The broader Standard & Poor's 500 Index plunged more than 4.7 per cent for its lowest close since October 2005 and sharpest drop since the September 2001 attacks.
News of the venerable Lehman Brothers' failure came hours after financial services firm Merrill Lynch & Co agreed to a takeover by Bank of America Corp - the product of a frantic weekend of talks.
Negotiations throughout the weekend failed to produce a buyer for the 158-year-old Lehman Brothers, after the US Treasury refused to risk taxpayer money to facilitate a deal, leading to the fourth-largest US investment bank's bankruptcy filing in the morning.
The developments in the US earlier sent stocks in Asia and Europe into a nosedive as fears of further bank failures in the world's largest economy spread throughout global markets.
Other financial firms under threat included bank Washington Mutual and American International Group Inc, the largest US insurer. AIG reportedly needs to raise 20 billion dollars in capital and sell another 20 billion dollars in assets.
The US Federal Reserve Board, the rate-setting central bank, asked finance giants Goldman Sachs Group Inc and JP Morgan Chase to help make up to 75 billion dollars in short-term financing available to AIG, US media reported. Shares in AIG were down more than 60 per cent Monday.
In a surprising deal announced late Sunday, Merrill Lynch, a stock brokerage and investment bank, agreed to be bought out by Bank of America for 50 billion dollars in stock.
Bank of America chief executive Kenneth Lewis said Monday that the acquisition left the banking giant best positioned to weather the financial storm that he said was unlikely to end before 2010.
"The combined company is a much stronger entity and will survive almost anything as a result of the combination," Lewis said.
Bank of America's share price plunged 20 per cent Monday.
The Dow industrials fell 504.48 points, or 4.42 per cent, to 10,917.51. The S&P 500 was down 59 points, or 4.71 per cent, to 1,192.7.The technology-heavy Nasdaq Composite Index plunged 81.36 points, or 3.6 per cent, to 2,179.91.
The US currency fell to 70.13 euro cents from 70.30 euro cents on Friday. The dollar plunged against the Japanese currency to 104.86 yen from 107.94 yen on Friday, its largest one-day decline since 1999.
Bank of America had reportedly been in talks to acquire Lehman, which became the largest casualty to date after more than a year of turmoil arising from the bursting of the US housing bubble.
A record rate of home foreclosures has severely undermined Wall Street's market for mortgage-backed securities. Many banks had been taking on greater debt in the last decade without maintaining enough cash reserves to meet a sharp downturn.
Banks and mortgage lenders have already reported more than 500 billion dollars in losses and writedowns off bad debt from the crisis. The International Monetary Fund has forecast 1 trillion dollars in total losses.
President George W Bush warned that "painful" short-term adjustments were needed in the financial sector but insisted economic fundamentals remained strong.
Banks took out 70 billion dollars in short-term loans from the Federal Reserve on Monday - the largest one-day injection of Fed reserves into the financial system since September 2001. The Fed had announced Sunday that it would accept a wider array of securities as collateral for loans.
A group of 10 major banks on Sunday set up an independent 70-billion-dollar fund that each could tap into in emergencies.
On Tuesday, the Fed's Board of Governors in a previously scheduled meeting will decide whether to slash interest rates to keep credit available to US companies and consumers.
Earlier this year, the Fed helped engineer the sale of another troubled investment banking firm, Bear Stearns. More recently, the federal government acted to take over the government-chartered mortgage facilitators Fannie Mae and Freddie Mac, which undergird the mortgage-backed securities markets.
The Bear Stearns and Fannie-Freddie bailouts could cost taxpayers as much as 200 billion dollars.
Paulson defended his decision not to rescue Lehman, saying the situation was "very different" from that of Bear Stearns.
"I never once considered that it was appropriate to put taxpayer money on the line" for Lehman, Paulson told reporters, but he would not rule out the possibility of other bailouts in the future.