That situation changed – virtually overnight – to one characterised by a lack of liquidity and a re-evaluation of the pricing of risk, and this resulted in substantially increased interest rate premia. Banks became especially careful in their transactions with one another, and a considerable tightening of interbank markets ensued the world over. Central banks on both sides of the Atlantic reacted by granting special liquidity facilities with virtually unprecedented amounts and maturities. As the end of the year approached, conditions in the interbank markets improved markedly, though they were still far from their prior state. On the other hand, the fundamentals of important financial undertakings became an ever greater source of concern. The general economic outlook deteriorated significantly, spurring greater pessimism in the global equity markets. Iceland certainly did not escape the effects of these global developments. Here in Iceland, those developments emerged in the form of higher interest rate premia, shrinking credit supply, and risk aversion. Risk aversion means, among other things, that companies and regions at the periphery – if it can be expressed that way – feel the effects of the changes more than others do. This periphery includes Iceland and its banks. Among Icelandic banks, these changed conditions emerge most clearly in wide CDS spreads.
But the change was small, and then CDS spreads increased once again, as they did for many banks. The fact that Moody’s announced a change in its outlook for the banks’ credit ratings was no help. To some degree, the sizeable CDS spreads arise from suspicion vis-à-vis Icelandic banks. In their penetration into new markets, Iceland’s banks have doubtless threatened competitors that were established in those markets and were subjected to stiff competition as a result. Perhaps it also matters that Iceland’s banks are in a peripheral area and that such banks are generally subjected to higher premia than are banks in large countries. The size of the banks in comparison with the national economy is doubtless a factor as well. Otherwise, higher premia could be explained by the fact that in recent years Iceland’s banks sought out credit in the global bond market. When conditions for such transactions were most beneficial, there was considerable demand for the banks’ bonds because they were considered to fit unusually well with the various CDOs that were then popular among investors. They generated relatively good yields, especially given the banks’ credit ratings. Conditions have changed dramatically, and there is no longer a demand for such instruments. It would seem that many of them are unwinding – that is, that bonds are being sold off, including bonds from Icelandic banks.