Fed steps in but stocks dive; UK to rescue banks

NEW YORK/WASHINGTON (Reuters) - The U.S. Federal Reserve stepped forward as a commercial lender of last resort and signaled a readiness to cut interest rates as stocks spun lower for a fifth straight day and pressure mounted for a coordinated, international response to the most dangerous financial shock since the Great Depression.

Financial shares tumbled, led by Bank of America Corp, a day after the largest U.S. bank said it would sell $10 billion in new stock and stoked fears that other banks may also need to raise capital.

The British government was readying a rescue package for the UK banking system likely to include public money injected into the banks. That plan will be announced on Wednesday, just five days after the U.S. government approved a $700 billion bailout fund that has failed to calm markets.

U.S. Federal Reserve Chairman Ben Bernanke said the U.S. economy was being battered by a financial crisis of "historic dimension" and that the risk for inflation has eased with the falling prices for oil and other commodities.

"In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate," said Bernanke.

In an unprecedented move, the Fed also created a new commercial paper facility that would buy short-term, highly rated debt, stepping into the corporate debt market in a program that falls outside the $700 billion rescue plan approved by the U.S. Congress on Friday.

Stocks remained under pressure while U.S. government bond prices recovered and gold prices moved higher in a continued flight to safety.

The S&P 500 index shed another 6 percent. That broad measure of the U.S. stock market has now dropped 15 percent over five days, its weakest run since 1987.

Japan's benchmark Nikkei stock index fell about 4 percent early in its Wednesday session.

Iceland, the North Atlantic island facing down a threat of "national bankruptcy," took over its second-largest bank and propped up a battered currency.

At ground zero in the crisis, the interbank lending market remained stalled, with the cost of borrowing dollars, euros and sterling all higher as financial institutions sought to preserve capital and remained unwilling to lend to each other.

ROOM FOR LOWER EUROPEAN RATES

Analysts credited the Fed with trying to create a fire break in the still-developing crisis, but said it was not enough to stop a wealth-destroying cycle in the markets.

U.S. consumer borrowing dropped for the first time in a decade in August as banks began to tighten credit standards and consumers pulled back from spending.

Fed fund futures have priced in a 50-basis-point rate cut by the Fed this month, with a 75-basis-point cut an outside possibility. Expectations have built that the weekend meeting of Group of Seven officials in Washington could set the stage for coordinated rate cuts including the European Central Bank.

"Certainly there will be room now for Europeans to have lower interest rates," International Monetary Fund Managing Director Dominique Strauss-Kahn told a TV interviewer.

U.S. President George W. Bush, whose credibility with voters on economic policy has plunged, spoke with European leaders to coordinate the response to the market turmoil.

"I have been in close contact with European leaders. I was on the phone with them this morning to ensure that our actions are closely coordinated," Bush said.

The White House had earlier said Bush spoke with British Prime Minister Gordon Brown, French President Nicolas Sarkozy and Italian Prime Minister Silvio Berlusconi.

In Tokyo, Japanese government officials and media said France had proposed an emergency summit meeting of the leaders of the richest economies and Russia.

The crisis that began with defaults in the $11 trillion U.S. mortgage market is also washing up on Asian shores, pushing South Korea to call for emergency talks with Tokyo and Beijing, and forcing a policy easing from India.

COUNTING THE TOLL

Shares of Bank of America Corp dropped 26 percent -- a record one-day decline -- after a surprise earnings announcement a day earlier in which the bank halved its dividend and said it would sell at least $10 billion in new stock to raise capital.

Bank of America said it had raised its $10 billion by selling 455 million shares at $22 each -- a sale price 7 percent below Tuesday's close.

Insurer MetLife Inc said after the New York close that it would issue 75 million shares to raise capital. The insurer, which has seen its stock drop almost 40 percent in recent weeks, said recent Wall Street failures had cut into its projected third-quarter investment gains.

Investors has been worried insurers will be hurt by investment losses and exposure to recent corporate calamities including the bailout of AIG and collapses of Lehman Brothers Holdings Inc and Washington Mutual Inc, as well as real-estate related debt.

Entering the U.S. corporate earnings reporting season, other companies were expected to reinforce the view that the world's largest economy shuddered into recession at the start of the current quarter.

The largest U.S. aluminum producer, Alcoa Inc, posted a drop in quarterly earnings of more than 50 percent on crumbling demand for metal to make planes and cars, and said it would halt major investments. The result was worse than expected and underscored the growing risk of a deepening downturn.

"The sad thing here is that I don't think Alcoa is going to be alone this earnings season," said Brian Hicks, co-manager of the Global Resources Fund. "I think there will be quite a few earnings misses due to the fact that it looks like conditions have weakened much more than people expected.

(Reporting by Reuters bureaus around the world; Editing by Brian Moss, Steve Orlofsky, Toni Reinhold, Gary Hill)