AIG rescue signals to Wall St that crisis not over

DETROIT (Reuters) - The U.S. government's eleventh hour $85 billion (47 billion pound) rescue loan for American International Group was billed late on Tuesday as a way to prevent a broader collapse and ease nerves on Wall Street. But instead, it fuelled panic the financial crisis may be far from over.

"We have seen two major failures this week and investors are simply not sure if it's going to end with AIG and Lehman Brothers)," said Cleve Rueckert, a research analyst at Birinyi Associates.

"There is a lack of confidence in any of the solutions the Fed and the government have come up with so far. Investors fear a vicious downward spiral," he added.

Coming just days after Lehman's collapse -- the largest U.S. bankruptcy ever -- and the fire sale purchase of Merrill Lynch by Bank of America, the Fed's largess saw other financial stocks in particular take an absolute pasting.

Morgan Stanley shares plummeted as much as 43 percent on Wednesday, while those of larger rival Goldman Sachs dropped as much as 27 percent.

Overall, U.S. stocks dropped more than 4 percent. U.S. gold futures -- a safe haven investment in times of uncertainty, ended up 9 percent. U.S. one-month Treasury bill yields fell to zero as investors fled to ultra-short dated government paper out of riskier assets.

The problem stems from persistent concerns about the stability of the global banking system, which is heavily exposed to the faltering U.S. mortgage market. In fact, what investors are now facing is an unwinding of the so-called "shadow banking system." This system consists of all the levered investment conduits, vehicles and structures created by major investment banks that are now facing major liquidations.

"The reason that Goldman Sachs, Morgan Stanley and many of the other (financial institutions) are still under attack is because nobody really knows how to value these firms now," said Donald Straszheim, Vice Chairman of Roth Capital Partners.

Straszheim said the strategy of financing too many risky assets with too little capital -- a lovely profit driver for banks such as Lehman when times were good -- has turned into a killer now as the U.S. housing crisis has soured those assets.

TOO LITTLE, TOO LATE?

The uncertainty among investors has been compounded and magnified by the blistering pace at which the financial crisis has deepened -- Lehman's failure, Merrill's sale and the AIG bailout have all come in under a week.

"What would normally take any other industry years to achieve such sweeping restructuring and consolidation has for (the) financial industry been violently compressed into literally days, and in some cases hours," Bernard Baumohl, Managing Director and Chief Global Economist of The Economic Outlook Group LLC wrote in a research note.

"This face-flattening acceleration of major acquisitions, historic failures and unprecedented bailouts has caused much anxiety, confusion and for many investors a bad case of vertigo."

The uncertainty has caused many investors to panic.

"We're in the sell first ask questions later scenario and that is clearly what is going on with Morgan Stanley and Goldman Sachs," said John Schloegel, vice president of investment strategies for Capital Cities Asset Management. "I don't even know anymore ... I am still stunned after the AIG news on Monday and here we are on Wednesday and nobody can catch up with it."

Some investors complain the U.S. government has worsened the problem by always being one step behind the crisis.

"The system will remain unstable and fragile," said Pimco Chief Executive Mohamed El-Erian. "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."

Others maintain the Fed's move to nationalize AIG by taking a 79.9 percent equity stake in exchange for the rescue loan was flat out wrong and the insurer should have been left to fail as should the banks that lent irresponsibly during the recent housing boom.

"We need this collapse to purge the economy of the excesses of recent years," said Peter Schiff, president of Euro Pacific Capital Inc. "The banks loaned too much money to people who couldn't pay it back.

"People have only now realized just how bad the situation really is and that's what you're seeing on Wall Street. The chickens have come home to roost."

(Additional reporting Jennifer Ablan and Kristina Cooke; Editing by Andre Grenon)