By Renae Merle

Washington Post Staff Writer

Monday, September 15, 2008; 5:55 PM

The demise of Lehman Brothers, the country's fourth-largest investment bank, and the sale of brokerage firm Merrill Lynch sent U.S. stocks plunging today in one of the toughest trading sessions in years, with the Dow Jones industrial average losing more than 504 points.

The whiplash of financial news rattled investors and got worse as the day wore on. At the same time, American International Group (AIG), the country's largest insurer, appeared to get needed assistance as it scrambled to avoid a cash crunch.

The Dow closed down 504.48, or 4.4 percent, pushing past a 300-point decline during the final hour of trading. The technology-heavy Nasdaq was down more than 3.6 percent, and the Standard & Poor's 500-stock index was down 4.7 percent.

The financial sector was among the hardest hit. Bank of America closed down 21 percent, while Wachovia fell 25 percent. Goldman Sachs and Morgan Stanley, which report quarterly earnings this week, closed down 12 percent and 14 percent respectively.

AIG closed down 61 percent.

"We had a very, very tough day on the market," said Art Hogan, chief market analyst at Jefferies & Co. "Investors are anxious about the spillover effect of Lehman and what is the next shoe to drop."

The 504-point fall is the Dow's sixth-largest point drop ever and was the biggest loss for the Dow since the terror attacks of Sept. 11, 2001.

After trading down about 300 points most of the day, investors dumped their shares in the last 30 minutes of trading. Ultimately investors remained concerned about how the unwinding of Lehman Brothers will play out, analysts said. The Federal Reserve is also scheduled to meet tomorrow, but it is unclear what additional action it might take to calm the markets, they said.

"It looks like [investors] are afraid of what is going to happen," said Douglas S. Roberts, chief investment strategist for Channel Capital Research. "Especially in front of the Fed meeting. They are not sure what the Fed is going to say."

Oil prices fell about $5 a barrel to close at $96, the first time prices have closed below $100 in months. Hurricane Ike did not do as much damage as some had feared, and overall demand for fuel continues to decline, analysts said.

Some analysts expected $100 a barrel to be the new low point, said Phil Flynn, oil analyst at Alaron Trading in Chicago. "One hundred dollars is a major point psychologically. Now that we're below that, you open up a lot of new possibilities on the down side," he said. "One of the reasons that oil is weak is that [there is an acknowledgment that] the slowdown in the economy could affect everything, and that includes demand for oil."

Investor jitters were most focused on Lehman Brothers, the 158-year-old investment bank, which filed for Chapter 11 bankruptcy protection today after failing to attract a suitor during a furious weekend of negotiations. Bank of America announced an agreement to buy brokerage and investment banking giant Merrill Lynch for about $50 billion.

Both constitute major restructuring of the financial sector, which has struggled to absorb losses from the mortgage crisis.

Investors have also grown concerned about the stability of AIG. New York Gov. David Paterson (D) said the country's largest insurer could use a $20 billion cash infusion from its subsidiary company to ease a financial crunch. It will essentially allows AIG to provide a bridge loan to itself.

"It's no secret that the company has been talking to the Feds and talking to us," Paterson said. "They asked us what assistance we could provide, and this is our idea." Paterson said today's action could also help the federal government influence other financial institutions to get involved.

At a White House briefing, Treasury Secretary Henry Paulson said that the financial markets are "working through a difficult period" but that the system remains sound and resilient. "Nothing is more important right now than the stability of our capital markets, and so I think it's important that regulators remain very vigilant; we're very vigilant," he said.

Paulson said he never considered it proper to put taxpayer money on the line to help Lehman. But when asked whether the government would ever step in again like it did in March to broker the sale of Bear Stearns to J.P. Morgan, Paulson said: "Don't read it as no more. Read it as that . . . it's important, I think, for us to maintain the stability and orderliness of our financial system."

The Federal Reserve's refusal to directly step in to help save Lehman Brothers could be positive for the market over the long term, economists said. Some had expected government action after the government seized control of mortgage giants Fannie Mae and Freddie Mac last week and brokered the sale of Bear Stearns to J.P. Morgan.

"It's a good thing for the market," Jefferies & Co.'s Hogan said. "You don't want to replace capitalism with socialism. You can't have the government taking over everything."

Even as investors digested the historic news surrounding Lehman and Merrill Lynch, some were raising concerns about how it could spill over into other parts of the economy. There will be renewed pressure on the Federal Reserve to cut interest rates tomorrow at its scheduled meeting, economists said.

"The bankruptcy of Lehman Brothers will put further deflationary pressure on financial markets and the economy at a time when such pressure can be ill-afforded," Brian Bethune, chief U.S. financial economist for Global Insight, said in a research note.

Lehman's bankruptcy could put other major financial institutions at risk, said Bethune. "Suffice to say that further bankruptcies of major financial institutions would be a process that the economy cannot support at this particularly fragile juncture of the business cycle," he said.

Risk-adverse investors are likely to move away from U.S. assets, dragging down the value of the dollar compared with a range of foreign currencies, said Joseph Brusuelas, chief U.S. economist at California-based Merk Investments. Already, Treasury bond prices have surged today. "There is a concern about the basic stability of the market going forward," he said.

Global stocks also plunged on the weekend news, and central bankers tried to calm the situation amid deepening uncertainty about the resilience of the global financial system and the strength of the world economy. China's central bank announced it was cutting a key interest rate to uphold growth, and U.S. industrial production fell faster than expected in August.

In Europe, the FTSE-100 share index closed down 3.9 percent in London, the Paris CAC-40 was off 3.7 percent and Germany's DAX 30 index of blue chips sagged 2.7 percent.

Asia's biggest stock exchanges in Japan, Hong Kong and South Korea were closed for holidays, but India's Sensex tumbled 3.4 percent, Taiwan's benchmark plummeted 4.1 percent and Singapore dropped 3.2 percent.

Correspondent Ariana Eunjung Cha contributed to this report from Shanghai, and special correspondent Karla Adam contributed from London.