The FTSE 100 was down 153.3 points at 5050.9 and the FTSE 250 was down 186.3 points at 8522.1 at 12:12 pm this morning.
Banking issues remained in turmoil amid mounting concern about the financial health of the American International Group, the insurance giant whose credit ratings have been downgraded at Moody's and Standard & Poor's.
"The market is still digesting Lehman [which filed for bankruptcy yesterday] and Merrill [which has been taken over by Bank of America, the giant commercial lender] and now we have this headache about AIG," said on trader, expecting the sell off to accelerate after trading commences on Wall Street.
Another citied speculation the Lehman was unwinding its positions across the market, causing the latest move down.
HBOS was the hardest hit this morning - down more than 23 per cent or 54.5p at 178p - despite words of support from Collins Stewart analyst Alex Potter, who said that the bank did not have the sort of liquidity problems being anticipated by the market.
"We believe yesterday's sharp fall in HBOS's stock price was driven by reports that HBOS has more than £110bn of debt refinancing to face in the coming three months.
We actually make the gross refinancing requirement for the group to be around £127.9bn using last available data but this is clearly a rolling event. Firstly, the company had no apparent liquidity issues in the first quarter of 2008 (the period this amount relates to) but we do believe that the position currently is of a similar quantum.
Secondly, we would point to the around £60bn of liquidity assets the bank has (and is confident it could realise value for) as well as the around £30bn of normal loan repayments we estimate occur each quarter for the bank. So the net exposure can be as low as sub-£40bn in the coming three months if the bank restricted new lending," said Mr Potter, adding:
"We have also been assured that the liquidity issues affecting the banking industry relate to term funding generally above 12 month maturities… We do no believe HBOS has a liquidity issue."
Bradford & Bingley was trading lower, down 6.35 per cent or 2p at 29.5p, after Moody's downgraded its ratings for the bank. Cazenove, which weighed-in on the move this morning, said the news was "significant, leaving key ratings at the lowest investment grade and with a negative outlook".
"This will make it increasingly difficult for B&B to obtain wholesale funding at competitive rates, a point noted by Moody's in its assessment that B&B is becoming increasingly reliant on the SLS [the Bank of England's Special Liquidity Scheme, which allows banks to swap mortgage assets for more liquid government bonds]," the broker said, adding:
"The business model is in question, in our view, but we regard the value of B&B to a third party as limited given the evidently high risk loan book and lack of franchise compared with other UK banks."
Weaker oil prices aided British Airways, up 8.25p at 269.5p, and Thomas Cook, up 4p at 259.5p.
Enterprise Inns was up 2p at 210.5p after Redburn upgraded the stock to "buy" from "sell". Senior trading sources dismissed rumours attributing the strength in the stock to a bear squeeze. "There is this suggestion that the hedge funds are being forced to close positions because they have been asked to return stock to Lehman and also that Lehman is closing its own short positions - but we can't see any evidence of it at our end," the source said.
Insurance stocks were under pressure as the market awaited clarity on the funding position at AIG. Old Mutual was down 6.29 per cent or 5.7p at 85p and Prudential lost 3.45 per cent or 17.25p to 482.75p.
Mining and oil issues suffered the same fate, thanks to weaker commodity prices. Cairn Energy eased back to 2117p, down 213p, while Xstrata lost 153p to 2121p.
On the mid-cap FTSE 250 index, staffing group Michael Page was down 25.87 per cent or 83.75p at 238p after Adecco abandoned its attempt to take over the company.