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Analysts said the one-notch downgrade, citing poor growth prospects and political instability, was ominous for the global economy and would add to mounting strains on European banks as talks to avoid a Greek default drag on.

S&P's rating is now three notches below rival agency Moody's, putting Italy below Slovakia and on a par with Malta.

"There is a wide perception that policy-makers are one step behind markets," IMF chief economist Olivier Blanchard told a news conference after the IMF warned that both Europe and the United States could slip back into recession.

"Europe must get its act together," he said.

Another IMF official said talk of splintering the euro zone was "crazy."

Italy's downgrade overshadowed glimmers of progress in Greece's negotiations with international lenders to avoid running out of money within weeks, and news that Brazil was willing to pump in $10 billion through the IMF to aid Europe.

A Greek Finance Ministry official said on Tuesday the government has agreed to front-load austerity measures and is close to securing a deal with its international lenders.

But investors had larger problems on their minds.

"Italy is a much bigger deal than Greece," said Kathy Lien, director of currency research at GFT in New York.

DEBT ITALIAN STYLE

Italian Prime Minister Silvio Berlusconi said S&P's decision did not reflect reality and his government was already preparing measures to spur growth.

Under mounting pressure to cut its debt, the government pushed a 59.8-billion-euro austerity plan through parliament last week, pledging a balanced budget by 2013.

But there has been little confidence that the much revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of stagnant growth.

"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P said in a statement.

Europe has come under increasing global pressure to resolve a crisis that has seen numerous sovereign rating downgrades and financial rescues for Greece, Portugal and Ireland.

A bailout of Italy would overwhelm euro-zone resources.

Analysts said the crisis should be addressed by policy-makers starting with the U.S. Federal Reserve Board meeting on Tuesday and Wednesday, and the G20 and IMF/World Bank in Washington later in the week.

"I think it's going to necessitate some sort of action by the G20 this weekend," Lien said.

That leaves plenty of scope for disappointment.

The United States has heaped pressure on euro-zone leaders to act more decisively, but received a decidedly cool response.

An EU document, obtained by Reuters, showed the bloc will call on China to boost domestic demand, and on the United States and Japan to tackle their public deficits as part of global efforts to rebalance growth, suggesting there will be no meeting of minds in Washington.

A government official in Berlin said Germany would stress the importance of consolidating public finances, a rebuff to U.S. calls for Europe's stronger economies to provide more stimulus, which the official branded "not helpful."

BANK STRESS PILES UP

In the latest signs of stress on the banking system due to the debt crisis, sources said the Bank of China had stopped foreign-exchange forwards and swaps trading with top French banks Societe Generale, BNP Paribas and Credit Agricole as well as Switzerland's UBS.

The move by a bank that is a big market-maker for China's onshore foreign-exchange market reflected a broad unease about counterparty risk in the euro-zone crisis, three sources with direct knowledge of the matter said.

French banks are among the most heavily exposed to Greece, which ratings agency Fitch said on Tuesday was likely to default but stay in the euro zone.

A Paris-based source said German engineering giant Siemens withdrew an unknown amount in deposits from SocGen in July, although that was because of underperformance and not fears over the French bank's financial health.

And in a sign of growing funding troubles, commercial banks took 201 billion euros in the European Central Bank's main seven-day refinancing operation on Tuesday, the highest volume since early February.

The head of the European Central Bank, Jean-Claude Trichet, urged in a newspaper interview that European banks strengthen their balance sheets to improve their resistance to the crisis.

Finnish Prime Minister Jyrki Katainen said in a television interview: "If a euro-area country were to end up in very bad shape, it would impact banks' health. If one or more significant banks were in bad shape, it would spread irrational panic to the whole banking market, which could cause good banks to suffer.

"We have both country risk and banking market collapse risk, but we are working every day to avoid these risks and to create as much stability as possible," he told MTV3.

GREEK DRAMA DRAGS ON

A Greek finance ministry official said Athens was close to a deal with European and IMF inspectors on extra austerity measures to secure the release of an 8-billion-euro loan installment vital to pay state salaries and pensions next month.

But a source in the troika of lenders said no agreement could be clinched until their top officials returned to Athens. They have so far conducted talks by telephone to raise pressure on Greece to comply.

The international lenders are demanding public-sector job cuts, higher heating oil tax and more pension cuts to close a gap in this year's budget deficit due to a deeper-than-forecast recession and poor revenue collection.

Finance Minister Evangelos Venizelos held what Greece termed "productive and substantive" talks by phone with senior EU and IMF officials on Monday after promising as much austerity as necessary to win a vital next tranche of aid.

Experts were thrashing out details all day on Tuesday and Venizelos was to confer again with the EU/IMF mission chiefs by telephone at 1700 GMT, his office said.

Italy, the euro zone's third-largest economy, has been dragged to the center of the debt crisis over the past three months as concern has grown about its ability to handle debt equal to 120 percent of GDP.

S&P cut its ratings on Italy to A/A-1 from A+/A-1+ and kept its outlook negative. The move was a surprise because the market had thought Moody's was more likely to downgrade Italy first. Moody's said last week it would take another month to decide on its action.

