Shares of Wall Street firms Morgan Stanley and Goldman Sach plummented on Wednesday and the UK's biggest mortgage lender, HBOS Plc, looked set to be bought as signs of financial industry distress abounded.
Tuesday's $85 billion rescue of insurer American International Group, did little to calm nerves on Wall Street and around the world.
The cost of borrowing overnight dollars spiked above 10 percent, indicating a deep lack of trust spooking the inter-bank lending market in Europe.
And Bank of Ireland became the latest bank to cut its dividend, causing a sell-off in Irish banking shares.
Shares of the two largest U.S. investment banks, Goldman and Morgan Stanley, fell 11 percent and 16 percent respectively in early trading, even after both reported better-than-expected earnings on Tuesday.
The cost of protecting their debt also spiked.
AIG's newly appointed chief, former Allstate CEO Edward Liddy, was poised to hold a big yard sale to pay off the $85 billion loan from the U.S. Federal Reserve.
AIG, which has businesses ranging from life insurance to airplane leasing in 130 countries, is currently paying more than 11.4 percent interest on the loan.
Top-tier companies have shown keen interest in buying assets from AIG, New York's insurance regulator told business television channel CNBC.
Shares of HBOS whipsawed after news that it was in merger talks with Lloyds TSB.
The talks underscore how quickly authorities around the world are ditching long-held beliefs about free markets and competition as they seek to counter the credit crunch.
Lloyds, for example, was previously blocked from buying a smaller mortgage bank.
Then there was the shock British government decision in February to put Northern Rock into public hands — the first major nationalisation in Britain since the 1970s.
U.S. authorities also have moved to prop up the financial system.
BARCLAYS SWOOPS
The AIG rescue comes just over a week after the bailout of mortgage finance companies Fannie Mae and Freddie Mac, and six months after the Fed brokered the sale of failed investment bank Bear Stearns to JPMorgan Chase.
AIG's bailout brings to about $900 billion the total of U.S. rescue efforts to stabilize the financial system and housing market. Authorities may get much of that money back provided asset prices don't slide further.
British bank Barclays Plc gave Wall Street a small boost on Tuesday by agreeing to buy Lehman Brothers Holdings Inc's Manhattan headquarters and investment bank for $1.75 billion and taking aboard 10,000 staff.
The week has already seen two legendary Wall Street firms bite the dust, with Lehman filing for bankruptcy and Merrill Lynch throwing itself into the arms of Bank of America.
Barclays stock rose 10 percent but major European stock indices turned lower after Wall Street slid at the open.
AIG's lifeline bought time for investors to confront unprecedented financial turbulence that has altered the shape of Wall Street.
"Thank God," exclaimed Daniel Fuss, an influential bond manager who oversees more than $100 billion at Loomis, Sayles & Co in Boston. "AIG is interwoven with so many people and touches many companies around the world. This is a huge relief to many parts of the financial markets."
The Fed stepped in amid worries that a collapse of AIG could cause far-reaching damage to the global financial system, although some market players argued that the government's move brings just short-term respite and could do long-term harm.
"What the U.S. government is doing is basically delaying the recovery of the economy really by keeping AIG alive and by going back to the printing press to issue more U.S. dollars, which long-term should be negative to the U.S. dollar," said Ronald Chan, head of Asian equities at Fortis Investments in Hong Kong, where he oversees $1.5 billion.
On Tuesday, U.S. stocks clawed back from their largest one-day drop in seven years on speculation about the AIG and Lehman deals.
SENSITIVE TIMING
The rescue kept AIG from surpassing Lehman as the largest corporate failure ever.
The move comes at a sensitive time given job losses and tax rates are key issues in the battle for the White House between senators John McCain and Barack Obama.
"In current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said in a statement.
AIG faced a cash crunch after $18 billion of losses over three quarters, largely because of complex securities that are tied to mortgages, and which plunged in value as the nation's housing crisis deepened.
Investors and credit rating agencies grew more doubtful that AIG could offset its losses with enough capital, which became prohibitively costly to raise as its share price plunged.
