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, nobody could have seen the crash coming. 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 Icelanders, the victims of unforeseeable events.
Things were going great, the banks were in excellent shape and the “fundamentals” 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 community and politicians.
Except this isn’t true. Many saw the writing on the wall and tried to warn that the Icelandic financial miracle was probably nothing more than a giant bubble.
Of course nobody could have predicted exactly what was going to happen. 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 warnings 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 everyone 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 inflate—that people had “learned their lesson” and more reasonable expectations would guide their attitudes. In 2002, Margeir Pétursson, stock trader and chess grandmaster, who later founded the investment 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 involvement 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 aggressively to amateur daytraders, insisting 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 market. 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 investment companies that specialised in privatising companies through leveraged takeovers. And the banks, by this time they had begun their expansion abroad, and the era of the Icelandic financial miracle 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 speculative 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 February 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 domestic 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 capital to finance both a domestic takeover boom and an international expansion.
As a result, the index of financial services 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 Grapevine).
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 continued to rise more and more, market participants 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 Íslandsbanki warned that there was a real danger of a sudden fall in prices if anything 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, investors became more confident. Bank analysts’ 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 companies, loading them with too much debt. There were also those who warned that these takeovers were beginning to resemble the corporate raids, which had hollowed out many American firms in the 1980s. Then Prime Minister Davíð Oddsson warned that the banks themselves were becoming too leveraged and that they were too dependent on foreign capital markets for their financing.
The harshest criticism, however, came from abroad. In 2004, as the Icelandic banks and allied corporate Vikings began their expansion in Denmark, the Danish press began to report very critically on the Icelandic “financial miracle,” pointing out that it was impossible to understand the complex makeup of the various investment and holding companies at its heart and their relationship to the banks, or to explain the ballooning of the banks and the rapidly rising asset 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 Danske 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 carried any weight in Iceland as the financial community, business leaders, politicians and the media united in dismissing it. The common refrain was that these foreigners just didn’t understand Icelandic finance. The banks, with the help of eager politicians, launched a public relations campaign and the Icelandic Chamber of Commerce paid two respected economists 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 glowing report titled “Financial stability in Iceland” 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, Vísbending, 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 economic policy, much like American economic policy, was based on promoting a giant asset bubble, and that it was unlikely 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 Iceland,” but rather as “the greatest financial fiasco in Icelandic history.”