Traders on the floor of the New York Stock Exchange watch the Federal Reserve decision on interest rates, September 16, 2008.

Wall Street dealmaking reached fever pitch, with Morgan Stanley holding preliminary sale talks, while other financial firms scrambled to find buyers as fear gripped markets, sending Asian stocks sharply lower.

With the financial landscape undergoing its most dramatic transformation since the Great Depression, potential takeovers lurked for No. 2 U.S. investment bank Morgan Stanley (MS.N), weakened top U.S. savings bank Washington Mutual (WM.N) and major UK mortgage lender HBOS (HBOS.L).

Panicked matchmaking followed the surprise $85 billion rescue of insurer American International Group (AIG.N) by the U.S. Federal Reserve on Tuesday that did little to calm investors’ nerves.

The MSCI index of Asia stocks excluding Japan fell 3.9 percent, while Tokyo shares were 3.6 percent lower. Hong Kong was especially hard-hit, with the Hang Seng index falling 6.6 percent in late morning.

“After the bailing out of AIG failed to reassure the market, it is difficult to imagine what could really stop the un-orderly deleveraging that is going on,” French investment bank Calyon said in a Thursday note.

Morgan Stanley was discussing a merger with U.S. regional banking powerhouse Wachovia (WB.N), while CNBC reported that London-based HSBC Holdings (HSBA.L)(0005.HK) and Chinese state financial conglomerate CITIC group were also eyeing the venerable Wall Street firm.

The Government of Singapore Investment Corp (GIC) said it would consider all possibilities, including taking a stake in Morgan Stanley if approached.

A Morgan Stanley spokesman in Hong Kong declined to comment. A spokeswoman at HSBC, which this week became the world’s biggest bank by market value, also declined to comment. A CITIC official could not immediately be reached in Beijing.

Shares in Industrial and Commercial Bank of China (1398.HK), which had been the world’s most valuable bank until being surpassed by HSBC on Wednesday plunged 13.5 percent.

“Stop The Insanity,” pleaded a research note from Swiss bank UBS as U.S. financial shares appeared to be in free-fall. The U.S. stock market plunged 4.7 percent to a three-year low and the dollar slumped, while gold and oil soared.

The system of lending between big banks was essentially frozen by cash hoarding and distrust, creating crises of liquidity and confidence. Overnight U.S. dollar lending rates have soared this week and traded as high as 8.5 percent on Thursday.

Japan and Australia pumped an additional $17 billion into money markets on Thursday to prevent banks from hoarding cash.

“Banks are reluctant to lend money to each other, everybody seems to sit on stockpiles of cash,” said Markus Ammann, a trader at Bayerische Hypo und Vereinsbank in Hong Kong.

The AIG rescue capped a week of bailouts, bankruptcy and moves by central banks around the world to flood the financial system with funds to prevent it from seizing up.

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

“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.”

’ANYTHING’S POSSIBLE’

The U.S. Securities and Exchange Commission stepped in to curb short-selling, but share slumps stoked talk that Wall Street’s two surviving investment banks may have to join up with a commercial bank to survive.

Morgan Stanley CEO John Mack got a phone call from Wachovia on Wednesday but is also pursuing other options, the New York Times reported.

“In this market, anything’s possible. It seems like the market wants the investment banking model to disappear,” said Danielle Schembri, a bond analyst covering brokers at BNP Paribas in New York.

Washington Mutual, beleaguered by mortgage losses, put itself up for sale, sources familiar with the situation said. Potential suitors include Citigroup (C.N), JPMorgan (JPM.N), Wells Fargo (WFC.N) and HSBC.

“I think there’s going to be a lot of mergers and acquisitions for either good reasons or because people don’t have choices,” said Wells Fargo Chairman Richard Kovacevich.

He said his company was “buying with both hands” and said that he felt “like a kid in a candy store” given the distressed state of financial assets, but he declined to comment on targets.

In Britain, Lloyds TSB (LLOY.L) struck a deal to buy major mortgage lender HBOS for 12 billion pounds in stock ($22 billion), a source familiar with the situation said.

The merger mania spread to other trading businesses. U.S. power firm Constellation Energy (CEG.N) was talking to potential suitors after its shares fell 58 percent this week on investor concerns the credit crisis has hurt its power trading.

CREDIT CRUNCH

As banking shares imploded, the White House said it was “concerned about other companies.”

On the U.S. presidential campaign trail, John McCain blasted Wall Street’s “casino culture” and Barack Obama stressed protection for mom-and-pop investors.

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

Morgan Stanley’s Mack blamed short sellers, or investors who bet on falling stock prices, saying in an internal memo: “We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.”

The U.S. government was looking to raise $40 billion to boost the Fed’s firepower as a major U.S. money market fund “broke the buck,” or fell below $1.00 a share — a rare event that has the potential to panic retail investors.

“When the $1.00 value of money funds is questioned, that’s as scary as it gets,” said David Reilly, director of portfolio strategies at Rydex Investments in Rockville, Maryland.

U.S. authorities have spent $900 billion to prop up the financial system and housing market. Authorities may get much of that money back — if asset prices do not slide further.

The AIG rescue came just over a week after the bailout of mortgage finance companies Fannie Mae (FNM.N) and Freddie Mac (FRE.N), and six months after the Fed brokered the sale of failed investment bank Bear Stearns to JPMorgan Chase (JPM.N).

Two legendary firms bit the dust over the weekend. Lehman Brothers Holdings Inc (LEH.N) filed for bankruptcy and Merrill Lynch & Co (MER.N) CEO John Thain struck a deal to sell out to Bank of America Corp (BAC.N).

Source: Reuters