Iceland’s financial meltdown

There was an early casualty of the economic downturn whose demise set in motion the cataclysm of the ensuing years. Perhaps more attention should have been paid to a country 1,000 miles away from mainland Europe competing with Wall Street and Canary Wharf

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The year 2008 was catastrophic for    Iceland. The country’s financial system disintegrated under a banking system that had ballooned to 10 times the size of its economy, and its three major banks, Glitnir, Landsbanki and Kaupthing, all collapsed. By midway through 2008, Iceland’s external debt was €50bn, against a gross domestic product of only €8.5bn. Icelanders had somehow managed to amass debts of around 850 percent of their GDP.

The currency, the Icelandic króna, declined more than 35 percent against the euro from January to September 2008. From trading at 131 to the euro on October 8, it crashed to 340 in a single day. Inflation rocketed to 18.6 percent – Iceland’s economy was in freefall. On October 6, 2008 Iceland’s (former) prime minister Geir Haarde said there was ‘a very real danger… of national bankruptcy’. To compound matters, on October 8, 2008 the British Chancellor of the Exchequer, Alistair Darling, announced that the government was taking steps to freeze the assets of the Landsbanki in the United Kingdom under the provisions of the 2001 Anti-terrorism Act.

But it was not just British customers of Landsbanki that were in trouble. Lured by high interest rates, British investors – that’s to say individuals, local authorities, companies and charities – had in the region of US$30bn tied up in all three Icelandic banks and their subsidiaries. And it went further than the United Kingdom. German banks invested US$21bn, while the Netherlands and Sweden between them invested more than US$700m. This was not a local problem.

By December 2008, the International Monetary Fund agreed a US$2.1bn loan for Iceland under its fast-track emergency financing mechanism. A month later, Haarde’s   government fell apart and for the first time in Iceland, the country voted for a majority left-wing government.

This is Iceland we are talking about – not long ago regarded as the fifth richest nation in the world and ranked as one of the happiest countries in the world. Not any more.

As of 2009 there were more than 30 separate cases being examined by the Icelandic special prosecutor, and international anti-corruption adviser Eva Joly reckons the banking scandal is one of the biggest and most important investigations Europe has ever known. She is already talking in terms of embezzlement, fraud and ‘questionable financial practices’, and the investigation has only just started.

In the beginning, there was ice
How on earth did it happen? To understand the economic boom and bust, you need to understand what we are talking about in terms of Iceland. By any stretch of the imagination, it is a weird place. A volcanic rock situated in the north Atlantic, it is just south of the Arctic circle. It is 287 km from Greenland, 420 km from the Faroe Islands and almost 1,000 km away from mainland Europe in the form of Norway.

The first Norwegians settled on Iceland around 874, but it must have been a godforsaken place. Prone to volcanic eruptions, the only land mammal living on the island when humans first arrived was the Arctic fox. There are no native reptiles or amphibians on the island, and it only boasts 1,300 species of insects, compared with the million or more in the world generally. The place is isolated.

Iceland was, and remains, good for fishing though, and specifically whale hunting, which can be the only reason anyone would look to live there. Iceland has a long tradition of subsistence whaling, a policy that has continued, with increasing controversy, on and off to this day. The early reliance on whales is reflected in the strange Icelandic language, too. ‘Hvalreki’ is the word for both ‘beached whale’ and ‘jackpot’, which maybe says it all about Iceland.

Size-wise the place is 103,000 square km, not that much smaller than England. Yet it is home to only 300,000 people, whereas around 49 million live in England. In terms of the population, rather than using family names, as is the custom in other mainland European countries, Icelanders use patronymics. Girls add the suffix ‘dóttir’ (daughter) to the patronymic and boys add ‘son’. So Jón Jóhannesson is the son of Jóhannes. Katrín Karlsdóttir means Katrín, daughter of Karl (the Icelandic telephone directory is listed alphabetically by first name rather than surname). Like many things about Iceland, the names are a little confusing.And in case you are unsure about the Icelandic menu, traditional dishes include cured ram scrota, cured shark, black pudding and, erm, singed sheep heads. So there you have it: small volcanic rock, middle of nowhere, tiny population, unusual names, fishing-based economy, challenging food – oh, and complete and utter financial collapse. So what went wrong and how did it happen so fast?

