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Iceland: The country that became a hedge fund

Okay, not really. But its main banks and business tycoons took huge risks and its citizens borrowed to the hilt. Now this island nation is paying the price.

By Peter Gumbel, Europe editor
Last Updated: December 4, 2008: 10:58 AM ET

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Icelanders protest in Reykjavik, some calling on officials to resign for bungling the financial crisis.
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Reykjavik once hosted financiers and entrepreneurs. Bankruptcy lawyers have taken their place.
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Icelanders, here at a pub, are taking pay cuts to save jobs, but worry about the country's future.

(Fortune Magazine) -- On a gloomy morning in early August, more than a month before Wall Street and the world's financial system seized up, a senior aide to Iceland's Prime Minister paid a visit to the Russian embassy in Reykjavík to make a controversial request: Bail us out.

Iceland had one of the richest economies in Europe, but it had a problem. Its three main private sector banks had become so large that their assets amounted to more than ten times the gross domestic product of the country - and there were signs that they might run into trouble.

Iceland had asked its traditional allies for help, but to its consternation, its pleas to the U.S. Federal Reserve, the Bank of England, and the European Central Bank went unheeded. Instead, the answer was always, "Ask the International Monetary Fund" - a drastic step Iceland didn't want to take.

That left Russia. "We knew that talking to them would create a shock, and that was partly the point," says a senior Icelander involved in the démarche. Iceland, after all, is a founding member of NATO and housed a U.S. Navy air base during the Cold War. The Russians sell oil to Iceland but have long sought a much closer relationship.

Inside the embassy, Russian ambassador Victor Tatarintsev listened intently. The seasoned diplomat, a canny political operator reputed to be close to Russian Prime Minister Vladimir Putin, knew an opportunity when he saw one. As he heard the plea, says the Icelandic source, "there was a big grin on his face."

Iceland's Russian gambit did indeed stir a reaction when it became public in early October. "Of course we would not have accepted any political strings," Prime Minister Geir Haarde tells Fortune. "This loan would not have indicated any change in our foreign or security policy."

Still, his phone rang off the hook, and IMF officials rushed to put in place an emergency $2.1 billion rescue package. By then it was too late. Iceland had already become the first nation to fall victim to the global financial crisis.

Today the economy is in unbelievably horrible shape: The three banks - Kaupthing, Landsbanki, and Glitnir - are in receivership. The stock market has lost 90% of its value. The central bank is technically insolvent, its modest pile of assets dwarfed by a mountain of liabilities.

The currency, the krona, has lost more than half its value. GDP is expected to drop by a stomach-churning 10% in 2009, and unemployment will probably hit a 40-year high. At Reykjavík's port sit gleaming new Range Rovers and other SUVs that are now unsellable, and newspapers are exhorting the public to buy no-frills Icelandic goods.

Above all, the nation's future is heavily mortgaged. Claims from Britain alone amount to half of what's left of its GDP. "It's like a neutron bomb that has wiped out all monetary assets but left the people intact," says Ólafur Isleifsson, a former IMF official who teaches at Reykjavík University's business school.

If it has become conventional wisdom that the U.S. decision in September to allow the collapse of Lehman Brothers was a critical error that caused a worldwide seizing-up of bank lending, then Iceland is the sovereign version of Lehman Brothers. It was a bubble everyone knew about, one that was allowed to inflate to perilous proportions - and then was popped, partly for reasons of political expediency.

As with Lehman, the damage has spread. Creditors - owed more than $70 billion - can expect just pennies on their dollar; they include about 150 British and Dutch municipalities, the German banks that were Iceland's biggest lenders, and hedge funds from Manhattan and Milan that used the island nation's sky-high interest rates and buoyant currency to finance highly leveraged transactions.

The blame game is only just beginning. But it's already clear that Iceland's demise was a result of flawed economic and monetary policy, bungled crisis management, and a calamitous breakdown of international cooperation. Iceland's business and political community bear an important part of the responsibility, even as they now play the victim.

But others share the blame, including the government of British Prime Minister Gordon Brown, which used controversial antiterrorism legislation to deliver the death blow to Iceland's banks. Other governments, too, adopted an every-nation-for-itself attitude during the crisis that raises doubts about future cooperation among European Union countries.

For Icelanders, the big question is how they ended up in such a mess. (Even Iceland-born singer Björk has complained about the crisis in the London Times.) For a few heady years they binged on the country's newfound wealth and borrowed heavily to buy houses, fancy cars, and flat-screen TVs.

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