A storm is brewing in Iceland. Homeowners have waited since October for words from the governments of Geir Haarde and then Johanna Sigurdardottir on how the state is going to tackle their problems. 

They are still waiting and they are getting angrier every day. 

The thing is that pretty much all home loans in Iceland have become subprime loans in less than a year. If you have invested in a home in the past decades then you have had two options: 

a) A price-indexed loan in Icelandic Kronas. 

- Back in the eighties the government had battled a massive inflation and decided to implement price-indexation on loans. 

- This was done to protect the owners of capital, in effect lenders from losing their money if they lent it to someone else. 

- The price indexation has the effect that if the consumer price index rises then the capital of your loan does so as well, and so do your payments. So a 5% annual inflation means that your 10 million krona loan grows to 10.5 million. 

- Nothing on the other hand was done to protect borrowers from inflation. They still received their wages in an ISK that wasn’t price indexed, so they in fact suffered a double loss on the inflation rising. The rising cost of the loan and the shrinking purchasing power of their wages. 

- This created an unbalance in the economy, whereas the banks and lenders were said to have both a belt and suspenders to keep their pants from falling down. The costs of inflation were effectively transferred to wage-earners and borrowers.  

- Now you could technically still get loans that weren’t price indexed but you should have tried asking your bank for one. Fat chance, they were in a position to direct you solely to price indexed loans.  

- The intent of the price indexation was to protect people’s savings. What it ended up doing was create an environment where lenders and borrowers did not share a common interest in doing everything to suppress inflation. With money flowing into the economy and overheating, the banks should have stopped lending money a lot earlier than they did. They didn’t because they kept receiving payments while things were good and it didn’t matter how much they charged. 

- Since the Central Bank of Iceland set itself a goal of inflation at 2,5% since March 2001 it has spectacularly failed. Since 2004 inflation has been on the rise from 5% up to almost 20%. 

- Anyone can see that home-prices must maintain a fantastic rise to keep up so that people don’t end up losing their home-owners equity.  

- The banks realized that they were selling a product that was fast becoming undesirable. 

So around 5-6 years ago they introduced a new and brilliant product: 

b) Currency loans. 

- Homeowners sick of real interest rates on their properties never dropping below 10% and sometimes touching 20% looked at the low interests rates offered by other currencies as their way out of the swamp.

- The Yen and the Swiss Frank were especially popular. A 50/50 combination soon proved a hit in the auto-loan market. 

- This meant that instead of paying the exorbitant rates that came with the ISK they could greatly lower their monthly payments. Why pay 30.000 when you can pay 15.000 AND your capital doesn’t rise with inflation but decreases instead? 

- There was a double gain on offer. If the ISK got stronger then the capital would decrease as well because of the exchange rate. Absolutely brilliant. 

- But there is always a catch and always some small print somewhere. If the ISK would weaken then the capital would rise accordingly. People were told that currency loans were brilliant if you could handle monthly fluctuations of 15-20%. 

- With almost no unemployment and Iceland becoming richer by the day it was a small detail. Somewhere between 8-15% of homeowners decided to risk the gamble. 

- And then the Icelandic krona’s index went from 109,7 to 251,5 in 18 months. 

The combined effect of these two natural disasters is apocalyptic. Lets say two neighbors each bought his home for 35 million with a 10 million downpayment a couple of years ago. So each took a loan for 25 million. 

Mr. A now probably owes the bank in excess of 30 million even though he paid the bank 5 million of his income from the last two years onto the loan.  

Mr. B is even worse off. He now owes between 50-60 million to the bank. If he was making payments of 150.000 per month then they are now fluctuating above 300.000. 

Meanwhile the housing market has plummeted and there are hardly any transactions taking place. The Central Bank assumes that home prices have or will decrease by almost 50% this year meaning that all loans in Iceland are effectively subprime loans. You cannot sell without assuming debt without an asset behind it. You cannot move if you want to, or what is worse, if you need to. And with thousands of apartments coming into the posession of the banks needing some cash inflow the rent market has shrunk as well, so people cannot even rent their apartments to make ends meet. 

Now the argument has been made that borrowers know the risk when seeking loans. People entered into the agreements with the banks of their own free will. That is true but in fact their choices were limited and no less important they were participating in their society. 

- Loans without price indexation were impossible to find for common people. 

- Competition was minimal. No foreign banks dared offering loans to Icelanders so the local banks were relatively hassle free.

