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Iceland, again

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The IMF has published a self-evaluation of its massive lending program to Iceland — a program which Iceland has now exited. Although a little technical, it’s an interesting read, but of course the people who should read it — the Irish Department of Finance types who mocked Iceland in 2009-2010 — won’t. There are two take-aways from the report. One is what Iceland did about the banks; that ship has sailed for us now but it’s no harm understanding even after the fact how bad the choices were. The other is how to deal with the overhang of personal debt, which is still a big issue for Ireland and one where informed choices can be made. Quotes below the fold. Short version: no blanket guarantees, no pari passu rubbish about senior unsecured creditors, no NAMA, and an aggressive approach to reducing domestic corporate and household debt burdens (update: the IMF makes the Iceland case of household mortgage debt a centerpiece of their Spring 2012 World Economic Outlook).

[prior to the IMF program]
Following the collapse of the Iceland banking system, the authorities had few options but to ring-fence domestic stakeholders to preserve the financial system. The main objectives of the authorities’ strategy were to: (i) preserve the functioning off the domestic payment system; (ii) limit the absorption of private sector losses by public sector; and (iii) create the conditions for rebuilding a domestic-banking system. The government extended a blanket
guarantee to domestic depositors to stem bank runs and imposed controls on capital outflows to maintain domestic liquidity and avoid additional pressure on the exchange rate. The Emergency Act (October 6, 2008) empowered the FME with broad-based powers to intervene in failing institutions, granted all deposits seniority over the unsecured claims in case of bank failures, and allowed government to inject capital into the newly created domestic banks that were carved out from the failed banks.

While the authorities’ old/new bank restructuring approach had shortcomings, it ensured the continuity of vital domestic banking services. The authorities did not follow an established good-bank/bad-bank approach. Instead, they split the failed banks along domestic/foreign lines.10 This approach had some shortcomings, in particular: (i) the evaluation process proved extremely difficult, time-consuming, and contentious, thus delaying the
recapitalization of the new banks; (ii) the new banks remained with a large share of nonperforming loans (NPL)—45 percent of total loans in late 2008, leaving the resumption of the new banks’ intermediation function dependent upon a successful private-sector debt restructuring; and (iii) the new banks remained vulnerable to exchange rate fluctuations, given their substantial net open foreign currency positions, as a large share of domestic loans was
denominated in foreign currency or indexed to the exchange rate. However, the approach had crucial benefits—it preserved the functioning of domestic payment system (domestic payments and transaction accounts), achieved an immediate downsizing of the banking sector, and solved the problem of excessive reliance on wholesale funding as the new institutions were largely funded by deposits.
[during the program]
creditors of the new domestic banks were offered the option of converting their claims into equity holdings, thereby granting them potential upside gains insofar recovery rates turned out to be higher-than-originally estimated. Accordingly, given the difficulties in valuing the assets of the three large failed banks, an agreement was reached whereby the creditors of the old banks became the shareholders of two of the new banks through a debtto-equity swap operation (the third one remained fully state-owned), instead of receiving a compensatory note. The severely undercapitalized part of the savings banks sector was also intervened and either sold to other banks, resolved through purchase, or liquidated.Leasing and credit card management companies were restructured without public support. The net fiscal costs of the banking crisis are estimated at about 20 percent of GDP, with significant portion attributable to losses on loans made by the CBI in the months before the banks failed
[on private debt]
Given the scale of the problem, progress on private sector debt restructuring was initially slow due to a number of factors, but accelerated towards the end of the program. The authorities’ approach favored market-based voluntary workouts and strengthening the legal framework.* The framework for household and corporate debt restructuring was built up in stages during the program, with input from Fund staff, and aimed to encourage and expedite voluntary out-of-court workouts (given also limited court capacity); expand the coverage of debt-distressed individuals; reduce conflict of interest among creditors (the “hold out” problem) and asymmetry of information between debtors and creditors. These successive adjustments fueled private sector expectations of more generous debt relief offers in the future, holding back potential settlements. Following the October 2009 accord on payment smoothing, the authorities agreed with lenders towards the end of the program (December 2010) on a comprehensive package of measures and clearly indicated, as suggested by Fund staff, a sunset clause for the restructuring offer (mid-2011). Since then, the pace of private sector debt restructuring has accelerated, although the latest Supreme Court ruling (February 2012) may result in further delays of private debt restructuring.

