Sept. 16 (Bloomberg) -- Credit markets seized up as the collapse of Lehman Brothers Holdings Inc. and downgrades of American International Group Inc. drove the cost of borrowing in dollars overnight to the highest level since 2001.

The London interbank offered rate, or Libor, that financial institutions charge each other for loans soared 3.33 percentage points to 6.44 percent today, according to the British Bankers' Association. The increase was the biggest in its history. The rate was as low as 2.07 percent in June.

Banks are raising 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 today 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 that started in August 2007 when banks became wary of lending to institutions holding securities tied to U.S. subprime mortgages, claimed Lehman as its biggest victim when the fourth-largest U.S. securities firm filed for bankruptcy yesterday.

Figuring Out Losses

The New York-based company was one of the 10 largest traders of credit derivatives, according to Fitch Ratings. It may take until next year for investors to figure out how much they have lost on derivatives trades with Lehman, said John Jay, a senior analyst at Boston-based Aite Group, a financial- services consulting firm.

Derivatives are financial instruments linked to stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather.

Standard & Poor's, Moody's Investors Service and Fitch all cut their ratings on AIG yesterday. AIG probably has one day to raise $75 billion to $80 billion, New York Governor David Paterson said today on cable-television channel CNBC. A collapse would be felt beyond the insurance industry, he said.

``They have tentacles into everything, and they are certainly critical to the ongoing health of the financial markets, or lack of health,'' said Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, which manages about $150 million in assets.

AIG tumbled as much as 74 percent in New York trading today, bringing its decline this year to more than 94 percent.

Losses, Writedowns

Since the start of last year, the world's biggest financial institutions posted almost $515 billion in subprime-related losses and writedowns. Eleven U.S. banks collapsed since January. Corporate bond sales in the U.S. and Europe have slumped 42 percent from a year ago, according to data compiled by Bloomberg.

Libor, set by 16 banks including Citigroup Inc. 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.

Concern about turmoil in the financial markets drove investors to the safety of government debt, pushing the yield on the 10-year Treasury note fell to the lowest level in five years. 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 all traded at records.

`Like a Heart Attack'

Other parts of the credit market suffered, with average yields on overnight U.S. commercial paper backed by assets such as credit cards and car loans jumping 54 basis points to 3.45 percent, the highest since March. The extra yield investors demand to hold U.S. investment-grade bonds instead of Treasuries rose 36 basis points yesterday, the biggest one-day increase on record, and the spread on European financial company debt climbed 26 basis points, the most since at least 1999, according to Merrill Lynch & Co. indexes.

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

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 difference between what banks and the U.S. Treasury pay to borrow for three months, the so-called TED spread, widened almost 49 basis points in the past two days to 201 basis points. It was about 50 basis points before the credit crisis began.

In the U.S, the overnight rate for loans fell as the Fed added $50 billion in temporary reserves to the banking system today through repurchase agreements, or repos. The fed funds rate declined as low as 2 percent, after opening at 3.75 percent, according to ICAP Plc, the world's largest inter-dealer broker. The rate has climbed back to 4 percent.

Other central banks pumped cash into money markets. 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).

`All a Mess'

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.''

Banks began to hoard cash when rising defaults on subprime mortgages led two Bear Stearns Cos. hedge funds to seek bankruptcy protection on July 31, 2007. To avert further money- market dislocations the Fed in March backed JPMorgan's takeover of Bear Stearns, which was on the verge of collapse. On Sept. 7, the Treasury seized control of Fannie Mae and Freddie Mac, the two biggest U.S. mortgage-finance companies, after federal examiners found the companies' capital was too thin and of low quality.

The Fed declined to offer similar backing to a rescue of Lehman at the weekend, forcing the 158-year-old firm into bankruptcy after both Barclays Plc and Bank of America Corp. pulled out of talks.

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 13:19 EDT