ICELAND - A GLIMPSE AT THE FUTURE?

A few years ago we took a great trip to Iceland. We hopped around the island hiking and traveling to remote locations from black sand beaches to an inactive volcano rim to tiny towns tucked in nordic style locations on the water.

The year after, Iceland went bankrupt. The Cliffnotes version is that Iceland's three largest banks offered above market interest on deposits, borrowed in the public markets and lent the incoming funds out in a very aggressive manner to speculative borrowers.

The overleveraged borrowers who overpaid for assets all of a sudden could not service their debts. Then the great asset bubbles deflated and the borrowers could no longer pay back the banks. The three largest Iceland banks, that somehow grew to 10 times the size of Iceland's GDP, failed.

The Iceland kroner crashed as did the banks and the Icelandic economy. Google the Financial Times for a good series on Iceland. One bank was an internet bank, Icesave. Icesave had attracted over $5 billion of deposits from UK and Dutch depositors. Of course when the banks failed, the tiny Iceland deposit insurance fund was instantly bankrupt.

What did the UK and Dutch governments do? They reimbursed all their citizens deposits with Icesave? Why would they do this? They were not UK and Dutch obligations. Hey, all those "innocent" depositors were getting an above market interest rate. Did they think there was no risk?

So, the UK and Dutch governments now want Iceland to repay the $5 billion. In today's jaded financial world, $5 billion sounds like a rounding error. It is only $5 billion. Let me show you how much $5 billion is to Iceland.

Iceland only has 300,000 citizens. That's right, 300,000; about the size of Cincinnati. So $5 billion amounts to $18,000 for each citizen. Not each family, each citizen. So on Saturday, the citizens of Iceland voted on whether or not to ratify an agreement made by their government to repay the UK and Dutch governments. They voted 93% against paying them back. 93%!!!!

The UK and Dutch governments have pledged to keep Iceland out of the EU. The IMF has threatened to hold back more loans to try to stop Iceland's freefall. The threats fell on deaf ears.

I can hear the Icelanders at the polls now. 'I have a family of four. I am not voting to take on $76,000 of debt because some bankers took deposits, paid themselves big salaries and then lent the money to companies that couldn't pay them back. So they won't let us into the EU. Big deal. And so what the IMF won't lend us money. The money Iceland borrows is just to repay the money all the banks borrowed and threw away.'

This referendum appeared to be a way the Icelanders could finally show how frustrated and angry they are at all involved. The way out? That will take a much longer blog.

But here is today's thought. How many more countries will go through an Icelandic event?

Cheers

SHOULD GREECE SELL ISLANDS?

There appears to be some in the German government that think that Greece should sell some of its islands to raise money to reduce debt. Once again sounds like creditors dealing with a financially troubled company. Sell your non-core assets. This will not be the last time or the last country where you will hear this.

I expect to hear suggestions such as these for the next 10 years. What do I hear for this Mediterranean island? These works of art? This slightly used military hardware?

Stay tuned.

SOVEREIGN DEBT & THE EMPEROR WITH NO CLOTHES

There has been much written and spoken about the financial state of various countries, especially Greece at the moment. I received an email from a friend regarding a one page piece written by George Soros on the situation which on one hand offered a solution and on the other hand admitted the solution wouldn't work.

When I returned from the golf course, where I have successfully raised my handicap (it is easier than lowering it), I sent off this rambling reply.

As for the Soros piece, I am afraid the situation is too complicated and interrelated to address in a one pager. We appear to live in a world where the vast majority of the countries on the planet are overlevered by any measure and especially against GDP. Think of the situation as an industry where most of the players have too much debt and supply far outstrips demand (only much more complicated.)

The past two decades of globalized growth were fueled by easy and cheap credit which overstated global demand and inflated asset values as we all know now. Add to that the large recession we have been enduring (oh, that's right it is over, I forgot) and you get worldwide deleveraging of the consumer, albeit involuntarily, and unprecedented leveraging by governments to mitigate the short term effects of the recession.

The various governments had to print money (stimulus programs) to replace trillions of credit which disappeared due to the Lehman failure. (Please thank the US and UK governments for this.)

Some countries have and will blow up. See Iceland for a small but meaningful story of asset bubbles and overleverage. Following in short order, Dubai, Greece, Spain, Ireland, Portugal, Italy, Eastern European countries, Baltic countries and oh yea, Argentina which still has its leftover debt problems.

Behind the curtain is the UK. The UK has massive levels of consumer debt; much more than the US. This will restrain the consumer from spending and spurring the growth required to address the problem. The UK will have to push the pound down to import customers from other countries to be the UK's consumer. Good luck.

So, back to our troubled industry of broken countries (technical term). All these overleveraged countries need growth like troubled companies need sales. However, their infrastructures assume credit driven growth which isn't on the horizon. In fact they are all relatively shrinking as tax revenues have nose dived everywhere. As a result, they will have to cut expenses (read 'formerly essential services'). This will lead to anywhere from protests to riots (again see Iceland and Greece).

Interest rates are artificially low right now. Personally, I see this as a transfer of wealth from savers (getting nothing for their money) to borrowers (paying nothing for their money). These low interest rates have propped up asset values somewhat because 'what else can you do with your money?' if you have any. Asset values have also been propped up by convenient accounting changes to mark to market accounting which is further propping up commercial real estate and the banking industry.

Moreover, the current interest rates are not indicative of the true credit risk of these countries. The low rates are a stop gap to stop the recession (I forgot again that the recession is over). I see devaluations and hyperinflation in the future. This is the time honored way financially troubled countries deal with their debt when they can't pay back the debtholders.

Finally, the US continues to skate by as the biggest debtor nation on the planet (think the emperor with no clothes). Curiously, not only is there no plan in sight to reduce the debt, there isn't even a plan to stop the debt from growing. And this is the world's reserve currency? Only because all the other currencies are worse.

More to follow in the future.

THE GAZPROM UKRAINE SAGA

THE GAZPROM UKRAINE SAGA

This is a guest post from one of my followers, Pat.

I'm sure you have seen headlines about the Gazprom Ukraine natural gas problem over the past few weeks. If you are like me (Mike, not Pat), you looked at them and said, "whatever". However Pat says at its core, it is a business problem not a political problem.

In short, Russia's Gazprom transmits gas to Europe via a pipeline that runs directly through the Ukraine. Until 2009, the Ukraine has had a sweetheart deal with Russia providing it with gas at rates less than 50% of the market rate. Further, the Ukraine was taking its time paying Russia for the gas. In addition, there is widespread belief that the Ukraine was using more gas than it reported. Russia apparently warned the Ukraine months ago that the old days were over and the Ukraine must pay the market rate. Further, Russia wanted the past due payables paid with late fees and penalties. No agreement was reached, so Russia stopped pumping.

Who's at fault? What should Russia do? What should the EU do considering they receive over 30% of its gas from this pipeline?

Pat says it is his view that the Ukraine is the party primarily at fault and is holding the EU hostage. It is time for the Ukraine to start paying Russia something close to a market rate and consider their past deal a blessing.

Check out this article about the deal the parties may have reached.

UPDATE
Courtesy of the Financial Times

It appears the gas is flowing as there is an agreement for the Ukraine to pay for its natural gas at a 20% discount off the market price. Now back to their remaining issues. The cost to insure its bonds against defaults through credit default swaps has jumped to record highs. It has $30 billion of debt due this year which must be rolled over. One of its biggest banks, Prominvest, ran out of money at the end of last year and its currency has depreciated by about 35 per cent since September.

We haven't heard the last of the Ukraine.

Special thanks to Pat

Cheers, Mike