Oct. 3 (Bloomberg) -- Arni Einarsson looks out over the Atlantic Ocean from his Room With A View Hotel in Reykjavik and offers a gloomy outlook for Iceland after the government bailed out Glitnir Bank hf.

``Nobody trusts anyone any more, and in banking trust is everything,'' says Einarsson, 49, who's managed the hotel for seven years. ``As long as people trust you, you can build a very long domino chain. But once that trust is gone things start falling.''

That's a common concern on the island the size of Cuba that's home to 320,000 people. Iceland spent a decade punching above its weight as the three biggest banks amassed assets valued last year at nine times the country's $19 billion gross domestic product. The demise of Iceland's third-biggest bank has shaken the economy. Stodir hf, an investment firm that owns 32 percent of Glitnir, has filed for protection from creditors.

The cost of insuring against a default by Iceland's government and the three banks has surged to a record, credit- default swaps show. Glitnir, Kaupthing Bank hf and Landsbanki Islands hf have the worst creditworthiness among European lenders, according to the swaps.

``The focus now is clearly on Iceland as a country risk,'' said Mikko Ayub, Helsinki-based head of investment product sales at Nordea Bank AB.

The krona has slumped 14 percent against the euro since Sept. 29, when the government said it would pay 600 million euros ($842 million) for 75 percent of Glitnir. Inflation, now at 14 percent, is almost five times the central bank's target.

Government Bailout

The government bailed out Glitnir after the bank was unable to secure short-term funding. Glitnir had a deposit-to-loan ratio of about 30 percent, the lowest among Iceland's biggest banks, meaning it had to rely on money markets for financing.

``The government's ownership in Glitnir will strengthen further the capital base of Glitnir and remove all doubt that the bank can cope with the current environment,'' said Bjorn Richard Johansen, an Oslo-based spokesman for Glitnir.

Landsbanki had a deposit-to-loan ratio of 63 percent at the end of the first half, the bank said in a Sept. 29 statement. Andew Walton, a bank spokesman in London, declined to comment.

``Kaupthing is a very liquid bank, our position is strong and we have a light maturity profile in coming quarters,'' Kaupthing spokesman Jonas Sigurgeirsson said.

Outside Glitnir's headquarters in Reykjavik, Anna Vignir said many people are concerned about what happens next.

``Because Iceland is so small and because there are extensive cross-shareholdings, if one part collapses, the rest follows like a house of cards,'' said the 48-year-old Glitnir customer.

`More Nervous Than Ever'

That view is shared Bill Blain, who produces a daily market report for bond broker KNG Securities LLP in London.

``The whole market is more nervous than ever on Iceland,'' he said. ``For the first time even normally positive commentators have doubts about the competency of the system.''

Prime Minister Geir H. Haarde yesterday said the Glitnir bailout wouldn't end the banking ``crisis'' in Iceland.

``The economic situation has in a short space of time changed very much for the worse,'' Haarde said in an address to parliament in Reykjavik. ``Government, companies, households and people have seldom faced such great difficulties.''

Other politicians have said Iceland, which shares a trade agreement with the European Union but has shunned full membership, may need to seek shelter by adopting the region's single currency, the euro.

Overseas Expansion

Kristinn K. Olafs, a taxi driver in Reykjavik for more than a decade, is worried about the future. Olafs spent about 4.5 million kronur ($40,000) a year ago on a new cab. Today, he says he'd have to pay 8 million kronur.

Iceland's banks were sold to investors in the 1990s and were permitted to offer mortgages in 2004, contributing to the island's real-estate boom.

Kaupthing's profit jumped more than 50-fold from 2000 to 2005 after it borrowed abroad to finance expansion. It acquired financial services companies FIH Erhvervsbank A/S of Denmark in 2004 and Singer & Friedlander Group of the U.K. in 2005.

Landsbanki purchased Teather & Greenwood and Kepler Equities of the U.K. and Merrion Capital Group of Ireland in 2005, as well as the U.K.'s Bridgewell Group Plc last year.

Glitnir's assets grew more than ninefold from 2002 through 2007 as it acquired Swedish financial services companies Fischer Partners and Tamm & Partners Fondkommission AB, and Finnish money-management firm FIM Group Oyj. The expansion forced Glitnir to rely heavily on wholesale markets, rather than deposits, for its funding needs.

Crossholdings

As the nation's banks grew, they helped fund a web of investment firms with stakes in other Icelandic companies.

Stodir, the Glitnir investor, also has holdings in insurer TM and real estate company Landic Property. Exista hf, a financial services firm, owns almost 25 percent of Kaupthing. Bakkabraedur Holding BV, owned by the founders of food maker Bakkavor Group, in turn owns 45 percent of Exista.

Landsbanki this week agreed to sell its European broking units, including Teather & Greenwood and Bridgewell, to Straumur Burdaras Investment Bank hf for 380 million euros.

Some Icelanders aren't shedding tears for Glitnir.

``They thought they could sit around inside all their buildings and keep on generating money on their computers,'' said Olafur J. Bjarnason, 61, a Glitnir customer. ``In the end, it is still hard work and diligence that creates value.''

To contact the reporter on this story: Niklas Magnusson in Stockholm at nmagnusson1@bloomberg.net; Helga Kristin Einarsdottir in Iceland at einarsdottir@bloomberg.net.

Last Updated: October 2, 2008 20:01 EDT