Oct. 2 (Bloomberg) -- Interest rates on three-month dollar loans rose to the highest since January, short-term corporate borrowing fell by the most ever and high-yield loans tumbled, exacerbating the credit freeze that's paralyzing business around the world.

The London interbank offered rate that banks charge each other for loans rose for a fourth day to 4.21 percent, boosting the Libor-OIS spread, a gauge of cash scarcity among banks, to a record, while a drop in financial issuance caused the U.S. commercial paper market to tumble 5.6 percent to a three-year low, according to the Federal Reserve.

The crisis deepened after the worst month for corporate credit on record. Leveraged loan prices plunged to all-time lows, short-term debt markets seized up and even the safest company debt suffered the worst losses in at least two decades. Credit markets have frozen as financial institutions hoard cash to meet future funding needs amid deepening concern that more banks will collapse.

``The credit window is closed,'' Jim Press, president of Chrysler LLC, the third-largest U.S. automaker, said today at the Paris Motor Show. The financial rescue plan must be approved because ``it's important for us to restore credibility in our banking system.''

The U.S. Senate passed the Bush administration's bank-rescue package yesterday with inducements for the House of Representatives to approve the measure after an earlier version was rejected. The legislation, approved on a 74-25 vote, authorizes the government to buy troubled assets from banks rocked by record home foreclosures.

Stocks Fall

Stocks dropped for a second day as reports showed a worsening economy and Treasury yields fell as traders speculated central banks will have to cut interest rates to prevent a global recession. The Standard & Poor's 500 Index slid 33.63, or 2.9 percent, to 1,127.43 at 11:23 a.m. in New York. The yield on two- year notes tumbled 15 basis points, or 0.15 percentage point, to 1.66 percent at 10:09 a.m. in New York, according to BGCantor Market Data.

Interbank rates have soared as governments in Europe and the U.S. rescued six financial institutions in the past week. The Libor-OIS spread, the difference between the three-month dollar rate and the overnight indexed swap rate, widened to a record 260 basis points today. It was 197 basis points a week ago and 79 basis points a month ago.

Euro Libor

The Libor rate for euros advanced 3 basis points to a record 5.32 percent. Libor, set by 16 banks in a daily survey by the British Bankers' Association, is used to set rates on $360 trillion of financial products worldwide, from home loans to derivatives.

``We still see upward pressure on maturities from one week,'' said Patrick Jacq, a fixed-income strategist in Paris at BNP Paribas SA, France's biggest bank. ``The situation is still blocked and we're unlikely to see spreads decline before confidence has been restored.''

The market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 as banks and insurers were unable to find buyers for the short-term debt amid the worst U.S. financial crisis since the Great Depression. Financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7 percent, to a two-year low.

The market dropped for a third straight week, losing a total of $208 billion, as money-market funds faced withdrawals from investors, said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York.

Broad Purge

``The purge is broad and is impacting issuers with far more predictable cash flows -- regular run-of-the-mill companies in need of working capital,'' Crescenzi wrote today in a note to clients. ``The declines add to the urgency for fixes to the credit crisis and bolster the case for a Fed rate cut.''

The U.S. market for short-term debt backed by assets including mortgages and car loans fell $29.1 billion, or 3.9 percent, this week to a seasonally adjusted $724.7 billion, according to the Fed. Non-financial issuance was little changed, down $900 million to $199.1 billion.

Lenders are balking at offering cash for longer than a day even as central banks pump an unprecedented amount of money into the banking system. The European Central Bank today offered $50 billion of overnight funds at a marginal rate of 2.75 percent. The Swiss National Bank awarded $9 billion. The Bank of England sold $8.9 billion.

Futures traders put the odds that the Fed will cut the target interest rate at least 25 basis points later this month at 100 percent. The rate is currently 2 percent.

Leveraged loan prices tumbled 8.57 cents in September to a record low of 79.8 cents on the dollar. Price declines will make it harder for junk-rated companies to borrow as investors may opt to buy existing debt at distressed levels and as capital- constrained banks restrict lending.

Corporate bonds with the highest AAA ratings lost 6.5 percent in September, the most since at least 1989, according to Merrill Lynch & Co.'s U.S. Corporates, AAA Rated index.

To contact the reporter on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net

Last Updated: October 2, 2008 11:36 EDT