speculator (?)) from drowning?
No?
Good.
An elderly lady receives an e-mail from the son of a deceased (but wealthy) African general, asking whether he could transfer 10 million into her bank account in return for a 20% cut. All the son needs is the sort code and the account number. Not realizing she’s the victim of a Nigerian 419 fraud, she e-mail back her bank details. A couple of minutes later, she receives an e-mail back from the general’s son: Iceland savings?! What is this, some sort of scam?
http://www.icenews.is/index.php/2008/11/15/icelands-first-batch-of-economic-crisis-jokes/
http://listverse.com/humor/20-hilarious-credit-crunch-jokes/
How can “There are lots of lessons to be learned from a compliance and risk management perspective.” if economic cycles are a part of human nature?
Michael –
You can learn lessons to prevent similar problems in the future. But the next cycle will be based on different problems. The financial system gets pulled in because they are the source of capital for the over-exuberance. The herd mentality keeps pushing capital into the problem area until they realize (too late) that there are problems.
This current bust came from US home prices. The last one was Dot-com. The one before that was commercial real estate. . .
Doug,
I am a great fan of a couple of books about the Tulip crisis in 1630. As far as I can see, there is virtually no understanding about how to prevent this type of problem.
Personally, I would like to see a negotiation simulation run many times using an abstract version of the tulip auction to see just what you need to do to deflate investment prices when they cross the line into gambles.
The Amsterdam Parliament suspended the use of the Courts to enforce the promissory notes and delivery contracts after the implosion.
What I wonder is, had this outcome been foreseen would the musical chairs have ended earlier and with less price appreciation?
Michael –
It will happen again and the government can do little to stop the fluctuations in the economic cycle.
That is at the macro level. I am focusing on the micro level. What lessons can I learn to prevent my company from making these risky bets? What lessons can you bring back individually to your company?
The economy will always move like a herd. You want to make sure that you survive and become stronger when predators start picking off the herd.
A division of Goldman made boatloads of money sell mortgages short. Unfortunately for them, another division got stuck holding some long.
Looking back, what should have been different?
1. The mortgage origination process had no incentive to see that the mortgages got paid. You need to have people keep a latent economic benefit tied to repayment of the debt.
2. Interest rates were too low.
3. There should not have been incentives to get marginal borrowers into home ownership
4. The rating agencies should be paid by the purchasers not the originators of debt.
5. The ratings for operating companies and structured investments should be separated. There are only a handful of AAA rated operating companies. Why were there so many AAA rated structured investments? The two rating mean different things.
There are lots of others, but those are the ones on my mind.
Suppose you are right.
Were any these observations or recommendations, 1-5, unavailable prior to the sub-prime fraud being discovered?
I don’t think so.
Why do people know how to research and discover that an investment opportunity is a scam or fraud after they have been defrauded but not before?
Michael –
I think the sub-prime fraud was caused by those five things. There was insatiable thirst for AAA mortgaged back securities and a push to get marginally qualified people into home ownership.
I am sure that the mortgage brokers and mortgage borrowers saw the excessive greed/ fraud involved. Those NINJA loans (No Income, No Job, No Asset verification) are liars loans. There is little use for them except to make a loan against the value of the real estate instead of the borrower’s ability to repay the loan. There were a staggering number of NINJA loans in some of these toxic assets.
I am not sure anyone saw all of these problems or could have predicted this end result.
We can learn lessons from history, but it cannot predict the future.
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