Sept. 16 (Bloomberg) -- The cost to protect against a default by Wall Street banks soared as the prospect of a failure by American International Group Inc. seized credit markets.

Credit-default swaps on Morgan Stanley, Goldman Sachs Group Inc., Wachovia Corp. and Citigroup Inc. all traded at record highs as investors sought to hedge against potential losses on their holdings and to replace hedges they had with Lehman Brothers Holdings Inc., which filed for bankruptcy yesterday. Contracts on AIG, the biggest U.S. insurer, and Washington Mutual Inc., the U.S. savings and loan cut to junk yesterday, traded at distressed levels.

``We're in a very dangerous situation, and almost anything can happen,'' Roger Altman, chief executive officer of Evercore Partners Inc. and a former U.S. deputy Treasury secretary, said in a Bloomberg Television interview. ``It's entirely possible that we'll see other failures, and the ripple effects from a broad economic view could be quite negative.''

A failure by AIG, which sold banks and investors protection on $587.5 billion of fixed-income assets, would add to potentially billions in losses the markets face from Lehman's failure. Investors and dealers in the $62 trillion credit-default swap market already are sifting through their exposures to Lehman while also dealing with contracts linked to Fannie Mae and Freddie Mac which are being settled in the largest technical defaults in the market's decade-long history. The government's takeover this month of the mortgage-finance companies triggered the defaults.

``Counterparties are being judicious in their actions at this point, given what's happened,'' said J.J. McKoan, who oversees about $65 billion as director of global credit at AllianceBernstein Holding LP in New York. ``Few are willing to take on new risk positions.''

CDX North America

Credit-default swaps on the Markit CDX North America Investment Grade Index jumped as much as 34 basis points to a record 229 basis points and were trading at 207 basis points as of 12:35 p.m. in New York, according to broker Phoenix Partners Group.

An index created by Credit Derivatives Research LLC that tracks credit-default swaps on 15 banks and securities firms, known as the CDR Counterparty Risk Index, jumped 90.8 basis points today to 406.2 basis points. It earlier rose to a record 409 basis points, said Dave Klein, manager of credit indexes at CDR in Walnut Creek, California.

Buyers of protection on AIG paid a record 54 percent upfront and 5 percent a year, according to Phoenix. That's up from 33 percent yesterday and means it cost $5.4 million in advance and $500,000 a year to protect $10 million in bonds for five years.

``If AIG goes under, there could be a domino effect,'' said Andrea Cicione, a credit strategist at BNP Paribas SA in London. ``AIG is very connected to the financial system and it is very connected to the real economy.''

Debt Protection

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline signals the opposite.

Credit-default swaps on Morgan Stanley jumped 263 basis points to 762 basis points, according to CMA Datavision. They traded as high as 850 basis points, Phoenix prices show.

Contracts on Wachovia, the fourth-biggest U.S. bank, rose 135 basis points to 753, CMA data show. Goldman Sachs surged 198 to 548. Citigroup jumped 80 basis points to 360 and JPMorgan Chase & Co. climbed 51 to 246.

Bank of America

Bank of America Corp., which agreed to buy Merrill, the world's biggest brokerage firm, for about $50 billion, increased 52 basis points to 257 basis points, according to CMA. Merrill contracts climbed 202 to 550.

``If AIG spirals in the same way as Lehman, the ramifications will be much more substantial,'' said Jim Reid, head of fundamental credit strategy at Deutsche Bank AG in London. ``The rating downgrades have accelerated the need for an imminent response.''

Contracts on the AAA rated finance arm of General Electric Co., GE Capital, rose 95 basis points to 457 and earlier reached a record 490, according to CMA.

Credit swap sellers demanded 49.5 percentage points upfront to protect against a default by Seattle-based Washington Mutual, CMA data show. The upfront price rose to as high as 51.5 percentage points earlier. The contracts imply that investors have priced in a more than 89 percent chance the company will default in the next five years, according to a JPMorgan valuation model. WaMu was cut three steps to BB- yesterday by Standard & Poor's.

In London, credit-default swaps on the Markit iTraxx Europe index of 125 companies with investment-grade ratings climbed 21 basis points to 145, JPMorgan prices show. In Tokyo, the Markit iTraxx Japan index rose the most since 2004, increasing 49 basis points to 179, Morgan Stanley prices show.

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Abigail Moses in London Amoses5@bloomberg.net

Last Updated: September 16, 2008 12:44 EDT