February 2010 1

IcesaveWe demand a reasonable Icesave agreement to avoid

national bankruptcy

February 2010 2

We demand a reasonable Icesave agreement to avoid national bankruptcy

Icesave is not a debt of Iceland• The UK and Dutch governments are claiming reimbursement for payments of €3.91bn to Icesave

depositors of the failed Landsbanki Bank• These payments were much greater than the EU maximum guarantee and were made to save their own

banking systems. All depositors have been reimbursed• Iceland adhered to flawed EU banking directives, which were not designed to deal with a complete

collapse of a local banking sector as experienced by Iceland• The UK and Netherlands demand a state guarantee of Icesave deposits, but there is no mention of a state

guarantee in the EU directives

Forced obligations taken on with sovereign safeguards• In the Brussels guidelines, agreed upon by the EU and all parties to the dispute, Iceland agreed to cover

Icesave deposits in accordance with EU banking directives (which do not specify a state guarantee of deposits)

• It was also agreed that the resolution would take into account the unprecedented situation of Iceland and enable the restoration of its economy

• In August 2009 Iceland consented under duress to reimburse the disputed €3.9bn, but with safeguards that protected against national bankruptcy

• These safeguards were subsequently rejected by the UK and Netherlands

February 2010 3

We demand a reasonable Icesave agreement to avoid national bankruptcy

Economic warfare by the Dutch and UK governments• The UK used anti-terrorist laws against Iceland, a co-founder of NATO• Iceland has been denied clarification of the disputed Icesave claim in a court of law• Only half of Landsbanki’s assets can be used to cover the guarantee stipulated by EU directives. The other half is

commandeered by the UK and Netherlands to arbitrarily reimburse depositors beyond the EU minimum• Excessive interest rates of 5.55% mean that the UK and Netherlands profit from the forced reimbursement by Iceland• The UK and Netherlands are blocking vital IMF loans until Iceland accepts their claims

A grave risk of bankruptcy for Iceland• The banking collapse made Iceland’s external debt one of the highest in the world• Iceland’s exposure is unsustainable. The Icesave obligation is equal to 50% of Icelandic GDP, equivalent to £700bn for the UK

or €270bn for the Netherlands• Key economic variables indicate that Iceland will be unable to meet the repayments in foreign currencies stipulated by the

Icesave loan agreements

A new solution is needed• The assets of Landsbanki assets are valued at €6.6bn (£5.7bn or ISK1,164bn) above the €3.9bn being claimed from Iceland

for the minimum deposit guarantee• Responsibility and costs for flawed banking regulation must be shared and Iceland should receive compensation for

reputational damage due to the use of anti-terrorist law• Iceland must be able to restore its economy in conformity with the Brussels guidelines

February 2010 4

The Icesave obligation in numbers

•UK and Dutch claim € 3.91 billion against Iceland

€ 3.91 billion•Ex

pected obligation per Icelandic family is € 48,000

€ 48,000

•The obligation bears a high interest rate of 5.55% compared to the 15 year gilt rate of ca. 4.40%

5.55%

•Icelandic population is 317,000 – the size of a small city in Europe

317,000

•The Icesave obligation is about 50% as a percentage of Icelandic GDP

50%

•Only about half of Landsbanki’s assets can be used to cover the guarantee stipulated by EU directives

51%

February 2010 5

Landsbanki bank• Does NOT pay interest

on the claim

Iceland• Pays 5.55% interest• Receives no interest

UK / Netherlands

Iceland pays the interests

0% 5.55%

Iceland pays €2.02 billion of

interests

The estate of Landsbanki does not compensate the interests of the Icesave obligation

February 2010 6

No accumulation of foreign exchange

Significant amount of debt maturing• Iceland will not pay up it’s debt

at maturity until 2016 without refinancing. Hence more debt has to be paid after 2016

3.1%• Iceland has to pay on average

3.1%* of GDP annually in foreign exchange only for Icesave

Trade surplus of goods and services has been above 3.1% in only six

years of 64 (1945-2008)

20162009 2023

* Based on Morgunbladid 5 February 2010

February 2010 7

The current agreement is bad in comparison

• The current agreement– Iceland pays 5.55% interest. That equals 1.26% spread on the base rate– The base rate, the OECD CIRR rate in €, was 4.29% in June 2009. Note that at that time, the

base rate in £ was 3.94%. Hence the spread on the pound obligation was 1.61% - despite the use of the anti-terrorist legislation against Iceland

• Bradford & Bingley – floating LIBOR with lower spread– The UK bank Bradford & Bingley was taken over by the FSA in 2008. Deposits were moved

to other financial institutions. The FSCS guaranteed deposits and was funded with a loan from Bank of England and later the British Government

