Sun Jul 4th, 2010 at 07:01:41 PM EST
One of the main gaming tables in the pre-bust Icelandic financial casino were loans denominated in ISK but with interest indexed to other currencies. The Iceland Supreme Court has declared that indexing to be illegal; Iceland law requires that loans denominated in ISK must be indexed in ISK. That done, there is a big debate on about who gets stuck with the bill for reforming these loans. There is a lot of chest-thumping obscuring things, but it really comes down to this: Who was more responsible for making sure the loan was right at the start, the borrower or the lender? I've chimed in at a few sites, but the following is taken from a series of chimes at The Iceland Weather Report.
For more information on the Alcoa development, see my earlier diary post.
When Alcoa started throwing money, the economy heated up real fast, and the government had taken no steps in anticipation of it, since the Independence Party loves its Austro-Chicago Economics Kool-Aid. To head this off, the government jacked rates, which created an enormous arbitrage spread between ISK and the rest of the world, since everyone else was desperate to hold rates down. Financial players were looking for ISK paper the way a junkie looks for a fix. That's why the loans were denominated in ISK even though they were pegged off shore: The lenders wanted the paper to play the spread, occasionally to hold but typically to flip on the secondary or derivative markets.
There were just two, teeny tiny problems with this financial nirvana. First, arbitrage spreads always close. This one slammed shut in dramatic fashion. Second, as the Supreme Court has now pointed out, the interest calculation on these loans is illegal, since ISK loans require ISK-based interest calculations. This would have defeated the lenders' purpose, though. They didn't want Icelandic paper; they wanted ISK paper. They knew what they wanted, they took the risk, and they wrote the loans accordingly. And they got away with it, at least for a time, as the government viewed "regulatory enforcement" as being on par with "baby rape" (and it was far from the only government to hold such an attitude). But that was then, this is now, and the piper must be paid. Those loans must be rewritten.
Then there were some comments, there and elsewhere, about how the borrowers should have been responsible for understanding the risks of foreign currency indexing. My response to what I consider a red herring argument:
Yes, swimming in international waters can wreck you really quickly. Just ask the small, US farmers who were thrown into international markets over the last 40 years by federal ag policy and then plowed under. But simply to say that the loans were extremely risky and therefore a bad idea and the borrowers shouldn't have entered into them doesn't fly. After all, the loans were illegal too, but no one seemed to be paying much heed to that.
The issue was, as it always is, the power to access and apply information. There is an inherent disparity in power between a commercial lender and a consumer borrower, which is why we have consumer protection laws. On one hand you have library and online articles about risk, many of which the borrower can't understand. On the other hand you have the lender across the table, gainsaying those articles. And the lender has a legal obligation to make disclosures, but here's USD50 against a doughnut hole that either those disclosures were not made or were buried on page 93 in 4 pt. type. Either is a violation of the law.
The lenders wrote these loans, they denominated and indexed them for their own purposes, and they knew or should have known the indexing was illegal. They put out an illegal product, and they should have to pay to remediate it, the same as an auto manufacturer who puts cars with bad brakes on the road. The alternative is to say to the lenders, "You made illegal loans and you illegally failed to make disclosures in order to close those loans, but we're going to make the borrowers or the taxpayers cover you." Talk about moral hazard.
In a consumer loan transaction, if the table was tilted toward you at closing, you're at the front of the line to fix whatever goes wrong, and it's your job to convince everyone otherwise.
P.S. If you want serious information about this, check Bjarni Kristjansson's comment in the IWR link I provided above.
P.P.S. If you're just a sock puppet for Hannes Holmsteinn and his ilk, don't expect me to treat you civilly.