Barclays (BARC.L) emerged as a potential buyer of some of felled investment bank Lehman Brothers' assets, as the financial sector carnage spread on fears American International Group (AIG.N) could be the next to fall.
Barclays, the UK bank that pulled out of emergency talks to save Lehman (LEH.P) over the weekend, is in talks to buy the investment bank's core U.S. broker-dealer business, people familiar with the matter told Reuters on Tuesday.
But concerns intensified that AIG, once the world's largest insurer by market value, could be the next victim after a ratings downgrade, causing a rout in stock markets already battered on Monday after Lehman sought bankruptcy protection.
"We expect near-term weakness for the European banks as markets digest the systemic consequences of the failure ... we are undeniably more cautious following the weekend's events," Keefe, Bruyette & Woods said in a note.
Leading European stock indices were down between 1.4 and 2.2 percent in morning trading. The Dow Jones Stoxx banking index (.SX7P) was 3 percent weaker by 4:09 a.m. EDT. UBS (UBSN.VX) fell 9.6 percent, HBOS (HBOS.L) lost 11.5 percent, and Barclays was 2.9 percent lower.
AIG's illiquid shares (AIG.DE) on the Frankfurt stock exchange were 4.8 percent off.
Asian share markets, many of them closed for a holiday on Monday, tumbled as investors absorbed the weekend's dramatic events on Wall Street, where Merrill Lynch (MER.N) agreed to be sold to Bank of America (BAC.N) for $50 billion.
Shares in AIG plunged nearly 61 percent on Monday and the U.S. Federal Reserve hired investment bank Morgan Stanley (MS.N) to review options for the firm, a person familiar with the situation said on Monday.
AIG has lost 92 percent of its value this year.
BRITS STEP IN
Barclays -- which quit frantic talks over the weekend to rescue Lehman after U.S. authorities failed to guarantee trading obligations -- is now looking to buy Lehman's U.S. broker-dealer business, including equity, fixed income, M&A advisory and other parts, the sources said.
The talks mainly involve the core U.S. business, with 8,000 to 10,000 staff, but could include some of its global businesses, the sources said, and a deal could save thousands of jobs and many of the core investment bank operations.
There is an urgency to the talks, as a deal would need to be struck before staff and clients leave and damage the franchise, the sources also said.
But markets focused on AIG's ratings downgrade, which could force it to post more collateral and nullify insurance contracts, possibly setting in motion a chain reaction that could threaten its survival.
"You don't just have a potential impact on the reinsurer side, you have it on the institutions that might be holding AIG paper," said Lorraine Tan, director of research for Asia at debt rating agency Standard and Poor's in Singapore.
"This would have a much bigger impact than a bank going down like Lehman or Bear (Stearns) or even a Wachovia (WB.N) or WaMu in the U.S. AIG has a much bigger presence globally. Their reach to a global customer base is quite sizable," she said.
Top U.S. savings and loan Washington Mutual Inc (WM.N) saw its rating cut to "junk" status by Standard & Poor's amid concerns about mortgage losses. Its shares slid in after-hours trading after a 27 percent drop in the regular session.
Moody's Investors Service cut AIG's rating to A2 from Aa3, a two-notch downgrade. S&P lowered the rating to A-minus from AA-minus, a three-peg reduction, and Fitch Ratings reduced its standing to A from AA-minus, a two-notch cut.
AIG's ratings are still investment grade, although all three agencies said more downgrades could follow.
Again seeking a private solution to Wall Street's woes, the Fed had asked JPMorgan Chase & Co (JPM.N) and Goldman Sachs Group Inc (GS.N) to explore arranging $70-$75 billion in loans to support AIG, among other financing options, another person familiar with the situation said.
AIG turned to the Fed late on Sunday after failed talks with several buyout firms and Warren Buffett's Berkshire Hathaway (BRKa.N). The company has also said it was exploring asset sales.
MARKETS TUMBLE
European credit spreads widened sharply early on Tuesday, surpassing last session's high, after AIG's downgrade.
By 0900 GMT, the investment-grade Markit iTraxx Europe index
was at 143.5 basis points, according to data from Markit, 18.5 basis points wider versus late on Monday.
"The second leg of the subprime crisis has begun," Jun Kwang-woo, head of South Korea's Financial Services Commission told reporters. "It could be painful but a recovery, once in place, may be rapid."
Asian stocks tumbled across the board, with Tokyo (.N225) down more than 5 percent at a three-year low.
Japanese government bond futures jumped by their daily limit of three full points as investors fled to safe havens, while Japan's central bank said it would strive to maintain stability in financial markets.
Darkening one of the few bright spots from the weekend's mayhem, Bank of America -- which would surpass Citigroup Inc (C.N) as the largest U.S. bank by assets with the planned takeover of Merrill -- saw its shares plunge by 21 percent.
"The concern for Bank of America is the debt that they are acquiring," said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco.
The state of New York, where AIG is based, sought to bolster the stricken insurer with a complex asset swap giving it a $20 billion lifeline, but its longer-term rescue depended on additional funding.
