By Walden Siew

NEW YORK (Reuters) - Credit markets weakened on Friday, led by banks and insurance companies on concerns about ratings quality, as world stocks plummeted amid continued worry about the deepening financial crisis.

Traders also were nervous about projected losses surrounding an auction to settle an estimated $400 billion in credit default swaps on Lehman Brothers (LEHMQ.PK: Quote, Profile, Research) debt that kicked off early Friday.

U.S. investment-grade and high-yield bond spreads traded at record high levels, a sign of investors' perception of risk. The main U.S. investment-grade credit derivative index widened further to about 217 basis points on Friday, reflecting the edgy tone, from 198.25 basis points late Thursday, according to data from Markit Intraday.

Debt protection costs for Morgan Stanley (MS.N: Quote, Profile, Research) , General Electric (GE.N: Quote, Profile, Research) and Merrill Lynch (MER.N: Quote, Profile, Research) climbed amid sharp swings in U.S. stock markets, traders said. Merrill Lynch's five-year credit default swaps traded at 400 basis points versus 365 on Thursday, according to Phoenix Partners Group.

Morgan Stanley's five-year credit default swaps rose to an upfront payment of 24 percent the sum insured plus 500 basis points a year, from 19 percent on Thursday, according to Phoenix.

That means it would cost $2.4 million to insure $10 million of debt plus $500,000 a year. Moody's Investors Service on Thursday warned it may cut the long-term debt ratings of Morgan Stanley and Goldman Sachs (GS.N: Quote, Profile, Research). For details, see [nHKG147209]

"It's a situation that is outside their control," said Robbert Van Batenburg, head of research at Louis Capital in New York on Morgan Stanley. "The bottom line in this type of business is that it's based on trust and when your clients do not have any trust anymore in the sustainability of your company as an ongoing concern they're going to pull their business away from you."

GE's five-year CDS also widened to 600 basis points versus 565 basis points on Thursday, Phoenix Partners said.  Continued...