Financial Crisis Is Showing No Signs of Ending Soon

Wall Street plunged to a three-year low Wednesday as the bailout of insurer AIG failed to calm fears that the financial crisis enveloping global markets would just keep escalating.

But late news of possible deals involving Morgan Stanley and Washington Mutual might help ease market jitters on Thursday.

As the Wall Street meltdown ended its third day, the Dow fell nearly 450 points, while Europe closed sharply lower and Asia ended mixed.

The US dollar fell, while oil prices rebounded sharply. Gold, meanwhile, staged its biggest rebound ever.

Rattled investors are now worried about which financial institution will be the next to fall after the AIG bailout, the bankruptcy of Lehman Brothers and the purchase of Merrill Lynch by Bank of America .

The two remaining Wall Street investment banks, Morgan Stanley and Goldman Sachs Group , saw their shares plunge on lingering worries about their ability to remain independent.

Late Wednesday, Morgan Stanley was said to be considering a merger with Wachovia or another bank. Among those other banks was China's Citic.

Also, Washington Mutual , the struggling savings and loan, has put itself up for auction, the Times said.

Strategists, meanwhile, said that the turmoil so far threatens to go beyond the financial services sector, hurting corporate profits and spreading panic among increasingly overstretched consumers. Already, banks are increasingly reluctant to lend to one another.

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"What does tomorrow bring? Will it start spilling over into consumers? Will there be runs on the banks? There's a million things going on," said Angel Mata, managing director of listed equity trading at Stifel Nicolaus Capital Markets. "Hopefully, we'll see a capitulation soon when everybody throws in the towel."

Late Tuesday night, the Federal Reserve said the New York Fed bank will lend up to $85 billion to AIG in a plan aimed at saving the insurer from a "disorderly failure" that could wreak economic havoc.

But on Wednesday, investors doubted whether the rescue plan would be enough, sending AIG shares sharply lower.

The Fed move was the latest in a string 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.

Is your money safe? Watch video at left.

Also worrying investors was news on Tuesday that the Reserve Primary Fund, a money-market mutual fund, fell below $1 a share in net asset value because of losses on debt issued by now-bankrupt Lehman Brothers Holdings. (Is your money-market fund safe? Click here to find out.)

"Every investor is now questioning each and every investment they have anywhere on the planet," said John Schloegel, vice president of investment strategies at Capital Cities Asset Management in Austin, Texas. "It's leading them to sell anything that has any type of risk -- to sell first. It's an unusual situation we are in right now."

A break below important technical support for both the Dow and S&P 500 accelerated the market's slide, traders said.

The bank-to-bank cost of borrowing overnight dollars fell more than a percentage point Wednesday, but the premium paid for the greenback and sterling over three months swelled, fanning fears that the supply of credit might be drying up in the global financial system.

The drop in Morgan Stanley's shares came despite the bank's posting quarterly results that beat Wall Street's estimates.

Banks frantically seeking dollar funds have been stonewalled by others increasingly reluctant to lend amid uncertainty and nervousness following the collapse of Lehman Brothers and the bailout of AIG.

The U.S. Securities and Exchange issued new rules governing the conduct of people who profit from stock declines as shares of major financial institutions plummeted on fears of a global credit crunch.

Ripple effects of the credit crisis. See video at left.

The three SEC rules cover shares of all publicly traded companies and follow a brief emergency rule this summer that was aimed at curbing illegal short selling in 19 major financial stocks.

The AIG rescue came just two days after U.S. authorities refused to rescue investment bank Lehman Brothers. The Fed stepped in amid worries that a collapse of AIG could cause far-reaching damage to the global financial system.

"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."

But others worried that the rescue of AIG brings short-term relief but may lead to other problems down the road.

• Slideshow: Victims of the Credit Crunch—So Far

"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, chief investment offer for Asian equities with Fortis Investments in Hong Kong.

AIG's lifeline bought time for investors to confront unprecedented financial turbulence that has altered the shape of Wall Street, but did little to ease a funding squeeze. The cost of borrowing rose sharply, indicating a deep lack of trust among banks after Lehman Brothers filed for bankruptcy protection.

The rescue of AIG, whose failure would have been larger than Lehman, comes on the heels of a government bailout just over a week ago of mortgage finance companies Fannie Mae and Freddie Mac. It also comes six months after the Fed helped to finance the fire sale of failed investment bank Bear Stearns to JPMorgan Chase.

The move comes at a sensitive time given job losses and tax rates are key issues in the battle for the White House between U.S. Senators John McCain and Barack Obama.

AIG will pay interest at a steep 8.5 percentage points above the three-month London Interbank Offered Rate, equal to about 11.4 percent.

That gives AIG a big incentive to embark on a massive asset sale program to pay back the loan quickly.

"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.

—Reuters contributed to this report.

© 2009 CNBC