Two weeks ago, as the fate of Europe hung in the balance; I got a witty email from a friend. “What’s the difference between Ireland and Iceland?” The answer: “Two years and a letter” “LOL, ROFL …!” I responded. In case it isn’t clear, two years ago Iceland collapsed and ironically, there is only a single letter of difference in their names. Then I thought about it. That’s where the similarities end.
Iceland was one of the first victims of the Banking Crisis. The three large national banks were essentially giant hedge funds using deposits to invest in all sorts of businesses. When they had tapped all the deposits in Iceland, they went overseas looking for deposits. Offering mid-teens interest rates, it was easy to borrow from yield hungry investors. The banks then invested the money in assets that appeared to offer higher returns. In typical hedge fund fashion, they ended up with a motley assortment of esoteric asset classes.
When the world economy collapsed, people suddenly started paying attention to the highly leveraged Icelandic banks. It wasn’t long before a run on the bank made it impossible for them to roll over their term deposits. In one week, all three of them halted redemptions and begged for government assistance.
The small nation of Iceland was in a bind. Combined, these three banks were roughly ten times the size of the economy—far too big to bail out. Besides, bailouts weren’t yet de rigueur central banking strategy. Iceland took decisive action anyway—they told the creditors to pound sand.
There was no bailout for creditors. Depositors lost money. Bond holders lost money. Everyone lost money. It was painful. Foreign countries retaliated and seized assets. No one could believe that if a bank failed, there could actually be losses. It was considered unthinkable.
Iceland followed up this injustice by devaluing their currency the Krona, which lost almost half its value. Then, the most amazing thing happened, Iceland got back to business. Hedge fund managers went back to the fishing boats that they had worked on previously. Bond traders went back to tending livestock. In a blink of a second, the hedge fund economy dissolved. People went back to real jobs. The nation of Iceland didn’t need an army of financial analysts; they needed employees for the traditional Icelandic businesses of farming and fishing.
In the summer of 2009, I spent two weeks in Iceland trying to understand the country. I wanted to learn more about how such a small island could suddenly become the epicenter for a thriving finance industry. I wanted to know how it could have all gone so bad so suddenly. Mostly, I wanted to gain an appreciation of the place because I expected there to be bargains in the rubble of their economy. I identified a country of highly educated and hard working individuals and I told myself that when the bargains finally did appear, I wanted to invest in Iceland.
Now, two years later, I am stunned; the bargains lasted for mere seconds. It’s all fixed. I thought they’d muddle through with years of money printing and chaos trying to prop up zombie businesses. Instead, it’s all done. Kaupthing Bank, the largest Icelandic bank is being recreated at 26c on the Euro of the senior debt. It is the same with many other bankrupt companies. No bailouts—the bond holders now own the asset at whatever the new fair value is. It’s the way this should work. Some people gained, and most people lost fortunes, but it’s all been resolved. Iceland is going back to business. Amazingly, Iceland expects positive economic growth in 2011. In just two years, Iceland has put the collapse behind it.
This is in sharp contrast with Ireland where the government decided to let taxpayers shoulder the burden for the banking system. Ireland is now so horribly overwhelmed with debt that it will still likely default; only the event will be pushed further into the future. Meanwhile, the interest expense will act as a drag on the Irish economy for years until that default happens.
According to OECD, Iceland’s budget will be in surplus by 2012 compared with Ireland’s anticipated deficit of nearly 10% of GDP. Which is a better solution? Of course, creditors in Icelandic banks are trying to recoup $86 billion after the three largest banks failed in 2008. A lot of people are facing a lot of pain. However, by taking the hit and moving on, everyone is in a better position. The people of Iceland can get on with life rather than living in a state of non-growth for years. The treasury isn’t burdened with a huge debt burden. Even the creditors are likely better off. Sure, they didn’t get paid at par, but most of the Irish bondholders won’t see their bonds get paid at par either (even if the ECB has guaranteed it this time). The creditors in Iceland will get pieces of recapitalized and functioning businesses. If Iceland grows as I expect it to, they will get a lot of their money back over time.
It is time for bondholders around the world to shoulder the burden for stupid investments. If you lend someone money and they cannot pay you back, you are a fool and deserve to lose money. You should not rely on the national government to pay you back. It isn’t the people’s fault you are a fool. You shouldn’t rely on a supranational governmental agency like the ECB to pay you back and you shouldn’t rely on the IMF. If you made a bad investment, it is your fault. Bailouts only harm the citizens of a country while a few select individuals with political connections stand to benefit. Iceland did the right thing. I was expecting a multi-year muddle. I missed my chance. Looking back at how Iceland handled this crisis, I want to be an investor in the country. Europe will muddle along for years with endless bailouts. Iceland will be a success. Two years and a letter separate Iceland and Ireland, but there’s a world of difference beyond that.