Hedge Funds Attacked Iceland’s Banking System by Shorting the Currency (the Króna) and Bonds Using Credit Default Swaps

In the Geyser crisis, international hedge funds attacked Iceland’s leveraged and mismatched banking system, as well as its government, by shorting the currency and the bonds of the banks via credit default swaps. Even the government’s own bonds were not immune to this attack. Iceland became an international headline. Banks tried to defend themselves against the distrust by pointing to their stellar ratings from the rating agencies. Yet high default swap spreads indicated a general distrust of the Icelandic financial system. Newspaper articles about the faltering currency and the widening CDS spreads further eroded confidence in the banks, causing the spreads to widen. The króna weakened, making the situation a focal point of media attention. The market view that the Icelandic banks would not be able to refinance themselves turned into a self-fulfilling prophecy, but only because the financial system was vulnerable due to its mismatching and credit expansion. Credit default swaps would eventually reach almost 1,000 basis points; the cost to insure $1,000 of debt was almost $100.

Yet Iceland’s time had not yet run out. As Armann Thorvalddsson, himself a leading Icelandic banker, recognizes, “What eventually got us out of the situation was the fact that the world was still drowning in liquidity. Although the European bond market had had its fill of Icelandic bank exposure, money was available from other markets at a price.” Market participants realized that Icelandic banks still had access to funding and would not yet become illiquid. Moreover, the CBI increased interest rates (from 9 to 12.75 percent) to attract foreign funds and raise confidence. The króna stabilized and CDS spreads narrowed gradually, though they never reached their previous low levels. The collapse was prevented for the time being. Thanks to the ample liquidity in the interbank markets, the party could continue. From 2006 to 2007, asset prices soared, for everything from companies to wine to fine art. Everyone in Iceland seemed to become a millionaire. Even so, Icelandic banks became somewhat more cautious and tried to improve their liquidity situation. Landsbanki tried to increase its access to wholesale funding markets by tapping the internet deposit market with Icesave, an online retail bank that attracted billions of pounds when it opened in the UK. Kaupthing followed suit with its own internet deposit platform, Kaupthing Edge.

—Philipp Bagus and David Howden, Deep Freeze: Iceland’s Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 75-76.

A Credit Default Swap (CDS) Is a Form of Insurance to Compensate for a Loss If a Debtor Defaults

Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom.

Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.

—Philipp Bagus and David Howden, Deep Freeze: Iceland’s Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.