Iceland Saga - how corporate debt became sovereign debt

On Sunday afternoon, Reuters was reporting that 93 percent of those voting had voted not to reimburse. Discussions between the three governments had been progressing days before the vote and are expected to resume very shortly but such a resounding rejection has implications for all parties and will no doubt mean further deliberations which all, at government level at least, are anxious to draw to a satisfactory outcome.

The referendum came about because Iceland's President Olafur Grimsson, in the first week of January refused to sign into law a bill authorising reimbursement that had been passed by the Althing, Iceland's parliament, on 30 December 2009. Mr Grimsson acted within his constitutional authority and may well have reflected upon the very small parliamentary majority authorising reimbursement.

The collapse of Iceland's banks in October 2008, though dramatic, had not come so unexpectedly in all quarters. During early spring 2008, Iceland suffered a currency crisis and on 01 April, USA Today ran the headline "Bank Default worries slam Iceland's currency" with reporter David J Lynch commenting: "Iceland's economy is minuscule, and its population is smaller than that of Pittsburgh, but its banks are deeply involved in global markets." The same article goes on to quote some harrowing statistics for Iceland's economy with a very telling paragraph:

"Amid the continuing financial turmoil, Iceland has drawn increasingly critical reviews. In February, Moody's downgraded the debt of the major banks and earlier this month lowered to 'negative' from 'stable' its outlook on the country's banking industry." This on 01 April 2008!

The attraction of opening investment and savings accounts in Iceland with very enhanced returns at a time when the same funds invested in Europe or USA offered so poorly is easy to understand. For Iceland, the rapid expansion of its banking and finance sector was done with full government support as a means to diversify the economy away from its dependence on the fishing industry, still some 40 percent of export earnings. Banking gave the country hi-tech and well paid jobs. With hindsight, it appears to have been too lightly regulated by Iceland's financial authorities.

When the crisis did break, on and after 06 October 2008, emergency legislation was passed allowing the Financial Supervisory Authority of Iceland to take over the domestic operations of Iceland's private banks.

Government officials, including the then Prime Minister, Geir Haarde and Central Bank Governor David Oddsson, announced that the state did not intend taking over the banks' foreign debts or assets. Quoting from Sweden's E24 News, Geir Haarde addressed the nation saying: "No responsible government takes risks with the future of its people, even when the banking system itself is at stake. The Icelandic nation and its future takes precedence over all other interests."

If this address comforted Icelanders and the setting up of new banks averted a domestic catastrophe, what of the foreign savers, an estimated £8bn worth for UK accounts alone and the combined balance sheets of the Icelandic banks amounting to some ten times Iceland's GDP?

The British Government was as furious with the Icelandic Government as with the offending banks and Prime Minister Gordon Brown branded Iceland's failure to guarantee British savers, over 220,000 of them, as "totally unacceptable and illegal". Using the Anti-terrorism, Crime and Security Act 2001, Part 2 (Freezing Orders) Chancellor of the Exchequer Alistair Darling, whilst stating that all £4bn invested in Landsbanki Icesave accounts would be met by the UK Government, a freezing order was being put into effect - 08 October 2008 - against all Landsbanki assets in the UK.