---
In the past few weeks, as European banks started disclosing the level of their potential losses from buying US subprime assets, two things broke down. First, the various money-market funds started facing redemptions once it turned out they too had exposure to derivatives written on US subprime assets. They then had to stop purchasing ABCP and CP in the market, putting the onus on banks to carry the entire burden.
Banks, of course, were the main sponsors of SIVs, although some of the largest ones facing the biggest issues now are actually run by non-bank financial entities such as brokers and hedge funds. In any event, once the SIVs could no longer fund themselves in the CP market, their game was up - their assets were illiquid because of the current level of losses in the underlying securities (borrowers defaulting on their obligations much more frequently than was initially assumed, which helps to drive the price of derivatives down a whole lot faster).
This meant that many bank-sponsored SIVs had to be absorbed by their sponsors, which in turn caused the banks to record both investment losses and stretch their capital. Under the rules of global banking, having assets ranging from loans to derivatives attracts various degrees of capital requirement to ensure that banks have enough of their own equity at stake in investments rather than only risking the money from depositors or other banks that help to fund their own book. When risky assets are purchased wholesale, no one knows for sure how valuable these assets are and therefore how much loss the banks have to take.
In this environment, banks stopped trusting one another. LIBOR has jumped well past the circuit-breakers such as penal overnight borrowing that exist, because of this lack of trust. Even as the US Federal Reserve cut its discount rate to just 50 basis points over the target rate, banks found it difficult to convince one another of their stability and solvency.
http://www.atimes.com/atimes/Global_Economy/II08Dj02.html