Financial crisis mounts as stocks fall

By Jack Reerink and Douwe Miedema

NEW YORK/LONDON (Reuters) – Shares of Wall Street firms Morgan Stanley and Goldman Sachs plummeted on Wednesday and Britain’s biggest mortgage lender neared a sale in the latest signs of extreme distress in the financial industry.

Tuesday’s surprise $85 billion (47 billion pound) rescue of insurer American International Group by the U.S. Federal Reserve did little to calm investors’ nerves, and U.S. stocks dropped as much as 4.1 percent.

The White House said it was “concerned about other companies” while the U.S. presidential candidates struck populist tones, with Sen. John McCain blasting Wall Street’s “casino culture” and Sen. Barack Obama stressing protection for mom-and-pop investors.

The Fed move capped a week of bailouts, a bankruptcy on Wall Street, and central banks around the world flooding the financial system with money to prevent it from seizing up.

The result: a seismic shift in the financial industry, with some of Wall Street’s biggest names disappearing overnight.

“The fear is who is next,” said John O’Brien, senior vice president at MKM Partners in Cleveland. “It almost feels like people scour the books and say who is the next likely target that we can put a short on. And that spreads continuous fear.”

Shares of Morgan Stanley and larger rival Goldman fell as much as 43 percent and 27 percent, respectively, even after both reported better-than-expected quarterly earnings on Tuesday.

“I’m assuming that Goldman Sachs and Morgan Stanley are lining up dancing partners. They don’t want to be … this week’s victim,” said William Larkin, fixed income manager at Cabot Money Management in Salem, Massachusetts.

The drama kept traders glued to their screens: In the capital of the hedge fund industry, Greenwich, Connecticut, an industry conference for 500 people had 200 empty seats.

“A lot of people who are seeing massive red ink and are suffering the most are not here,” said Jean de Bolle, the chief investment officer at Byron Advisors.

The cost of protecting Morgan Stanley’s and Goldman’s debt spiked, reflecting investor fears that their debt issues are no safer than junk bonds.

“The credit crunch and credit contraction is intensifying,” said Peter Boockvar, equity strategist at Miller Tabak & Co in New York. “The action in Morgan Stanley in light of what was better-than-expected numbers last night is disconcerting.”

Goldman spokesman Lucas van Praag said: “We think the markets will positively differentiate those financial institutions that have global, diversified business models and that outperformed through this crisis.”

Morgan Stanley spokeswoman Jeanmarie McFadden declined to comment.

PROPPING UP THE SYSTEM

In the latest sign of regulatory anxiety, the U.S. Securities and Exchange Commission curbed short-selling, or investor bets on declining share prices.

“Seems like the SEC is a day late on the rule … Morgan Stanley is clearly in the short-sellers’ sights,” said Andrew Brenner, senior vice president at MF Global in New York.

Other distress signals had popped up earlier: The cost of borrowing overnight dollars spiked above 10 percent, indicating a deep lack of trust spooking the interbank lending market in Europe.

And Bank of Ireland became the latest bank to cut its dividend, causing a sell-off in Irish banking shares.

Lloyds TSB was in advanced talks to buy domestic rival HBOS Plc to create a 28 billion pound mortgage giant.

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 shocking British government decision in February to take over troubled bank Northern Rock — the first major nationalization in Britain since the 1970s.

U.S. authorities also have moved to prop up the financial system.

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 — if asset prices do not slide further.

The week has already seen two legendary firms bite the dust: Lehman Brothers Holdings Inc filed for bankruptcy, and Merrill Lynch & Co threw itself into the arms of Bank of America.

Barclays gave Wall Street a small boost on Tuesday by agreeing to buy Lehman’s Manhattan headquarters and investment bank for $1.75 billion and taking aboard 10,000 staff.

YARD SALE AT AIG

AIG’s newly appointed chief, former Allstate CEO Edward Liddy, was poised to hold a big yard sale to pay off the Fed loan. There are plenty of interested bidders, AIG’s main regulator told business television channel CNBC.

AIG, which has businesses ranging from life insurance to airplane leasing in 130 countries, has a big incentive to raise cash: It is currently paying more than 11.4 percent interest on the $85 billion loan.

Japan’s cash-rich insurers and Australia’s top player, QBE Insurance, are seen as potential buyers. And then there is billionaire investor Warren Buffett.

“It wouldn’t surprise me to see him in the fray, though he might not want all the businesses,” said Michael Nix, a portfolio manager at Greenwood Capital Associates in Greenwood, South Carolina.

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 U.S. housing crisis deepened. The rescue kept AIG from surpassing Lehman as the largest corporate failure ever.

If it was meant to prevent a deepening of the credit crisis or sooth investors, it did not work.

“The system will remain unstable and fragile,” the chief executive of top bond fund Pimco, Mohamed El-Erian, told Reuters. “Further action will be required that targets both, and I stress both, institutions and the system as a whole. Otherwise, and as has been repeatedly the case in this crisis, seemingly bold policy actions will turn out to be too little, too late.”

(Additional reporting by Svea Herbst-Bayliss, Jon Stempel, Jennifer Ablan, Joseph Giannone, Jeffrey Hodgson and Kevin Plumberg; Editing by John Wallace and Maureen Bavdek)