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The European Central Bank swept into the bond market to buy up Italian and Spanish debt and sling a safety net under the euro zone's third and fourth largest economies. But bickering persisted in Europe over a longer-term rescue plan.

In the United States, President Barack Obama called for urgent action on the U.S. budget deficit but his proposal on taxes was promptly rebuffed by Republicans.

The G7 finance ministers' and central bankers' pledge on Sunday to help smooth markets if needed provided little solace.

Selling that began in Asia and Europe accelerated in the United States, where the broad Standard and Poor's 500 index plunged 6.7 percent to close at 1,119.46, its worst sell-off since December 1, 2008. The Dow Jones shed 634.76 points to 10,809.85.

A huge blow to investor confidence was the Standard and Poor's downgrade of the U.S. sovereign credit rating late Friday, which compounded spreading concerns that the worsening euro-zone debt crisis and a faltering U.S. economy heighten the risks of a double-dip recession.

"People are asking, can the economy still grow in face of all this?" said John Carey, portfolio manager at Pioneer Investment Management in Boston, with $260 billion under management.

Realization on both sides of the Atlantic that the political obstacles to quick budgetary reform are so huge and the monetary options so limited, it has deepened the pessimism.

The worsening market turmoil puts significant pressure on the U.S. Federal Reserve at its regular policy meeting on Tuesday to announce some fresh measures of support for a damaged U.S. economy.

"If the Fed does nothing, it could prove to be a disappointment at this point," said JP Morgan analysts.

Stock losses have wiped more than $3.8 trillion from investor wealth globally in the last eight days and sent investors rushing for safety in the Swiss franc, the Japanese yen and gold. In the United States, estimates of recession risks are rising. Goldman Sachs had put them at one in three last week, before the latest sell-off.

"This massive move in the equity market does dim the economic outlook for the next six months," said Carl Riccadonna, senior U.S. economist at Deutsche Bank in New York. "We would put the recession odds at about 40 percent and about two weeks ago they were at about a 10 percent chance."

The G7 financial policymakers from major industrialized nations said on Sunday they stand ready to provide extra cash if markets seize up, are consulting regularly and could cooperate to smooth volatile FX markets if needed.

Particularly worrisome was a more than 20 percent plunge in the shares of Bank of America, the largest U.S. bank. AIG sued it for $10 billion for allegedly deceiving investors, on top of mounting concerns about the size of its potential losses from mortgages litigation and questions about management. The bank has shed nearly one third of its market value in three days.

ECB TO THE RESCUE

On the political front, Obama said he hoped that Standard and Poor's stripping the United States of its prized AAA credit rating would add urgency to U.S. budget cutting plans.

Standard and Poor's cut the ratings of credits tied to the U.S., sovereign debt to AA-plus, namely government mortgage agencies, clearing houses and insurers. The Treasury market soared on Monday despite the downgrade as investors fled stocks.

Obama called for both tax hikes and cuts to welfare programs as part of the $1.5 trillion in deficit reduction that a special committee would deliver in late November. But Republican House Speaker John Boehner once again rejected the call, saying tax hikes were "simply the wrong approach."

Obama also spoke with Italian Prime Minister Silvio Berlusconi and Spanish President Jose Luis Zapatero, welcoming measures by their governments to address the economic turmoil in Europe.

Traders estimated the ECB bought about 2 billion euros in Italian and Spanish debt after it agreed on Sunday to broaden its bond-buying program for the first time to halt an attack on the Mediterranean countries.. Italian and Spanish yields declined sharply.

"The intervention by the European Central Bank this morning seems to have been working," Irish Finance Minister Michael Noonan told RTE public radio.

"Last week the risk was that as bond rates in Italy went toward 7.0 percent, they'd be driven into some kind of bailout program. They have fallen by almost one percent this morning so they are well out of the bailout territory now."

But French sovereign credit default swaps hit a record high of 160 basis points as the U.S. rating downgrade raised questions about how long other AAA countries, such as France, could hold onto their top-notch ratings.

The ECB move was seen as only a temporary solution however, due to the sheer size of Italy's bond market -- $1.6 trillion. European stocks sank to their lowest in nearly two years, with the German DAX closing down 5 percent as doubt about governments' ability to deal with the euro zone debt crisis and its impact on economic growth emerged.

A bailout of Italy would overwhelm Europe's emergency fund. Germany has so far opposed expanding it, a view unchanged on Monday, but French Finance Minister Francois Baroin said: "The allotment is 440 billion (euros) and we've already said if we need to go further we will go further."

