March 31 (Bloomberg) -- Iceland's lenders are under attack from what its central bank called ``unscrupulous dealers'' amid concern reliance on foreign funding may undermine their operations.

The cost to protect the country's biggest lenders from default is the highest of 81 banks worldwide with credit-default swaps listed on Bloomberg. The country's benchmark index of stocks has shed 20 percent this year, while the krona has lost almost a quarter of its value against the euro.

``The longer this goes on, the worse it gets,'' said Olivia Frieser, a London-based bank analyst at BNP Paribas SA, France's biggest lender. ``It is a question of confidence.''

Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf have increased their dependence on borrowing outside of the $16 billion island economy as a global rout in credit markets makes it tougher for firms to fund themselves. They account for about 80 percent of the country's gross external debt, which is five times gross domestic product.

``Iceland has been likened to a hedge fund because the banks borrowed to invest in equity,'' Paul Rawkins, a senior director at Fitch Ratings in London, said in an interview. ``It was a punt on getting higher returns to pay off the debt. They are exposed now, and sentiment has shifted against them.''

The banks' credit ratings ``remain under close scrutiny,'' Rawkins said. Moody's Investors Service has a ``negative outlook'' on the Icelandic banking system, the company said in a report on March 14, citing rapid loan growth and concern about lower earnings.

Ratings Scrutiny

The nation of 300,000 has been among the hardest hit as the credit market freeze prompted investors to shun all but the safest government assets. The financial sector's net $35.3 billion of debt represents 211 percent of the country's gross domestic product, according to Fitch.

Attacks on the country's Reykjavik-based banks ``give off an unpleasant odor of unscrupulous dealers who have decided to make a last stab at breaking down the Icelandic financial system,'' central bank Governor David Oddsson said at its annual meeting in Reykjavik. ``They will not get away with it.''

Credit-default swaps on Kaupthing Bank, the nation's largest lender, increased to a record 16.5 percent upfront and 5 percent a year to protect 10 million euros ($15.8 million) of bonds, CMA Datavision prices show. The cost rose from 15.8 percent in advance and implies a 59 percent risk of default within five years, a JPMorgan Chase & Co. valuation model shows.

Glitnir, Landsbanki

Credit-default swaps on Glitnir, Iceland's third-biggest bank, traded at 17 percent upfront and 5 percent a year, according to CMA, up from 16 percent in advance. The cost implies a 60 percent risk of default, according to the JPMorgan model. The contracts have soared from 2.02 percent, or 202 basis points, with no upfront payment at the start of the year.

``It's very important that the Icelandic Financial Supervisory Authority, in cooperation with other countries, investigates the market and determines whether the allegations are true,'' Glitnir spokesman Bjoern Richard Johansen in Oslo said in a phone interview today.

Contracts on Landsbanki, the second-largest lender, rose 68 basis points to 850 basis points, CMA prices show. The credit- default swaps traded as high as 9.5 percent upfront and 5 percent a year on March 28, according to CMA.

Landsbanki spokesman Andrew Walton and Kaupthing spokesman Jonas Sigurgeirsson were not immediately available for comment.

``The banks' reliance on wholesale funding is their Achilles heel, and their profitability will come under pressure in 2008, but the CDS reaction smacks of panic,'' Simon Adamson, a London-based senior analyst at CreditSights Inc., said in a note to clients dated yesterday.

Debt Speculation

Iceland's krona climbed against all 178 currencies monitored by Bloomberg, and as much as 3.4 percent against the euro, before trading at 119.4239 versus the common European currency. It dropped to a record low of 127.985 on March 19.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicate deterioration in the perception of credit quality; a decline, the opposite.

Iceland's Financial Supervisory Authority started investigating market movements last week, the FSA said in an e- mailed statement today.

The regulator is seeking to find out ``whether particular parties have systematically distributed negative and false rumor regarding the Icelandic financial system in order to profit from it,'' Hreinsdottir said.

Legal Threat

Kaupthing may take legal action against Bear Stearns Cos., the collapsed U.S. broker, the Financial Times reported today. Three executives of the New York-based company visited Iceland in January along with representatives of four hedge funds, the FT said. If Kaupthing decides to file a lawsuit, it will be able to subpoena e-mails and records from Bear Stearns and possibly the hedge funds, the newspaper said.

Bear Stearns London-based spokeswoman Jessica Shepherd- Smith didn't provide an immediate comment.

Credit-default swaps on the Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings increased 25 basis points to 580 today, according to JPMorgan.

The Markit iTraxx Europe index of 125 companies with investment-grade ratings rose 6 basis points to 123.5, JPMorgan prices show.

The CDX North America Investment Grade Index increased 1 basis point to 142.5 in New York, according to broker Phoenix Partners Group.

To contact the reporter on this story: Abigail Moses in London Amoses5@bloomberg.net

Last Updated: March 31, 2008 17:52 EDT