Analysis of Icelandic Pension Funds - On solid ground?

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I analyzed the balance sheets of the pension funds in Iceland. This information is available in the Central Bank of Iceland's website. My assessment is that the pension funds in Iceland are on shaky grounds. I feel the pension funds have been constrained by the current capital controls regime. There is enough research to point out that Capital Control regimes don't work, that topic is for another day post. There is limited supply of invest-able assets in Iceland and that is what prompted me to look into this problem. I wanted to see how the composition of assets in the Pension funds have evolved over the years and what can one infer from this. It is understandable that the Pension funds want to be their own Private Equity funds and have invested in running their own funds. This is not a very good strategy and once again I fear the Pension funds would think that they can run their own hedge funds to accommodate the lack of supply of assets and manage their risk. If there is one thing that we know about hedge funds is that they go bust and I don't even want to contemplate what would happen if one of the Icelandic Pension goes bust. Pension funds wanting to hedge their own bets is evident when one looks at their balance sheet where they are starting to take Derivative positions, at the end of October 2011 the derivatives position stands at mISK -63.256 (-$516.797.385,62), this line item started showing up in the balance sheet since 2008. Derivatives are weapons of mass destruction and I sure do hope the teams that are running the Pension funds know what they are doing and they don't have any off-balance sheet liabilities that are tied to the derivative positions. This is what brought down Lehman brothers!

1. Cash and Deposits: The total amount of Cash and Deposit was mISK 153.964 ($1.257.875.816,99) at the end of October 2011. Cash holdings have increased by over 242% since the end of 2007. This amount is earning negative yield in bank deposits. The pressure to deploy this capital is only going to increase and given the dearth of assets, I fear it is going to give rise to an asset bubble either in commercial real estate or Government securities.

2. Government and Municipalities bonds: This is the most troubling development after the collapse of the Icelandic financial system. Government bonds being owned by the pension funds has increased by over 335% and Municipal bonds by over 92% since the end of 2007.  Increasing the government borrowing for investment purposes is a good thing i.e building infrastructure for the country or building power plants etc. I think the increase in Government borrowing has been fully utilized to pay interest and to recapitalize the banks. A functioning banking system is one of the pillars of the society. 

3. Housing bonds: The pension funds have been investing in the housing market since the inception of the pension fund system in Iceland, however the amount of money going into the Housing fund has dramatically increased since 2003. Looking at the graph it is quite clear who is the underwriter of the entire real estate market in Iceland.

The composition of the invested amount between Domestic securities and Foreign securities is quite interesting as well. When the world markets have given some terrific returns since the financial crisis in 2008, the Pension funds in Iceland have relatively mild exposure thereby mild return since the collapse. Again, one wonders if that is the right strategy? While they have been increasing the supposedly "risk-free" Icelandic Government bonds the investing world has been screaming that Government Bonds are not "risk-free", have you looked at Greece Bond prices lately? or for that matter the French Bonds?

The spreadsheet with the raw data can be found here, I had to do considerable work to make the data tell me the whole picture as the information provided by the Central Bank is not easy to analyze.

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Iceland Debt Position - Are we out of the water?

I find it very strange that everyone seems to think that Iceland is out of the water in terms of all its problems... I hate to be the bringer of bad news, look at the Government debt as a % of GDP figure below it stands at around 92%, if you combine this with the household debt (94% of GDP) which is again an interesting measure which usually gets ignored the world does not look that great. I don't care what the rating agencies are saying.

I am quoting the research report from Islandsbanki

Household loans written down by ISK 173 bn.

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The restructuring of household debt continues. In September the write-downs of financial undertakings, the Housing Financing Fund and pension funds amounted to over ISK 9 bn.  ISK 4.5 bn. of this amount was in write-downs under the 110% solution scheme, ISK 4 bn. were written down as a result of recalculated loans and ISK 0.5 bn. were written down under special debt adjustments. This is according to information, which the Icelandic Financial Services Association (SFF) has collected from financial undertakings, the Housing Financing Fund and pension funds, and which was published yesterday. Total write-downs on individual loans since the financial crash amount to ISK 172.6 bn., which corresponds to around 11% of the estimated GDP for this year.  

Most write-downs due to recalculations 

The lion's share of the write-downs there have been in the Icelandic financial system since the collapse of the banks are due to the recalculation of illegal loans, since a total of ISK 96 bn. has been written off in this manner, i.e. 55% of the whole. A total of 13 thousand housing mortgages have been recalculated and subsequently written down by ISK 57.5 bn. Some 57 thousand car loans have also been written down by ISK 38.5 bn. Write-downs under the 110% solution scheme amount to ISK 31.7 bn. and write-downs through special debt adjustments amount to ISK 6 bn.Even though a lot of progress has been made in the restructuring of debt, the process is still far from over. The length of time this process has taken has a negative impact, since uncertainty with regard to the debt position and slow restructuring have delayed the recovery of the economy. According to the figures published by the Icelandic Financial Services Association, one quarter of the applications for the 110% solution are still being processed, i.e. 4,300 applications. The processing of special adjustment applications has also gone slowly, since 40% of the applications for debt mitigation, i.e. 552 applications, are still being processed. Finally, over 3 thousand households still had frozen loans at the end of September. All this demonstrates that the financial restructuring of households is still in progress, more than three years after the financial collapse. Despite these write-downs of Icelandic household debt, debt levels are still very high by international standards. At the end of June, household debt amounted to around 94% of the estimated GDP for this year, although it has decreased since its peak in 2008 when it was almost 130% of GDP. It is clear that this high level of Icelandic household debt will significantly limit the prospects for growth in private consumption and household investment, and restrict economic growth in Iceland in the years ahead.