- If everyone in Iceland had said to themselves that something was up and stopped borrowing money for homes then society would have grinded to a halt. Of course they didn’t, jobs were plentiful, the housing market on the rise and consistent propaganda from the government and the banks that people should borrow, invest and spend like there was no tomorrow. People participated in their society because they believed in it. One of the slogans from the Independence Party’s 2006 campaign was “When all is considered,  strong economic management is the biggest welfare issue”. That’s how you appease both ends of the spectrum in one sentence. Pure PR heaven. 

Since last autumn, the governments have indicated that something would be done to relieve the plight of Icelandic debtors. But there is a dilemma. 

- The state is in deep financial trouble. How deep down it really is is unknown because the cat hasn’t been let out of the bag yet. But the IMF and Oliver Wyman have used words like “largest in history”, “worst in 80 years”.

- Everyone knows that Iceland is entering extremely rough times. Welfare will be cut, taxes will rise and the state is facing an unenviable wall of debt that need to be paid off. The interest payments alone will cripple a large part of the economy. 

- Foreign debtors obviously will want as much as they can for Iceland’s outstanding debt. It will be a heavy burden for the state, i.e. everyone in Iceland for a long time. 

- So therefore it makes no sense from the standpoint of pure economic theory to cancel debts. You assume debt and pay it off. If you don’t you lose your home. That is how the world works.  

But this is still unacceptable to Icelandic homeowners. 

- Yes, they borrowed that money and some people assumed a lot of risk by borrowing more than they could chew and in currencies different from the one their wages are in. 

- But most people didn’t expect this magnitude of risk and agreed to pay their loans under drastically different circumstances. They expected (or hoped) for a lower inflation. They expected low unemployment. They expected steadier purchasing power. And they trusted their banks. 

- That was probably the biggest mistake. It appears that the owners and top management of the banks were systematically lowering the ISK to inflate their annual and quarterly reports. 

- The reason Iceland is in such deep trouble is the wrecklessness of these people who either started savings accounts abroad without care for the safety of their depositors or lent stupendous amounts of money to closely related individuals or businesses. The word on Kaupthing for example is that more than 50% of their loans were made to just 10 different individuals or businesses. 

- This is an equivalent of someone renting you an apartment, breaking in and wrecking it and then asking you to pay the damages. This is a question of fairness to the wage-earning homeowners of Iceland and being able to trust that the society you belong to punishes those who do wrong instead of letting them off the hook. 

During the election campaign, the Progressive Party introduced their plan of a 20% drop of all loans and that probably delivered them a relative gain in the end. The Independence Party jumped aboard on the idea when they were getting more desperate but most were sceptical. Everyone knows that this will be at a cost so reducing loans for businesses or large investors wasn’t appealing. 

The Social Democrats and Left Greens on the other hand rejected these kind of reductions. They have passed bills that allows people in bad situations to extend their loans but that is like putting a band aid on a person experiencing a heart attack. Also it is not transparent enough. Who gets help and why? 

It is frightful to say outloud what many are thinking. If it hadn’t been the Progressives who had put the idea forth in the first place, but someone from their own ranks then it would have been given greater consideration with the government. Party politics might still do some damage to an already crushed nation. 

Unfortunately other ideas have not been allowed to float to the top in the cesspool of Icelandic politics. I personally am intrigued by the Zingales’ Plan whereas the bank renegotiates with borrowers to drop their loans by an agreed percentage, say 40-50%. The bank in turns receives the same amount from the eventual sales profit of the home once the borrower decides to sell it. Whereas the 20% flat cut is hard to swallow for creditors, they might see an opportunity to regain some of what they are receding in the Zingales plan. 

While recommending that it be given a closer look that doesn’t mean that it could be the only or satisfying solution. What has happened in Iceland despite the nation’s current state of denial is an economic and systematic collapse. People are injured, confused, frightened and angry. What is needed from the government is a response similar to what is expected after a natural disaster. Relief must be provided, oppurtunity must be given, hope must be presented and then there has to be a clearing of the ruins. Once that is done, we must be careful not to continue living in the same houses that collpased and build different ones, stronger and more trustworthy. 

At the time of writing, the rescue people are taking a lunch break before approaching the ruins. Let’s hope someone has a plan with a different type of architecture in mind.

Related posts:

1. In the ruins
2. Two days later – our homes are at risk
3. The Non-Existent Housing Market
4. Heartbreaking
5. You have two options, to be shot or to be hanged