For centuries, fishing came first in Iceland. Then in 1971, Iceland expanded its zone of exclusive fishing rights to 80 km from the coast, and expanded it further to 320 km in 1975. British fishermen were not very happy about this unilateral move, and the so-called ‘cod wars’ resulted in mutual net cutting, the ramming of vessels, and ultimately came close to an all-out fight.

The inner circle
But something else also changed. During the 1970s, the Icelandic government introduced fishing quotas. Each fisherman was assigned a quota based on his historical catches. He would then be entitled to a percentage of the catch in any given year. These quotas were worth a great deal, and fishermen could, if they chose not to do the fishing themselves, sell their quota on to someone else. The quotas could even be borrowed against at the banks. And soon, fishing was making a few people very rich indeed.

It was a seminal moment in the financial development of the Iceland economy, and it is familiar territory – financial engineering and clever modelling. Of course not all complicated financial engineering is a bad thing. What is key is that those selling complex financial products understand them – plus they should have a basic entrepreneurial concept of the profit, loss and risk attached to them. History is littered with cases of senior people not really understanding the products they are responsible for and as a result coming unstuck. Iceland was about to come unstuck.

It was this new-found wealth, held by a tiny percentage of the small Icelandic population, that would go on to cause problems. Now gird your loins for an assault of Icelandic names, and try to keep up – it is important. Three families in particular came to the fore: frozen food entrepreneurs Lýdur Guðmundsson and his brother Ágúst; shipping and brewing moguls Björgólfur Guðmundsson and his son, Thor Björgólfsson; and retail tycoon Jóhannes Jónsson and his son, the so-called ‘pop star’ entrepreneur, Jón Ásgeir Jóhannesson.

Lýdur and Ágúst Guðmundsson are co-founders of the Bakkavör food group, which makes ready-meals for the likes of UK retailers Tesco, Asda and Marks & Spencer. They also founded an investment vehicle called Exista, which had a 23 percent stake in the country’s largest bank, Kaupthing. Lýdur was vice-chairman of the bank.

More colourful than those two were Björgólfur Guðmundsson and his son Thor. They were involved in setting up a brewery, called Bravo, in St Petersburg, Russia, eventually selling it to Heineken. They too founded an investment company, with a 32 percent stake in the country’s biggest investment bank, Straumur, and a 45 percent stake in the second biggest bank, Landsbanki. Björgólfur was chairman of Landsbanki and Thor chairman of Straumur.

And last, but not least, there is Johannes Jönsson and his son Jón Ásgeir Jóhannesson. Jón was born in January 1968, graduated from the Commercial College of Iceland in 1989 and became, aged 21, managing director of his and his father’s bargain supermarket business, Bónus. It was the start of a mega rise in the retail sector, which ultimately, under the name of the Baugur Group, took over large chunks of famous UK high street brands and a dizzying number of other interests. Jóhannesson also created an investment vehicle, called Stoðir, which took a 32 percent stake in the country’s third largest bank, Glitnir.

With great power…
So while Iceland is a cold and inhospitable place, its banking and business world was decidedly cosy. Here were these few people with massive stakes in the nation’s three banks. And what did these banks do? They lent money to each other. When the dust started to settle following the collapse of the nation’s economy, investigators discovered a quite unbelievable state of affairs. Almost half of all the loans made by Icelandic banks were to holding companies, many of which are connected to those same Icelandic banks.

These same banks allegedly lent money to employees and associates so they could buy shares in the banks – using the same shares as collateral.

