The Link Between U.S. Sub-Prime Crisis and Iceland - Case Study Example

? Iceland’s Financial Crisis: An Analysis BY YOU YOUR SCHOOL INFO HERE HERE Iceland’s Financial Crisis: An Analysis The Link Between U.S. Sub-Prime Crisis and Iceland There is absolutely a linkage between Iceland’s financial crisis and the United States sub-prime mortgage crisis. In 2007 and 2008, the United States experienced a significant volume of defaults on sub-prime mortgage loans that was caused by high inventories of homes available on the consumer market that created incentives for lenders to offer mortgages to individuals without necessarily sustaining good credit or adequate financial resources. During this time period, home values began to fall dramatically and sub-prime rates eventually readjusted so that individuals owed up to double their original mortgage value on homes that were no longer even worth their original market value. A vast variety of the sub-prime mortgages offered to individuals who actually did not maintain quality resources to sustain an adjustable home loan interest rate were suddenly forced into foreclosure, which left lending institutions with a significant inventory of now bank-owned homes worth less than their mortgage values at the time of signing. As the housing bubble burst and grew more fiscally unsound, global investors found that the many derivatives (swaps) associated with home mortgages were no longer viable and lucrative opportunities for investment (Simkovic, 2011). Many investors from the European Union and the United States began looking for better investment opportunities, leaving financial institutions offering these derivatives with considerably less quarterly and annual revenues stemming from mortgage-backed swaps and securities. Because mortgage-related derivatives were, for many years, adequate and lucrative profit opportunities for financial institutions, many offering these securities backed by mortgage guarantees had not diversified their revenue-earning capacities. As such, investment trading partners in the United States witnessed capital depletion rapidly where many institutions required significant fiscal bailouts to keep the entity afloat. Further complicating this situation was what is referred to as a bank run, where nearly five billion dollars in investment resources were withdrawn domestically and internationally in a 48 hour period by concerned and speculating investment firms and independent investors (Altman, 2009). Low-valued credit default swaps, a variety of mortgage related derivatives, and banking facility capital depletion soon hit Iceland and many other European countries. Iceland, after banking privatization had been established, was very dependent on making investments in international capital markets (Olsen, 2010). However, this instability and credit downgrading that occurred during the sub-prime crisis in the U.S. had destabilized multiple investment opportunities associated with mortgage-backed securities and derivatives. Thus, a once lucrative revenue source for Icelandic banks and other financial institutions no longer provided adequate capital infusion for the now-private banking facilities in the country. Since there had not been enough portfolio diversification in Iceland to spark domestic investment opportunity to offset dependencies on international investment losses, the exchange rate of the Icelandic currency value was affected and derivatives relationships with foreign banking partners were largely nullified. As the IMF and the U.S. Central Bank began changing monetary policy and increasing regulation to correct the sub-prime crisis, it inflated the U.S. dollar which only served to further weaken the value of the Iceland currency on the international exchange markets. How could the Iceland Crisis have been Avoided? Firstly, Iceland should have recognized that the U.S. would not necessarily have explosive gains on mortgage-related securities and derivatives that would endure indefinitely. The U.S. had a long history of a volatile housing market which should have provided adequate clues that various credit default swaps and other securities would not always be stable. Analysis of past performance in mortgage-backed securities would have allowed for more shrewd stimulus plans to encourage domestic investment rather than relying on international markets for investment and capital growth opportunities. Secondly, now-privatized Icelandic banks did not have adequate asset procurement and stability to guarantee liquidity in the event of major international banking and currency-related crises (Guomundsson, 2010). Icelandic banks should have been more proactive in determining what would be the most viable and sustained investment opportunities for asset procurement prior to the crisis, rather than relying on the FX Swap Markets to, as in the past, easily convert one currency to another at interest rate spreads favorable for asset management and capital stability. If Iceland banks had invested their capital into more stable accounts and securities, it would have been much easier to ensure asset-based liquidity. During the fiscal crisis, Iceland could barely move its current assets with much buyer speculation and concern over investment risk (Guomundsson, 2010) as the majority of these assets were linked to the international currency and swap markets. The Importance of Political and Economic Sovereignty in Iceland Iceland is a stable democracy in which human rights are a major concern and focus of government (Olsen, 2010). Prior to the financial crisis, the assets of Old Landsbanki, a major European bank, were frozen in the United Kingdom under the Anti Terrorism, Crime and Security Act from 2001 (Iceland Chamber of Commerce, 2012). Though this is just one example, this closure of activities from Old Landsbanki has significant fiscal consequences for the Icelandic banking sector. In this instance, the United Kingdom had the regulatory powers established to intervene in banking assets without consultation with other EU member countries. This is primarily why Iceland deems economic sovereignty important in the country as many banks are connected with international capital and investment markets, allowing subsidiaries to be regulated by foreign government and not the Icelandic government system. When other countries can impact the stability of financial trading partners, it lessens control over the Icelandic government to guarantee longevity of international banks impacting domestic financial stability. Iceland is left, in many situations, to have to appeal to NATO, the EU or the WTO to gain advocacy and intervention when foreign political actors have domestic or international authorities to disrupt the Icelandic financial system and its stability. Steps as Head of State to Improve Iceland’s Economy As head of state, it would be crucial for Iceland to continue to push for membership in the European Union. Even though Iceland values its political and economic sovereignty, the