October 16, 2008 – 11:16 am

The cold water of the credit crunch swept Iceland’s Landsbanki Islands out to sea, forcing all of Europe into panic.

Glitnir Bank hf, Landsbanki Island hf and Kaupthing are unable to finance about US$61-billion of debt, 12 times the size of the economy, according to data compiled by Bloomberg. Their collapse has affected 420,000 British and Dutch customers, and frozen assets held by universities, hospitals, councils and even London’s police force. The government is seeking a loan from Russia and may ask for aid from the International Monetary Fund to help guarantee deposits.

That action led to the three day closing of Iceland’s stock market and an ensuing 77 percent cliff dive on reopening. Now it poses a threat to CDO’s, which insure the banks’ solvency.

Iceland’s collapsed banks pose a “substantial” risk to collateralized debt obligations that made bets on corporate debt, according to Standard & Poor’s.

And has caused spreads on credit default swaps to soar:

The cost of hedging against default by the Icelandic government has soared to 948 basis points, according to CMA Datavision prices for credit-default swaps. That means it costs 948,000 euros a year to insure 10 million euros of debt for five years. It compares with 118 basis points for the Czech Republic and 238 basis points for Morocco.

European governments can freeze all bank assets, but will never make whole what has been lost. That presumably is the motivation to work with Landsbanki Islands and Iceland’s other ailing banks.

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