Fannie, Freddie fears, inflation slam Wall St

NEW YORK (Reuters) - U.S. stocks fell for a second straight session on Tuesday as credit worries hit bank shares and a report showing inflation remains a threat despite slower growth stoked the market's anxiety.

Fears that U.S. home finance firms Fannie Mae (FNM.N) and Freddie Mac (FRE.N) may need a government bailout soured investors on financial shares for a second day even after Freddie had little trouble selling new debt.

Financial companies were the biggest drag on the Dow and the S&P 500, with top mortgage lenders Bank of America (BAC.N) and Wells Fargo (WFC.N) down more than 3 percent each. The KBW index of bank stocks .BKX fell 3.4 percent.

Lehman Brothers LEH.N shares had another dismal day, tumbling 13 percent after JPMorgan Securities forecast that the investment bank will take a further $4 billion in write-downs tied to losses on mortgage-related investments.

Shares of Home Depot (HD.N), the world's largest home improvement retailer, fell 3.7 percent to $25.96 after the company, a Dow component, forecast weakness into 2009 as the housing slump continues.

"The uncertainty with regard to financials has kept the downward pressure on," said Bucky Hellwig, senior vice president at Morgan Asset Management in Birmingham, Alabama.

"Home prices keep falling, assets continue to deteriorate, the economy continues to slow, which can only worsen the unemployment rate and increase delinquencies," he added. "There's seemingly no end to this cycle, and that's to the detriment of any financial stock."

The Dow Jones industrial average fell 130.84 points, or 1.14 percent, to 11,348.55. The Standard & Poor's 500 Index .SPX slid 11.91 points, or 0.93 percent, to 1,266.69. The Nasdaq Composite Index .IXIC lost 32.62 points, or 1.35 percent, to 2,384.36.

After the closing bell, shares of Hewlett-Packard Co (HPQ.N) rose about 3 percent to $45 after the world's biggest computer maker reported a higher quarterly profit and strong sales for its notebook computer and printer business.

During the regular session, sectors sensitive to high oil prices generally weakened. The Airline Index shed 7.8 percent.

Oil has declined sharply in recent weeks from a high above $147, but it seems to be consolidating losses in recent days.

U.S. crude oil prices gained $1.66 to settle at $114.53 a barrel, after briefly rising above $116 earlier.

The main focus was on financial stocks. Shares of insurer American International Group Inc (AIG.N) lost 5.9 percent to $20.32 after Goldman Sachs cut its price target on the stock to $23 from $30.

Lehman Brothers tumbled 13 percent to $13.07.

Bank of America's shares fell 4.2 percent to $28.08 and Wells Fargo shed 3.5 percent to $27.79.

Home builders also slid after the Commerce Department said housing starts in July fell 11 percent, the lowest annual rate in more than 17 years. Pulte Homes (PHM.N) , the No. 3 U.S. home builder, declined 3.7 percent to $12.07. The Dow Jones index of home builders' shares dropped 3.5 percent.

Freddie Mac shares fell 5 percent to $4.17 while Fannie Mae dropped 2.3 percent to $6.01 after plunging more than 20 percent each on Monday.

Some analysts said a $3 billion Freddie Mac debt offering on Tuesday was indicative of the queasiness in the market.

Despite its implied government guarantee, Freddie's five-year note issue priced at 1.13 percentage points above five-year Treasuries. A similar issue in March priced at a spread of 1.055 percentage points.

"What it's showing is that there's a great deal of concern about the solvency of these companies," said Fred Dickson, market strategist and director of retail research at D.A. Davidson & Co in Lake Oswego, Oregon.

On the Nasdaq, shares of Staples Inc (SPLS.O) tumbled 4.2 percent to $23.55 after the U.S. office supply chain said tough market conditions hurt quarterly results.

Adding to market unease was a report showing the Producer Price Index shot up in July at the fastest annual rate in 27 years, while core prices that omit volatile food and energy posted their fastest rise since November 2006.

That unnerved investors because it puts the Federal Reserve in an increasingly difficult position when it comes to maintaining its policy of low interest rates.

But Anna Piretti, senior economist at BNP Paribas in New York, said weakness in U.S. domestic demand should contain prices going forward.

"Consumers are not likely to make very large ticket purchases when prospects in the labor market are weakening and confidence remains very low," she said.

Trading volume was light on the New York Stock Exchange, with about 1.01 billion shares changing hands, well below last year's estimated daily average of roughly 1.90 billion, while on Nasdaq, about 1.77 billion shares traded, also below last year's daily average of 2.17 billion.

Declining stocks outnumbered advancing ones by a ratio of nearly 3 to 1 on both the NYSE and the Nasdaq.

(Additional reporting by Walter Brandimarte and Ellis Mnyandu; Editing by Jan Paschal)