Brazil could make up to $10 billion of its own money available to help Europe through various channels, including the IMF, or by making bond purchases, and has urged other large emerging market countries to provide similar support, an official told Reuters.

It has previously said it was in talks with the four other big emerging economies or so-called BRICS -- Russia, India, China and South Africa -- to make coordinated purchases of bonds of euro zone countries.

Brazil's contribution by itself would almost certainly be too small to make a major difference to Europe's debt and it will have a tough time convincing its risk-averse fellow BRICs to bankroll a European rescue -- no matter how the aid is structured.

(Reporting by Reuters bureaus; Writing by Raju Gopalakrishnan and Paul Taylor; Editing by Catherine Evans)

Housing starts decreased the most since April, down 5.0 percent to a seasonally adjusted annual rate of 571,000 units, the Commerce Department said on Tuesday.

Offering a glimmer of hope for the sector, permits for future construction rose 3.2 percent.

Economists polled by Reuters had forecast housing starts to fall to a 590,000-unit rate in August. Housing starts are at less than a third of their peak during the housing boom.

"The housing market is not only bad, but still missing low expectations," said Sal Catrini, a managing director for equities at Cantor Fitzgerald & Co in New York.

An overhang of previously owned homes on the market has left builders with little appetite to break ground on new projects and is frustrating the economy's recovery from the 2007-09 recession.

On Monday, the National Association of Home Builders said already depressed U.S. homebuilder sentiment dipped in September.

"It (the housing market) won't improve until the labor market improves substantially and that doesn't look like that would happen this year," said Scott Brown, chief economist at Raymond James in St. Petersburg, Florida.

U.S. Treasuries prices pared early losses after the disappointing data, while stock futures rose as investors waited to see if the Federal Reserve would offer aid to a sputtering U.S. economy after a two-day policy review that begins today.

July's housing starts were revised down to a 601,000 unit pace, which was previously reported as a 604,000 unit rate.

Housing starts and completions may have been affected by tropical storms in August, including Hurricane Irene which pummeled the East Coast at the end of the month.

Starts in the Northeast fell 29.1 percent last month, a bigger decline than any other region. New residential construction fell 3.3. percent in the South.

Compared to August of last year, total starts were down 5.8 percent.

Housing starts for multi-family homes fell 13.5 percent to a 154,000-unit rate. Single-family home construction -- which accounts for a larger share of the market -- dropped 1.4 percent to a 417,000-unit pace.

New building permits rose to a 620,000-unit pace last month. Economists had expected overall building permits in August to fall to a 590,000-unit pace.

Permits were boosted by a 4.5 percent rise in the multi-family segment. Permits for the construction of buildings with five units and more increased 0.6 percent. Permits to build single-family homes climbed 2.5 percent.

New home completions fell 2.7 percent to a 623,000-unit pace in August.

(Additional reporting by Caroline Valetkevitch and Richard Leong in New York, Editing by Andrea Ricci)

* The Federal Open Market Committee begins a two-day meeting on interest rate policy. The Fed is expected to try to push already low long-term interest rates even lower this week by tilting toward longer-duration bonds in its portfolio, a move known as Operation Twist.

* Samsung Electronics Co (005930.KS) is considering legal action to ban sales of Apple Inc's (AAPL.O) new iPhone, a source familiar with the matter said, in what could be its strongest step to defend against claims by Apple that the South Korean company had copied its product designs.

* ICSC/Goldman Sachs release chain store sales for the week ended September 17 at 1145 GMT. In the previous week, sales rose 1.3 percent.

* Standard & Poor's cut its unsolicited ratings on Italy by one notch, a surprise move that sharply increases strains on the debt-stressed euro zone and piles pressure on policymakers to take more decisive action to resolve the crisis.

* International lenders told Greece on Monday it must shrink its public sector to avoid running out of money within weeks, as investors spooked by political setbacks in Europe dumped risky euro zone assets.

* Bank of China, a big market-maker in China's onshore foreign exchange market, has stopped foreign exchange forwards and swaps trading with several European banks due to the unfolding debt crisis in Europe, three sources with direct knowledge of the matter told Reuters on Tuesday.

* The U.S. Commerce Department releases housing starts and permits for August at 1230 GMT. Economists forecast a 590,000 annualized rate for starts versus 604,000 in July, and a total of 590,000 permits in August versus 601,000 in the prior month.

* Securities regulators have sent subpoenas to hedge funds and other trading firms as they probe possible insider trading before the U.S. government's long-term credit rating was cut last month, the Wall Street Journal said, citing people familiar with the matter.

* Major companies reporting results include Oracle (ORCL.O), ConAgra Foods (CAG.N), Adobe (ADBE.O) and Carnival Corp (CCL.N).

* At 125 GMT, Redbook releases its Retail Sales Index of department and chain store sales for September versus August. In the prior period, sales rose 0.2 percent.

* U.S. trade officials will announce a major trade enforcement action against China on Tuesday, according to an advisory from the U.S. Trade Representative's office.

