Lehman Bros., AIG, Merrill

A line in the sand.

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"It's pretty big. It's pretty bad."

That's this morning's reaction on Wall Street to the news that Lehman is expected to declare bankruptcy today, Merrill Lynch agreed to a fire sale to Bank of America, and insurer American International Group is being forced to raise capital as its shares plummet.

Today marks the capitulation of a huge chunk of the banking sector, and it's exactly what Wall Street has been afraid of since the start of the credit crisis: large-scale contagion, spreading among the largest banks with speed and severity enough to send nervous markets running for the hills.

Stocks are already tumbling. AIG lost half its value, while the Dow sank more than 300 points in early trading before steeling itself for what could be one of the most volatile weeks in years.

This latest turn marks the worst blow so far in this year-old housing and credit crisis, which has included the implosion of Bear Stearns, the failure of the bank IndyMac, and the government takeovers just last week of Fannie Mae and Freddie Mac.

"The fallout from these casualties keeps growing," says Beth Ann Bovino, an economist with Standard & Poor's.

Today will also be remembered as the day the Federal Reserve drew a line in the sand, refusing to bail out Lehman and deciding that its attempts to shore up the financial system had to end somewhere. What happens next is far from clear. The Fed is meeting tomorrow and could decide on an emergency cut in interest rates. It has already extended lending to banks, widening its standards for collateral and giving banks as much leeway as possible to keep their shareholders and depositors confident.

"They need to get something out there," Bovino said.

Undoubtedly, the failure also increases fears that the economy, which may be in recession already, will now face a deeper and longer slowdown made worse by an extended period of already tight credit conditions.

Here's the latest:

A timeline of events.

Lehman could be the biggest bankruptcy ever.

Nouriel Roubini says the business models of broker-dealers Goldman Sachs and Morgan Stanley are inherently unsustainable.

Investor Wilbur Ross sees 1,000 bank closures.