A woman walks past a tote board tracking the level of the TSX in Toronto's financial district on Monday. (Nathan Denette/Canadian Press)

Stock markets took another beating on Monday as the credit crunch claimed more victims in the U.S. financial sector.

Investors bailed out after Lehman Brothers, the fourth-largest U.S. investment bank, filed for bankruptcy protection and Merrill Lynch agreed to a $50-billion US takeover by Bank of America.

Meanwhile, New York state regulators will allow American International Group Inc. to borrow $20 billion US from its subsidiaries so that AIG can continue to operate.

In the wake of that news, the S&P/TSX index tumbled to a loss of 515.55 points to close at 12,254.03.

On Wall Street, the Dow Jones industrial average shed 504.48 points — it's biggest one-day drop since the attacks of Sept. 11, 2001 — to end at 10.917.51. The Nasdaq composite dropped 81.36 points to close at 2178.91.

The market carnage arose as Lehman and Merrill became the latest institutions to wither due to heavy involvement in the subprime mortgage market and the resulting credit crunch.

U.S. Treasury Secretary Henry Paulson tried to calm roiled markets and the U.S. public, saying people can remain confident in the "soundness and resilience in the American financial system." Paulson also said the U.S. government never considered using public money for a bailout of Lehman.

The stock price of 158-year-old Lehman Brothers crumbled more than 94 per cent to just 21 cents. AIG shares fell more than 60 per cent to $4.76.

Merrill Lynch actually finished up, gaining one cent to close at $17.06.

Canadian financial stocks felt the carryover effect from the problems in the U.S. CIBC was off 4.8 per cent at $61.11 after the bank said it had about $25 million in exposure to Lehman Brothers.

Royal Bank was down by 2.2 per cent at $48.10, while TD was off 1.6 per cent at $61.30 and Scotiabank eased 2.4 per cent to $46.60. Bank of Montreal ended off 1.6 per cent at $48.34.

Sun Life Financial said it holds $334 million of Lehman bond securities and approximately $15 million net value of Lehman derivative instruments. Sun Life said it expects to take a charge in the third quarter on the value of its Lehman holdings. Sun lLife gave up 78 cents to finish at $39.74.

Amid the heavy stock liquidating, one Toronto-based money manager cautioned against panic selling.

"If you follow your emotion and say, 'I have to sell everything and get out of this market,' you inevitably sell near or at the bottom of the market," said David Baskin, the president of Baskin Financial Services.

"Whereas those who say, 'This feels awful, but I'm not going to do anything about it, I'm going to let the rational part of my brain take over here and not give in to the emotions' — those are the people who end up six months later saying , 'Gee, what was all that about?' "

One economist said he believes there is still more pain to come for the U.S. financial sector.

"We're not quite done yet," TD Securities strategist Eric Lascelles told the CBC, adding that with U.S. home prices still soft, there is still more bad news ahead.

Oil slides

Lower oil prices were also playing a big role in the retreat of equities in Toronto. News about Lehman and Merrill, coupled with reports that damage caused by Hurricane Ike to oil and gas infrastructure along the Texas coast of the Gulf of Mexico was less than feared, helped push crude prices lower.

Light, sweet crude for October delivery dropped $5.47 US to settle at $95.71 a barrel on the New York Mercantile Exchange. It marked oil's first settlement under $100 US since March 4.

The damage was not confined to North American markets. Stocks in Asia and Europe also faced a heavy selloff.

In London, the FTSE-100 share index closed down 3.9 per cent, while the Paris CAC-40 was off 3.7 per cent and DAX 30 of Germany dropped 2.7 per cent.

Exchanges in Hong Kong and South Korea were closed for holidays. Major indices in India, Taiwan and Singapore all dropped more than three per cent.

With files from the Associated Press