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Iceland (pg.2)

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

Sitting in a café overlooking the pond that divides central Reykjavík, Arnaldur Indridason, the country's leading crime novelist, waves his arm at the idle construction cranes in the distance. "I don't think Iceland realized where the money was really coming from," he says, "or how fragile it all was."

Iceland used to be one of Europe's poorest countries, a bleak place that survived mostly on fishing revenue and the occasional adventurous tourist who came to bathe in the natural hot springs or explore the moonlike lava fields. Davíd Oddsson almost single-handedly changed that.

A onetime actor and producer of radio comedy shows, Oddsson, 60, was elected mayor of Reykjavík while in his early 30s and went on to become Iceland's longest-serving Prime Minister, in office from 1991 to 2004. With thick, wavy hair, he's moody, witty, and an outspoken free-marketer who likes to quote Milton Friedman and has modeled himself on Britain's Margaret Thatcher.

It was Oddsson who engineered Iceland's biggest move since NATO: its 1994 membership in a free-trade zone called the European Economic Area. Oddsson then put in place a comprehensive economic-transformation program that included tax cuts, large-scale privatization, and a big leap into international finance.

He deregulated the state-dominated banking sector in the mid-1990s, and in 2001 he changed currency policy to allow the krona to float freely rather than have it fixed against a basket of currencies including the dollar. In 2002 he privatized the banks. When he stepped down as Prime Minister in 2004, he did a stint as Foreign Minister before becoming governor of the central bank in 2005.

Oddsson's policies seemed to have paid off handsomely - for a while. In the decade from 1995 to 2005 the economy recorded annual average growth of more than 5%, far faster than most of its European trade partners, and on a per-capita basis, Iceland amazingly became the world's fifth-richest country. Its fishing industry expanded, and it developed a geothermal energy business.

But the principal fuel for Iceland's boom was finance and, above all, leverage. The country became a giant hedge fund, and once-restrained Icelandic households amassed debts exceeding 220% of disposable income - almost twice the proportion of American consumers.

Icelanders can thank Oddsson and other policymakers for turning them into a nation even more profligate than the U.S. Regulators loosened rules on mortgage lending to allow financing of as much as 90% of the value of a property, up from 60%. And the central bank's actions made it irresistible for businesses and consumers alike to borrow in foreign currency: A series of interest rate hikes by the central bank, aimed at taming inflation, unwittingly sent the free-floating krona soaring on international markets. That made imports cheaper for Icelanders, further fueling the consumption boom.

Given the choice of borrowing in krona at double-digit interest rates or in foreign currencies at far lower rates, many Icelanders chose the latter. "When you bought a car, you'd be asked, 'How do you want the financing? Half in yen and half in euros?'" recalls Gunnar Haraldsson, who heads the economics department at the University of Iceland.

Nor did authorities do much to discourage a band of brash Icelandic entrepreneurs who took control of the banks and used them to build global business empires. A group led by Björgólfur Thor Björgólfsson, 41, who made his fortune with a Russian brewery, successfully acquired a 45% stake in Landsbanki, once Iceland's national bank.

A longhaired 40-year-old grocery magnate named Jón Asgeir Jóhannesson snapped up a 32% holding in Glitnir. And a pair of brothers who got their start processing cod roe executed a reverse takeover of Kaupthing. Their ostentatious shows of wealth (Jóhannesson owns a yacht named Viking) flew in the face of Iceland's egalitarian traditions: One mogul brought in Elton John to perform at his 50th-birthday party in January 2007.

But the real eyebrow-raising behavior was the way the entrepreneurs created highly leveraged investment funds that used the banks and a complex web of other shareholdings as collateral.

The banks expanded rapidly abroad - by the end, about 60% of loans were outside Iceland - and the investment funds followed suit, snapping up stakes in companies ranging from American Airlines (AMR, Fortune 500) to Saks Fifth Avenue (SKS) and a slew of British apparel firms. The government and the central bank did nothing to rein in Iceland's oligarchs; indeed, the government actively encouraged the banks to expand lending, ratchet up their leverage, and take greater risks.

The central bank reduced the minimum-reserves requirement - the percentage of assets the banks were required to deposit with it - freeing more of their capital. And it seemed blind to the outsized risks to the nation that the banks' ballooning balance sheets posed.

Several international organizations, including the IMF and the Organization for Economic Cooperation and Development, warned of the perverse effects of Iceland's monetary policy. It was ineffective in fighting inflation and turned the country into a fixture in the "carry trade" business, as hedge funds and other financial market players borrowed in low-yielding currencies like the Japanese yen and invested in high-yielding Icelandic krona.

In dollar terms, Iceland's stock prices rose ninefold from 2003 to 2007 on the back of this foreign demand. The investments were often short term and highly speculative, but Iceland encouraged them. In 2005 the government started issuing krona-denominated "glacier bonds" to better satiate this international appetite.

It was a dangerous game to play, and it quickly went wrong. In April 2006 the rating agency Fitch abruptly downgraded its outlook for Iceland, citing concerns about the banks. Investors panicked, and the currency and the stock market both plunged 25% in a matter of days.

Now infamous credit default swaps - a type of speculative insurance - on Iceland's banks soared. The incident prompted stern warnings from some international experts, including American economist Robert Aliber, who gave a lecture in Reykjavík in May 2008 urging the banks to split off their Icelandic commercial-banking operations from their volatile investment-banking activities.

The banks did unwind some of their opaque cross-shareholdings and move to strengthen their balance sheets. Landsbanki and Kaupthing started up Internet banks that offered very attractive rates targeted at British and Dutch retail customers.

But the central bank did little to guard against tougher times. It increased its foreign-currency reserves - but to less than $4 billion. And other than a swap agreement with Scandinavian central banks in May 2008, it failed to secure credit lines from others around the world.

Oddsson declined to comment for this article. In a statement, the central bank said that its international peers declined to help "largely on the grounds that the Icelandic banking system was far too large and that swap agreements would not make any difference."

That's only half the story. Officials in Iceland and at central banks elsewhere say that Oddsson's approach was deeply flawed: He penned short notes to other central banks that barely struck them as serious requests for help.

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