– This sets an example of financing of depositary guarantee funds• Floating LIBOR plus spread for seven years, fixed 5.55% interest thereafter

– Since the accrued interest for the first seven years are such a significant amount it would be better if the obligation would bear floating rates, not fixed

• UK and Dutch would get all payments from Landsbanki for seven years– UK and Dutch would receive all payments from Landsbanki, tha Iceland would otherwise

get– The involved parties would negotiate on the payments of the remaining principal

Looking at a few examples it becomes clear that the current agreement puts unnecessarily heavy burden on Iceland. All the examples assume a seven years grace

period and maturity of 15 years

February 2010 8

Comparison – a few examplesMillions of € Reference rate Spread Principal in

seven yearsTotal paid

Current agreement CIRR in €, 4.29% 1,26% 2,901 2,685

Bradford & Bingley 12 month LIBOR 0.32% the first three years.1.00% thereafter

2,374 2,036

Floating rate 12 month LIBOR the first seven years.Fixed 5.55% thereafter

1.26% 2,568 2,280

UK and Dutch receive everything that the estate of Landsbanki pays the first seven years. Iceland will cover what is left

No interest for the first seven years. Fixed rate of 5.55% thereafter

1,414 854

InDefence is not taking a view on these examples. They are here to show that the current agreement is bad compared to other options.

February 2010 9

Extensive risk factorsForeign exchange risk can cause a weak Krona over the next years

• The obligation is denominated in foreign currencies which is different from an obligation in the domestic currency

• Creditors holding general claims benefit from a weaker krona. Because the claim has been fixed in kronas, a weaker krona means that priority claims will be paid in full and general claims will be partly paid

• The foreign exchange risk is partly due to Icelandic law as they force the claims to be fixed in kronas at the exchange rate of 22 April 2009

Risk associated to the recovery of Landsbanki assets• There has not been an independent assessment on the asset value of Landsbanki• Because of the interests that Iceland has to bear, it is of great importance when the

payments from Landsbanki are being made. The later the payments are made, the higher the obligation becomes for Iceland

The obligation reduces economic growth• When a part of the fiscal budget exits the economy because of Icesave it reduces economic

growth and leads to a lower standard of living. This is mentioned in a paper from the Institute of Economic Science (IoES) at the University of Iceland

February 2010 10

A weaker currency means less recovery and greater obligationIf the krona weakens from current level the obligation will grow since it is denominated in foreign currencies. Unfortunately the payments from Lansdbanki will not increase to the same extent. Hence the net obligation will grow on a weakening of the krona. If the krona revalues the recovery rate will not change that much. We take into account that the assets of Landsbanki are mainly denominated in foreign currencies.

40% 30% 20% 10% 0% -10% -20% -30% -40%0

300

600

900

1200

1500

0%

20%

40%

60%

80%

100%

Recovery left Obligation leftRecovery as a % of obligation right

Changes in the exchange rate of the krona % - negative numbers indicate devaluing

Billi

ons o

f kro

nas

February 2010 11

There are two recovery rates

1. Recovery rate of Landsbanki claims– This is the proportion of claims that are met by Landsbanki assets– If a claim is worth 100 and 80 are paid back by the bank, the recovery

rate is 80%– This proportion never gets above 100%

2. The proportion of the Icesave obligation (principal) that gets paid by Lansdbanki assets– If the obligation is 120 and 80 are paid by the bank then 67% of the

obligation is met by Landsbanki assets• The claim on Landsbanki is krona denominated but the obligation

is in € and £.– Therefore these two recovery rates are not the same

• See some examples on the next page

February 2010 12

There are two recovery ratesThe FX rate effects both of the recovery rates Graphical presentation

CLAIM

100

OBLIGATION120

80

67%80%

Here, 80% of the claim is paid back but that payment only covers 67% of the

obligation

40% 30% 20% 10% 0% -10% -20% -30% -40%40%

60%

80%

100%

Claims recovered % Obligation recovered %

Changes in the exchange rate of the krona (positive numbers indicate strengthening)

February 2010 13

Recovery risk• No one outside of Landsbanki has valued the banks

assets– The portfolio is partly in kronas but mainly denominated

in foreign currencies– Foreign denominated loans to domestic parties are often

paid in kronas. Therefore krona assets are a greater proportion of the asset portfolio than on might think at first

• The value of the assets depends inter alia on the exchange rate of the krona– Depends on how the value develops in the denominated

currency– Depends on the exchange rate of the krona. A weaker

krona gives greater value in kronas– The final recovery rate (rate of claims recovered) never

exceeds 100%– The recovery rate surges of the krona devalues but

plunges if the krona revalues. See graph to the right

• There will be no payments from Landsbanki until legal disputes have been settled. That could be in 2011 at best, perhaps laterCollection in billion

kronas 2009 2010 2011 2012 2013 2014 Later TOTAL

Assumed recovery 191 124 78 183 55 204 333 1,168

To Iceland 97 63 40 93 28 104 170 596

The x-axis shows percentage changes of the exchange rate from current level. Positive numbers indicate strengthening and negative numbers weakening

