Deleveraging and Volatility: Iceland As An Example

It is doubtful that any level of sophistication in the use of financial instruments will ever create a new paradigm of permanently lower volatility. Complicated derivatives and securitizations are useful in creating new ways of pricing and transferring risk, however they do nothing to change basic human emotions such as greed and fear, nor do they change people’s appetites for risk.

After a prolonged period of low volatility, investors start to feel comfortable taking on greater risk, often with borrowed money. No matter what the latest risk control methods are, it is inevitable that an increase in risk-seeking behavior and use of leverage will eventually lead to a spike in volatility, as has been witnessed in the markets in recent weeks.

When investors are extended, as they are now, they are not in a position to hold on through the downturn and wait for better times. The most vulnerable ones will have to liquidate their holdings early on, thereby amplifying the original move.

A highly leveraged investor can be likened to a poker player who is low on chips and can ill afford to call bluffs – in the case his opponent is not bluffing, the game could be over. Recent events have raised the profile of deceased economist Hyman Minsky, whose “Minsky Moment” has become a popular phrase in the financial press to sum up the process by which credit tightens following excessive speculation.

What I have found surprising when reading about the financial markets in my native Iceland is how the U.S. sub prime issue is widely considered to have little fundamental links to other markets. While the latest vintages of U.S. sub prime loans may be some of the most ill-conceived loans made in recent times, it seems clear that lending standards have become lax the world over in the last couple of years.

Global stock markets have experienced an almost uninterrupted bull market since 2003 and real estate markets have performed even more impressively. As long as asset prices are rising, the loans for which those assets are a collateral do not seem in danger. This was true for sub prime mortgages in the U.S. until housing prices started to falter.

It was also true for global stock markets until last month. After good times in recent years, stock markets as well as real estate markets all over the world could have far to fall. Such a fall would reveal how prudent lenders outside the sub prime U.S. market have been.

Iceland presents an interesting example as it is a microcosm of extremes. In the last five years, the Icelandic stock market has risen 544% and housing prices have close to doubled in the same period. Icelandic asset price increases have come in a period of impressive economic progress, but the success has also fostered an investment culture where one’s competence and confidence are considered proportional to one’s use of leverage.

Many investments and home purchases are financed in foreign currencies as Iceland has one of the world’s highest interest rates (as such, it is popular among carry traders, which raises questions about its volatility in the near term). My familiarity with Iceland allows me to conclude that many people there have a blasé attitude toward the global financial risks the country is exposed to. It makes me wonder about similar risks hidden elsewhere around the world.