Reykjavík Grapevine - 18.06.2010, Blaðsíða 10

10
The Reykjavík Grapevine
Issue 08 — 2010
It is easy to forget how new modern
finance – securities trading and invest-
ment banking – is to Iceland, especially
when we consider the enormous size
that the Icelandic financial bubble had
grown to by the fall of 2008, and the
even more grandiose dreams attached
to the further growth of the banks and
various investment companies. In fact,
we cannot speak of a modern capital
market, or even a financial market, in
Iceland until the early 1990s.
CREATING A CAPITAL MARKET
The first steps, however, had been
taken in the mid ‘80s by free market
visionaries. Laying the foundation for
the free market reforms of the ‘90s
they set about creating a modern capi-
tal market: for a modern capital market
does not emerge on its own out of thin
air. Just like all other markets, it has to
be created. And it cannot be created by
decree alone, and it does not magically
emerge via the cutting of red tape or
taxes.
Still, the first step was relatively
straightforward and simple: creating a
central marketplace where buyers and
sellers of securities could meet to trade
stocks and bonds. In 1985, the Icelandic
stock exchange was founded. However,
the first stocks were not listed until
1991.
The main reason was that in 1985
Iceland had neither buyers nor sell-
ers of stocks, and very few companies
whose stock could be traded. Establish-
ing a stock exchange was not enough:
the state also had to create both the
supply and the demand for stocks. In
order to convince the public of invest-
ing in stocks, a law was passed in 1984
that offered a tax rebate to anyone who
invested in common stock.
“SHAREHOLdER NATION”
Creating a modern stock market was
not an end in itself. The ultimate goals
were threefold. Firstly, the goal was to
wean Icelandic companies off their re-
liance on cheap debt supplied by the
state controlled investment funds, and
get them to raise equity from investors.
Secondly, a stock market was necessary
if the ambitious plans of the free mar-
ket visionaries for privatisation were to
be achieved.
The third goal was a tad more ide-
alistic, namely the creation of a “share-
holder nation” or a “shareholder de-
mocracy.” The concept had been
around in conservative
circles for decades,
first articulated by long serving conser-
vative MP and ideologue, Eyjólfur Kon-
ráð Jónsson. As early as the sixties he
had argued that the best way to elimi-
nate the conf licts between capital and
labour – and to ensure the public sup-
port of more business friendly govern-
ment policies – was to make the general
public into shareholders in the largest
private companies.
THE IdEA TAKES FLIGHT
It was only in 1990, after the tax rebate
had been increased that stock trading
took off—and in order to meet this in-
creased demand the securities firms—
all of them partially or wholly owned by
the banks – set up new mutual funds,
marketed as “stock funds”, that entitled
their investors to the tax rebate.
There was a wrinkle, however: a le-
gal loophole made it possible to organ-
ise closed end mutual funds as regular
joint stock companies – thus exempting
them from the very limited legislation
that governed regular mutual funds.
The funds were marketed as a way for
small investors to diversify their port-
folios, yet there were no legal require-
ments that funds actually diversify
their holdings.
There was very little criticism of this
arrangement, and the securities firms
argued that it allowed them necessary
“f lexibility”. And in any case, there
were no apparent problems: no signifi-
cant scandals that shook people’s belief
in the market or their chosen vehicle,
the mutual funds. Why attack a non-
existing problem with legislation?
The fact that no obvious problems
cropped up, along with the fact that the
market grew, appeared to confirm the
idea that the market would “take care
of itself” – that the main problem of
the f ledgling Icelandic financial mar-
ket was its small size, especially lack
of liquidity, and that the invisible hand
would solve these problems as the stock
market grew.
And indeed, by the end of the ‘90s
it appeared that the free market ideo-
logues had been proved correct and
their dreams realised: Iceland now had
a modern capital market and a vibrant
stock exchange, listing most large and
medium sized private companies as
well as several newly privatised state
owned enterprises. The most encourag-
ing development was the mass partici-
pation of the public in the stock market
– largely through the mutual funds.
The vision of the Icelandic economy as
a “shareholder democracy” appeared
within reach.
THEN THE BUBBLE BURST
“The bursting of the millennium
bubble exposed Icelandic investors to
a completely novel experience: stocks
could actually lose value! Ever since
stocks were first traded in the late ‘80s
the market had known only one direc-
tion: up. Between 1987 and 1992, the
market rose by 700%. This amazing
bull market was followed by a short
“bear market”, in which – instead of
falling – prices simply stood still. In the
spring of 1994, then, the great bull mar-
ket of the ‘90s took off, growing some
480% before the bubble burst.
In 2000, then, when the broad mar-
ket fell for the first time,
the public was spooked. People rushed
to withdraw money from the market.
Including the mutual funds."
And now the curious make-up of
the mutual funds became a problem.
Regular open-ended mutual funds
were exempted from income taxes.
