Bernanke, testifying before Congress, said that while the large U.S. banks will likely recover from the recent credit crisis, others could fail.

"Implying that some banks may fail stirs concerns for any investor who's familiar with financial and economic history," said Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors. "Investors have been very edgy about credit market conditions and banks' financial conditions. Very edgy. And this doesn't remove that edginess."

Earlier, stocks had fallen in response to a Labor Department report that first-time unemployment claims rose last week by 19,000 to 373,000, the highest level since late January.

Scott Wren, equity strategist for A.G. Edwards & Sons, said he still believes there's less than a 50 percent chance of a recession, but that it's clear employers are cautious about hiring.

"To consistently see claims up near 400,000, that's pretty telling often-times of a recession," he said.

"As of right now US economic growth is at zero," he said, adding the longer it stayed this way the greater the risk of a deep recession.

Wall Street giants Goldman Sachs and Merrill Lynch have both forecast that the US economy will contract in 2008.

The US Federal Reserve has said 2008 growth will be between 1.3% and 2%.

The forecast, made last week, was half a percent lower than the Fed's previous estimation.

The gloomy outlook was blamed on falling house prices, reduced bank lending, turmoil in the financial markets and higher oil prices.

Mr Greenspan also predicted that booming oil prices, which reached a record of more than $101 last week would keep rising and that the US housing market would see more misery before the tide turned.

The volatility that pummeled stocks in January returned with the news that the service sector shrank last month for the first time since March 2003. The report from the Institute for Supply Management wiped out the nascent optimism about the economy that had sent stocks surging higher last week.

"The report drives a nail into the coffin from investors' minds that we're in a recession," said Todd Salamone, director of trading at Schaeffer's Investment Research. "That doesn't mean stock prices in the months ahead will be lower. But when you see headline numbers like this, there tends to be a reactionary sell."

The ISM said its index of service sector activity, which accounts for about two-thirds of the economy, dropped below 50, a level that indicates contraction. Economists had expected another month of growth.

It's possible the service sector, which includes businesses ranging from restaurants to retailers to banks, could bounce back in February as the manufacturing sector did in January after its December contraction. The benefit of the Federal Reserve's two big interest rate cuts in the latter part of January could also help spur the service sector back into growth mode later this year.

Microsoft views Yahoo as its best chance to thwart Google, which has leveraged its leadership in Internet search and advertising to emerge as an increasingly serious threat to the world's largest software maker's persuasive influence on how people interact with computers.

Google already controls nearly 60 percent of the U.S. search market, and has been widening its lead, despite concerted efforts by both second-place Yahoo and third-place Microsoft. By combining, Microsoft and Yahoo would have a 33 percent share of the U.S. search market, according to the latest data from comScore Media Metrix.

By joining forces, Microsoft and Yahoo also would widen their narrowing advantage over Google in providing free e-mail accounts -- a service that helps foster more loyalty with users and create more advertising opportunities.