This story has two beginnings. The first is a tale grossly over-simplified.
In the beginning there was securitisation, and the lawyers and the financiers looked on securitisation and it was good.
"“The article … addresses its core question: is the securitization process a zero-sum game or does it truly reduce net financing costs? The short answer is simple: securitization is an alchemy that really works.”
"“Securitization, in short, brings to financial technoqlogy what the sought after philosopher’s stone promised to bring to base metals – the ability to turn them into gold!” (at pp 134 and 154 of S Schwarz, “The Alchemy of Asset Securitization” (1994) 1 Stanford Journal of Law, BUsiness and Finance 133)
But was this fool’s gold? For bundling up the rights to payment from debts and transferring them elsewhere transferred risk, risk guaranteed by the credit default swap – a vehicle exposing the financiers involved to the risk of bad debt because they were effectively underwriting the packaged products – and when financiers have exposed themselves to these risks and debts go bad then unbundling the swap transactions and the securitised products is problematic. (And on this general area see the excellent little CBS documentary that Aaron posted the other day). One bad debt in a bundle is perceived to poison the others, and consequently confidence in these products (which retain a value because most people will still pay the debts) falls through the floor, as the complexity of the products means quantification of the losses is not an easy task. And hence, banks become less confident in each other – because a number of these institutions are potentially exposed to these risks, andan inability to work out how bad it is means that (a) banks worry about having enough to meet their own liabilities; and (b) banks worry about the exposure of their own debtors and are concerned that those who owe them money, or to whom they may lend money in future, may have unquantified liabilities that will drag them under and mean that the debtor cannot repay the loan.
And hence confidence plummets – and inter-bank lending seizes up.
Our second story begins domestically. Since the coming to power of the SNP in Scotland any speech referring to the economy from a government minister has made reference to our northern "neighbours" – populated by 300,000 citizens Iceland has been held up as a model economy to follow. From ALex Salmond’s first speech as first minister Iceland has been referred to. IN that speech in May last year Salmond said,
"Scotland sits at the heart of one of the wealthiest parts of our planet. In Ireland, to our West; in Iceland, to our North; and in Norway, to our East, we see an arc of prosperity, with these nations sitting at the very top of world quality of life and wealth league tables. I don’t say today that Scotland can be instantly transformed into an economic powerhouse but I do say that if we are to look objectively around us we can learn many lessons about how to make Scotland more successful."
So, Iceland was one of the nations that could teach us lessons – a small independent country booming while Scotland failed. A country with a phenomenal rate of growth in comparison with the poor Scottish rate.
And given the lead from the first minister (and his repetition of the approach in various speeches – such as his February speech in trinity College, Dublin or his Tartan week speech in April at Harvard University (and to be fair to the great leader the emphasis in some of his speeches is on the Icelandic rate of growth – see his speeches of October and November last year) it is not surprising that others in the great leader’s cabinet followed the line. For example, in November last year John Swinney was pointing out Scotland’s underpeformance in comparison with various countries including Iceland
"For too long Scotland’s economy has underperformed. Not only does our historically low growth rate compare poorly with the UK, but we are left standing by successful small independent countries like Ireland, Iceland, Denmark, Norway and Finland."
And also in November Jim Mather was making a similar point
"We need to face the fact that Scotland’s growth record over the last three decades has been mediocre. But the current situation is a great opportunity to catch up and converge with the arc of prosperity that surrounds our country – Ireland to the west, Iceland to the north, Norway to the east. These countries are amongst the wealthiest in the world and they illustrate Scotland’s potential for sustained economic growth."
But, all was not as it seemed. Whether the impact of following an Icelandic model would be appreciated by Scots is not clear. Iceland traditionally has high interest rates relative to other European countries (15 1/2 % in April) and was in April running an inflation rate of 8%. And alongside this in April it was being reported in the media that all was not well in the Icelandic economy. On April 24th The EConomist reported that the chief of Iceland’s central bank was warning of big trouble – based on the foreign indebtedness incurred by the Icelandic financial sector. Iceland’s economic growth was based on borrowing – and borrowing from the international money markets – international money markets where the impact of the credit crunch was beginning to be felt. And while they had avoided the credit default swaps and securitised assets that were underpinning the problems in other countries the exposure to the international market was beginning to cause problems – because, for reasons explained above, banks were starting to lose confidence in each other – and the liabilities in these credit default swap agreements were beginning to crystallise. Iceland’s financiers were worried.
However, still the Scottish ministers banged on about Iceland.
For example, how about Adam Ingram, speaking in May 2008 on regenerating rural Scotland? He said,
"Norway, Iceland and Ireland are respectively the first, second and fourth most prosperous countries in the world according to the UN Human Development Index. As we know, all these countries declared their independence in the 20th century and have clearly benefited from not being part of a larger political union. Because Scotland has not enjoyed the success of Norway, Iceland and Ireland, our economy has lost out on an opportunity cost of many billions of pounds. A low growth economy concerns every one of us, because it will dramatically affect the way we live in future. It affects our job opportunities, our incomes, and the profile of our population."
And in September, when apparent that things in Iceland are starting to get very serious indeed, the Scottish government still bangs on about Iceland in the government programme for 2008-9, Section 4
"Scotland’s economic growth rate has lagged behind that of the rest of the UK for far too long. And over the last few decades the rapid increases in wealth in small, independent countries such as Ireland, Iceland and Norway have not been matched in Scotland; poverty and disadvantage remain stubbornly persistent. Yet Scotland has the people and assets to create a much wealthier and fairer nation. Our education system is one of the best in the world. Our financial services, life sciences and tourism industries have a global reputation. "
Passing over Scotland’s global reputation in financial services (HBOS? Royal Bank of Scotland? where stands their global reputation now? Would Mr Salmond still describe both, as he did in his Harvard speech as follows "And of course we Scots are lucky enough to have the one of the best brands in the world – a global recognition and affection for our culture that money cannot buy. Take financial services. With RBS and HBOS – two of the world’s biggest banks – Scotland has global leaders today, tomorrow and for the long-term. And a growing number of American firms – not least JP Morgan, Morgan Stanley and State Street – are discovering that the Scottish financial sector can do anything you can do in London and can do it better and rather importantly in the current environment can do it at lower cost." That’s right, anything you can do in London we Scots can do it better at lower cost…) what has this rapid increase in wealth in Iceland been based on? Foreign borrowing. And where has that led?
A country on the verge of bankruptcy, where a European nation is potentially going to default on the nation’s obligations.
So, a note to Scottish ministers. Stop mentioning Iceland. Because if you keep quiet about it for a while the punters might forget that this is the path you wanted us to follow.
ETA and while writing this I miss David Farrer writing a brief update on the Icelandic position. Apparently they’re trying to stave off the evil day by borrowing from RUssia (A Very British Coup anyone?) and are proposing to use a US airbase as collateral to try to persuade the west to help out. So, that explains what lies behind SNP nuclear policy…