The gains were taxed only in the form
of capital gains taxes on the members
when they cashed out of the funds.
The “stock funds,” because they were
organised as regular joint stock compa-
nies, were not exempt from paying in-
come taxes. By reinvesting their profits,
however, they could defer these taxes.
This strategy worked well enough
while money f lowed into the funds, but
when investors cashed out, the funds
were faced with a serious problem: they
would have to start unloading assets on
a falling market, thus depressing prices
even further, while at the same time
shouldering a sizable tax bill.
At the same time the banks and se-
curities firms that sponsored mutual
funds had acted as market makers for
their shares. The result was that in the
aftermath of the millennium bubble,
the banks and securities firms came to
own large blocks of shares in the mu-
tual funds, thus tying up large amounts
of their capital.
LEvERAGE TO THE RESCUE
The banks hit upon a simple solution:
to turn the mutual funds into leveraged
investment companies. This develop-
ment began in the spring of 2001 with
the transformation of the oldest “stock
fund” Hlutabréfasjóðurinn hf – found-
ed in 1986 – into a leveraged invest-
ment company Straumur.
By 2004, all the major mutual “stock
funds” that had served as vehicles for
the public participation in the stock
market had disappeared, either merg-
ing with various leveraged investment
companies or, as in the case of Kaupth-
ing, being absorbed by the investment
bank itself. Instead of holding shares
in a mutual fund with a diversified
portfolio the investors now held shares
in leveraged investment firms. Rather
than aiming at diversification the lever-
aged investment companies concentrat-
ed their holdings, buying controlling
stakes in a small number of firms, of-
ten with the goal of taking them private
and “reorganising” them (frequently by
piling on debt and/or selling off assets).
The ownership also changed. In-
stead of being held by a large number
of small investors (as the mutual funds
had been), the investment companies
were controlled by a few large investors.
The result was that the inf luence of the
small investors was virtually nil.
dIvERSIFICATION? WHO NEEdS IT!
Over the next years these investment
companies became a
dominant force on the
Icelandic stock market, push-
ing up share prices as
they participated in the
leveraged buyout
boom that pro-
pelled the
stock market bubble. In the process
most medium sized companies disap-
peared from the stock exchange, and
the ownership of those left became in-
creasingly concentrated.
The result was that the stock mar-
ket became less and less “democratic”
– and the vision of a “shareholder de-
mocracy” became i ncreasingly dis-
tant. Considering how momentous this
transformation was it is amazing that it
took place virtually unnoticed and with-
out any protest or public discussion.
The reason, of course, was that the
small shareholders were happy to enjoy
the rising share prices of the invest-
ment companies: employing the magic
of leverage they were able to post amaz-
ing returns. In 2004, Atorka, one of
these firms, posted a 73,3% return on
its capital. With returns like those, who
needed diversification?
The implications, however, were
serious. By using leverage to take pub-
lic companies private, the investment
companies were not only undermin-
ing the idea of a shareholder democ-
racy, they were defeating a second
achievement of the tax rebate. Rather
than strengthening the capital base
of Icelandic companies they became
increasingly leveraged. This leverage
was to achieve monstrous proportions,
and played a key role in weakening the
economy so that when the global finan-
cial crisis hit in the fall of 2008, it set in
motion a chain reaction in Iceland.
THE LEvERAGEd UNdERTAKERS
OF THE REvOLUTION
There is an obvious irony in the fact
that the mutual “stock funds”, which
had become the main vehicle of the
government policy to increase stock
ownership and achieve the dream of
a shareholder democracy,
had become the undertak-
ers of this dream.
The reason was, of course,
that while laying the foundations
for the financial market the gov-
ernment and the legislature had
not shown much foresight – it
was simply assumed that the
market would take care of it-
self. The government could
offer incentives like the tax
rebate, but market par-
ticipants should be trust-
ed to find the best way
to make use of these
incentives: the
more f lexibility fund managers and the
securities firms had to respond to op-
portunities and changes in the market,
the better.
But as history teaches us, revolu-
tions tend to have unintended conse-
quences, and sometime they even “eat
their children.”
The Icelandic financial revolution
that took place in the 1990s is no excep-
tion.
Article | Finance
The Financial Revolution That Ate Its Children
The bursting of the
millennium bubble
exposed Icelandic investors
to a completely novel
experience: stocks could
actually lose value! Ever
since stocks were first
traded in the late ‘80s the
market had known
only one direction: up.
Magnús Sveinn Helgason is a historian. He most recently authored addendum
five to the SIC report, and is currently working on a book on financial bubbles.
How the vision of
a shareholder de-
mocracy was per-
verted and turned
into the dystopian
dream of the island
as a giant hedge
fund.
Words
Magnús Sveinn Helgason
Illustration
Stock ownership by Icelandic
investment funds 1997 - 2009
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