How can one expect economic growth when there is an over-hang of debt at the Governmental level (the biggest spender) and all the households (the second biggest spender) the total investments or capital expenses that have been made in Iceland account for a very small portion of the overall current account. The only saving grace has been the tourism industry and in my opinion that is going to slow as well as there is a global slow down as predicted by many nodal bodies.

Structural change of an economy - Iceland

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I have been on a road trip in India positioning Iceland as a possible destination for Indian companies to locate to and to invest into. It has been an interesting experience. During the trip I have had some very heated and exciting conversation with my colleague on what should Iceland be doing, what about the Icelandic Krona? the mortgage mess? etc

These talks and arguments gave rise to me consider writing my next paper on the "Structural Change of a Micro Economy - Iceland". There is so much of misconception about the Icelandic Krona and currency/monetary policy in Iceland that I find it interesting that many Icelanders think the root cause of their problem is the Icelandic Krona (ISK), which is far from the truth. Currency exchange rates are a symptom of a monetary and structure of the economic system, it can never be the cause. Much has been written about this.

What happened in Iceland was a major financial collapse, due to the imbalance between the ISK denominated liabilities and Other currency denominated assets. The root cause of the problem was over-issue of ISK denominated bonds by all the banks and financial service companies in Iceland. They used the period of easy money to extend ISK denominated bonds and turned around and invested that in other currency assets in most cases and in some cases into the Icelandic economy. When there is such an imbalance something has to give and the currency had to be devalued by more than 50%. The mortgages in Iceland are inflation linked therefore puts a major burden on households. It took a while for me to understand why the inflation is always uncontrollable in Iceland. My hypothesis is that inflation is Iceland is caused due to the high and constant imbalance between the imports vs exports and the Current Account. This imbalance gets exasperated when the currency is strong which is what happened between the periods of 2006 to 2008 until the collapse. Now the ISK is the best thing that has happened to Iceland, the monetary system has been put under capital control by the Central Bank of Iceland which allows for correcting the imbalances.

My argument now is that, the ISK will not be freely floated for sometime to come which is a good thing because it allows Iceland time to adjust its economy structurally. The easy fix for correcting the imbalance between imports vs exports is to manipulate the currency this is not a sustainable strategy as capital is fluid and flows where the returns are attractive. I think Iceland can use the current ISK regime to attract Foreign Direct Investment to really match the imbalances. Focus on High Technology, High Value Added products and Higher end design products. Similar to Fisheries and Aluminum which are not very high value add but are exported nevertheless... use the renewable energy to produce things that are in the higher value chain and is of high demand in the world market. I believe Iceland has the infrastructure, Human Capital and the Will to be a major player in the world market... I see it in the grass root companies that are starting to come out of Iceland, this is one of the main reasons that I went into Venture Capital investing.

The Icelandic Government and Leadership should focus on policies that encourage the above sectors, provide clear incentives, make it simple and really restructure the economy... however, politics as it stands in Iceland and any country is inefficient.

Related articles

• S&P raises outlook on Iceland from negative to stable (business.financialpost.com)
• Why Not The Worst? (krugman.blogs.nytimes.com)
• Don't Blame The Krona (krugman.blogs.nytimes.com)
• World Needs More Canada latest (Nordic dep't) (macleans.ca)

Policy implications if we use Power Law distribution

I have been working on my first paper with the title "Can Power Law help us avoid highly improbable tail events?" the premise of the argument is that if some economic variables fall in the Power Law distribution then policies associated with those economic variables need to be handled differently. For example, I am taking the problem of the Icelandic Krona, I have written about the Icelandic Krona before and I am convinced that it follows a Power Law distribution.

If we know that ISK follows a power law distribution and future fluctuations in ISK are going to follow the Power Law distribution should the Icelandic state still use the currency in its current form? or should it switch over to a more stable currency say the Euro? this debate is on-going in Iceland and I am afraid people are viewing this decision with their political lense and not the economic lense.

Just a simple switch in the probability distribution of the ISK has some serious policy implications. Lets do a simple thought experiment: The Financial Supervisory Authority of Iceland used a 20% devaluation of the ISK as a basis to stress test the banks in Iceland, why did they choose 20% because they thought ISK followed a Gaussian Normal Distribution and a 20% devaluation is a 2 or 3 sigma event or a very low probability of occurance, however if we change the distribution to Power Law a 20% devaluation of the ISK has a much higher probability therefore they would have chosen a much higher deviation for the stress test say 50% this would have shown the true color of the Icelandic banks capital adequacy and vulnerability to wholesale funding. The question is if the stress test had been done in 2006 when Iceland had a mini crisis, the FSA could have put a stop to the aggressive borrowing by the Icelandic banks which in turn would have reduced the leverage of the companies in Iceland and the citizens.

So choosing the right probability distribution matters! atleast that is the basis for my PhD thesis lets hope the thesis could influence some policy choices.

Icelandic Krona vs US Dollar - A Power Law Distribution

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The Icelandic Krona currency exchange index follows the Power Law, it can be seen in the most rudimentary of analysis...

Here is the analysis of ISK-USD exchange rate data for however long I could get, a simple histogram shows visually that the exchange rate is distributed by a power law. In addition, I was able to do a Log plot of the observations and it clearly follows a path that should give us

enough indication that the ISK exchange does not follow a Normal "Bell" curve distribution.

However, last week I was talking to a currency trader and he told me that before the crash of the Icelandic Krona last year, they calculated the proabability of ISK crashing and they found it to be a 8 sigma (read highly unlikely! or A Black Swan) event... the fact that it happened proves atleast to me that the methods and theory used to analyze the ISK is not correct. I am writing a paper with Dr.Helgi Tomasson with University of Iceland with the title "Can Power Law help us avoid the highly improbable tail events?" hopefully we will be able to answer the above question.

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