* U.S. reinsurer Transatlantic Holdings (TRH.N), which rejected a takeover offer from Warren Buffett's Berkshire Hathaway (BRKa.N), is exploring a "limited standstill" agreement with Validus Holdings (VR.N), the Wall Street Journal said, citing people familiar with the matter.

* President Barack Obama laid out a $3.6 trillion plan on Monday to cut U.S. budget deficits partly by raising taxes on the rich, but Republicans rejected it as a political stunt and made clear the proposal had little chance of becoming law.

* UBS AG (UBSN.VX)(UBS.N) Chief Executive Oswald Gruebel will seek a vote of confidence at a board meeting in Singapore for plans to slash the investment banking division that caused a $2.3 billion loss due to unauthorized trading, a Swiss newspaper reported.

* European shares turned positive in early trade as investors went bargain hunting following sharp falls in the previous session. The pan-European FTSEurofirst 300 .FTEU3 index of top shares was up 0.4 percent. .EU

* Japan's Nikkei average .N225 fell 1.6 percent after the market reopened following a holiday on Monday.

* The Dow Jones industrial average .DJI on Monday dropped 108.08 points, or 0.94 percent, to 11,401.01. The Standard & Poor's 500 Index .SPX lost 11.92 points, or 0.98 percent, to 1,204.09. The Nasdaq Composite Index .IXIC edged down 9.48 points, or 0.36 percent, to 2,612.83.

(Reporting by Atul Prakash; Editing by David Holmes)

The UBS board is due to meet in Singapore on Wednesday and Thursday for one of the four regular meetings it holds every year, said two sources with direct knowledge of the arrangements.

"Of course the investment bank matter will be discussed and the way forward," a UBS insider said.

The meeting in Singapore has the added benefit that the Singapore sovereign wealth fund GIC, which is UBS's biggest shareholder with a 6.4 percent stake, can be consulted.

The meeting, scheduled before the rogue trades came to light last week, coincides with the Singapore Formula One Grand Prix, of which UBS is a major sponsor.

UBS is under pressure to scale down, ringfence or even split off its risky investment banking business from its core wealth management unit in order to shield private clients.

The bank was widely expected to speed up an overhaul of its investment bank that had been planned for announcement at an investor day on November 17, though big shareholders have signaled they could wait until that date while the bank completes an internal investigation, one source at the bank said.

Gruebel said on Sunday he would "bear the consequences" of the $2.3 billion trading loss that was discovered last week but did not want to quit, adding the affair would influence the future strategy of the investment bank.

Another UBS insider said this did not necessarily imply Gruebel would leave immediately, but he might be thinking of forgoing his annual bonus again, speeding up restructuring or making other senior management changes.

Investment bank head Carsten Kengeter, who is also in the firing line, told staff he was fully committed to working closely with them to repair the damage to the bank's reputation.

"Now is the time for everyone across the investment bank to demonstrate ... that we are not going to let a single calculated act of deception deflect us from achieving our long-term strategic goals," he said in a memo obtained by Reuters.

Citing unnamed sources, the Tages-Anzeiger newspaper reported that Gruebel wants to carry out the restructuring himself and is seeking a board vote of confidence that he should stay on at least until 2013 or else he will step down.

UBS declined to comment on the report.

WEBER TO STEP IN EARLIER?

The loss is a heavy blow to the reputation of Switzerland's biggest bank, which had just started to recover after its near collapse during the financial crisis and a damaging U.S. investigation into its aiding wealthy Americans to dodge taxes.

The UBS board has set up a committee chaired by independent director David Sidwell, former chief financial officer at Morgan Stanley (MS.N), to conduct an independent investigation into the unauthorized trades and the bank's control systems.

London trader Kweku Adoboli was charged on Friday with fraud and false accounting dating back to 2008.

Gruebel, a gruff 67-year-old German who previously ran Credit Suisse (CSGN.VX), was brought out of retirement in 2009 to help clean up UBS after huge losses on subprime assets forced the Swiss government to bail out the bank.

He initially indicated he would only stay in the job for a couple of years to get the bank back on its feet but suggested recently that he could stick around at least until former Bundesbank boss Axel Weber takes over as chairman in 2013.

The Tages-Anzeiger reported that one option under discussion was that Chairman Kaspar Villiger could hand over to Weber a year earlier than planned.

Meanwhile Sergio Ermotti, the former deputy boss of UniCredit (CRDI.MI) who joined UBS as Europe, Middle East and Africa chief in April, could be given new responsibilities as he is groomed as a potential successor to Gruebel.

Singapore's GIC said on Monday the losses on its investment in UBS were offset by good investment decisions, which had helped its portfolio rebound to a level seen prior to the global financial crisis, but did not comment on the latest loss.

The stake was worth around 2.5 billion francs, which means the sovereign wealth fund has lost about 77 percent of its 11 billion franc investment in UBS made at the end of 2007, excluding dividends, according to Reuters calculations.

($1 = 0.885 Swiss Francs)

(Editing by Sophie Walker)