Iceland (pg.3)

Officially the Bank of England, the U.S. Treasury, and the European Central Bank won't comment. But, says a senior official at the ECB in Frankfurt, "if you want to put in place a swap agreement with us, you call [ECB president Jean-Claude] Trichet and make an appointment to come to see him. Then you fly to Frankfurt to discuss your request and explain how it is supposed to work. You need to win him over. Oddsson didn't even try."

On Aug. 14, Iceland's banking regulator, Jónas Jónsson, announced that he had put the three banks through a "stress test" to see how they would perform if their assets or the krona dropped in value. The conclusion: "The banks are solid and can withstand considerable financial shocks," Jónsson noted enthusiastically. Less than six weeks later all three banks were defunct.

Lehman's collapse on Sept. 15 played a critical role because it led to the drying-up of interbank lending around the world. The Icelandic banks were highly vulnerable because deposits covered only a fraction of their loans, despite the success of their new Internet-banking operations.

Glitnir, named after the Norse god of justice, was the most exposed. On Friday, Sept. 26, its senior executives met with Oddsson seeking a liquidity infusion of up to $900 million. Earlier that week, they told Oddsson, one of Glitnir's biggest creditors, Germany's Bayerische Landesbank, had canceled a previously promised $200 million credit line. The reason: The Germans had just taken part in a $400 million loan to the Icelandic state, and because of the turmoil in banking markets, they told Glitnir executives, their bank had hit the limit of its exposure to Iceland. The German bank won't comment on individual client relationships but says it is writing off about $1 billion of its $1.8 billion exposure to Iceland.

Oddsson didn't seem particularly sympathetic to Glitnir's plight, nor did he seem alarmed that a global bank was turning bearish on Iceland. He initially declined the request for funds - he later trashed the collateral Glitnir offered for a loan as "love letters" - and bank executives say he simply didn't return their increasingly frantic calls after the meeting.

The principal shareholders of Landsbanki and Kaupthing, nervous about the fate of their peer, made their own proposals to the central bank. Among other ideas, they suggested merging Glitnir with Landsbanki. They, too, got no reply.

Instead, on Sunday, the central bank announced that the government was taking a 75% stake in Glitnir in return for a cash injection of $750 million, valuing the bank at less than half the market price of the previous Friday. That quickly backfired: Standard & Poor's and other rating agencies immediately downgraded Iceland's sovereign rating.

The domino effect was immediate: Landsbanki had been using Iceland paper as collateral for refinancing transactions with the European Central Bank, so it had to put up more funds, making its situation even more precarious. It was nationalized promptly the following weekend. Officials involved in the rescue say the main goal at this stage was to save the strongest bank, Kaupthing, which received a $625 million infusion.

But Oddsson's erratic behavior doomed even that bank and compounded Iceland's financial and diplomatic problems. In an interview he gave to Iceland's state-owned TV in early October he slammed the banks for being "reckless" and said Iceland's mistake was not to have "cut the banking system down" beforehand, but rather to have acquiesced to its "daredevil expansion abroad."

He also insisted, "We do not intend to pay the debts of the banks that have been a little heedless." The following day Britain's Chancellor of the Exchequer, Alistair Darling, called his Icelandic counterpart and then announced that Iceland was refusing to honor its obligations to British depositors.

Britons had deposited more than $5 billion in Icelandic banks, mainly in the Internet banks set up two years earlier, and had invested additional billions in the nation. Invoking a new antiterrorism law, the British government froze the assets of Icelandic companies in the U.K. By taking control of the British subsidiary of Kaupthing, the last survivor of the three banks, it automatically triggered the default of its parent company back in Iceland.

Iceland started quarreling with British officials over how much compensation it would pay to about 150,000 Britons who had put their money in its banks, although it backed off in November after Britain and the Netherlands put up obstacles to its IMF bailout. And Oddsson continued to flip-flop. First the central bank announced it was fixing the krona exchange rate to prevent it from falling further; the next day it issued a clarification: The exchange rate hadn't been fixed at all. Then came the Russian "loan."

On the morning of Oct. 7, Oddsson announced to the public that Ambassador Tatarintsev had called him earlier in the day to tell him that Moscow was providing a $5.2 billion loan. Putin, he said, had personally signed off on the deal, and the rate would be 30 to 50 points above the London interbank offered rate.

The correction from Moscow came within hours: The Russians were interested in offering a loan, but no final decision had been made. What happened? Icelandic sources say that Ambassador Tatarintsev had actually received the equivalent of a preliminary term sheet for a loan that morning; Oddsson jumped the gun. On Nov. 19, Iceland announced that Russia would join Scandinavian countries in contributing $3 billion on top of the IMF loan.

The end of the world is a staple of Icelandic myths, where it's known as Ragnarok - the doom of the gods. Life in Reykjavík can sometimes feel a bit post-apocalyptic these days. Downtown at the once-hot 101 Hotel, business has slowed to a trickle of foreigners.

Sitting at the nearby Café de Paris, Gunnar Sigurdsson, who works in the marketing department of an ice cream factory and moonlights as an amateur theater director, complains that his mortgage payments are shooting up even as the value of his apartment is tumbling. He's already accepted a 10% pay cut at work.

He's never before been involved in politics, but in mid-October he organized a town-hall meeting with members of Parliament to talk about what had happened and what happens next. Several hundred people showed up to vent. "People are angry about everything," he says.

Foreign currency is scarce and being rationed by the central bank, with the help of a team from J.P. Morgan, making it hard for Iceland's remaining businesses to get financing for their operations. But the biggest problem is image.

"It will take time for foreigners to forget," says Hördur Arnarson, CEO of machinery firm Marel Food Systems, one of the country's leading exporters. Arnarson believes it was a mistake for the nation to have its own currency, and he strongly favors Iceland joining the European Union and adopting the euro as soon as possible.

Iceland still has some powerful export sectors in fish and aluminum. Its national pension system has taken some hits but remains well funded. There's even one bright spot to the currency collapse: Iceland's yawning current-account deficit will be transformed into a surplus within months.

"It's a bleak picture," Prime Minister Haarde says, "but it's not unmanageable." In Icelandic folklore, after all the havoc and destruction of Ragnarok, a new, cleansed world rises from the sea. Icelanders are hoping that such rebirth isn't just the stuff of mythology.  

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