Nikkei pares losses, but mood remains dark

(Updates to midafternoon)

TOKYO, Aug 26 (Reuters) - Japan's Nikkei stock average was down 0.7 percent on Tuesday, paring earlier losses as the dollar edged up slightly on the yen, but Sony Corp (6758.T) and other exporters still dragged on the market as sentiment remained grim. Mitsubishi UFJ Financial Group (8306.T) and other banks suffered after their U.S. peers were hit by growing worry over the health of the U.S. financial sector, while builder Asahi Homes Co 1913.Q plunged after its majority shareholder filed for court protection.

"Everyone knew things were bad for U.S. financial institutions, but with results just over they thought the bad news would probably take longer to filter out," said Yutaka Miura, senior technical analyst at Shinko Securities.

"Now, it seems as if the market is already feeling the chill of autumn."

Trading volume was extremely thin for the third consecutive session, echoing what market players said was a similar lack of activity overseas.

"Stocks are suffering around the world, losing out to bonds and some commodities as investors shy away from equity risk," Miura added.

By midafternoon the benchmark Nikkei had lost 83.94 points to 12,794.72, up from earlier lows that saw it down more than 1 percent as short-covering emerged.

The broader Topix had shed 0.9 percent to 1,228.71 after earlier falling more than 2 percent.

U.S. financial shares were battered from a number of quarters, including a tumble in the shares of American International Group Inc (AIG.N) after Credit Suisse forecast a huge loss and cut its target price on the world's biggest insurer [ID:nN22333859].

Mitsubishi UFJ Financial Group lost 1.6 percent to 817 yen and Sumitomo Mitsui Financial Group (8316.T) fell 2 percent to 651,000 yen.

Sony shed 2.1 percent to 4,210 yen and Canon Inc (7751.T) was down 0.8 percent at 5,070 yen. Industrial robot maker Fanuc Ltd (6954.T) was down 1.8 percent at 8,010 yen.

Asahi Homes, which trades on the Jasdaq startup market, plunged 29.3 percent to 41 yen after it said its majority shareholder had collapsed with 62 billion yen ($567 million) in debt, hit by higher costs and a housing slump in Japan. (Reporting by Elaine Lies; Editing by Chris Gallagher)