Fueling those concerns, American Home Mortgage, which had seen most of its capitalization vanish in recent weeks, announced it has filed for bankruptcy.
"The American Home Mortgage bankruptcy filing seems to have cut into enthusiasm," said Peter Cardillo, chief market economist at Avalon Partners.
The market had rallied in the fist minutes of trade, attempting to rebound from a sell-off Friday, with the hard-hit financial services first benefiting from an upgrade of Merrill Lynch & Co. Inc.
But the Dow Jones Industrial Average gave up an advance of over 80 points and was recently up 49 points at 13,232.
Out of the Dow's 30 stocks, 21 still advanced, led by Altria Group Inc. , Verizon Communications , Merck & Co. Inc. and Wal-Mart Stores Inc. .
Merck rose 1.5% after Cowen & Co upgraded the stock. Wal-Mart gained 1.2% after saying it is setting up a joint business-to-business venture in India.
Art Hogan, chief market strategist at Jefferies & Co. tells MarketWatch that traders are hoping to "find some stabilization," following last week's tough losses.
The market is trying to "price-in worst-case scenario as it pertains to everything that's involved in the residential real estate market, the credit derivatives market, the financial markets," he said.
The S&P 500 gained 1.6 points to 1,434, while the Nasdaq Composite fell 9.1 points to 2,502.
E-Trade Financial was among shares weighing the most on the Nasdaq, losing 6.5%.
Trading volumes showed 853 million shares exchanging hands on the New York Stocks Exchange and 1.1 billion shares trading on the Nasdaq stock market. Declining issues topped gainers by 22 to 9 on the NYSE and by 19 to 9 on Nasdaq.
The bankruptcy filing from American Home Mortgage accentuated credit-market worries.
On Friday, those concerns and a weak jobs report drove a sell-off that marked the Dow's third worst day of the year. The Dow fell 281 points, the S&P 500 fell 39 points, and the Nasdaq lost 64 points.
The declines followed a downgrade of the outlook for investment bank Bear Stearns by Standard & Poor's on concerns about its reputation, its exposure to mortgages and mortgage-backed securities and on debt taken from unsuccessful leveraged finance underwritings.
Over the weekend, Bear Stearns assigned blame for its troubles. Warren Spector, its co-president and co-chief operating officer, resigned.
The credit worries persisted Monday, but some investors believe that recent selloffs have been excessive and that there are attractive bargains for the taking. The market is eager for the Federal Open Market Committee's decision on interest rates on Tuesday.
"The market remains very jittery," said Avalon's Cardillo. "The focus now will be on the Fed decision. I don't expect it to cut rates tomorrow, but I do think the market is correct in thinking that if the situation worsens, the Fed may say it is ready to injection liquidity and cut rates."
"Right now the market needs to calm its nerves, but it will be hard to do so," he said. The fed funds rate stands at 5.25%. The central bank has left rates unchanged since June, 2006.
Stocks in action
Shares of American Home Mortgage were halted, after the mortgage lender forfeited most of its market capitalization in recent sessions. The company, which last week revealed that many of its creditors were demanding their money back, revealed its bankruptcy petition in a government filing.
Another mortgage lender, Countrywide Financial revealed in a Securities and Exchange Commission filing its liquidity sources as of June 30. It had a net $186.5 bilion available, and characterized various sources by reliability as high, moderate, moderate-to-high and moderate-to-low -- with $81.3 billion in agency and private-label MBS and ABS falling into the latter category.
Bear Stearns fell 2.8% after defending its actions in the credit market and laying off a key executive over the weekend.
Merrill Lynch Co. Inc. fell 1.4%. UBS upgraded the stock to a buy rating, saying the fallout from the mortgage and credit businesses is mostly priced into the stock at this time.
Another stock that got an upgrade from UBS was TD Ameritrade . The stock was down 0.2%.
Shares of the French bank Natixis climbed in overseas trade after the company held to its 2007 profit outlook and said it's cut its entire loan exposure to U.S. subprime mortgages and two-thirds of its trading exposure.
Treasurys were under slight pressure in the early going, after rallying during much of last week as stocks fell. The benchmark 10-year Treasury note last was down 5/32 at 98-14/32 with a yield of 4.879%.
The dollar dropped slightly against the euro and the yen early Monday, continuing to react to last week's weaker-than-expected employment and services-sector growth data. "Traders are sidelined until Tuesday's FOMC meeting, as they try to determine the Fed reaction to the latest problems in the housing sector," said Boris Schlossberg, senior currency strategist at DailyFX.com.
The euro was last up 0.3% at $1.3816, while the dollar was down 0.1% at 117.89 yen.
Commodities were under pressure in early trade, with the front-month crude contract down 98 cents at $74.50 a barrel. Traders are worried that a slowing U.S. economy will result in lower energy demand.
The front-month gold contract was down $1.50 at $67.10 an ounce.
By Nick Godt