country needs more influence in setting international laws that currently impact the financial system in Iceland either directly or indirectly. As one example, a recent situation occurred where a charity organization known as Naomi House went bankrupt virtually overnight. Naomi House was a hospice located in England sustaining 8.7 million USD in assets that were held in Icelandic banks (Forelle, 2008). These assets were frozen by government agents in the United Kingdom and will likely never be available again as valid deposits for Icelandic banks. Iceland must gain a voice within the European Union as a decision-maker and opponent of various international regulations that allow for asset freezing (and similar legal actions) to avoid continuous losses of Icelandic deposits and investments negatively impacted by foreign government interventions. Currently, many of these difficulties are out of the control of the Icelandic government. Further, a representative from the International Monetary Fund stated in regards to Iceland, “You have to understand. Iceland is no longer a country. It is a hedge fund” (Lewis, 2009, p.1). Foreign banks and private investors look toward Iceland as an opportunity to hedge against other business and investment losses, thus seeking capital investment in the country. Though this guarantees higher deposits and revenues for many Icelandic banks, it also subjects the country to investor speculation and imposes considerable risk regarding investment stability that is largely out of the control of the government to correct or improve. As head of state, I would begin discussions with private banks and the Central bank to determine more effective domestic investment growth and stimulation to dissuade using Icelandic banks for risky hedging activities. Business Opportunities Created by the Crisis Governmental changes that now provide Iceland with more financial sovereignty and impending, potential control as an EU member nation have provided opportunities for business growth. In 2010, the Iceland Supreme Court ruled that loans which are provided in foreign currency are exempt from the rules that guide indexation of loans that are provided in the Icelandic kronur (Ministry of Economic Affairs, 2011). This essentially means that Iceland can now segregate foreign currency loans from domestic currency loans. With this positive segregation from international influence in finance, Iceland can allow foreign investors to procure domestic loans in foreign currency for asset procurement (such as real estate or direct capital investment in plant construction) without concern over sudden spikes or declines in international currency values affecting plant or real estate values. This infuses more stability into important capital investment projects that improve infrastructure growth in Iceland and the ability to improve GDP through better export practices and opportunities. Iceland can now choose, essentially, whether to offer loans in domestic currency or foreign currency with an entirely set of guiding and regulatory rules associated with exchange rates or default, giving the country more control over its fiscal assets. Ethics and the Financial Crisis and SWOT Analysis The ordinary citizen was affected quite negatively. In 2008, the unemployment rate was approximately six percent in Iceland; while today it stands at over eight percent. The crisis made it more difficult for large organizations such as hospitals, schools or other important industries to obtain adequate credit for capital investment or expansion. Inability to procure credit as a result of banks being cautious about risk management has created instability in the labor market. The increase in interest rates and private debt transfer to the taxpayer also increased inflation on consumer products that take away considerable disposable income levels for regular Icelandic laborers. The following is a SWOT Analysis of the Iceland banking crisis: Strengths More stability in setting interest rates on foreign currency loans Government acknowledgement of independent capital growth strategies free of international interventions More effective strategies for stabilizing banking assets in the future by avoiding deleveraging. Weaknesses No EU membership approved currently Better auditing and oversight of financial institutions and systems Ongoing credit downgrades Opportunities More independent banking domestically Improved exchange rate market regulations for import export activities Better asset management for privatized banking facilities Threats Considerable authority with international governments to affect deposits and fiscal movement in banks Continued volatility in U.S. banking partners and uncertainty Market speculation in a variety of securities markets. The Icelandic financial crisis was largely due to short-term thinking on behalf of government, banks and investors associated with the longevity and stability of the derivatives and securities markets. If these important actors had been more proactive in assessing the exchange rate market and developing appropriate fiscal policies, the high level of inflation and interest rates prior to the crisis would not have occurred. It would have given Iceland the opportunity to avoid repayment of the multi-billion dollar IMF bailout and prevented fiscal tightening to stabilize banking facilities. Now that welfare-related spending had to be restructured, even the public citizen was negatively affected while the government attempted to stabilize financial growth and reduce its debt burdens. The fiscal crisis, as a whole, gave Iceland a new template by which to control foreign and domestic currency loans that give the country more flexibility in the event of catastrophic international banking and investment centre stabilities. References Altman, R. C. (2009). The Great Crash 2008: A Geopolitical Setback for the West. Foreign Affairs. Retrieved from http://www.foreignaffairs.com/articles/63714/roger-c-altman/the-great-crash-2008 Forelle, C.. (2008). The Isle that Rattled the World. The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB123032660060735767.html Guomundsson, M. (2010). The Financial Crisis in Iceland and the Fault Lines in Cross-Border Banking. Bank for International Settlements. Retrieved from http://www.bis.org/review/r100129a.pdf Iceland Chamber of Commerce. (2012). Iceland’s Financial Crisis. Retrieved from http://www.vi.is/files/1350175258Icelandic%20Financial%20Crisis.pdf Lewis, M. (2009). Wall Street on the Tundra. Vanity Fair. Retrieved from http://www.vanityfair.com/politics/features/2009/04/iceland200904 Ministry of Economic Affairs. (2011). Iceland. Retrieved from http://eng.efnahagsraduneyti.is/media/Acrobat/Pre-Accession-Economic-Programme- 2011_Iceland.pdf Olsen, E. (2010). Iceland’s Financial Crisis. Drexel University. Integrative Case 2.1 Simkovic, M. (2011). Competition and Crisis in Mortgage Securitization. Harvard Law School. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1924831 Read More