more on Iceland

so what happened in Iceland, where are things headed, and is it a one-off microsystem gone off the rails, or a bellwether for the developed world

Iceland was a dirt poor fish+agriculture economy, under external Danish rule until 1944 when it unilaterally declared independence, the Danes being otherwise occupied.

Over the next 40 or so year it grew a modern economy, very slowly, building a tight Scandinavian social democracy, with currency and import controls and a developing industrial economy. The export driver was fish - and fishing was, and is, relatively tightly regulated to sustain stocks of the primary commercial stocks, after a near ruinous lesson when the very lucrative herring fisheries collapsed in the '60s from overfishing.

The in the late '80s and early '90s, the economy deregulated, banks and other state institutions were privatized and the economy rapidly went post-industrial - still with a base of fish export and energy intensive metals (aluminium and iron alloys).
Software, entertainment, tourism, sport, light tech industry and fashion became important economic sectors, with the internal economy heavily service based.

Iceland got a windfall by getting a foot in the door with the Baltic countries, through a peculiar accident of diplomatic history, and became a gateway for a lot of the post-industrial development there, using their relatively well educated population. Russian investment also came through after perestroika.

In recent year, after mergers and rebranding, the three commercial banks started very aggressive expansion in Europe - going after investment banking, private banking and online deposits - and very intense acquisition with high leverage investment.
Icelandic firms bought banks, investment firms, high end retail and trophy investments, using borrowed money.

As markets tightened in 2007, the highly leveraged Icelandic banks became exposed.
They responded by trying to improve their depositor base, which meant attracting European depositors.
This is a dangerous tactic, because the banks were exposed to long term loans covered with short term deposits that could be pulled instantly. Unstable.
At this point the banks should have deleveraged and sold assets into the peak, not doubled down.
Also, the banks were booking very large profits and paying huge dividends, driving up stock prices. Some of this money should have been held in capital reserve.

The peg pulled out that started this stack tumbling was, strangely, Lehman Brothers going under. Turns out Lehman did most of the short term credit lines for the Icelandic Banks.
This bankrupted the smallest bank, Glitnir, immediately. They had a short term loan that was rolling over right then, and no one would extend them a new line of credit. They got taken over.

Next to go was Landsbanki, which had "icesave", an aggressive online operation in the UK offering high interest rates on deposits. With stories in the press of Glitnir going under there was a classic bank run - online. Bank collapsed, unable to come up with cash to cover depositor withdrawal but sitting on a pile of illiquid assets.
I closed my Landsbanki account in 2004, btw.

This left Kaupþing, the largest and best capitalised of the Icelandic banks.
I've looked over their last annual report, and they should have survived, their asset base was solid and they were well hedged - negligible US mortgage exposure, little exposure to credit default swaps.
What killed Kaupþing was the UK government freezing their UK assets - nominally because of fears they'd collapse and leave depositors dangling. This killed their cashflow instantly, and they were dead. Put down.
There is a lot of bitterness in Iceland over this, the UK government did this as a political move, without co-ordination, to be seen to be "doing something".

So... the bank deposits are insured. Iceland guarantees about $30,000 per depositor and the UK government another $100,000. Now some depositors, including institutional investors, were over the limit, but they were taking the risk, chasing the return. Tough shit. Right?
A large part of the short term losses seem to be in the private banking divisions. Loans to UK billionaires to pick up UK investments at high leverage near the frenzy of the peak market seem now to be defaulting - in case anyone is wondering where the deposits of UK councils and charities ended up.

Well... the UK seems to feel the entire Icelandic nation is personally responsible for the deposit losses. These were private banks, regulated on both sides and with normal depositor insurance - so how the nation get to pick up the responsibility?
I mean, if Barclays blows up through bad US mortgage bets, will the UK take national responsibility for their US exposure? I think not.

Well, the Icelandic insurance fund had not caught up with the rapid expansion of the banks, it is under capitalized, oh by a factor of 50 or so. The responsibility expanded much more rapidly then the banks contribution to the fund. It'd have taken several decades to get the fund to a proportionate size. And this sort of collapse is a once-per-century sort of event.

So, what is the government liability.
Well, the banks held something like $60 billion in liabilities, if I remember the numbers right. They also had somewhat over $60 billion in book assets.
Unfortunately, when you liquidate assets rapidly you don't get book value.
Now vulture investors are snapping up a lot of the subsidiaries and portfolios of the Icelandic banks, at a discount.
Right now it looks like a ~ 10% shortfall when the assets are liquidated.
Which is ~ $6 billion, or about $20,000 per person. Which sucks but does not completely kill the economy.
That ought to cover the insured depositors, comfortably. Other claimants would line up for the rest of the money, until it ran out, depositors over the insured limit are near the bottom in claims, ahead of shareholders.

Or, some assets might get a good price and there might be more money than expected. Kaupþing, for example, hedged against currency devaluation, which is very sensible - with the króna collapsed, this should be a nice lump of cash coming their way, depending on the size of the position.

The actual crisis in Iceland is lack of cash and unwillingness to provide credit.
Merchants in Iceland can not get good shipped without paying hard cash upfront and the currency reserves are depleted. The country needs a few billion $ short term loan just to turnover commerce. There is almost literally no market for the króna - you couldn't get a price on it on European currency exchanges.

Things are loosening up - after all the country still works, and exports are continuing, earning money. Icelanders abroad earn money, and not just pop stars and football players.
Further, individuals and institutions invested abroad during the good times. Icelandic pension funds are overcapitalized and heavily invested abroad. Short term relief in the last couple of weeks came from major pension funds selling assets and bringing the currency back, then buying into Icelandic investments - government bonds make sense now, and some will start to move into the stock market looking at well run firms promising income with low debt, value stocks. The pension funds ultimately need to pay locals in the long run.

Currency control has been informally re-established - if you want dollars or euros you need to show need - travel plans or imports. Individuals who took foreign denominated debt for houses or cars are screwed. (and what the fuck were they thinking anyway, my dear cousins). There will be unemployment spikes as importers, merchants and some service sectors contract sharply.
Then it will bounce back.

The big question right now is asset possession - the ill gotten gains.
Major stockholders and executives in the banks took out a lot in dividends and bonuses; there is sentiment for recovering some of those assets, especially those stashes in foreign safe havens - that will be a political battle. I checked the constitution, (and I am not a lawyer), and the contingent historical focus is on forced exile and deportation being wrong, property seizure in the interest of the nation is permitted, and I don't see even bills of attainders being unconstitutional.
Might be a really bad idea politically, even if popular.

Ultimately, the issue is the assets of the broad upper middle class - people who caught the tide 10-15 years ago and have foreign investment but are not ultra-rich. If some of those assets come back - whether because the individuals need the cash, or because they feel a nationalist sentiment to do so, or just because the want to bottom feed on the market crash - if they do, the pain will be shorter. If they don't, then there will be interesting political times, with high income inequality and extreme wealth disparity, for the first time since colonial times.

Interesting times.

I am very curious as to what plays foreign investment banks and hedge funds made on Iceland in the last few weeks.
In particular if Renaissance's Medallion fund took positions - volatility in emergent markets is supposed to be one of their plays.

This is my personal take on what happened from what I've seen from the outside.
May have got some details wrong or missed some steps.

Grauniad: Kicking Iceland while it's down

Grauniad: Britain has betrayed Iceland

comments worth reading on the Grauniad articles

Bloomberg: hoarding in Iceland

NYT: Iceland on the brink

BTW: I get the impression the main source of currency in Iceland right now are foreign financial journalist doing colour stories.