Iceland: The country that became a hedge fund

    Icelanders can thank Oddsson and other policymakers for turning them into a nation even more profligate than the U.S. Regulators loosened rules on mortgage lending to allow financing of as much as 90% of the value of a property, up from 60%. And the central bank's actions made it irresistible for businesses and consumers alike to borrow in foreign currency: A series of interest rate hikes by the central bank, aimed at taming inflation, unwittingly sent the free-floating krona soaring on international markets. That made imports cheaper for Icelanders, further fueling the consumption boom.

    Given the choice of borrowing in krona at double-digit interest rates or in foreign currencies at far lower rates, many Icelanders chose the latter. "When you bought a car, you'd be asked, 'How do you want the financing? Half in yen and half in euros?'" recalls Gunnar Haraldsson, who heads the economics department at the University of Iceland.

    Nor did authorities do much to discourage a band of brash Icelandic entrepreneurs who took control of the banks and used them to build global business empires. A group led by Björgólfur Thor Björgólfsson, 41, who made his fortune with a Russian brewery, successfully acquired a 45% stake in Landsbanki, once Iceland's national bank.

    A longhaired 40-year-old grocery magnate named Jón Asgeir Jóhannesson snapped up a 32% holding in Glitnir. And a pair of brothers who got their start processing cod roe executed a reverse takeover of Kaupthing. Their ostentatious shows of wealth (Jóhannesson owns a yacht named Viking) flew in the face of Iceland's egalitarian traditions: One mogul brought in Elton John to perform at his 50th-birthday party in January 2007.

    But the real eyebrow-raising behavior was the way the entrepreneurs created highly leveraged investment funds that used the banks and a complex web of other shareholdings as collateral.

    The banks expanded rapidly abroad - by the end, about 60% of loans were outside Iceland - and the investment funds followed suit, snapping up stakes in companies ranging from American Airlines (AMR, Fortune 500) to Saks Fifth Avenue (SKS) and a slew of British apparel firms. The government and the central bank did nothing to rein in Iceland's oligarchs; indeed, the government actively encouraged the banks to expand lending, ratchet up their leverage, and take greater risks.

    The central bank reduced the minimum-reserves requirement - the percentage of assets the banks were required to deposit with it - freeing more of their capital. And it seemed blind to the outsized risks to the nation that the banks' ballooning balance sheets posed.

    Several international organizations, including the IMF and the Organization for Economic Cooperation and Development, warned of the perverse effects of Iceland's monetary policy. It was ineffective in fighting inflation and turned the country into a fixture in the "carry trade" business, as hedge funds and other financial market players borrowed in low-yielding currencies like the Japanese yen and invested in high-yielding Icelandic krona.

    In dollar terms, Iceland's stock prices rose ninefold from 2003 to 2007 on the back of this foreign demand. The investments were often short term and highly speculative, but Iceland encouraged them. In 2005 the government started issuing krona-denominated "glacier bonds" to better satiate this international appetite.

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