* Initially, Fund staff and authorities contemplated the idea of establishing an Asset Management Company (first review). This could have helped reducing the uncertainty about banks’ balance sheet. However, the idea was subsequently dismissed (second review) on the ground that it would have entailed delays in the process due to the need to set up a new authority; upfront additional costs for the state, whose financial conditions were already distressed; and renewed conflicts with the new bank shareholders about asset valuation, which had been already marked down.
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6 Responses to “Iceland, again”

  1. # Comment by EddieL Apr 13th, 2012 20:04

    A country with a population of less than 1/10 of Ireland’s had the brains to do what needed to be done. The best our government could come up with was a version of the emperor’s new suit where everyone had to go along with the idea that we were ubfit, stupid or incompetent if we did not agree with the bankes and give them billions for an invisible banking system.
    However it has now dawned on all that default on debt not incurred by the state is now inevitable and that is only part of the legacy which will need to be dealt with if the exercise is not to be repeated.

  2. # Comment by FERGUS O'ROURKE Apr 15th, 2012 09:04

    You are uncharacteristically unconvincing in this. Perhaps some day, you might take a critical look at at the important differences between Iceland’s problems, its overall position, the options open to it, and the future outlook for it, and Ireland’s.

    But my main reason for commenting is your throw-away “no pari-passu rubbish about senior unsecured creditors” remark.

    The default position in every country, as far as I am aware, is that all creditors -whether of banks or otherwise – rank pari-passu. In other words, ordinarily no-one has an entitlement to be paid ahead of any other creditor.

    Legislation and regulations can and do change this. Contract arrangements can also do so.

    Contracts include bond agreements, which often (but not always) give privileges (a higher interest-rate or a right to convert into shares, for example) to bond-holders in return for putting them lower down “the pecking order” for payment.

    By contract, creditors can also put themselves *higher* up in that order. An example would be a mortgage lender, who is entitled to be paid ahead of anyone else when the mortgaged property is being sold.

    In the United States, but not in Ireland, bonds issued by banks (but not by, for example, municipal authorities) are legally deemed to be subordinated to other creditors.

    Turning to the position of the Irish banks, the legal position is that in 2007 (date chosen to avoid confusion with guarantee rights) a rich investor who put €1 million on deposit with AIB had no better right to be repaid than one who bought AIB bonds for €1 million, unless s/he agreed to terms saying otherwise.

    You refer to this as “pari-passu rubbish”. I suggest that you need to explain yourself better.

  3. # Comment by P O'Neill Apr 15th, 2012 14:04

    Hi Fergus.

    Here’s an interesting recent piece by Felix Salmon (Reuters pundit). Pari passu is not as settled as Irish DoF presented it even for sovereign debt, let along bank debt. Under the DoF interpretation, such debt could never be restructured outside of bankruptcy, and I don’t think that’s right. In any event, even under that interpretation, the government could have done to the senior unsecured creditors and said, all right lads, we’re putting Anglo and Irish Nationwide (and maybe AIB) into bankruptcy, we’re covering most of the depositors with deposit insurance, and good luck with getting your money from the carcass. I think that would have gotten their attention.

  4. # Comment by FERGUS O'ROURKE Apr 18th, 2012 15:04

    It will take me some time to follow all of that up. Don’t hold your breath ! :-)


    As far as I know, t’bould Felix is not a lawyer,and some of his statements seem rather peculiar to me, even allowing for the very particular circumstances that he is describing, and the specific legal context in which they are being considered. True it is that I can normally choose which of my creditors to pay and in which order, but Felix might care to consider the concept of fraudulent preference.

    As for your own spin about daring creditors to get money from carcasses, I am not going into that detailed discussion yet again. However, I do repeat my question from above: just why should someone with €1m invested in a bond – perhaps with less than a year to maturity – accept less than a depositor with $1m to his/her/its name ?

    In the U.S., the answer is easy: “them’s the rules, and you knew ‘em when you bought the bond”. Not so here in Ireland.

  5. # Comment by FERGUS O\'ROURKE Apr 18th, 2012 15:04

    Oops, the second amount should read €1m as well as the first.

  6. # Comment by sweeterjanss May 26th, 2012 07:05

    As for your own spin about daring creditors to get money from carcasses, I am not going into that detailed discussion yet again. However, I do repeat my question from above: just why should someone with €1m invested in a bond – perhaps with less than a year to maturity – accept less than a depositor with $1m to his/her/its name ?