The share rally on Monday that followed the bailout of Freddie Mac and Fannie Mae was reversed abruptly yesterday as fears mounted over the future of Lehman Brothers, the embattled Wall Street bank.

Shares in Lehman Brothers fell by a record 45 per cent to close at $7.90, helping to send the Dow Jones industrial average down by 280 points or 2.43 per cent to 11,230.70 as the brokerage’s woes underscored the risks that remain for financial groups looking to shore up damaged balance sheets. The S&P 500 fell by 43.28 points, or 3.41 per cent, to close at 1,224.51.

AIG, the world’s biggest insurer, fell by 19 per cent to $18.37 on fears that its large exposure to the mortgage markets could force the company to raise fresh capital. The company, which has recorded unrealised losses of more than $20 billion over the past three quarters on credit default swaps that guarantee mortgage-linked securities, has already raised more than $20 billion (£11.7 billion) this year, severely diluting shareholders’ investments.

Shares in Washington Mutual, the savings and loan institution which on Monday ousted its chief executive amid mounting losses from sub-prime investments, fell by 20 per cent. Radian and PMI, the mortgage insurers, recorded share price declines of 24 per cent and 23 per cent, respectively.

Investors’ confidence in Lehman collapsed after talks fell through with the state-owned Korean Development Bank about a takeover or a capital injection as South Korean regulators became increasingly concerned about a deal as they discovered more about the state of the Wall Street brokerage’s finances. The group is desperate for cash after announcing $8.2 billion of writedowns on mortgage-related investments in the past year. It may disclose a further $5 billion hit with its third-quarter results next Thursday.

Lehman, which is understood to be talking to other potential investors, promised on Monday that it would disclose “key strategic initiatives” with its results, although it is not known to what extent these will address the capital shortfall that the group faces.

Fears over Lehman’s future spilt over into the options market. Its option volume was five times the normal level, with puts outpacing calls by a factor of 1.71, according to Trade Alert, the options analyst.

The collapse of the talks with KDP prompted Standard & Poor’s, the ratings agency, to review portions of Lehman’s long-term and short-term debt, in a move which it said could lead to its ratings being lowered.

Lehman’s latest woes came as it emerged that JPMorgan and other significant investors in Fannie Mae and Freddie Mac would need to take substantial writedowns on their equity holdings in the mortgage groups. JPMorgan is thought to be preparing to write off most, if not all, of the approximately $600 million of shares that it holds in Fannie Mae and Freddie Mac combined. This is because the US Government’s plan to inject up to $200 billion into the groups, announced on Sunday, will dilute the holdings of their existing investors.

Last month JPMorgan estimated that the $1.2 billion of preferred shares that it held in Fannie Mae and Freddie Mac had lost about half their value. It is thought that JPMorgan will write off the shares’ remaining value. JPMorgan declined to comment. Sovereign Bancorp, of Philadelphia, is expected to write down a large part of the approximately $900 million of shares that it holds in Fannie Mae and Freddie Mac.

Fannie Mae’s shares dived by 90 per cent on Monday to close at 73 cents, and Freddie Mac’s by 83 per cent to 88 cents. These drops brought the total decline for each group to 99 per cent over the past year. Yesterday Fannie Mae rose by nearly 32 per cent to 96 cents and Freddie Mac added almost 7 per cent to close at 94 cents.

Fannie Mae and Freddie Mac risk being delisted from the New York Stock Exchange (NYSE). Companies whose shares close below $1, on average, over 30 days receive a letter from the exchange giving them six months to get their shares back above $1.

Explore Markets

• United States

• Europe

• Japan

• China

• Russia

• The Gulf

• India

• Africa

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive