It’s happened. Credit is now frozen solid in the wake of the unprecedented events of the past two weeks. Banks have been caught like deer in the headlights of serial financial failures, rescues, and nationalizations (including Lehman Brothers (NYSE:LEH) and AIG (NYSE:AIG), to name only the most recent) on a scale that harks back to the crash of 1929.

The chaos and fear reached new heights this week as the banking community was on a deathwatch for Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), and a money-market fund manager announced they would “break the buck.” Back on Main Street, individual investors are left pondering what it all means and, more importantly, what it means for them.

When the music’s over, turn out the lights
In a 2007 interview with the Financial Times, then Citigroup (NYSE:C) CEO Chuck Prince notoriously encapsulated bankers’ insouciance and irresponsibility at the height of the credit bubble, saying: “When the music stops in terms of liquidity, things will be complicated … We’re still dancing.”

He didn’t get it all wrong: “Things” are now very complicated, for bankers and for the rest of us, as all “dancers” cleared the dance floor this week, sidelined by a fear of ruin that tore through the financial community like an earthquake. The shock waves are still being felt despite central bankers’ best efforts to stabilize the short-term funding markets.

Did you say negative interest rates?
Wednesday, a flood of investor-refugees swamped the safe haven of the U.S. Treasury market, bidding up three-month Treasury bills above their face value so that yields briefly turned negative, something not seen since 1940. (Investors normally purchase T-bills at a discount to their face value and receive the full face amount at maturity.)

In other words, the U.S. government was able to borrow money from investors and get paid for the privilege! Although the yield on three-month T-bills is no longer negative, it closed Thursday at a measly 0.08%, down from 1.55% last week; that’s equivalent to receiving 80 cents in interest on a $1,000 one-year loan.

These disruptions followed Tuesday’s session, during which the overnight LIBOR rate more than doubled to 6.44%. (LIBOR: London Interbank Offered Rate, the interest rate London banks charge each other in the interbank market. Well over a fifth of all interbank lending takes place in London!) Even banking stalwarts, such as Bank of America (NYSE:BAC) and UBS (NYSE:UBS), which don’t look ready to fail, reported overnight borrowing rates in excess of 6%. Longer-term LIBOR rates also rose sharply.

“That’s fascinating,” you’re thinking, “but why should I care at what rate a bunch of Johnny-Foreigner bankers decide to lend money to each other?” It’s a legitimate question, which I’ll get to in just a moment.

LIBOR: It’s not just about the bankers
Although yesterday’s announcement that the Fed and other central banks would pump $180 billion in liquidity into the financial system brought the overnight LIBOR rate down, longer-term LIBOR rates remained high.

If that persists, it will entail increases in the borrowing cost of individuals and companies that have debt with a floating rate indexed on LIBOR. Although that may sound like an abstraction, 6 million mortgages in the U.S. are in that category, including nearly all subprime mortgages and over 40% of prime adjustable-rate mortgages. Maybe you can see where I’m going with this.

A LIBOR pop quiz
Try your hand at the following quiz to see whether you can trace the mechanism by which a disruption in the interbank market can ripple through the financial markets and the broader economy. Complete the two paragraphs below by choosing the missing words from two choices:

A sustained increase in the LIBOR rate would entail [1] (higher/lower) mortgage resets, making it [2] (even harder/easier) for mortgage borrowers to meet their payments. That, in turn, would [3] (fuel/reduce) loan delinquency and home foreclosure rates and [4] (weigh on/boost) home prices.

As home prices [5] (continue to drop/rise), mortgage-related securities [6] (gain in/lose) value, forcing banks to take [7] (more/fewer) writedowns on their holdings. As bank losses -- and failures -- mount, banks become increasingly [8] (unwilling/willing) to lend to each other, out of fear that the borrower may be the next domino to fall. That fear prompts them to demand punitive lending rates, pushing the LIBOR rate up. Presto! We’ve come full circle in this destructive cycle.

(Answers: [1] higher; [2] even harder; [3] fuel; [4] weigh on; [5] continue to drop; [6] lose; [7] more; [8] unwilling)

The ugly, the bad, and the good
As we’ve seen, a malfunctioning interbank market can have a direct adverse effect on the ability of businesses and individuals to obtain credit, and on their cost of borrowing. Furthermore, it limits the ability of the Fed to implement monetary policy, as the relationship between the interbank rate and the Fed funds breaks down. (Worse, there is evidence to suggest that a new lending facility the Fed introduced in December 2007 to alleviate stresses on the interbank market is ineffective in lowering longer-term LIBOR rates.)

This week’s shocks are uncomfortable for all investors and will be particularly painful for certain participants, but they are also useful in getting us one step closer to the end of this crisis. Once every drop of fear has been wrung out of the market, prices will find a bottom as banks and investors begin to price risk and assets with a clear head and an eye strictly on the fundamentals.

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Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.