NEW YORK: Stocks plunged yesterday as investors remained worried about chaos in the US financial market even after the Federal Reserve forged an extraordinary $85 billion rescue of insurance giant American International Group Inc.

The Federal Reserve’s emergency loan to shore up AIG, the world’s largest insurer, temporarily lifted some uncertainty about the stability of the US financial system, but the market plummeted as investors kept a wary eye on the company, which is reeling from billions of dollars in souring mortgage debt.

The two Wall Street investment banks left standing after a week of stunning upheavals – Goldman Sachs Group Inc. and Morgan Stanley – also remain under scrutiny. And the troubles in banking could exacerbate economic problems. The Commerce Department said yesterday that housing starts fell by 6.2 per cent in August to the slowest building pace since January 1991.

The Dow Jones industrial average dropped more than 340 points yesterday. A 500-point drop on Monday marked the largest in the Dow Jones industrials since the 11 September, 2001, terrorist attacks, as the venerable Wall Street giant Lehman Brothers filed for the biggest bankruptcy in US history.

Investors fear that a failure of AIG, the world’s largest insurer, would set off even more financial turmoil than the collapse of Lehman.

“We dodged a bullet, but we want to make sure it’s a complete cease-fire,” said Jack A. Ablin, chief investment officer at Harris Private Bank, noting that AIG still needs to unwind its investment positions, sell off assets, and possibly get more cash.

The government was taking other measures to help alleviate the turmoil. The Treasury said it will start selling bonds for the Fed in an unprecedented effort to aid it with its lending efforts, while the Securities and Exchange Commission said it will strictly prohibit naked short-selling starting today.

Short-selling is when traders borrow shares of a stock they expect to fall and sell them – if the stock does indeed fall, the traders buy the cheaper shares to cover the borrowed ones and profit from the difference. Naked short-selling occurs when sellers don’t actually borrow the shares before selling them; it’s a practice some say is partially responsible for the huge drop in the shares of investment banks like Lehman, Merrill Lynch and Bear Stearns Cos., which JPMorgan Chase & Co. bought earlier this year.

The Fed said on Tuesday night that it was acting to shore up AIG after determining that a disorderly failure of the company, whose financial dealings stretch around the world, could hurt the already delicate markets and the economy.

Asian stock markets partly recovered yesterday after the US government announced the bailout plan for AIG, but later dipped as the news failed to persuade many investors that the financial turmoil would ease soon. European stocks rose after two days of declines.

AIG, a company little known off Wall Street, does business with almost every financial institution in the world and insures $88 billion worth of assets including mortgages and corporate loans.

Under the plan orchestrated by the Fed during a day of crisis talks, the US government will provide an emergency $85 billion loan at an interest rate of about 11.5 per cent to AIG, and in return receive a 79.9 per cent equity stake in the company, similar to the way the government took control of faltering mortgage giants Fannie Mae and Freddie Mac.

The White House yesterday defended the takeover, framing it as another move to protect the economy and declining to rule out further bailouts.

“You have a government that is willing to lead, act where appropriate, and govern to make sure that we limit broader financial harm to the economy,” said White House press secretary Dana Perino.

President George W. Bush approved the loan on Tuesday after being presented with a recommendation from Treasury Secretary Henry Paulson during a meeting of economic advisers.

The pressure already had grown when all three major credit rating agencies cut AIG’s ratings at least two notches late on Monday night. New York Gov. David Paterson had agreed to allow AIG to use $20 billion of assets held by its subsidiaries to pay for its business – essentially giving it a bridge loan from itself – but indicated that the company had only 24 hours to find the cash needed to stay in business.

A collapse of AIG would force Wall Street to untangle the complex credit derivatives markets and send the market scrambling to figure out who owes what to whom – or even who owns what.

The Fed stepped in hours after it decided, in its first unanimous vote this year, to keep the closely watched federal funds rate unchanged at 2 per cent. At the same time, however, the Fed noted that strains on the market have “increased significantly” and said it was ready to act if needed.

As AIG teetered, central bankers around the globe scrambled to revive credit markets. The Fed injected $70 billion into the American financial system. The European Central Bank pumped one-day financing of nearly $100 billion into the 15-nation zone. The Bank of Japan added $24 billion, and Britain’s central bank almost $36 billion.

Cash left world markets on Monday like an outgoing tide. The interest rate banks charge each other for overnight loans soared as high as 6 per cent – far above the Fed’s target rate of 2 per cent and a sign banks did not trust each other enough to make even 12-hour loans.

Meanwhile, British bank Barclays PLC said on Tuesday it had agreed to acquire Lehman’s North American investment banking and capital markets businesses for $250 million in cash, just two days after walking away from a deal to purchase all of Lehman’s.

The British bank will also purchase Lehman’s New York headquarters and its two data centres in New Jersey for $1.5 billion. The deals require approval from the bankruptcy court.

Meanwhile, Lehman executives continue to negotiate a potential sale of its prized investment management division, which includes money manager Neuberger Berman. The division was once valued by as much as $10 billion by Wall Street analysts, but now could fetch much less considering Lehman’s bankruptcy proceedings.

A person familiar with the negotiations, who spoke on condition of anonymity because the talks are ongoing, said Lehman was focusing on trying to sell the business to private-equity firms. The sale is expected to happen in a matter of days, the person said.

Separately, Bank of America Corp., which in July bought battered Countrywide Financial Corp., began to work out how it would digest its $40 billion acquisition of Merrill Lynch after its shotgun wedding with the brokerage on Sunday.

In the wings, Goldman Sachs Group Inc., which began the year as one of five large investment banks and is now one of two, reported its worst profit drop since going public in 1999. Goldman’s third-quarter profit dropped 71 per cent to $810 million, while revenues plummeted 50 percent.

The only other major US investment bank left standing, Morgan Stanley, had better news. It reported solid quarterly profits – though down seven per cent from a year earlier – and surpassed Wall Street’s expectations.

Earlier this year, the federal government engineered the sale of Bear Stearns to JPMorgan Chase.

On the campaign trail, Republican presidential nominee John McCain told ABC’s Good Morning America yesterday that he had not wanted the AIG bailout, but said millions of people whose finances were tied up in the company were in danger of having their lives destroyed.

He blamed greed, excess and corruption for AIG’s problems. He also said that Congress and federal regulators had paid no attention to the problem. (AP)