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

Credit-default swaps on New York-based AIG soared to a record and its bonds traded at distressed levels. Merrill also reached a record and contracts on Lehman approached the intraday all-time high from yesterday. Contracts on Washington Mutual Inc. fell after American Banker said that JPMorgan Chase & Co. is in ``advanced talks'' to buy the biggest U.S. savings and loan, a report that was later disputed by CNBC.

``There's not a lot of capital out there for financial firms,'' said Len Blum, managing director at Westwood Capital LLC, a New York-based investment bank. ``The investors who put capital into financials earlier got burned and others are focused elsewhere in the world.''

Lehman's struggle to find buyers for assets has led to concern that other financial companies, sitting on devalued mortgage-related assets, may not find investors as speculation grows that the worst U.S. housing slump since the Great Depression hasn't bottomed.

Credit-default swaps on AIG, the biggest U.S. insurer, soared on concern that it may be the next big financial firm to run short of capital after $587 billion in contracts guaranteeing home loans, corporate bonds and other investments plunged in value. Standard & Poor's and Moody's Investors Service have said AIG's credit ratings may be cut if its mortgage assets fall further or if potential capital needs aren't addressed. AIG may have to post more than $13 billion of collateral following a downgrade, it has said in regulatory filings.

Turnaround Plan

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 shrank by 46 percent 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. The plan may be announced sooner, a person familiar with the company said.

``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.

More Collateral

The insurer disclosed in an Aug. 6 filing that a ratings cut may have ``a material adverse effect on AIG's liquidity.'' The company was forced to put up $16.5 billion in collateral through July 31 to investors who bought protection from AIG through credit-default swaps.

AIG's International Lease Finance Corp. 5 percent bonds due in 2010 fell 4.4 cents to 87.6 cents on the dollar as of 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.

Debt that trades at a spread of 10 percentage points or more over Treasuries is considered ``distressed,'' indicating investors are concerned that the issuer will default.

Bondholder Protection

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.

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, 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.

An index created by New York-based Credit Derivatives Research LLC that tracks credit-default swaps on 15 banks and securities firms, known as the CDR Counterparty Risk Index, rose 28.7 basis points to 215.2 basis points, reaching the highest since the collapse of Bear Stearns Cos. in March. The index, which has climbed 52.5 the past week, reached a record 250.09 basis points on March 14, two days before JPMorgan bought Bear Stearns in an emergency sale backed by the Federal Reserve.

Lehman, Merrill

Five-year credit-default swaps on New York-based Lehman rose 195 basis points to 695 basis points, according to Phoenix. The contracts traded as high as 790 basis points yesterday. 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.

``Any bidder for Lehman could argue they don't want to pick up all the parent company debt,'' said Ricardo Kleinbaum, a credit strategist at BNP Paribas SA in New York. ``Resources are running low both from banks and the federal government.''

Contracts on Merrill, the third-largest U.S. securities firm, climbed 95 basis points to 465 basis points, Phoenix data show. Morgan Stanley, the second-largest securities firm, rose 22 to 262, according to CMA, and Goldman Sachs Group Inc., the largest, climbed 18 to 198.

Contracts on the finance arm of General Electric Co. climbed 32 basis points to a record 215 basis points, CMA data show. Fairfield, Connecticut-based GE received about half its revenue and profit from financial units last year.

Washington Mutual

Credit-default swaps on Seattle-based WaMu are trading at levels that imply a 75 percent chance the company will default in the next five years, a JPMorgan valuation model shows.

Credit-default swap sellers demanded 37 percentage points upfront and 5 percentage points a year to protect WaMu bonds from default for five years, Phoenix prices show. The upfront cost fell from 39 percentage points yesterday and has been as high as 49 percentage points. They initially dropped to 29 percentage points after the American Banker report. Investors can use the contracts to hedge against risks other than default, such as the risk the company will be cut below investment grade.

Fitch Ratings yesterday cut WaMu's ratings one grade to BBB- and placed a negative outlook on the company, saying it may struggle to raise capital, if needed, amid ``the most difficult'' market conditions in several decades.

WaMu, which this week replaced Chief Executive Officer Kerry Killinger with former Independence Community Bank CEO Alan Fishman, said in July that rising home loan delinquencies may lead to losses of as much as $19 billion over the next 2 1/2 years.

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

Last Updated: September 12, 2008 18:59 EDT