NEW YORK (Reuters) - Insurer American International Group Inc struggled for survival a day after a financial tsunami swept away investment bank Lehman Brothers and forced the sale of rival Merrill Lynch in the biggest financial industry shake-up since the Great Depression.

AIG scrambled for a financial lifeline on Monday after investment bank Lehman Brothers Holdings Inc failed to find a rescuer and Merrill Lynch & Co Inc agreed to be taken over by Bank of America Corp.

The U.S. Federal Reserve has hired investment bank Morgan Stanley to review options for AIG -- which has lost some 92 percent of its value so far this year -- a person familiar with the situation said Monday.

AIG’s precipitous stock decline has led ratings agencies to threaten downgrades that could force it to post more collateral and nullify insurance contracts, possibly setting in motion a chain reaction that could threaten its survival.

In an ominous sign, two ratings agencies went ahead with downgrades after the market closed on Monday.

“AIG seems to be the next guy on the chopping block,” said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey.

Again seeking a private solution to Wall Street’s woes, the Fed had asked JPMorgan Chase & Co and Goldman Sachs Group Inc to explore arranging $70 billion to $75 billion in loans to support AIG, among other financing options, another person familiar with the situation said.

Fearing a financial meltdown, the U.S. presidential candidates sparred Monday over who could best restore the system’s health, with Republican John McCain pledging reform and Democrat Barack Obama saying hands-off Republican policies were the problem.

U.S. stocks tumbled across the board, with the Dow Jones industrial average dropping 504 points as Wall Street had its worst day since markets reopened after the September 11 attacks.

There was speculation that Wall Street’s worsening meltdown could prompt the Fed to act.

U.S. short-term interest rate futures rose sharply Monday, reflecting the higher prospects for a rate cut at or before Tuesday’s Federal Reserve policy meeting.

And there were signs of widening macroeconomic shockwaves that could see a worsening of the credit crunch that has already threatened to worsen the housing downturn at the root of Wall Street’s troubles.

“Capital markets have been quite difficult, and this is just going to make it more so,” General Motors Corp President and Chief Operating Officer Fritz Henderson told the Reuters Autos Summit in Detroit.

Darkening one of the few bright spots from the weekend’s mayhem, Bank of America -- which would surpass Citigroup Inc as the country’s largest bank by assets with the planned takeover of Merrill -- saw its shares plunge.

“The concern for Bank of America is the debt that they are acquiring,” said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco.

“Secondly, is it too big of a purchase? They are dealing with Countrywide right now. Did they need to be dealing with this as well? There’s some concern they might have bit more than they could chew.”

‘SURVIVAL OF THE FITTEST’

Late on Sunday, the Fed said for the first time it would accept stock in exchange for cash loans and 10 of the world’s top banks agreed to establish a $70 billion emergency fund, with any one of them able to tap up to one-third of that. But the market shrugged off those moves.

The Dow Jones industrial average closed down 4.4 percent, while the Standard & Poor’s 500 Index lost 4.7 percent.

Lehman shares fell 95 percent to 18 cents, even as the once proud bank moved to sell 100 percent of its investment management unit and had a potential list of buyers, including private equity firms Bain Capital, Hellman & Friedman and Clayton Dubilier & Rice.

The events signaled a seismic shift in Wall Street’s power structure, with big-name investment banks biting the dust and major banks with large deposit bases surviving.

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“It’s a return to pure capitalism, the survival of the fittest. The government can’t and won’t bail everybody out,” said Justin Urquhart Stewart, investment director at 7 Investment Management in London.

“Investors will now retreat to the trustworthy banks, though that’s not a phrase that trips off the tongue easily nowadays.”

‘SHELL-SHOCKED’

Scores of Lehman employees showed up at dawn at the company’s New York headquarters, many dressed casually. Most carried duffel bags and suitcases, as if they were planning to pack up and leave.

Merrill workers were also uncertain about their future.

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New York Gov. David Paterson said Wall Street might lay off 40,000 workers in a worst-case scenario.

“Everybody has been shell-shocked,” a Merrill trader said on his way into the headquarters building. “Nobody thought we’d be bought by Bank of America in a million years. At least we won’t be bankrupt. It should be a interesting day at work.”

AIG could be the next U.S. financial giant to run into serious trouble.

U.S. Treasury Secretary Henry Paulson, who shocked many on Wall Street by insisting there would be no taxpayer funds to help Lehman, said at a news briefing there were private-sector talks under way in New York on AIG that had nothing to do with any government bridge loan.

“What’s going on in New York is a private sector effort, again, focused on dealing with an important issue that’s, I think, important that the financial system work on right now, and there’s not more I can say than that,” he said.

The state of New York, where AIG is based, did its best to bolster the stricken insurer with a complex asset swap giving it a $20 billion lifeline, but its longer-term rescue depended on additional funding.

The cost to insure the debt of AIG also surged on Monday. AIG’s credit default swaps jumped to 33.5 percent of the sum insured paid upfront, plus annual premiums of 5 percent for five years, from 13 percent upfront on Friday, according to Markit Intraday.

In a move likely to drive that cost up further on Tuesday, Fitch Ratings downgraded AIG’s debt to “A” from “AA-” and A.M. Best cut its financial strength rating.

BANK SHARES DROP

U.S. bank shares tumbled in the wake of the Lehman news, with Washington Mutual Inc down 27 percent and Wachovia Corp losing 25 percent. Morgan Stanley was down 13.5 percent, and Citigroup lost 15 percent.

Even Goldman Sachs, Wall Street’s No. 1 investment bank which is set to report quarterly earnings on Tuesday, saw a 12 percent drop in its shares.

Merrill shares rose as much as 33 percent to $22.68 before closing at $17.06, up a penny on the New York Stock Exchange. The Bank of America offer was worth $29 a share when it was announced, almost $12 above Merrill’s closing price on Friday.

Lehman’s bankruptcy petition followed three days of talks between various bank CEOs and regulators at the Fed’s fortress- like building in lower Manhattan.

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