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U.S. Stocks Close Sharply Lower as Rate-Cut Hopes Dim

Stocks closed broadly lower as already jittery investors expressed disappointment that the latest Fed minutes showed policymakers were reluctant to cut interest rates.

"The comments from the Fed not indicating that a rate cut was imminent and further deterioration in the financial sector -- all of this combined and we're down substantially here," said Brian Schaeffer, an NYSE floor specialist at Van der Moolen.

"Lack of volume is certainly part of it, but there are not a lot of big institutions out there deploying their capital right now in order to stabilize these markets," Schaeffer added.

The Dow Jones Industrial Average fell more than 2%, with similar losses seen in the S&P 500 and the Nasdaq Composite. It was the first time all three indexes fell more than 2% since Aug. 9.

All but one Dow component, Home Depot, ended the trading session in negative territory.

The markets turned lower after minutes from the Federal Reserve's Aug. 7 meeting did not offer any clear signal the central bank was closer to cutting interest rates. The Fed merely hinted at a rate cut, saying a response would be warranted if financial market conditions take a turn for the worse.

"I think it was a knee-jerk reaction," said Stephen Leeb, president of Leeb Capital Management. "They didn't shed any further light except that the Fed was prepared to react to more economic turbulence."

The central bank surprised financial markets on Aug. 17 when it cut the discount rate to add more liquidity to the banking system. Most investors now expect the Fed to cut the more important fed funds rate at its next regular meeting on Sept. 18.

Trading breadth was negative with declining shares outpacing advancers by almost seven-to-one margin on the NYSE. All 10 economic sectors tracked by S&P traded lower with declines led by financial stocks, which fell 3.2%.

Stoking credit concerns, Boston-based money manager State Street has as much as $22 billion in exposure to packages of retail and commercial loans backed by short-term debt, London newspaper The Times reported.

"There's some renewed concerns about credit defaults, not in the subprime mortgage area but in the credit card area," said Tom Schrader, managing director of U.S. listed trading at Stifel Nicolaus. "People are worrying that you're getting a spreading or contagion to the other debt instruments."

"There's a lot of headline risk happening here, investors are taking some profits after the runup last week," said Sebastian Leburn, chief investment officer at Weiss Capital Management. "The credit market remains a concern; that's certainly another negative for investors to digest."

Merrill Lynch shook up the sector earlier today after the company's equity research unit downgraded Bear Stearns , Lehman Brothers and Citigroup to "neutral" from "buy," citing the firms' exposure to debt markets.

"With financials downgraded by Merrill Lynch, you're looking at a lot of things weighing on the market," says Peter Costa, managing director at Eckhard & Company.

Barclays shares fell on reports the British bank's investment unit Barclays Capital has several hundred million dollars of exposure to four failed investment vehicles it arranged for clients, the Financial Times reported. The London bank later denied that it provided funding to Sachsen Funding, an investment vehicle for German bank Sachsen.

MedcoHealth Solutions said it is buying diabetes care providerPolyMedica for $1.5 billion in an all-cash deal. Medco, the largest drug benefits manager in the U.S., will pay $53 a share to PolyMedica shareholders, a premium of 17% over the stock's closing price Monday.

In economic news, consumer confidence deteriorated in August to its lowest level in a year on concerns about a softening labor market and market turmoil stemming from the subprime mortgage crisis.

House prices across the nation declined by 3.2% in the second quarter from a year earlier, suggesting the housing downturn has deepened, according to the S&P/Case-Shiller U.S. National Home Price Index.

Homebuilding stocks such as Centex , Lennar and Toll Brothers were all down sharply, trading near 52-week lows.

Treasury prices moved higher, sending yields lower.

Warren Buffett's Berkshire-Hathawayraised its stake in railroad company Burlington Northern Santa Fe to nearly 15%, according to documents filed with the U.S. Securities and Exchange Commission. Shares of Burlington Northern opened up 1.1%.

Major indexes in Europe were all firmly in red, while stocks in Asia finished mixed.

The Federal Reserve will release minutes from the Aug. 7 FOMC policy meeting this afternoon.