For the first nine months of this year, global merger activity wasn't doing too badly. In the absence of acquisitions by private equity firms, hobbled as they were by a lack of available financing, strategic acquirers had stepped into the breach and snapped up struggling rivals. As the year progressed, mammoth deals such as InBev SA's $60 billion acquisition of Anheuser-Busch Cos. and Roche Holding AG's $42.6 billion offer for Genentech Inc., were pushing announced global deal volume to its second-highest total ever.

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Then everything changed.

Following the collapse of Lehman Brothers Holdings Inc., credit markets seized up, global stock markets crashed and fears of a severe recession mounted. With confidence sapped, few buyers outside financial services seemed willing to take a chance with M&A. "The pillars that support a strong M&A market are very shaky," says Cary Kochman, Americas co-head of M&A at UBS Investment Bank.

Shaky, indeed. If recent weeks are any indication, nonfinancial M&A faces a period of catatonia. As one M&A lawyer puts it, "There are lots of things being looked at, but everything is in a state of complete flux. Until people feel like things have stabilized, they'll mostly be content to watch."

According to data provider Dealogic, deal volume for the first nine months of this year totaled $2.8 trillion, down 23% from a record $3.7 trillion for the same period last year. That's still "respectable," one M&A banker says. But M&A has slowed sharply since Lehman's Sept. 15 bankruptcy, which is credited with turning a major market disruption into a full-blown, worldwide credit crisis.

There is one contrarian sector to this slowdown: financial services. The industry at the epicenter of crisis has been a hotbed of activity; witness the forced mergers, private- and public-sector recapitalizations and one highly prominent bankruptcy.

However, if financial deals such as Bank of America Corp.'s proposed $44.4 billion acquisition of Merrill Lynch & Co., Wells Fargo & Co.'s $15.1 billion purchase of Wachovia Corp., and Lloyds TSB Group plc's $50 billion agreement to buy U.K.-rival HBOS plc are excluded, global deal activity in September was only about half of July's total, dropping to $199.3 billion, from $393.4 billion.

September's total is the third-lowest of the year, after the $156.7 billion in traditionally slow August and $189.7 billion in February. Nonfinancial activity in October seems destined to come in below that of September, with only $59.4 billion announced for the first half of the month. By contrast, there was $72.4 billion in financial M&A deals in October and a further $14.8 billion in insurance transactions.

Financial sponsor transactions, which drove M&A activity before the credit crunch began in the summer of 2007, are not expected to return in any size soon because there is little expectation that leverage will be available to finance the deals. "We're done for the year," says one partner at a prominent buyout firm. "The banks have told us they're not writing any tickets until at least December."

In strategic deals, nonfinancial transactions are down, not just because of an unwillingness on the part of potential buyers to move forward; some are actually pulling back from deals they've already proposed. On Oct. 13 alone, three contemplated transactions were abandoned when Waste Management Inc. backed away from a $6.7 billion hostile takeover of Republic Services Inc.; Vishay Intertechnology Inc. threw out a proposed $1.7 billion unsolicited offer for International Rectifier Corp.; and United Technologies Corp. abandoned its $3 billion bid for Diebold Inc.

For the year to date, 149 deals have been withdrawn or rejected, according to Dealogic. That's up from 98 for the same period last year and on pace with the highest yearly total since 2003, when 236 proposed deals failed.

The number of pulled deals will likely increase in the coming months. Research by Standard & Poor's indicates that the number of failed deals generally rises after market downturns. A report by S&P's Capital IQ analyst Richard Peterson says the number of pulled M&A transactions in the U.S. increased 44.2%, from 43 to 62, in the 30 days following the tech bubble's implosion in April 2000 and jumped some 45.8%, from 24 to 35, in the month after the Sept. 11 attacks.

Targets and acquirers face uncertainty, dealmakers agree. Transaction volume will be moribund until potential buyers and sellers get a clearer sense of where things are headed, says Paul Parker, head of global M&A at Barclays Capital, who joined the bank last month from Lehman. "In this environment, there's difficulty determining both value and certainty of value," he says, explaining that it's difficult for buyers to gauge the true value of targets as stock markets swing wildly.

Look at market movements last week: After an 18% drop in the S&P 500 the week prior, the largest weekly decline in history, last Monday, Oct. 13, had a record 11% jump in the index followed by a seesaw session the next day that began with strong gains but ended with the index down 0.5%. Then, on Wednesday, the Dow crashed 8%. Markets this volatile make it tough for targets to gauge whether an acquirer will ante up at the deal's close as their own stock valuations gyrate or if the dilution of a proposed deal becomes too great. Parker says that in the past year, the majority of stock deals have delivered lower value than when the deal was announced. "Until there is clarity on the direction of the economy, companies don't know how to make reliable projections with any degree of confidence."

But the pause in transaction activity doesn't mean there's no desire for deals, says James Woolery, a partner at New York law firm Cravath, Swaine & Moore LLP. He argues that the chill in M&A has created a growing, if frustrated, desire for transactions among companies that recognize opportunity in distressed markets but find themselves unable to take advantage. "There's an incredible amount of pent-up M&A demand," he says. "When the markets return to a position that would support transactions, you'll see those deals happen."

In the end, timing is the big question. "It's hard to predict how long this will last," says David Kirshenbaum, deputy head of global M&A at Citigroup Inc., adding that he expects some deals, especially those dependent on financing from banks, to extend their closing periods because of credit worries.

