There’s more pain to come for financial firms, as signaled by the bailout of Bear Stearns Companies Inc., says Sherry Cooper, chief economist at BMO Capital Markets.

“The announcement this morning of the Bear Stearns bailout by the Federal Reserve through J.P. Morgan Chase has sent reverberations throughout all markets worldwide, not only because this is another “too big to fail” scenario, but also because it has strong implications for a domino effect in the already weakened financial services industry and beyond,” she says in a research note.

Cooper suggests that other firms may be having liquidity problems of their own, noting that Lehman Brothers is the latest target of such rumours; and, pointing out that Bear’s saviour, J.P. Morgan, made it clear that lending to the troubled firm would not endanger its liquidity. “It is now widely speculated that J.P. Morgan will buy what they deem to be the most valuable pieces of Bear Stearns at markedly depressed prices,” she adds.

And, there may be trouble in store for other financial firms. “This is certainly not a contained development. Other firms will likely continue to suffer the results of the credit crunch and loss of investor confidence,” she says.

Indeed, she notes that the U.S. economy is in recession, and the risks are on the downside due to the loss of confidence, the liquidity squeeze and rising counterparty risk. “Expectations of near-term improvement have been dashed by the latest developments: the continued fall in the U.S. dollar, oil prices rising to US$110 a barrel, gold climbing to over US$1,000 an ounce, the U.S. housing market’s continued collapse, and the further downdraft in consumer spending,” she adds.

As a result, she predicts the Fed will cut interest rates next week, most likely by 75 basis points (or more). “Expect further declines in the earnings and shares of financial institutions, more large writedowns, and enormous global economic uncertainty. Sharp destabilizing developments like these cannot end with a soft landing. Central banks will try to mitigate the damage, but further damage there will be,” she concludes.