Kaupthing, for example, allowed a Qatari investor to purchase five percent of its shares, but it was later revealed that the Qatari investor bought the stake using a loan from Kaupthing itself. The bank was, in effect, buying its own shares. The notional value of the banks rose.

By far the biggest single loan paid out by Landsbanki UK went to Novator Pharma, a company owned by Björgólfur Thor Björgófsson, the son of Landsbanki’s biggest shareholder, and to companies associated with the Baugur Group. In the end, the Baugur Group owed Landsbanki something like ISK58bn.  Ultimately, the entire country’s economy was a giant pyramid scheme. And when the credit crunch hit, Iceland was knocked out cold.

Rock star
Of course during the build-up to the bubble bursting, the entrepreneurial business »            leaders-cum-bank owners were considered heroes in Iceland. One man in particular stood out: Jón Ásgeir Jóhannesson. His Reykjavik-based Bónus retail business soon grew to include several outlets in Iceland. In 1992, the owners of Hagkaup, a leading domestic retailer, acquired 50 percent of the shares in Bónus, and in 1993, Hagkaup and Bónus established a joint purchasing company named Baugur.

Baugur, incidentally, means ring of steel. Five years on, with Jóhannesson now Baugur’s president and CEO, the business was listed on the Iceland Stock Exchange. Baugur then embarked on an ambitious acquisitions trail, starting with 50 percent of the six-strong SMS supermarket chain on the Faroe Islands, 802 km to the southeast of Iceland. And soon he had the United Kingdom in his sights.

It is slightly mystifying how Jóhannesson managed to embark on such an audacious acquisition spree. The odds were rather against this young man from a small rock in the mid-Atlantic turning himself into a global retailing brand, yet he persevered, enthused, cajoled, encouraged and somehow willed it to happen. Perhaps there are similarities with Iceland’s Viking past, with mystical powers at work. Or was that black magic simply bravado, over-confidence and showmanship? Whatever it was, it started working.

In 1999 Baugur signed franchise agreements with Sir Philip Green’s Arcadia Group, and over the next few years it started snapping up stakes in a host of British retailers, including House of Fraser, Hamleys, Oasis, Karen Millen, Whistles, Coast and the frozen-food chain Iceland. Soon, retail fashion magazine Drapers Record had Jóhannesson, with his blond flowing locks and preference for dressing only in black, down as the ‘fourth most influential man in the British fashion industry’. That put him behind the likes of Philip Green and Stuart Rose, the director of Marks & Spencer, but above supermodel Kate Moss and designer Karl Lagerfeld.

The good times roll
While Jóhannesson professed to a ‘deep dislike of publicity’, he enjoyed the high life. Private jets, raucous parties on his private yacht, famous friends and an increasingly global property empire meant that he was rarely away from the gossip columns. In 2007, he married long-time girlfriend Ingibjörg Pálmaðóttir and the pair bought a US$10m New York apartment. According to the New York Times, they liked it so much that they came back a few months later and bought the duplex penthouse above it, with cash, for US$14m, and hired an architect to design a staircase to combine the places into one 7,000 square foot apartment with 2,000 square feet of terraces.

Meanwhile the Baugur business was split into two main areas. It invested in listed companies with potential, and started getting involved in management takeovers. In May 2004, it acquired a majority stake in the British jewellery chain Goldsmiths. In 2004 the founders of women’s fashion chain Karen Millen agreed to sell the business to Baugur Group in a deal worth £120m. This created a group that included Oasis, Coast, Karen Millen and Whistles, with more than £350m in sales and 550 stores.

Even these were small fry. In 2004 Jóhannesson was part of a consortium that offered £1bn for the supermarket group Somerfield, while in 2006 he secured a £351m deal to buy House of Fraser. He even expressed an interest in buying the Saks department store chain. He was still only in his late 30s.

