Fed steps in but stocks dive; UK to rescue banks

By Daniel Trotta and Kevin Krolicki

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 worst financial crisis 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, who is regarded as an expert on the Great Depression.

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 market has now dropped 15 percent over five days, its weakest run since 1987.

Earlier, Russia negotiated an emergency bailout for Iceland and unveiled an aid package for its own banks, Australia slashed interest rates by 1 percentage point to 6 percent, and Britain considered a massive injection of public funds.

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.

CALLS FOR GREATER COORDINATION

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.

"I think the Fed has done a reasonably good job considering the unusual situation we are in," said Joseph Trevisani, chief market analyst with FX Solutions.