The US stock market yesterday suffered one of its worst days since the terrorist attacks of September 2001, as the financial maelstrom that toppled Lehman Brothers threatened the future of AIG, one of the world’s biggest insurers.

The Dow Jones industrial average dropped 504.48 points, or 4.42 per cent, to 10,917.51, the worst points fall since it lost 684.81 on September 17, 2001, the first day of trading after the terror attacks. It was also the Dow’s sixth-largest points drop, just behind the 508.00 it suffered in the October 1987 crash.

Traders on Wall Street and in the City — where the FTSE 100 lost nearly 4 per cent to close at 5,204, — were left reeling after Lehman Brothers filed for Chapter 11 bankruptcy protection; Bank of America seized control of Merrill Lynch for just $50 billion (£28 billion), and AIG declared that it needed emergency funds.

Regulators scrambled last night to prevent AIG becoming the next domino to be toppled in the financial turmoil that brought down Lehman Brothers over the weekend. In a frantic day on which central bankers injected more than $100 billion in short-term loans to restore confidence across financial markets, AIG was poised to receive an emergency funding package worth up to $95 billion to keep it afloat.

Last night the Federal Reserve asked JPMorgan Chase and Goldman Sachs to organise loans of up to $75 billion for AIG, while New York State officials struck a deal allowing the insurer to borrow $20 billion of capital from its own subsidiaries.

AIG, best known in Britain as the sponsor of Manchester United, has been severely weakened after reporting $18 billion in losses over the past three quarters on guarantees that it wrote on mortgage-backed securities.

Banking stocks across the globe plunged in the wake of the collapse of Lehman and amid fears that others could follow.

Shares in Halifax Bank of Scotland, Britain’s biggest mortgage lender, slumped by as much as 40 per cent at one point before rallying to end the day 18 per cent lower. Royal Bank of Scotland and Barclays dived by 12 per cent and 10 per cent respectively. Some insurers were also weak: Friends Provident plunged by 18 per cent.

The US Federal Reserve pumped $70 billion of short-term funding into the money markets, the European Central Bank ¤30 billion and the Bank of England injected £5 billion to cope with the surge in demand for cash. Ten of the world’s biggest commercial banks, including Barclays, grouped together to announce a $70 billion emergency borrowing facility that would be available to any one of them if they ran short of liquidity.

Standard Chartered and Lloyds TSB emerged as the two biggest British unsecured creditors of Lehman, owed $77 million and $75 million, respectively. Aozura and Mizuho, the Japanese banks, were the biggest prospective casualties, together owed $752 million. Citibank is owed $275 million and BNP Paribas $250 million. The imploding Wall Street firm is in default on $150 billion of its own bonds. Dealers said that Lehman debt was trading thinly yesterday but bonds were changing hands for as little as 30 cents on the dollar, suggesting that few believe bondholders have any chance of recouping their investments in full.

Holders of Lehman-connected financial instruments with a face value of up to $800 billion now face weeks or even months in limbo, adding to the money market jitters. Analysts said that both credit default swaps — insurance policies against bond defaults — written by Lehman and CDSs written against Lehman’s own default were impossible to value. Lehman was a leading player in the $62 trillion credit derivatives market.

Hank Calenti, a credit analyst at RBC Capital Markets, said that initial estimates putting Lehman’s derivatives exposure at $690 billion were wide of the mark: “I would put the exposure closer to $800 billion,” he said. Mr Calenti said that there would also be a big knock-on effect on the commercial property market because of a likely auction of $32 billion of Lehman’s assets in the sector. Lehman tried and failed in recent weeks to offload $4 billion of securities backed by British residential mortgages.

In London the administrator to the European unit of Lehman revealed that the company had been stripped of any surplus cash before the collapse, leaving it so short that staff might not be paid this week. Tony Lomas, of PricewaterhouseCoopers, said: “Quite bluntly, there was no cash in the companies we were appointed to. We started the day with no certainty that we would have cash available to make payment due at the end of this week. We still don’t know what the position is.” Lehman operated a system under which all funds were channelled to New York each day. This meant that the coffers in London were empty when, at 7am yesterday, the administrator was told that the bank would receive no more support from its New York headquarters.

“This is a period of stress and distress for the people,” said Mr Lomas, who has handled the administrations of MG Rover and Enron (Europe) and said that the Lehman job was bigger than either. While job losses were inevitable, he declined to put a figure on how quickly and how many of the 5,000 UK employees would be dismissed. On Wall Street, Lehman was reportedly moving to sell its investment management division, Neuberger Berman, as early as this week. Bain Capital; Hellman & Friedman and Clayton Dubilier & Rice, the private equity firms, are thought to be frontrunners to buy it.

Hedge fund managers suggested that any firm that relied on Lehman for short-term liquidity or used it to clear and settle trades might struggle. “Any small fixed-income fund that had Lehman as its sole prime broker is going to be toast,” one said.

Times Recommends

• C&G axed - 1,660 jobs to be lost
• UK house prices rise 1.1% as buyers return
• Mixed reaction to US banks repaying bailouts