World markets set for rocky ride after banking crisis sends shudders through Wall St

The 280-point fall on the main Dow Jones index was largely due to fears over the state of US investment bank Lehman Brothers.

Investors had hoped that the government's bailout of mortgage giants Freddie Mac and Fannie Mae would slow the plummeting property market and help alleviate the credit crunch.

Plunge: A 280 point fall on the main Dow Jones index was largely due to fears over the state of US investment bank Lehman Brothers

But the euphoria soon melted away after it emerged talks between Lehman, America's fourth biggest investment firm, and the Korean Development Bank over a much needed cash injection have broken down.

The FTSE 1000 closed down 31 points at 5415, having initially posted a 78 point gain.

Asian stocks fell for a second day this morning, led by materials and shipping companies, over concerns slowing global growth will curb demand for resources.

The UK economy is contracting for the first time in at least a decade, the National Institute for Economic and Social Research said today.

Lehman has already racked up losses of over £4bn from bets on America's tainted sub-prime housing market, and more write-downs are expected at its forthcoming results.

The bank, which lost 30 per cent of its value on Tuesday, may bring forward the figures to reassure Wall Street, sources said. 

The growing crisis at Lehman reignited fears over the parlous state of the US financial system. 

Analyst Marc Pado of Cantor Fitzgerald said Lehman, needed 'to come out and reassure Wall Street that they are an ongoing entity'.

'Otherwise there's no mercy on Wall Street once they lose confidence in you.'

Lehman and KDB are thought to have been in talks for two months about the prospect of the state-run Korean bank taking a stake in Lehman. 

Lehman has been linked with a number of overseas financial firms as it tries to shore up its finances.

With over £20bn in free-falling commercial property assets, analysts say it is in dire need of raising some fresh cash. 

Todd Leone at US broker Cowen & Co said: 'Lehman's been rumoured to be in trouble for a while, and people were hoping the Koreans might bail them out.' 

More alarming data from the US housing market, showing transaction falling another 3.2 per cent in July, shattered any illusions there is a quick fix for America's  economic woes.

Bear Stearns was pushed to the brink of collapse by a loss of confidence among its funders and fears of crippling cash shortages. 

The Wall Street bank, employer of 14,000 people, was rescued from bankruptcy through a hastily arranged takeover by JP Morgan, backed by £15bn of Federal Reserve money. 

The fear was that if Bear failed it could had ripple effects across the global financial sector. 

Stockbrokers on this side of the Atlantic remained enraged at the seven-hour halt on the London Stock Exchange on Monday, which has cost them millions in lost commissions.

For many traders, the LSE's attempts to pin the blame on a software bug did not go far enough to undo the damage caused by the outage.