40% 30% 20% 10% 0% -10% -20% -30% -40%50%

60%

70%

80%

90%

100%

Claims recovered %

Changes in the exchange rate of the krona (positive numbers indicate strengthening)

February 2010 14

Economic growth reduced permanently

Icesave reduces economic growth

• Payments due to obligations is money that will not be spent on other things eg. investments or consumption• Less economic growth means lower standard of living

The risks have not been systematically identified

• In this situation, where the uncertainty is high and amounts are great it is in fact the risks that are of most importance• It is not good enough to consider a base case and certain variations

Not enough fiscal surplus to meet Icesave payments

• The IoES find the forecast of fiscal surplus by the Ministry of Finance optimistic• The IoES also believes that further debt raising is needed to pay the Icesave obligation

IoES* criticises the Central Bank for not systematically identify the risks associated to Icesave

Iceland will become a production economy

*IoES is the Institute of Economic Studies in Iceland

February 2010 15

Downward spiral of the economy

Less FX flowing to Iceland than anticipated

• It is hard to argue that the trade surplus will last that long and as much as the Central Bank assumes and it is contrary to what other countries have experienced• The Central Bank forecasted (in July 2009) a trade surplus of 154bln kronas in 2009. It turned out to be 130bln kronas (assuming trade surplus of services coming at 13bln kronas in

Q4 2009)*

Emigration a real threat

• Emigration on a large scale will increase the burden of those who are left

The worse the economy of Iceland performs, the more we have to pay

• In his paper, Dr Jon Danielsson points out that if the economy does well and the exchange rates recovers the debt will be reduced• If however, the economy does poorly, the debt will increase further• This is contrary to the Brussel guidelines, on taking into account the unprecedented difficult situation of Iceland and allowing Iceland to restore its financial system and its economy

* 13bln kronas is a bit above the average for the three preceding quarters

February 2010 16

Agreed to avoid Icelandic laws• The first €20,887 in each account

should have superpriority– This was one of the safeguards

approved by Althingi in August but was rejected by UK and the Dutch

– This safeguard is in accordance to Icelandic law

– This has been avoided under the current agreement

• This might increase the obligation of Iceland hundreds of millions of euros

• The next page explains the difference graphically with an example. There we have a deposit of €50,000 and assume that 80% of claims will be met by Landsbanki

Claim of €50.000 – comparing how much UK and Dutch will receive according to the current agreement (blue

bars) and according to Icelandic law (red bars)

50% 60% 70% 80% 90% 100%0

10,000

20,000

30,000

40,000

50,000

60,000

Recovery according to agreement Recovery according to Icelandic law

Recovery rateEu

ros

February 2010 17

Iceland takes on €20.887

Iceland takes on €20.887

A single deposit becomes two

claims

Given 80% recovery Iceland pays

EU maximum guarantee Iceland’s

share

Deposit beyond

maximum guaranteeUK/Dutch

share

€50.000

€20.887

€29.113

€4.177plus interest

Recovery from

Landsbanki

Ag

ree

me

nts

Icel

and

ic l

aw

One deposit – a single claim

Given 80% recovery Iceland pays

Interest€50.000

Iceland

UK / Dutch UK/Dutch receive

92%

UK/Dutch receive

80%EU

maximum guarantee Iceland’s

share

Deposit beyond

maximum guaranteeUK/Dutch

shareIceland

UK / Dutch

Recovery from

Landsbanki

Recovery from

Landsbanki

Recovery from

Landsbanki

Recovery from

Landsbanki

February 2010 18

Icesave: differs from other obligations

• Apart from Iceland’s claim on the estate of Landsbanki there are no assets behind the Icesave obligation

• It is misleading to compare the Icesave obligation to other obligations of Iceland– If one has got overdraft and the money is not used but are kept in the bank

there are no arrangements to be made in order to pay back the overdraft– Money will flow out of the Icelandic economy over the next few decades

because of Icesave – in exchange for nothing

Debt issued•When the state treasury issues debt or obligation it receives cash or a deposit•It can be in the form of a revolvong facility

There are some assets behind the

debt•The cash is depositet or invested in secure assets eg government bonds•The money can as well be used to refinance older obligations

Usual debt

Icesave

February 2010 19

Foreign direct investment (FDI)

•FDI brings FX in at the time when the investment is made (immediate effects)

•In the long run FDI gives FX in exchange for various domestic goods and services eg. energy and work

