Credit Market Carnage

The credit market is in turmoil after the US Congress rejected the bail-out plan. That's bad news for all of us.

I woke up this morning expecting to see share prices fall still further in London. After all, the rejection of the US government's bail-out plan was pretty shocking. However, as I write, the FTSE-100 is slightly up today. The stock market never ceases to surprise me.

But it's a different story in the credit market. Things are indisputably bad there -- bad for us all.

Libor

The best way to measure the health of the credit market is to look at Libor.

So what is Libor?

Libor stands for the `London Interbank Offered Rate' and is the rate of interest at which banks borrow from each other in the London market. There are actually lots of different Libor rates depending on the currency and the duration of the loan -- that time period could be overnight or as long as a year.

Libor is set by the British Bankers' Association (BBA) and Reuters.  It's an average of the various rates being charged by various banks in the market. These averages are then announced to the markets shortly after 11AM. Sadly the general public don't get to see the numbers until later - at TMF HQ we can get the news from our funky Bloomberg terminal.

Does it matter?

Until recently, most of us could ignore Libor. Commercial banks were happily lending and borrowing between each other and all was right in the world. Normally sterling Libor would only make a truly dramatic move if the Bank of England changed its base rate.

But that's all changed. Bankers have become nervous and are reluctant to lend to any bank that looks as though it might go bust. That's what has triggered the credit crunch and things have got much worse since last night's misguided vote by the US Congress.

Twenty-four hours ago you could borrow dollars overnight at an interest rate of 2.57%. But since the US rejection, that figure has soared to 6.88%. That's an astonishing rise and shows how worried people are in the credit markets. Other interbank rates have also jumped although the rises aren't as high.

High interbank rates matter because they mean that some banks can't get cash to lend on to businesses and ordinary people. If businesses can't borrow, some will fold and the economy will head into serious trouble...

Going forward

Somehow, we've got to get banks to trust each other again. There was a chance that Paulson's rescue plan would have achieved that. I just thank my lucky stars that I'm not a politician or a central banker because I'm not sure what the solution is.

I'm just relying on my faith that we will muddle through in the end. Humans are good at that.

More: Four Steps To Protect Your Portfolio From The Financial Crisis