NEW YORK (Reuters) – Manic and increasingly desperate dealmaking gripped Wall Street as shares of investment banks Morgan Stanley and Goldman Sachs plummeted amid more signs of distress in the global financial industry.

Morgan Stanley was discussing a merger with regional banking powerhouse Wachovia, the New York Times reported, while Washington Mutual, the country's largest savings bank, put itself up for sale, sources said.

The flurry of takeover talks followed the surprise $85 billion rescue of insurer American International Group by the U.S. Federal Reserve on Tuesday that did little to calm investors' nerves.

"Stop The Insanity," pleaded a research note from Swiss bank UBS as US financial shares appeared to be in free-fall. The US stock market plunged 4.7 percent to a three-year low, the dollar slumped and safe-haven U.S. Treasury bonds soared.

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

The result: a seismic shift in the financial industry, with some of Wall Street's biggest names disappearing.

"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."

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

That stoked talk Wall Street's two surviving investment banks may have to join up with a commercial bank to survive.

"I'm assuming that Goldman Sachs and Morgan Stanley are lining up dancing partners. They don't want to be ... this week's victim," said William Larkin, fixed income manager at Cabot Money Management in Salem, Massachusetts.

Top UK lender HBOS Plc took the first dance, saying it was in talks with rival Lloyds TSB to create a £28 billion ($50 billion) mortgage giant. British media reported the banks agreed to an all-stock deal.

The White House said it was "concerned about other companies" while the US presidential candidates struck populist tones, with John McCain blasting Wall Street's "casino culture" and Barack Obama stressing protection for mom-and-pop investors.

The objects of their ire were glued to their trading screens. In the capital of the hedge fund industry, Greenwich, Connecticut, an industry conference for 500 people had 200 empty seats.

"A lot of people who are seeing massive red ink and are suffering the most are not here," said Jean de Bolle, the chief investment officer at Byron Advisors.

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

"The credit crunch and credit contraction is intensifying," said Peter Boockvar, equity strategist at Miller Tabak & Co in New York. "The action in Morgan Stanley in light of what was better-than-expected numbers last night is disconcerting."

Goldman spokesman Lucas van Praag said Wednesday's drop in his company's share price was "the result of completely irrational fear and is not based on any fundamentals."

Morgan Stanley spokeswoman Jeanmarie McFadden declined to comment.

In the latest example of regulatory action with little apparent effect, the US Securities and Exchange Commission curbed short-selling, or investor bets on declining share prices.

"Seems like the SEC is a day late on the rule ... Morgan Stanley is clearly in the short-sellers' sights," said Andrew Brenner, senior vice president at MF Global in New York.

New distress signals had popped up earlier. The cost of borrowing overnight dollars spiked above ten percent, indicating a deep lack of trust in the interbank lending market.

And Bank of Ireland became the latest bank to cut its dividend, causing a sell-off in Irish banking shares.

The HBOS merger talks underscored how quickly authorities around the world are ditching long-held beliefs about free markets as they struggle to counter the credit crunch.

Lloyds was previously blocked from buying a smaller mortgage bank, and the British government shocked investors by taking over troubled bank Northern Rock in February — the country's first major nationalisation since the 1970s.

US authorities already 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 and Freddie Mac, and six months after the Fed brokered the sale of failed investment bank Bear Stearns to JPMorgan Chase.

Two legendary firms bit the dust over the weekend. Lehman Brothers Holdings Inc filed for bankruptcy and Merrill Lynch & Co threw itself into the arms of Bank of America Corp.

British bank Barclays Plc gave Wall Street a small boost on Tuesday by agreeing to buy Lehman's Manhattan headquarters and investment bank for $1.75 billion and taking aboard 10,000 staff.

AIG's new chief, former Allstate Corp CEO Edward Liddy, was poised to hold a yard sale to pay off the Fed loan.

AIG, which has businesses ranging from life insurance to airplane leasing in 130 countries, has a big incentive to raise cash. It is currently paying more than 11.4 percent interest on the $85 billion loan.

Japan's cash-rich insurers and Australia's QBE Insurance are seen as potential buyers. And then there is billionaire investor Warren Buffett.