Fed Hints at Rate Cut But Bear Market Takes Further 500-point Bite Out of Dow Jones

Alarm over the health of leading US banks sent Wall Street shares plummeting for a fifth successive day despite a broad hint from the Federal Reserve of an imminent cut in interest rates.

The Dow Jones industrial average slumped 508 points to 9,447. There were signs of a fresh collapse in confidence in financial institutions as Morgan Stanley, Merrill Lynch and Bank of America each lost a fifth of their value.

In a week, the blue-chip US index has fallen by 1,400 points, wiping 13% off share prices. The sell-off accelerated after the Fed's chairman, Ben Bernanke, warned of dark days ahead: "Economic activity is likely to be subdued during the remainder of this year and into next year." He spoke of "financial turmoil" in a speech to a conference in Washington.

Bernanke said the slowdown had eased the risk of inflation and in a sentence widely interpreted as a suggestion of an interest rate cut, he added: "The Federal Reserve will need to consider whether the current stance of policy remains appropriate."

In a mood of extreme edginess on Wall Street trading floors, speculation circulated that US banks were struggling to raise money. A rumor did the rounds that a planned $9bn investment in Morgan Stanley by Japan's Mitsubishi was falling apart, sending the US firm's shares down 20% despite its insistence that the deal was on track.

Bank of America took a hammering on suggestions that it was struggling to find subscribers for a $10bn fundraising. Its shares dived 26% although there were indications after the market closed that the cash call had been oversubscribed.

Merrill Lynch fell 25% because it is being taken over by Bank of America in a share-for-share transaction which is rapidly declining in value.

President George Bush, who was visiting an office supply company in a Washington suburb, acknowledged that times were "tough" but insisted the US would recover, saying: "We've been through tough times before. I wish I could snap my fingers and make what happened stop. But that's not the way it works."

The sell-off came in spite of an effort by the US central bank to thaw out the credit markets by using public money to purchase commercial paper - a type of short-term debt issued by companies to generate day-to-day funding.

Faced with the worsening environment, analysts at Deutsche Bank forecast that the US economy will shrink by 2% in the final quarter and unemployment could hit 7% next year. "Financial conditions are deteriorating at an ever faster pace," said Deutsche's economists in a note to clients. "The economy needs credit expansion and without it, activity could collapse."

The International Monetary Fund raised its estimate of losses from the global financial crisis to the US banking system to about $1.4tn (£800bn), up 45% from the $945bn it estimated in April and reaffirmed just two months ago.

The figures, released in its twice-yearly Global Financial Stability Review, gave fresh impetus to the push for a comprehensive and coordinated international response to the crisis, which the IMF said had become disorderly and more damaging than previously thought.

It also estimated that the global banks needed to raise $675bn in new capital in the next few years. The IMF's managing director, Dominique Strauss-Kahn, said the report "shows how serious a crisis we currently face".

"The time for piecemeal solutions is over. I therefore call on policymakers to urgently address the crisis at a national level with comprehensive measures to restore confidence in the financial sector. At the same time, national governments must closely coordinate these efforts to bring about a return to stability in the international financial system."

The global financial crisis has its roots in the US mortgage industry, where the sheer scale of liabilities on subprime loans is gradually becoming clear. The US Mortgage Bankers Association revealed yesterday that US lenders lost an average of $560 on every mortgage written last year.