By Colin Barr
July 30, 2010

Moody’s warned Thursday that Iceland could face another debt downgrade.

The rating agency said it changed its outlook on the country’s Baa3 sovereign rating to negative from stable for the second time in three months, citing continued turmoil in Iceland’s banking sector.

Moody’s pointed to a ruling last month by Iceland’s supreme court nullifying so-called foreign-exchange-linked loans. These are loans tied to the value of foreign currencies such as the euro and Swiss franc.*

People in Iceland and other peripheral European economies flocked to these loans during the boom of the past decade because they offered lower interest rates than domestic loans offered in domestic currency.

But when these weaker economies hit the wall in the financial crisis of 2007-2008, local currencies such as the Icelandic krona collapsed, vastly increasing local citizens’ debt burdens at a time when their incomes were at best holding steady. This did nothing to encourage local economic recovery, needless to say.

Similar scenarios have played out in places like Hungary, and the threat of further collapses loom over the big European banks, many of which have lent heavily to borrowers in stressed Eastern European economies.

While Iceland’s economy has already been more traumatized than most, the court’s decision “has the potential to cause substantial bank losses on foreign currency-denominated loans to domestic borrowers and may therefore require additional government support to the banking system,” Moody’s warns.

The country’s three banks collapsed in 2008, and the government is now pursuing a case against the former CEO of one bank.

That’s not the only unfinished business for Iceland’s banks, Moody’s notes. The rating agency also points out, not for the first time, that the country remains at loggerheads with the U.K. and Dutch governments over billions of dollars in depositor losses incurred in the collapse of the Icelandic banks.

That dispute started when overseas depositors put money in higher-yielding Icelandic accounts known as Icesave. Icesaving didn’t turn out to be such a hot idea, however, since the Icelandic banks then collapsed and Iceland’s government, itself running short of funds, didn’t make the depositors whole.

Moody’s says a failure to settle the dispute could cost Iceland with its benefactors at the International Monetary Fund and in the Nordic bloc. Fears that the IMF might back away from Iceland led Moody’s in April to cut its Iceland outlook to negative, before a bigger-than-expected funding commitment two weeks later led the rating agency to restore Iceland’s stable outlook — until now.

That’s a fair amount of, um, ratings volatility, though it’s hardly shocking for a hedge fund masquerading as a country.

In any case, Thursday’s comment from Moody’s comes as Iceland pursues membership in the European Union, a prospect that an EU official last week described as a “win-win.” That’s about the only time in recent memory anyone has associated either Iceland or the EU with victory.

*Update July 30: My thanks to a reader who notes that I botched the explanation of foreign currency linked loans. He writes:

The loans you mention in your article weren’t offered by foreign banks. They were offered by Icelandic banks, which borrowed in foreign currencies, repacked them in kronur and gave them to Icelanders. The Icelanders then paid these loans off in kronur, and the payments went up and down depending on the strength of the currency.

I have changed the wording accordingly.

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