Ultimately, the Baugur empire had stakes in businesses employing around 65,000 people across 3,800 stores and turning over £10bn. By any standards, the business was big. By Icelandic standards, it was unprecedented. Yet throughout this period of rapid growth, signs were starting to emerge that all was not as it seemed regarding Jóhannesson.

The evidence proves otherwise
In 2002 Baugur’s headquarters were the subject of a police raid, and in July 2005 Jóhannesson and others were charged on 40 counts, including tax and accounting irregularities, fraud and embezzlement. Jóhannesson denied the charges, calling them politically motivated, and all but one were dropped. In 2007 he was found guilty (upheld on appeal) on a single charge of a breach of book-keeping rules. Jóhannesson was given a three-month suspended prison sentence, but by relocating the business to the United Kingdom he managed to retain his position on the board of the company.

Yet the writing was on the wall for Baugur and Jóhannesson, and when the global credit crunch hit, the business collapsed, like much of the rest of the Icelandic business so-called miracle. On February 4, 2009 Baugur applied for protection from its creditors and was put into administration.

The inter-bank and inter-business lending and huge debt-fuelled growth strategies could not and would not last. A succession of academics and experts raised concerns – some even directly with the business and political elite – but they were dismissed as either jealous, bitter or somehow racist towards the plucky Icelanders. Allegations of Russian mafia involvement have also been roundly dismissed, and never proved.

Yet in retrospect, the signs were not only there, they were luminous pink, 80 storeys high and flashing ‘danger!’ It was insanity to believe that this small fishing nation, stuck in the middle of the northern Atlantic, could possibly be up there vying with Wall Street and London’s City as a centre of global economic activity. Perhaps it was inevitable.

In a Lonely Planet guide book, it says that centuries of isolation and hardship have created a specific national psyche for Iceland. It says that naturally for people living on a remote island in a harsh environment, Icelanders are ‘self-reliant individualists who don’t like being told what to do’. It cites the example of whaling, saying that while most Icelanders would never eat whale meat, the majority supported hunting – ‘a silent sticking-up of two fingers at the disapproving outside world’. The book also wonders, though, whether this confidence is not tinged with insecurity. ‘Icelanders know that it’s easy to be a big fish in a small pond, but how might they fare outside their cosy nation?’ the book asks. Well, if they did not know before, they know now.

Down and out
Speaking in March 2009, Jóhannesson admitted that his UK adventure had been a disaster. “I am still in a state of shock,’ he said. ‘It all happened so quickly I haven’t realised what happened. But it has been a total disaster scenario. I’m sad. I spent 11 years building this up. But I guess this is life. It is what it is.” He continued, “We definitely had too much on our plate. Not only the retail, but other things that were taking up our time. We will do it differently next time – it will be smaller, more focused.”

Gunnar Sigurðsson, Baugur’s UK chief executive, admitted that the group’s debt burden had been too heavy. “Clearly, at the end of the day, the amount of leverage in the business was too much. A once-in-10-years recession we would have survived, but not a once-in-100-years recession. At some point it got a little bit out of control, but we had a great team and we did some really good things along the way.”

Really? While the global recession may have speeded up the collapse, it is stretching credibility to place all the blame at the door of the global economy. The business plan was ill-conceived. They got it wrong.

Jóhannesson, for his part, is talking about dusting himself down and mounting some sort of business comeback, but after such a spectacular fall from grace, and while widely reviled in his now bankrupt homeland, it is unclear what form that will take. Some blame the small population, others talk about the inadequate regulatory oversight. There is talk of the irrational bravado of Icelandic men and the inability to listen to warnings. Ultimately, it was probably a bit of all these things. With investigations ongoing, the truth will out one day. Ultimately, in the case of Jóhannesson, it is about an entrepreneur having a little bit too much self-belief – and far too much debt.

Taken from the book: “How they blew it: The CEOs and entrepreneurs behind some of the world’s most catastrophic business failures”  by Tony Goodwin and Jamie Oliver