Iceland Banks Face $3.3 Billion Loss in Debt Relief Lawsuits

Iceland Banks Face $3.3 Billion Loss in Debt Relief Lawsuits
The scale of writedowns to date makes Iceland a world-leader in debt relief, according to Danske Bank A/S. Photographer: Paul Taggart/Bloomberg

Iceland’s banks are facing $3.3 billion in additional writedowns as the nation’s biggest homeowner protection group throws its weight behind borrowers suing their lenders for indexing mortgages to inflation.

Banks, which lost a similar case in 2010 for linking loans to foreign exchange rates, have already forgiven $2.1 billion in debt since Iceland’s 2008 crisis wiped out its financial industry. In two separate lawsuits, banks are now being sued for selling inflation-linked loans that allegedly clash with European Economic Area laws banning unfair terms in consumer contracts.

Vilhjalmur Bjarnason, chairman of the Homes Association in Reykjavik, which represents 10 percent of Iceland’s homeowners, is urging the courts to “correct the injustice” to borrowers he says followed a 2008 krona slump that sent inflation soaring as high as 19 percent. Gains in the consumer price index have added as much as 400 billion kronur ($3.3 billion) to private debt burdens, Bjarnason said in an interview.

The scale of writedowns to date makes Iceland a world-leader in debt relief, according to Danske Bank A/S. The government of Prime Minister Sigmundur Gunnlaugsson won April elections in part after promising voters he would cut debt burdens further.

The Homes Association is covering the legal costs of one of its members suing Iceland’s state-backed Housing Financing Fund, which the regulator has warned lacks sufficient capital to be deemed solvent. The HFF has lost money as Icelanders turned to competitors offering non-indexed mortgages.

No Opinion

The HFF’s loans follow Icelandic law, though the fund will review its lending practices if the law changes, said Karl F. Johannsson, a lawyer representing the lender.

“The Housing Financing Fund doesn’t have any particular opinion on inflation indexation,” Johannsson said.

Icelandic households owe the country’s banks 1.43 trillion kronur in loans indexed to inflation, according to a statement published by parliament in March. Linking debt to the consumer price index cost households 275 billion kronur from the beginning of 2008 through March this year, the central bank estimates.

Though inflation has eased since its peak in 2009, prices rose an annual 4.3 percent in August, exceeding the central bank’s 2.5 percent target, according to the statistics office.

“We’re in no doubt that the way the inflation indexation has been carried out is illegal,” Bjarnason said. The case is due to be heard by the District Court of Reykjavik later this month, he said.

Setting Precedents

Einar Pall Tamimi, a lawyer based in Reykjavik, has asked Iceland’s Supreme Court for permission to seek a legal opinion from the European Free Trade Association’s court in Luxembourg on whether Islandsbanki hf broke the law when it sold an inflation-linked mortgage to his client.

“We claim that the contracts we are aware of behind loans linked to inflation, both mortgages and car loans, are illegal and that they violate Iceland’s law on contracts,” Tamimi said in a telephone interview. “If we win our case, the outcome would be that all contracts on loans linked to inflation are illegal.”

Dogg Hjaltalin, a spokeswoman for Islandsbanki, declined to comment.

The HFF has issued 54 percent of Iceland’s inflation-indexed mortgages, while the rest were sold by the island’s commercial banks.

Borrower’s Risk

“Iceland’s practice of inflation indexation places all the inflation risks associated with lending money unilaterally on the shoulders of the borrower,” Olafur Isleifsson, a professor of economics at the University of Reykjavik, said in a telephone interview. “The lender, however, is protected against all kinds of fluctuations in consumer prices.”

The north Atlantic island’s former banking giants -- Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf -- all failed within weeks of each other in October 2008, leading to an $85 billion default that dwarfed Iceland’s $14 billion economy.

The ensuing collapse plunged Iceland into its worst recession since World War II, sending unemployment surging nine-fold and forcing the government to seek a $4.6 billion bailout from an IMF-led group.

Iceland responded to its crisis by cauterizing the outflow of capital with currency restrictions and passing bank losses on to bondholders. Though the island has since surfaced from its economic slump, households are still struggling to cope with debt loads that the central bank estimates reached 231 percent of disposable income in 2012.

“Unless we abolish inflation indexation of loans, raise salaries and bring down the cost of living, we’re likely to run into debt difficulties again,” Bjarnason said.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE