Deep Freeze by Philipp Bagus & David Howden

Author:Philipp Bagus & David Howden [Bagus, Philipp]
Language: eng
Format: epub
ISBN: 978-1-93355-034-3
Publisher: Ludwig von Mises Institute
Published: 2011-06-28T16:00:00+00:00

Chapter 6

A Timeline of the Collapse

Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom.

Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.

At a moment such as this, a vicious spiral may set in. Rising spreads indicate the market’s distrust of the banks, spurring even further demand for insurance, leading to even higher spreads on the debt, and so on, until the distrust in the bank reaches a point where the bank cannot receive further funding and it fails. Due to this self-reinforcing spiral of distrust and rising bank funding costs, reputable investors, commentators, and economists (most notably Warren Buffet), have called CDS instruments weapons of mass destruction. Indeed, CDSs can be used to take banks down by lowering the confidence in them. Yet they can only work if banks are vulnerable; that is, if they violate the golden rule of banking and mismatch maturities, or they mismatch currencies, or they do both. Only then will the distrust translate into funding problems that threaten the bank’s liquidity and eventually its solvency. When the bank matches maturities and currencies and holds 100 percent reserves to cover its deposits, the distrust may lead to

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