Reykjavík Grapevine - 29.07.2011, Blaðsíða 16

16
The Reykjavík Grapevine
Issue 11 — 2011
Finance | Bubbles
Soap bubbles. They are nice. These financial ones not so much.
Who’s Afraid Of The Big Bad Black Swan?
Following the financial
crash of 2008 one of the
most common comments
made was that “nobody
saw it coming,” and that really, no-
body could have seen the crash com-
ing. The implication, of course, is that
we can’t really fault the politicians or
the bankers for not having taken any
action. They were, just as all Iceland-
ers, the victims of unforeseeable
events.
Things were going great, the banks were
in excellent shape and the “fundamen-
tals” were strong. So, when the crash
came it was really a big evil “Black Swan”
that somehow came out of nowhere and
jumped the Icelandic banking commu-
nity and politicians.
Except this isn’t true. Many saw the
writing on the wall and tried to warn that
the Icelandic financial miracle was prob-
ably nothing more than a giant bubble.
Of course nobody could have pre-
dicted exactly what was going to hap-
pen. And nobody had predicted that the
entire financial system would collapse.
The collapse, when it came, was far
more complete and awful than anyone
had foreseen. But that does not change
the fact that there were numerous warn-
ings that Iceland had taken wrong turns
on its path to become a “global financial
centre” and that things could go horribly
wrong. And even if it has been popular
to argue that the banks had blinded ev-
eryone with their success, a number of
people did see that this success could
just as easily have been a bubble.
ALL BUBBLES ARE BLACK SWANS
After the dot com bubble burst there
was a general feeling that it would take a
long time before a new bubble could in-
flate—that people had “learned their les-
son” and more reasonable expectations
would guide their attitudes. In 2002, Mar-
geir Pétursson, stock trader and chess
grandmaster, who later founded the in-
vestment bank MP—one of the few banks
which survived the crash—estimated that
it would take at least three to four years
for any signs of a new bubble to emerge.
Several steps were taken to rein in
speculation and curb the worst excesses
of the dot com era. The banks stopped
making margin loans on unlisted stocks,
and drastically cut down their own in-
volvement in venture capital. When the
bubble burst, they took a huge hit on their
investments in unlisted shares, especially
in the Icelandic genetics firm DeCode.
Prior to listing on the Nasdaq, DeCode
had sold for as much as 65 dollars per
share in the gray market as the stock
traders of the banks marketed them ag-
gressively to amateur daytraders, insist-
ing that the price of DeCode would for
sure go to 100 dollars per share.
As it turned out the price never went
above 30 dollars after the company went
public in 2000. In fact, the stock started
a fast descent to less than 2 dollars a
share by the beginning of 2003, and by
the end of 2008 it had become a “penny
stock,” selling for less than a dollar per
share. The banks had only been able to
unload part of the stock on unsuspecting
customers and had to write off most of
their holdings. The lesson learned by the
banks was to stay out of unlisted high-
tech companies and venture capital, and
instead to focus on private equity and
listed companies.
Legislation governing the market was
also strengthened, for example with laws
to regulate mutual funds, which invested
in stocks. Together these moves cleaned
up the worst abuses and pretty much
eliminated unlisted shares from the mar-
ket. Since the speculative excesses had
been identified with unlisted shares, it
seemed that the problem of speculation
had largely been eliminated as well.
But of course it had not. The action
moved instead to the shares of invest-
ment companies that specialised in pri-
vatising companies through leveraged
takeovers. And the banks, by this time
they had begun their expansion abroad,
and the era of the Icelandic financial mir-
acle had begun.
THE FINANCIAL MIRACLE
While the public identified amateur day
traders to be the face of speculation, the
banks and investment companies were
after 2002 by far the most active specu-
lative force in the market. In fact, they
were both a speculator and an object of
speculation.
The banks had been the darlings of
Icelandic investors since the 90s. In 1998
when a 49% stake in the newly created
government owned FBA Investment bank
(which later came to form part of Glitnir)
and a 10% stake in Landsbankinn and
Búnaðarbankinn (which merged with
Kaupþing) were made available to the
public, a mania for bank stocks gripped
the nation. During the privatisation of
Búnaðarbankinn in December 1998, a full
third of the nation had subscribed for a
total of 42 billion króna, when there were
only 350 million on offer, making the offer
oversubscribed 122 times over, probably
a world record.
The banks and the Icelandic financial
system weathered the crash of the dot
com bubble pretty well. The Icelandic
stock market fell less than most major
markets, and bottomed out well before
other markets did. The drop was only
45% from the top of the bubble in Febru-
ary 2001 and its bottom in August 2001—
compared to the 78% drop in the Nasdaq,
which reached its lowest point in October
2002. Stock in the Icelandic banks fared
even better, putting them in an excellent
position to take advantage of relatively
low asset prices in foreign markets. A do-
mestic boom with rising real estate prices
provided them with a strong home base
while low interest rates following the 9/11
attack provided them with cheap capi-
tal to finance both a domestic takeover
boom and an international expansion.
