Sept. 12 (Bloomberg) -- American International Group Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. led a jump in the cost of protecting financial-company bonds from default amid concern firms will be hard-pressed to raise the capital needed to shore up their balance sheets.

Credit-default swaps on New York-based AIG soared to a record and its bonds traded at distressed levels. Contracts on Lehman approached a record reached earlier this week and Merrill contracts also rose.

AIG, which sold credit-default swap protection on more than $587 billion in securities linked to home loans, corporate bonds and other investments, faces ratings downgrades that could require it to post as much as $13.3 billion of collateral, Credit Suisse Group AG equity analyst Thomas Gallagher said last month.

Credit-default swap sellers demanded 12.5 percentage points upfront and 5 percentage points a year to protect AIG bonds from default for five years, according to broker Phoenix Partners Group. That means it would cost $1.25 million initially and $500,000 a year to protect $10 million in AIG bonds for five years. Yesterday, it cost $688,000 a year with no upfront payment, according to CMA Datavision.

AIG's market value shrunk by more than one-third this week on concern its credit ratings will be cut. Chief Executive Officer Robert Willumstad has promised to deliver a turnaround plan on Sept. 25 after the firm posted three straight quarterly losses totaling $18.5 billion.

``As distressed as they are, raising new capital could be extremely hard,'' said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California, today in an e-mail.

AIG Bonds

AIG's International Lease Finance Corp. 5 percent bonds due in 2010 fell 4.4 cents to 87.6 cents on the dollar at 10:16 a.m. in New York, according to Trace, the Financial Industry Regulatory Authority's bond-pricing service. The yield climbed to 14 percent, or 11.9 percent over Treasuries with similar maturities, Trace data show.

A benchmark gauge of credit risk linked to the bonds of 125 companies in the U.S. and Canada, including AIG, also rose. The Markit CDX North America Investment Grade Index climbed 6.5 basis points to 152.5 basis points as of 10:53 a.m. in New York, according to Phoenix.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Five-year credit-default swaps on New York-based Lehman rose 220 basis points to 724 basis points, according to CMA. The contracts traded as high as 790 basis points yesterday, Phoenix prices show. They had dropped to 500 basis points at the close of trading yesterday amid reports that the Federal Reserve and U.S. Treasury were trying to engineer a sale of the company.

Credit-default swaps, conceived to protect creditors against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Contracts on Merrill, the third-largest U.S. securities firm, climbed 31 basis points to 388 basis points, CMA data show. Morgan Stanley, the second-largest securities firm, rose 9 to 247 and Goldman Sachs Group Inc., the largest, climbed 9 to 189. Both are based in New York.

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: September 12, 2008 11:19 EDT