This is what happened when Altria Group Inc. and UST Inc. announced on Oct. 3 that they had amended their merger agreement to allow Altria, at its option, to extend the closing date for the $11 billion cash deal to early January. According to a filing with the Securities and Exchange Commission, Altria's committed lenders, Goldman, Sachs & Co. and J.P. Morgan Chase & Co., said it was preferable to close the deal in 2009.

Other proposed acquirers also find it difficult to meet deal-related obligations in light of the tumult. Sources indicate that Verizon Wireless has yet to be able to get fully committed financing to back its $28.1 billion acquisition of Alltel Corp. from TPG Capital and Goldman Sachs Capital Partners, and it has delayed an auction to divest operations in 100 markets.

On the other side of the coin, and safely assuming that an M&A slowdown will not last forever, many boards are beginning to worry about their vulnerability to hostile actions, according to Boon Sim, head of Americas M&A at Credit Suisse Group. "Their stocks have dropped dramatically," he says.

That worry is tempered by potential acquirers who are game to do stock deals, having seen their market capitalizations drop, while the general uncertainty that now reigns keeps even cash acquirers on the sidelines.

Woolery agrees with Sim, citing "a heightened state of awareness that some companies are vulnerable from an equity point of view." Lessening that sense of vulnerability, however, is that there are few buyers comfortable enough to make a hostile push. "There's a latent fear of being taken over," he says. "But right now, people are protected by volatility." Or, as one M&A lawyer puts it, "Everything is down; therefore everything is cheap." But, he cautions, "there's no magic bullet if your stock is trading at $3 now when it was at $20 a week ago."

Once technical market factors give way to economic fundamentals and the difficulties posed by a major recession, companies must seriously consider the danger of their positions, says Barclays' Parker. "If you haven't kept pace with the fundamentals, you will have to consider your defensive posture," he says.

Parker splits the M&A landscape into companies that are "critical," meaning on the verge of bankruptcy, and "constrained," meaning they have time but need to move quickly to right themselves, including spinning out secondary divisions or tangential businesses. The number of companies in the first category is expected to rise as recession pushes companies toward failure. This will allow the stronger players to pick up assets at cheap valuations, a process one banker refers to as "the normal course of business."

The second category will likely provide an increasing volume of deals. In fact, U.S. divestiture and spinoff volume, at $170.4 billion up until mid-October, is already higher than at any point this decade, up from $130 billion last year and $106.25 billion in 2000. This year has featured only 34 such deals, however, far below the 85 in 2000. That's because Altria's giant $111.3 billion spin-off in March of Philip Morris International Inc. has boosted 2008 volume.

Parker's last category, "unconstrained companies," refers generally to the cash-rich, who have the best options. That includes Warren Buffett's Berkshire Hathaway Inc., which in the past few weeks used some of its $32 billion cash pile to invest $5 billion in Goldman Sachs and $3 billion in General Electric Co.

"There are some compelling opportunities for corporate buyers to do deals in the coming quarters," says Gerry Hansell, a senior partner and the director of corporate development at Boston Consulting Group Inc. "But only those companies with outstandingly good balance sheets and liquidity will be able to do acquisitions."

Still, these are not normal times; they're not even normal bad times. During the credit crisis, where even banks are hoarding cash and refusing to lend to each other, companies find it difficult to justify risking any available liquidity for growth opportunities.

"There is reticence to pull the trigger, specifically on cash acquisitions," UBS' Kochman says. Woolery echoes that sentiment, saying corporate boards are looking askance at any risk in this environment. "There's a presumption against transacting at this point," he says. "The burden of proof on the management team to prove their case [for doing a deal] is higher."

But there are companies that see the writing on the wall and have decided to lock in whatever gains they can while they still have a chance. Take Baltimore power plant operator Constellation Energy Group Inc. The company has come under pressure as commodity prices have dropped and accepted a $4.7 billion buyout offer on Sept. 19 from MidAmerican Energy Holdings Co., a Berkshire Hathaway unit. That news prompted Constellation's oil and gas producing subsidiary, Constellation Energy Partners LLC, to hire Houston energy investment bank Tudor, Pickering, Holt & Co. Securities Inc. to review strategic alternatives, which could include a sale.

In sectors such as power and energy, rising operational costs, together with some cash-rich, acquisitive giants such as MidAmerican, will spur activity as soon as markets become stable, says Citigroup's Kirshenbaum.

Dealmakers agree that activity will be strong in healthcare, where uncertainty surrounding the healthcare policy of a new administration next year could spur companies to team up. According to S&P's Capital IQ unit, the 12 months ended Sept. 30 have featured about $156.6 billion of healthcare deals, up from $141.8 billion from the same period a year ago.

Technology and pharmaceuticals are also expected to be active consolidating industries once stability returns. Both industries includes cash-rich giants such Johnson & Johnson, Wyeth, Apple Inc., Oracle Corp. and Microsoft Corp., which earlier this year aborted a hostile action on Yahoo! Inc.

While resumption of that deal seems unlikely, some shareholders are agitating for talks. Mithras Capital LP, the St. Helena, Calif., investment firm and Yahoo! shareholder, earlier this month wrote both companies urging them to revive acquisition talks, proposing what Mithras termed a mutually agreeable sale price of $22 a share, or $31 billion.

"If Microsoft liked Yahoo! at $31, they'll love it at $12," one banker says jokingly. Eventually, that logic will return to M&A.