Updated from 1:31 p.m. EST

Dynegy

(DYN)

nixed its merger with

Enron

(ENE)

Wednesday, just hours after a debt downgrade dealt Enron a crushing blow. Enron shares plunged 81%, showing the market believes a bankruptcy filing is all but certain.

Dynegy and Enron had spent the last week making a last-ditch effort to save the merger, which was originally valued at more than $9 billion and would have combined two leading energy traders. But those talks were doomed by the downgrade, which tightened the financial vise around Enron.

The end of the merger deal substantiates the market's long-held skepticism, stemming in part from doubts about how forthcoming Enron has been about its problems. Investors have steadily voted against the agreement, steepening the slide in Enron's shares since its Nov. 9 announcement. Wednesday morning Enron stock dropped to $1.10 before it and Dynegy were halted for news of the deal's termination; afterward, Enron plunged anew, hitting 65 cents, down $3.46.

Ali

S&P helped deliver the knockout punch Wendesday morning by cutting Enron's long-term corporate credit rating a staggering six notches to B-minus from triple-B-minus. Rival ratings agencies Moody's and Fitch later followed suit, cutting Enron bonds to junk.

The new junk ratings immediately triggered Enron's obligation to repay some

$3.3 billion in outstanding debt. With the company facing a severe liquidity squeeze and its EnronOnline unit pointedly offline, traders were nearly unanimous in their assessment that the Houston energy trader won't be able to meet its obligations.

For its part, S&P noted in its report that there appears to be a "distinct possibility" Enron will file for Chapter 11 bankruptcy protection absent a merger.

Enron said nothing about those obligations, or the prospect of a Chapter 11 filing, in a Wednesday afternoon press release. The company said it is "exploring options" to "protect our core energy business," but offered no specifics.

Liston

Investors clearly expect Enron's imminent collapse to hurt Dynegy and other players, including the banks that were trying to prop the deal up.

J.P. Morgan Chase

and

Citigroup

, which lent large sums to Enron and took an instrumental role in arranging and trying to salvage the failed merger, skidded Wednesday amid fears that energy market dislocation could dent the banks' profits. Morgan was off 6% and Citi 5%.

The banks' total exposure to Enron is hard to gauge. They recently arranged a two-stage $1 billion credit to Enron that is secured by the Northern Natural Gas Pipeline and the Transwestern Pipeline Company. In October, Enron drew down $3 billion of credit lines to pay off $1.9 billion of short term debt. It didn't say at the time who the banks behind this credit were. Then there's the $690 million obligation to partnership that was meant to come due Tuesday, but was pushed back to mid-December. Banks may have had some exposure to that, since Enron last week said that its "lead bank" had informed it of the obligation's extension.

Enron had $14.3 billion of debt in mid-November, according to a quarterly SEC filing. Just over $9 billion of that was scheduled to come due by the end of 2002, according to the filing.

Leon Spinks

Meanwhile, despite its efforts to distance itself from the carnage, Dynegy saw its shares drop 12% as investors began to wonder just what the energy trader may have gotten itself into in its Enron dealings. Many investors were astonished to see Dynegy rushing into an acquisition of a distressed company with murky accounts and, quite possibly, a raft of hidden debt obligations. The riskiness of that strategy suggested that Dynegy was desperate to see Enron stay afloat.

It's almost impossible to tell at this stage how much damage an Enron collapse will do to Dynegy's business. Enron may have been a counterparty on trades that Dynegy is now unhedged on, and Dynegy may have to back out accrued profits booked on Enron trades. Without elaborating, Dynegy said in a Wednesday press release that it has stopped trading with Enron and that its exposure to Enron is $75 million.

In addition, Enron's allegedly aggressive accounting may have contaminated the entire energy market, especially longer-dated trades. With Enron no longer in the game, and auditors likely more vigilant, traders such as Dynegy may not be able to book the sort of upfront gains they used to.

One consolation is that Dynegy's $1.5 billion cash infusion, made possible with backing from

Chevron

, was secured by Enron's Northern Natural Gas pipeline. Dynegy moved to take ownership of that pipeline Wednesday by "exercising its option to purchase all the membership interests in the entity which indirectly owns all of the common stock of NNG." Enron said Wednesday afternoon that it was "reviewing" that claim in an apparent effort to keep Dynegy from taking ownership.

But even if Dynegy does take control of the pipeline, the credibility of top Dynegy managers, such as CEO Chuck Watson, will have been hit hard. If it turns out that Dynegy does suffer badly from an Enron crash, investors will complain that they should've been told about the vulnerability much earlier. And if Dynegy was too tied in to Enron's fortunes, serious questions about Watson & Co.'s risk management skills will be raised.

Kenny Norton

The ratings agency downgrades are doubly damaging for Enron because rating agencies played a critical role in efforts to shore up the Houston company. Some observers, noting the steep discount on Enron bond prices, had criticized the agencies' reluctance to downgrade Enron debt. But S&P and Moody's said they wanted to see if the Dynegy offer would revive Enron. Of course, as Enron's core operations continued to sputter even after the deal was agreed to, the rating agencies' position looked increasingly untenable.

Inevitably, if the deal doesn't go through and Enron implodes, some people will blame S&P for Enron's demise. S&P analyst Todd Shipman replies: "We have always promised people that we wouldn't overreact, and I don't think we have overreacted."

He adds that the turning point came when the rating agency stopped believing Dynegy and others could revise the deal terms and find cash in time to stop the deterioration in Enron's business. Also, he doubted whether those working to salvage the merger would come up with the sort of provisions needed to keep Enron viable.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.