(Additional reporting by Jonathan Stempel, Lucia Mutikani, Joe Rauch Laura MacInnis, David Lawder and Mark Felsenthal in Washington, Sarah Marsh and Noah Barkin in Berlin, and Gerard Bon and Paul Taylor in Paris. Writing by Stella Dawson; editing by Christopher Wilson)

The agency's move came late Friday after a wild week for stocks -- its worst in more than two years -- as lingering concerns about sluggish economic growth and heavy public debt loads in developed economies hit sentiment.

The impact of S&P's rating cut was felt in Asia and Europe. Japan's Nikkei stock average .N225 slid 2.2 percent at the close on Monday, while the FTSEurofirst 300 index .FTEU3 of top European shares fell 1.8 percent in early trading after a bounce following the European Central Bank's move to buy Spanish and Italian bonds.

Peter Cardillo, chief market economist at Rockwell Global Capital in New York, said he expected an intraday reversal after sharp falls at the open, similar to Friday's action.

Hedge funds are "selling out at levels that they are somewhat compelled to, so it feeds on itself said," he said. "The market is grossly oversold, valuations are attractive, and I think the market at this point has already discounted a growth slowdown."

S&P 500 futures fell 24.8 points and were below fair value, a formula that evaluates pricing by taking into account interest rates, dividends and time to expiration on the contract. Dow Jones industrial average futures lost 213 points, and Nasdaq 100 futures shed 49.25 points.

Last week's steep selloff in equities wiped about $2.5 trillion off global market valuations.

Safe-haven assets were in demand. Gold hit another record high of $1,715.01 an ounce and was set for its second largest daily gain this year.

Resource-related stocks will be under pressure as crude oil prices fell 3.3 percent to $84 a barrel on concerns over the economic outlook. Copper fell to a five-week low.

Sentiment worsened after the S&P cut the U.S. long-term credit rating by a notch to AA-plus late Friday on concerns about the debt situation in the world's largest economy. The downgrade could eventually raise borrowing costs for the U.S. government, companies as well as consumers.

Moody's on Monday repeated a warning it could downgrade the U.S. rating before 2013 if the fiscal or economic outlook weakens significantly, but said it saw potential for a new debt agreement in Washington to cut the budget deficit before then.

Analysts said the S&P 500 index could test Friday's intraday low of 1,168.09. Some trader look for a pullback to the 32.8 percent retracement of the rally from the index's bear market low on March 2009. That level is around 1,100.

(Editing by Jeffrey Benkoe)

With U.S. markets still to open after rival Standard & Poor's stripped the United States of its AAA rating late on Friday, Moody's said in a statement its own decision to affirm the AAA rating on August 2 was on the condition that further cuts were found.

"For the Aaa rating to remain in place, we would look for further measures that would result in the ratio of federal government debt to GDP, for example, peaking not far above the projected 2012 level of near 75 percent by the middle of the decade and then declining over the longer term," Moody's analyst Steven Hess wrote in a report.

"Last week's agreement suggests that coming to an agreement that would meet this criterion by early 2013 will be challenging, given the political polarization, but not necessarily impossible."

Questions about whether U.S. lawmakers will be able to agree on further budget savings next year lie at the center of the disagreement between the two ratings agencies.

While S&P downgraded the United States to AA-plus after last week's debt deal fell short of its expectations, Moody's is willing to give the government more time tackle its debt problems.

Moody's said the United States "continues to exhibit the characteristics compatible with a Aaa rating" despite the expected further deterioration in the government's debt metrics in the next few years.

"Over time, this status could be threatened if further measures to address the long-term fiscal situation are not adopted, but it is early to conclude that such measures will not be forthcoming," Hess said.

(Editing by Patrick Graham)

The immediate effects of the Standard & Poor's downgrade of the country's AAA credit rating late on Friday are likely to be modest, largely because it was expected and already at least partly discounted, experts said.

Many downplayed the likelihood of the sort of financial contagion experienced when Lehman Brothers went under in September 2008. Few had expected it to have to file for bankruptcy, and few were prepared for the fallout. Money market funds froze, some major commercial banks collapsed, and many major dealers and finance houses teetered on the edge of failure.

But even if that type of scenario is unlikely this time, bankers, lawyers and investors wonder if there could be longer-term consequences of S&P's downgrade, given that U.S. sovereign credit is bedrock to the world financial system.

The analysis is complicated because so many of the potential stress points for the financial system are relatively opaque areas like over-the-counter derivatives markets.

Adding to the difficulties is the concern that the downgrade is only one of the many issues roiling global markets. The European debt crisis is spreading, with Italy and Spain coming under the gun after Greece, and data in recent weeks point to a weaker U.S. economy than many investors had thought and have led to fears of another recession.

"I actually think it is going to end up having more of an impact than some of the news stories are suggesting," said Thomas Stoddard, a senior managing director at Blackstone Group who focuses on financial services investment banking.