Positive marginal effect of FDI

•Investors wish to exit with at least the same amount that they invested initially. This causes outflow of FX in the long run

Foreign exchange outflow

•FDI in FX generating companies means that the profits and hence the FX is taken out of the economy. Despite reinvesting, the investor wishes to exit eventually

•Trade balance is therefore less than one would think at first glance

The origin of income matters for the current

account balance

FDI has similar effects as external debt

February 2010 20

Foreign reserve drawed on

•Companies producing goods and service for exports eg. Saefood and energy companies owe in foreign denominated currencies more than ever before

•Hence these companies need their FX to service their debt so the state treasury will not have access to as much FX as before

State treasury not the only party in need of foreign

exchange•Due to foreign ownership and foreign debt of the exporting industry, there is an outflow of FX

•As we saw before, foreign investors want to exit with at least the amount they invested initially

FDI causes currency outflow

•Iceland needs to pay foreign debt in the next seven years. For example there is 1.3bln € due in 2011. That requires FX and has to be refinanced

•The Central Bank estimated that the owners of 250bln krona would like to exit immediately or as soon as possible

Difficult years ahead

It will be difficult for Iceland to get enough forwign exchange over the next few years in order to service external debt without draw on the foreign reserve.

Iceland needs to secure a foreign reserve for the next 15-20 years

If Iceland runs out of the foreign reserve there will be a default on external debts

February 2010 21

History of running a trade deficitSince 1945 there has been trade deficit in 44 years out of 64 (until 2008). On average the deficit has been 2.2% of GDP. Note that the figures on the x-axis show the centre of the interval. For example “0%” is the interval from -0.5% to 0.5%.

<-6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% >4%0

2

4

6

8

10

12

Trade balance as % of GDP

Num

ber o

f yea

rs

February 2010 22

Trade balance of goods and services as % of GDP – Icesave will not be financed by trade surplus

Iceland has a history of running trade deficit. In 1994 there was a record surplus, 5.15% of GDP. In seven years out of 64 (1945-2008) the surplus has been greater than 3.1% - the average annual payment of the Icesave obligation in 2016-2024. That is without mentioning other obligations that has to be serviced as well.

19451948

19511954

19571960

19631966

19691972

19751978

19811984

19871990

19931996

19992002

20052008

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

Trade balance as % of GDPAverage payments of Icesave obligation as % of GDP assuming 88% recovery

Year

Surp

lus/

defic

it

February 2010 23

A weak krona for the years to comeFX used to pay

Icesave

• Iceland needs excessive FX to pay back the Icesave obligation

• That FX is gained by external debt, FDI or positive balance of current account

Less supply of FX in Iceland

• As the state treasury needs more FX there will be less supply in the market

• Most likely the capital controls have to be in effect for the next few years in order for the state treasury to get hold of FX

FX becomes more expensive, the krona weaker

• Less supply of FX means higher price of FX given the same demand

• Less supply of FX means contraction in imported goods

• There might be restrictions on imported goods

How will the state treasury obtain FX belonging to the private sector?

February 2010 24

Terms• Economic statistics are from Statistics Iceland,

http://www.hagstofan.is and from the Central Bank of Iceland, http://www.sedlabanki.is

• Calculation assume the exchange rates of 14 January 2010. Then EURISK was 180,29 kr/€ and GBPISK was 202,28 kr/£. On 22 April 2009 the claims were fixed in kronas at the exchange rate 169,20 kr/€ and 191,10 kr/£

• Calculations are based on the excel file by Jon Danielsson (see right) with some additions

• Information on Landsbanki’s assets and liabilities are found here http://www.lbi.is

• This document is based on information that was known at the end of January 2010

References• The Bradford & Bingley terms

– http://www.fsa.gov.uk/pages/Library/Communication/Statements/2008/bradford_bingley.shtml

• The IoES report (in Icelandic)– http://www.mbl.is/media/34/1634.pdf

• Report from the Central Bank 15 July 2009 (in Icelandic)– http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=7199

• Landsbanki Assets and Liabilities– http://www.lbi.is/Uploads/document

/091124%20Survey%20of%20Assets%20and%20Liabilities.pdf

• Article by Dr Jon Danielsson, Morgunbladid 15 January 2010– http://risk.lse.ac.uk/icesave/files/english-7.pdf

• Excel file with calculation – Dr Jon Danielsson– http://risk.lse.ac.uk/icesave/files/reikningar.xls

• Report by InDefence on Icesave (in Icelandic)– http://dl.dropbox.com/u/3133573/umsogn_indefence_um_icesave_samni

nga10july2009.pdf

• The OECD CIRR rates– http://www.oecd.org/dataoecd/21/52/39085945.xls

Webpage: http://www.indefence.isEmail: info@indefence.is