NEW YORK — Mighty investment banks were laid low. Stocks put in their worst performance in seven years. About $700 billion was washed away on Wall Street.

The crisis set in motion more than a year ago by a series of bad mortgage bets produced its most devastating day yet yesterday, leaving investors to wonder which domino would fall next — and whether anywhere was safe for their money.

Capping a tumultuous 24 hours that redrew the American financial system, Lehman Brothers filed the largest bankruptcy in American history, and a second storied bank, Merrill Lynch, fled into the arms of Bank of America.

The carnage spread to Wall Street. The Dow Jones industrial average lost more than 500 points, more than 4 percent, its steepest point drop since the day the stock market reopened after the Sept. 11, 2001, attacks.

About $700 billion evaporated from retirement plans, government pension funds and other investment portfolios.

It was by far the most stomach-churning single day since a financial crisis began to bubble up from billions of dollars in rotten mortgage loans that have crippled the balance sheets of one bank after another and landed mortgage giants Fannie Mae and Freddie Mac under the control of the federal government.

"We are in the middle of a deep, dark recession, and it won't end soon. Here it is, and it is pretty nasty," said Barry Ritholtz, who writes the popular financial blog The Big Picture and is CEO of research firm FusionIQ.

And the fallout is far from over. American International Group, the world's largest insurer, is fighting for its very survival: New York Gov. David Paterson moved to allow the company to tap one of its subsidiaries for an emergency loan to stay above water.

"AIG still remains financially sound," Paterson said, even as the company's stock tumbled almost 60 percent as it scrambled to raise as much as $75 billion in capital. Almost $20 billion was wiped off AIG's balance sheet yesterday.

The market's direction today could hinge in large part on what happens with AIG and on the outcome of a Federal Reserve meeting on interest rates.

Like Lehman and Merrill, AIG has recorded large losses on mortgage-related debt. And as with Lehman, investors fear that a collapse of AIG would ricochet through the financial system and prompt another wave of selling in the stock market.

"AIG without a lifeline was a bigger story" yesterday than the Lehman Bros. bankruptcy, said Joe Battipagilia, market strategist at brokerage Stifel, Nicolaus & Co. in Florham Park, N.J. "You could crater the market on Tuesday with no resolution of AIG."

Meanwhile, the Fed meets today to decide interest rate policy. It's widely expected to keep rates at 2 percent, but some economists believe it could lower them to soothe Wall Street's frazzled nerves.

In Washington, Treasury Secretary Henry Paulson, who refused to toss a financial lifeline to Lehman, was unapologetic as the Bush administration signaled strongly that Wall Street shouldn't expect more rescues from Washington.

The American people should remain confident in the "soundness and resilience in the American financial system," Paulson said at the White House.

STEPPING IN

Six months ago, Paulson moved to prevent the collapse of Bear Stearns, brokering a deal for JP Morgan Chase & Co. to buy the firm at a fire-sale price with Federal Reserve backing. Earlier this month, he stepped in to help the government seize Fannie and Freddie in hopes of reversing the housing and credit crises.

But yesterday, Paulson said he "never once" considered it appropriate to put taxpayer money at risk to resolve the problems at Lehman Brothers, which was saddled with $60 billion worth of soured real estate holdings.

The result was one of the most momentous days in Wall Street history since legendary banker J. Pierpont Morgan helped broker the rescue of financial markets during the Panic of 1907.

The Dow industrials dropped 504.48 points to close at 10,917.51, the first time since July they have finished under 11,000. It was the sixth-largest point drop ever and the worst since Sept. 17, 2001, when the average fell 684.81 points on the first day of trading after the terror attacks.

In percentage terms, the fall for the Dow yesterday was its worst since the summer of 2002. The index has shed nearly a quarter of its value since its record high last October.

Broader stock indicators also fell. The Standard & Poor's 500 index lost more than 4 1/2 percent, and the Nasdaq composite index lost more than 3 1/2 percent.

Financial stocks fell as investors worried about the strength of banks' balance sheets. Washington Mutual Inc. dropped 27 percent to $2 a share, while Wachovia Corp. fell 25 percent to $10.71.

Stock prices also tumbled in Asia and Europe, and were down again in Asia early today.

While Lehman Brothers was filing for Chapter 11 and AIG was scurrying to find financing to stay afloat, Merrill Lynch was avoiding a similar fate with a $50 billion transaction to become part of Bank of America Corp.

The deal would create a financial giant rivaling Citigroup Inc., the biggest U.S. bank in terms of assets. Bank of America has the most deposits of any U.S. bank, while Merrill Lynch is the world's largest and most widely recognized brokerage.

"It was an opportunity of a lifetime," said Ken Lewis, Bank of America's chairman and CEO.

Lewis made the announcement at a news conference where he was flanked by a smiling John Thain, Merrill's chief executive. The two put the deal together in 48 hours, while they were taking part in marathon discussions at the New York Federal Reserve over the weekend to save Lehman Brothers. Merrill stock rose a penny yesterday.

One huge concern is that the Lehman bankruptcy will probably trigger even tighter credit — making it more difficult for everyone from large companies to small businesses to American homebuyers to borrow money.

It was a dark day for Lehman workers, too. Many of them brought gym bags, shopping totes and Lehman travel bags to cart home personal files and pictures from their desks at the company's midtown Manhattan headquarters. Gawkers lined up behind metal barricades, and bystanders took pictures with their cell phones.

The failure of Lehman and probable job losses at Merrill are also a blow to the New York City economy, which is still trying to absorb a blow from shrunken tax revenues after the collapse of Bear Stearns in March. The city and its outlying suburbs rely heavily on taxes paid by workers in the financial services industry.

In marathon sessions Friday night, Saturday and Sunday, government officials and the chief executives of major U.S. and foreign banks huddled at the New York Fed's building in downtown Manhattan, trying to work out a way to save Lehman.

They failed at that. But a group of 10 banks that includes JPMorgan, Goldman Sachs and Citigroup formed a $70 billion pool that banks or brokerages can tap to cover short-term funding needs.

There were also worries that Lehman's problems would infect other financial companies and spread to global stock markets.

The financial turbulence could also further derail consumer confidence in the economy just as stores prepare for the critical holiday shopping season. The upheaval in the financial system also means that those consumers with marginal credit history will have an even harder time getting loans, cutting into consumer spending.

"The backdrop even without this was tough. This certainly adds to the worry level," said Michael P. Niemira, chief economist at The International Council of Shopping Centers.

CANDIDATES' TAKE

Republican presidential nominee Sen. John McCain assailed "greed and corruption" on Wall Street and promised to clean it up, while his Democratic opponent, Sen. Barack Obama, blamed White House policies and said his opponent would only deliver more of the same.

Obama called it "the most serious financial crisis since the Great Depression." McCain declared in a new TV ad that "our economy is in crisis" and that only he and his running mate, Alaska Gov. Sarah Palin, could fix it. McCain also told voters in Jacksonville, Fla., "The fundamentals of our economy are strong."

The Los Angeles Times contributed to this report.