"Not having the U.S. as triple-A is just going to pop up in more places and have more frictional costs than people might suspect," Stoddard added.

A number of entities that are key players in the U.S. financial system -- including mortgage finance companies Fannie Mae and Freddie Mac, and securities clearinghouses like the Options Clearing Corp Depository Trust Co -- are likely to be downgraded by Standard & Poor's on Monday.

For Fannie Mae and Freddie Mac, losing their triple-A rating could lift borrowing costs, potentially making mortgages more expensive for consumers and adding to stress in the already unstable U.S. housing market.

Last month, S&P said it may also cut ratings for companies like the Depository Trust Co, which facilitates payment transfers among major banks, and several Federal Home Loan Banks and Farm Credit System Banks.

On Friday evening, when S&P cut the United States' sovereign rating by one notch to "AA-plus," it said it would offer more detail about the ratings for these companies on Monday.

DERIVATIVES MARKETS

Another source of potential stress is derivatives markets, where investors and banks often collateralize their positions using U.S. Treasuries.

If banks start demanding more Treasuries to collateralize the same exposure, investors could be forced to sell assets to come up with extra collateral, causing broader market declines. As long as Treasury yields are at all time lows, that risk seems relatively low, said a hedge fund trader who spoke on condition of anonymity.

Some derivatives transactions may have ratings triggers built into them that unwind the deals if the U.S. is downgraded, the trader said, but he said it is difficult to know how many such transactions are out there.

OCC, the world's largest equity derivatives clearing organization, said on Sunday it has no current plans to adjust its current valuations or haircuts on Treasuries used as collateral.

There are some factors working in markets' favor, analysts noted.

For one thing, major U.S. banks are better capitalized as credit losses have slowed. The U.S. banking system had $1.51 trillion of equity capital at the end of the first quarter, compared with $1.29 trillion in the fourth quarter of 2008. That roughly 17 percent of extra capital is supporting about 3 percent fewer assets than it used to.

If stresses become strong in areas like the repo market, a massive market that banks use to fund securities short-term, dealers are fairly sure the Federal Reserve can jump in to offer support, as it did during the credit crunch, the trader said.

Any impact in the derivatives market will be less than what the pessimists fear, said Michael Holland, founder of asset manager Holland & Co. "I don't expect major disruptions in markets just from the downgrade."

BORROWING COSTS

Borrowing costs for companies with top ratings like Microsoft Corp and Exxon Mobil Corp could drop, because triple-A rated debt may be even more attractive to some investors now, analysts said. Some companies have at times had more available cash on their balance sheets than the U.S. government in recent weeks.

In general, corporate borrowing costs may not rise following the U.S. downgrade. Last week, when many in the market were expecting the U.S. to be downgraded, six U.S. companies issued 30-year bonds, which is unusually long-dated for the corporate market.

Even highly-rated corporate bonds have seen their risk premiums rise in recent sessions, signaling that portfolio managers are still concerned about credit risk. As turmoil in Europe ratchets higher, those risk premiums may rise more. But investors' willingness to buy long-term corporate debt signals some confidence in the sector.

"To a certain extent, corporate debt may look even more attractive, especially cash-rich balance sheet companies with lots of liquidity," said Chip MacDonald, a financial services partner at law firm Jones Day.

STATE FINANCES

States that rely heavily on federal government spending -- such as Virginia and Maryland, which are home to many federal employees and defense contractors -- could suffer if Congress and President Barack Obama slice the federal budget more deeply.

A downgrade of Fannie Mae and Freddie Mac would affect billions of dollars of debt issued by public housing authorities secured by federally guaranteed mortgages.

Hospital credits could be weakened if the federal government slashes programs such as Medicaid -- the health plan for the elderly, poor and disabled that accounts for as much as 30 percent of state spending. Stocks in the health care sector sold off last week, amid fears of declining government support for spending in the sector.

"The degree of dependence on the federal government now becomes a state credit issue," said Philip Fischer a managing principal at eBooleant Consulting, in a recent report.

S&P is also expected to immediately downgrade pre-refunded bonds. When municipal bonds are refunded, investors are typically repaid from Treasuries held in escrow.

Debt issued by AAA-rated universities and colleges with global reputations might rise in price, said Evan Rourke, a portfolio manager, with Eaton Vance, citing Harvard and Princeton as examples.

Indeed, the immediate impact of the downgrade might be muted by the tax-free market's traditional strengths.

"I don't see a tremendous flight out of municipals. You might see credit spreads widening for lower-rated issues but we also think a lot will hold their ratings," Rourke said.

(Reporting by Paritosh Bansal and Dan Wilchins, additional reporting by Joan Gralla, Ben Berkowitz and Ann Saphir; Editing by Marguerita Choy)