Sept. 16 (Bloomberg) -- The cost of borrowing in dollars overnight more than doubled to the highest since 2001 as the collapse of Lehman Brothers Holdings Inc. and credit downgrades of American International Group Inc. led banks to hoard cash.

The London interbank offered rate, or Libor, that financial institutions charge each other to borrow soared 3.33 percentage points to 6.44 percent today, its biggest jump in at least seven years, according to the British Bankers' Association. The rate was as low as 2.07 percent in June.

Banks are driving up short-term lending rates on concern that AIG, the biggest U.S. insurer, will follow Lehman into bankruptcy and leave financial institutions with losses on $441 billion of credit derivatives. Central banks around the world pumped more than $210 billion into the financial system as they sought to alleviate the credit-market seizure.

``It's fear,'' said Imke Jersch, a senior money-market trader in Hanover at Norddeutsche Landesbank Girozentrale AG, Germany's fourth-biggest state-owned bank. ``You don't know who has exposure and who might not be getting their money anymore. It's a domino effect. You never know who might fall next.''

The credit freeze started in August 2007 when banks became wary of lending to institutions holding securities tied to U.S. subprime mortgages. Since the start of last year, the world's biggest financial institutions have posted almost $515 billion in losses and writedowns. Eleven U.S. banks have collapsed since January.

Shares Tumble

AIG tumbled as much as 74 percent today, taking its decline this year to more than 94 percent. Standard & Poor's yesterday cut the insurer's long-term counterparty rating three grades to A-, citing ``reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses.''

The reductions occurred after two people familiar with the situation said AIG is seeking $70 billion to $75 billion in loans arranged by Goldman Sachs and JPMorgan Chase & Co. to replenish capital. The insurer may get government assistance to avert a collapse, CNBC reported today, without saying where it got the information.

The yield on the 10-year Treasury note fell to the lowest level in five years as investors sought the safety of government debt. The cost of buying protection against default by Wall Street banks soared, as credit-default swaps on Morgan Stanley, Goldman Sachs Group Inc. and Citigroup Inc. all traded at records. Average yields on overnight U.S. commercial paper backed by assets such as credit cards and car loans jumped 54 basis points to 3.45 percent, the highest since March.

`Like a Heart Attack'

``I have never seen anything remotely like this. The money market was typically the one thing that always worked,'' said Luca Jellinek, head of interest-rate strategy in London at Royal Bank of Scotland Group Plc. ``It's the cardiovascular system of the financial body. When this happens, it's like a heart attack.''

Libor, set by 16 banks including Citigroup and UBS AG in a daily survey by the British Bankers' Association, is used to calculate rates on $360 trillion of financial products worldwide from home loans to credit derivatives.

The difference between the Libor for three-month dollar loans and the overnight indexed swap rate, the Libor-OIS spread that measures the availability of funds in the market, widened 12 basis points to 117 basis points, the most since at least December 2001. That compares with an average of 8 basis points in the 12 months to July 31, 2007, before the credit squeeze started.

Cash Injections

The Fed added $50 billion in temporary reserves to the banking system today through overnight repurchase agreements, or repos. The European Central Bank offered 70 billion euros ($100 billion) in a one-day refinancing operation and the Bank of England injected 20 billion pounds ($36 billion). The Bank of Japan added 2.5 trillion yen ($24 billion) and the Reserve Bank of Australia injected A$1.85 billion ($1.5 billion).

Traders raised bets the Fed will cut interest rates at a meeting today to buoy markets. Futures on the Chicago Board of Trade showed a 90 percent chance the central bank will lower its 2 percent target rate by a quarter-percentage point, compared with 68 percent yesterday and no chance a week ago. Policy makers are scheduled to announce their decision at 2:15 p.m. in Washington.

``It's all a mess out there, it's unbelievable, it's very tough,'' said Padhraic Garvey, head of investment-grade strategy in Amsterdam at ING Bank NV. ``There really is no sign of this going away. If the Fed were to cut rates, it's not necessarily going to solve anything.''

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Kim-Mai Cutler in London at kcutler@bloomberg.net

Last Updated: September 16, 2008 11:19 EDT