Bondholders, not taxpayers, bear brunt of Iceland's debt-forgiveness


OPINION: For Dublin to follow the Reykjavik model, the holders of bonds would have to do the forgiving

THERE ARE suggestions that the Government should take the route of Iceland and introduce widescale debt-forgiveness programmes for struggling mortgage holders.

It is estimated that the exercise could cost the Irish taxpayer up to €6 billion and it is argued that if the much more troubled Iceland can do it with the blessing of the International Monetary Fund, Ireland can certainly follow suit.

But is that really so?

An unprecedented event occurred in Iceland in October 2008: the country’s financial system totally collapsed and, in its wake, the national currency.

The failure of Lehman Brothers in mid-September 2008 created extreme levels of mistrust in the international financial community. In this brutal aftermath, almost all the financing lines of Icelandic banks were cut and they were left facing severe liquidity problems.

The typical policy response to a systemic crisis such as this – to use the central bank as a lender of last resort – was not possible, as the funding needs of the banking system dwarfed the capabilities of the central bank of Iceland.

The central bank’s foreign reserves amounted to about half the country’s gross domestic product (GDP), while the consolidated balance sheet of the banking sector was roughly 10 times its GDP.

The consequent systemic failure led to the three system banks being put into a resolution process and new ones established by Icelandic authorities.

The plan devised in the days that followed set out how the banks would be taken into public ownership one by one. It was decided a blanket guarantee should be given to domestic depositors in local banks and that other depositors should be first in line as claimants on the assets of the banks.

In each case, the restructuring involved the creation of a new bank, which held all deposits guaranteed directly by the sovereign. A preliminary evaluation of the assets was carried out, and assets amounting to deposits moved from the old banks to the new ones.

The assets were valued considerably lower than nominal value as the loan portfolios of the banks deteriorated considerably during the collapse. It is estimated that the write-offs of the total portfolio were more than 50 per cent of nominal value.

Mortgage loans were valued at approximately 70 per cent, primarily due to the fact that their principal had increased significantly in value due to either inflation or the fall of the national currency. The residual was left with the owners and the bond holders of the banks.

By fair assessment of the banks’ assets, they were given space to restructure their loan portfolio. At first the idea was to evaluate the payment capacity of each household, but it soon became apparent that the resources of the banks were insufficient and it would take too long. And the loan portfolio would deteriorate further.

Eventually, the Icelandic government initiated, among other measures, a uniform debt relief programme to which the banks agreed. The programme will write off home loans in excess of 110 per cent of the property for those who apply for it.

It is apparent the initial bondholders will carry most of the debt-relief costs in Iceland. The proposals in Ireland, on the other hand, suggest the Irish taxpayer pays the bill.

With the state of Ireland’s finances, it is difficult to imagine that a uniform debt-relief programme would be wise.

However, if the bondholders would accept debt restructuring (as I think they should as it would preserve the willingness to pay of households), the “Icelandic model” could be used in Ireland.

Dr Tryggvi Thor Herbertsson is an MP and professor of economics. He was special economic adviser to the prime minister of Iceland during its banking collapse