Updated from 1:22 p.m. EDT

Anyone lulled into a sense of security by the screaming stock market rally of the prior three days got a rude awakening Thursday.

The credit crunch in the U.S. markets for risky assets started to take the shape of a liquidity crisis Thursday morning, as banks in Europe and in the U.S. scrambled to obtain cash.

Investors fear that tighter lending standards and higher rates for bank-to-bank loans could lead to a more widespread contagion as the repricing of risk continues to evolve.

"I'm more concerned today about contagion than I was yesterday," says one fund of funds manager, who declined to be named.

Two days after taking a tougher-than-expected stance on monetary policy, the Federal Reserve responded to a surge of demand for money, and via an automatic response, injected $12 billion of reserves into the banking system Thursday morning.

Meanwhile, the European Central Bank -- which has been in an overt tightening mode for several months -- has allocated nearly 95 billion euros, or about $130 billion, at a fixed rate of 4% in a "fine-tuning operation" aimed to assure orderly condition in the euro money markets.

The central banks' actions come after the investment unit of BNP Paribas, France's largest bank, temporarily suspended three of its funds due to a lack of liquidity in the market. In addition, Dutch investment bank NIBC Holding said it lost at least 137 million euros on subprime investments, Bloomberg reports.

The Dow Jones Industrial Average plunged 385 points, or 2.8%, to 13,273, ending at session lows . The S&P 500 slid 42 points, or 2.8%, to 1456, and the Nasdaq Composite sank 53 points, or 2.1%, to 2560.

Treasury bonds rallied sharply as investors fled riskier assets and moved into safe ones. The 10-year Treasury rose 13/32 in price, yielding 4.79% vs. 4.86% Wednesday. Risk premiums on junk bond derivatives widened out by about 37.5 basis points early in the day but tightened back in to 25 basis points by the close.

T.J. Marta, fixed-income strategist at RBC Capital Markets, says traders were realizing that the biggest problems may be focused on Europe -- "for now," he adds.

Others also note that European and Asian investors may be at the center of the current credit malaise, but at least one believes there is more pain to come.

J. Kyle Bass, hedge fund Hayman Capital's managing partner, wrote a letter to investors dated July 30 warning investors of more trouble to come in the credit markets. Citing conversations with "a senior executive in the structured product marketing group of one of the largest brokerage firms in the world," Bass says the most levered structured credit products called CDOs and CLOs -- which are filled with underlying assets of the lowest credit-ratings -- sit in the investment portfolios of many Asian and European banks.

The banks were willing and sought-after buyers of these assets because they possess the much-ballyhooed excess pools of liquidity around the globe, based on their connection to petrodollars and trade surpluses.

Referring to the senior executive, Bass writes: "He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of subprime debt."

When the rating agencies start downgrading these structured products, he predicts that there will be forced selling because many of these institutions are mandated to hold only debt that has investment-grade credit ratings.

Dallas-based Hayman Capital is short credit in the U.S. in both subprime mortgage-backed securities and corporate credit, Bass writes. He adds the fund is long non-U.S. equities and debt.

BNP Paribas said it stopped withdrawals from funds with more than 2 billion euros in assets because it couldn't accurately asses the value of its mortgage-backed securities, the latest evidence that the crisis in the sector is spreading, belying the confidence shown in financial markets on Wednesday.

The ECB's action is the largest such operation in the bank's history, eclipsing the 69.3 billion euros it provided the day after the Sept. 11, 2001, terror attacks in New York. The Fed's action is not unusual, as such open-market operations tend to occur regularly on Thursdays, but the $12 billion is a bit larger than normal, according to Anthony Crescenzi, chief fixed-income strategist at Miller Tabak.

European bourses tumbled in response. Germany's DAX fell 2% and London's FTSE lost 1.9%.

Financial stocks were falling sharply Thursday amid the uncertainty. Also, Sanford Bernstein research analyst Brad Hintz sliced earnings estimates on the bulge bracket brokerage firms for 2007 and 2008.

Hintz cited expectations for weaker revenues from fixed-income trading and debt underwriting amid wider credit spreads and "more difficult market conditions to constrain" leveraged buyout and M&A activity in the fourth quarter and into 2008s.

Shares of Bear Stearns ( BSC), Goldman Sachs ( GS), Lehman Brothers ( LEH) and Morgan Stanley ( MS) were each lost more than 5% while Merrill Lynch ( MER) fell 4.4%.

Thursday's news follows nearly a month of market volatility that has featured failing hedge funds at Bear Stearns, the virtual shutdown of mortgage lender American Home Mortgage ( AHM) and steep losses at competitors such as Luminet ( LUM) and Accredited Home ( LEND).

Rumors about other hedge funds suffering big losses continue to make the rounds, including those centered on Goldman's Global Alpha Fund. Goldman Sachs said rumors that the fund will be shuttered are "categorically untrue," The Wall Street Journal reports. But Goldman is closing its $500M North American Equity Opportunities Fund, TheStreet.com's Mark Decambre reports.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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