NEW YORK -- Stocks suffered one of the worst sell-offs in history Monday, as investors adjusted to a new world in which the United States government doesn't have a perfect credit rating, and a fresh recession seems increasingly possible.
The Dow Jones Industrial Average lost more than 630 points, logging a drop of nearly 5.6 percent in its worst day since the depths of the financial crisis in late 2008. The Standard & Poor's 500 Index lost nearly 6.7 percent. The NASDAQ fell 6.9 percent.
The plunge eclipsed last Thursday's drop, which at the time was the worst day for the Dow since the 2008 crisis, and it comes after two weeks of nearly constant losses in stocks. Gloom pervades financial markets, despite the deal that Washington lawmakers struck last week to avoid a disastrous sovereign default, and despite reassurances from the nation's leaders that the economy's troubles will eventually be resolved.
A fundamental shift in attitudes is taking place, experts say, as financial players digest the possibility that the economy could begin to shrink.
"This negative possibility sitting there that we can articulate, and see, and almost taste at this stage, is a reason for stocks to go down," said John Richards, head of strategy at Royal Bank of Scotland in the Americas. "People are starting to factor in a double-dip recession."
The historic downgrade issued Friday by the rating agency Standard & Poor's amounts to the tip of an iceberg, as the company is in the process of reducing the ratings of credits associated with the federal government. These downgrades began Monday and are likely to continue, setting off new ripples of risk.
The mortgage giants Fannie Mae and Freddie Mac, which own or guarantee about half of all U.S. mortgages, saw their top grades docked by S&P on Monday. Federally backed debt issues of Tacoma, Washington and Miami, Florida, had their top grades lowered.
S&P docked the grades of bonds issued by Israel that are guaranteed by the U.S. government. It lowered the ratings of five U.S.-based insurers. It downgraded large institutions that facilitate investors' trades.
While the effects of these downgrades so far seem relatively muted -- some, like those for Fannie and Freddie, were expected -- the full risks might not yet have materialized, experts said.
One immediate effect was psychological.
"If there were people last week who were nervous about the economy and nervous about stocks, and needed some excuse to sell, this may well have provided the excuse," said Amar Bhide, a professor of international business at the Fletcher School of Law and Diplomacy at Tufts University.
A stream of economic data in recent weeks has reinforced a pessimistic outlook: Economic growth has slowed, the manufacturing sector has weakened, consumer spending has fallen and unemployment remains high. It's a potentially malevolent mix, economists say.
Investors shunned risk Monday, piling into Treasury securities despite the tarnished rating of long-term U.S. government debt. With a sovereign debt crisis building in Europe, and with grim American economic prospects, investors were eager to lend money to the government that by many measures is still the most reliable borrower in the world.
As demand for Treasury debt surged, interest rates on the 10-year note neared 2.3 percent Monday, a low that recalled early 2009, when the economy was suffering from a devastating financial crisis. Gold, which investors treat as a safe haven, climbed to fresh highs on Monday.
Although borrowing costs remain at historic lows, the downgrade could potentially affect funds that are required to hold highly-rated securities. And over time, it could push up yields on a range of assets that are tied to U.S. government rates.
In a recent quarterly filing with the Securities and Exchange Commission, Morgan Stanley underscored this uncertainty.
"Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations, the ultimate impacts on global markets and our business, financial condition and liquidity are unpredictable and may not be immediately apparent," the firm said.
But the direct effects of the triple-A downgrade are only part of the picture. Risks from the related downgrades could play out over the coming months and years, experts said.
"Fannie and Freddie are involved in securitizing mortgages, so if their costs go up, then implicitly we're going to see mortgage costs go up. Auto loans are going to go up, student loans are going to go up," said Andrew Lo, a professor of finance at the MIT Sloan School of Business.
"American voters are going to realize that the political impasse has consequences that will hit them in the pocketbook," he added.
The downgrades touched major components of the financial system. For some of these credits, especially in the municipal debt arena, ratings carry potentially greater meaning than they do for the U.S. government, which investors know is a safe bet. Downgrades could cause municipal investments to lose value, said Matt Fabian, managing director of the Concord, Mass.-based Municipal Market Advisors.
"When you start tampering with ratings that actually imply default risk, the implication is that default risk has increased for those credits," Fabian said. "There could be price declines. There could be selling in response to price declines."
These risks contributed to a broader picture of economic pessimism Monday, as investors lost appetite for holding risky assets like stocks.
And the stock market slide added a threat of its own, as hundreds of billions of dollars of wealth vanished.
"We're starting to whack consumer wealth again, which will impact spending," said Richards of RBS.
"That may have an immediate negative impact on consumer confidence, and possibly consumer spending," he added, "which is the last thing we need in an otherwise weakened economic environment."