As a result, the index of financial ser-
vices rose by 84% between January 2001
and January 2004, outpacing the overall
market, which rose by 64%. When the
banks began their foreign expansion
in earnest their shares rose even faster.
Between 2005 and mid July 2007, when
the Icelandic market topped, the index
of financial services rose by 183%, well
in excess of the Nordic financial index,
which rose by 66%.
IT’S ALL VERY REASONABLE
As discussed in the last issue of The
Grapevine, all of these rises seemed
“reasonable,” and the disappearance of
day traders from the market following the
dot com bubble as well as the curbing of
margin loans and the elimination of the
gray market all seemed to suggest that
they were not experiencing a bubble. But
by the spring of 2004, the daytraders had
returned to the market and there were
also serious signs of a housing market
bubble (See the June 17 issue of Grape-
vine).
At that time, Vísbending, a small but
respected weekly on economic affairs,
which publishes short academic pieces,
analysis, and editorials on the state of
the economy, warned that the market
was overheating. Vísbending argued that
because the investment strategies of the
daytrader were based on being the first
to move hot stock-tips and sensing the
mood of the market, the presence of a
large numbers of day traders increased
the element of herd behaviour, making
stock prices less rational.

As the year wore on and prices contin-
ued to rise more and more, market par-
ticipants and analysts sounded warnings
of a bubble. By October, bank analysts
were confident that there was indeed a
bubble in the market. At that point prices
had risen by a staggering 110% over the
previous 12 months. The analysts of Ís-
landsbanki warned that there was a real
danger of a sudden fall in prices if any-
thing caused the optimism of investors to
falter.
THE ANALYST WHO CRIED WOLF
But since nothing shook the optimism
of investors, prices did not fall, and they
simply continued to rise. So when none
of the dire warnings came true, inves-
tors became more confident. Bank ana-
lysts’ attitudes also changed; instead of
preaching caution they began predicting
that prices would just keep on rising.
But the naysayers didn’t fall silent.
There were numerous warnings that
leveraged takeovers—one of the most
important growth businesses of the
banks—were weakening Icelandic com-
panies, loading them with too much debt.
There were also those who warned that
these takeovers were beginning to re-
semble the corporate raids, which had
hollowed out many American firms in the
1980s. Then Prime Minister Davíð Odd-
sson warned that the banks themselves
were becoming too leveraged and that
they were too dependent on foreign capi-
tal markets for their financing.
The harshest criticism, however,
came from abroad. In 2004, as the Ice-
landic banks and allied corporate Vikings
began their expansion in Denmark, the
Danish press began to report very criti-
cally on the Icelandic “financial miracle,”
pointing out that it was impossible to
understand the complex makeup of the
various investment and holding compa-
nies at its heart and their relationship to
the banks, or to explain the ballooning
of the banks and the rapidly rising as-
set prices in Iceland without assuming
both were the result of a bubble. In 2006,
this criticism was more or less repeated
in a thorough report by analysts of Dan-
ske Bank, as well as reports from Credit
Sights, Barclays Capital Research and
Merrill Lynch. These were unanimous in
their verdict: The Icelandic economy had
overheated and there was serious danger
of a crash.
THE GREATEST FINANCIAL FIASCO
IN HISTORY
Unfortunately none of this criticism car-
ried any weight in Iceland as the financial
community, business leaders, politicians
and the media united in dismissing it. The
common refrain was that these foreign-
ers just didn’t understand Icelandic fi-
nance. The banks, with the help of eager
politicians, launched a public relations
campaign and the Icelandic Chamber of
Commerce paid two respected econo-
mists to give the banks a clean bill of
health. Fredric Mishkin and Tryggvi Þór
Herbertsson (who was later awarded a
special position as “advisor on economic
affairs” to the government) wrote a glow-
ing report titled “Financial stability in Ice-
land” which was then touted by bankers
and politicians alike.
But even if the financial community
and politicians believed their own hype,
not everyone did. For example, Vísbend-
ing, the economics weekly, continued to
publish regular articles pointing out that
there were ample reasons to doubt the
soundness of the financial miracle and
that things could go horribly wrong. In
2004, the weekly had warned of a bubble
and in 2005, it warned that Icelandic eco-
nomic policy, much like American eco-
nomic policy, was based on promoting
a giant asset bubble, and that it was un-
likely either country would be able avoid
the consequences. In a different article
from the same year, the editor pointed
out that there was a very real danger that
the “economic miracle” would not go
down in history as the “period of greatest
economic prosperity in the history of Ice-
land,” but rather as “the greatest financial
fiasco in Icelandic history.”
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Words
Magnús Sveinn Helgason
DeCode stock price
2000 - 2009
“Even if it has been popular to argue that the banks had
blinded everyone with their success, a number of people did
see that this success could just as easily have been a bubble.”