TREASURIES-Bonds gain on bailout uncertainty, WaMu fall

* Financial sector bailout talks continue

* Washington Mutual's failure renews safety bids

* Persistent credit stress drives Treasury safe-haven bid

* Stocks' late rebound caps bonds' gains (Updates prices, adds comments, changes byline)

By John Parry

NEW YORK, Sept 26 (Reuters) - U.S. Treasury debt prices rose on Friday as safety bids reignited after talks on a government bank bailout stalled and after the failure of Washington Mutual, the biggest bank closure in U.S. history.

As lawmakers clashed over the $700 billion financial sector rescue plan, hopes that a bill could be passed helped slightly ease extreme levels of stress in short-term funding markets, however, and a late rebound in stocks curbed some of the safe-haven bid for U.S. government debt, capping bonds' gains.

Fresh data showed the toll the crisis was taking on the economy and consumer confidence, underscoring the rising risk of a recession which could boost U.S. government bond prices. All eyes were on Washington, awaiting news of action that could unblock frozen credit markets and offer stock investors relief, which would likely diminish government debt's appeal.

Treasuries gained from the uncertainty in financial markets about the timing and exact shape of the bailout program.

"It's like a soap opera," said David Coard, head of fixed-income sales and trading at The Williams Capital Group in New York of the deliberations in Washington about the bailout.

"It's uncertainty and that stokes flight to quality. I guess people are still hopeful we will have a bill, but don't know what shape it's going to take. In the absence of that certainty, you get a safety bid for Treasuries," Coard said.

Adding to worries about the financial system was the closure of Washington Mutual (WM.N), once the biggest U.S. savings and loan and one of the banks hardest hit by the housing downturn and credit crisis. To read more see [ID:nN25440417].

"The last thing Congress wants to do is to tank the stock market. The health of the global financial system is dependent on the U.S. coming up with a plan," said Jessica Hoversen, fixed-income market analyst at MF Global Research in Chicago.

Renewed jitters also sparked market bets the Federal Reserve may slash key interest rates by as much as half a percentage point from the current 2.00 percent as early as October, according to interest rate futures.

"If there is a general public panic you are not going to hold that psychological issue at bay with these very esoteric credit facilities," said T.J. Marta, fixed income strategist with RBC Capital Markets in New York. "You need to hit it with something the general public understands," which might prompt the Fed to cut rates, Marta said.

With no immediate relief in sight from any bailout or rate cut, investors flocked to the safety of cash and U.S. government securities.

Two-year Treasury notes often attract safety bids and respond closely to expectations for central bank rate moves. The 2-year note's price, which moves inversely to its yield, was up 3/32 for a yield of 2.13 percent US2YT=RR, versus 2.18 percent late Thursday.

The benchmark 10-year note's price rose 3/32 for a yield of 3.85 percent US10YT=RR, versus 3.87 percent late Thursday.

The gap between between two-year and 10-year notes grew to about 174 basis points from 168 late Thursday.

CREDIT RISKS RUN DEEP:

Money markets remained effectively frozen, as investors ran for safety in cash and Treasuries.

To fund the Treasury and the Fed's rescue efforts for financial institutions, the U.S. government has flooded the market with $224 billion in Treasury bills and $58 billion in coupon debt sold this week.

At the same time, investors have been scrambling to snap up shorter-dated U.S. government paper as they shun riskier money market instruments issued by banks and companies.

One-month T-bill rates US1MT=RR were at about 0.11 percent, down from 0.40 percent late Thursday.

Early on Friday in New York, some retail investors bought T-bills at rates of just 0.04 percent, accepting negligible returns in exchange for safety, Marta said.

Credit markets remained dislocated as investors shunned securities not explicitly backed by the government, raising risk premiums and keeping market interest rates high.

The risk premium or spread on three-month dollar funds in the interbank market over the expected three-month rate on benchmark U.S. federal funds hit a record high on Friday.

That spread, a closely watched distress measure on credit markets, grew to 202.18800 basis points, 4 wider than Thursday.

As negotiations over the bailout continued, market participants warned the stakes were high should these efforts falter over the weekend.

If Congress has not made progress on a bill by Monday, "the situation in the money markets would likely get much worse," said Carl Lantz, U.S. interest rate strategist with Credit Suisse in New York.

In that scenario, Libor or the London Interbank Offered Rate -- a global benchmark for short-term borrowing -- could rise above 4 percent to even more distressed levels, while the ability of non-financial companies to roll over commercial paper and borrow short-term funds in that market could be impeded, Lantz said.

The U.S. 30-year bond US30YT=RR rose 12/32 in price for a yield of 4.38 percent, versus 4.40 percent late Thursday. (Reporting by John Parry and Richard Leong; Editing by James Dalgleish)