Global equity selloff wreaks havoc on money mkts

* MSCI world equity index down 1.2 percent at 304.88

* Woes at AIG deepen; Goldman Sachs results, Fed in focus

* O/n dollar rates surge; 25bps rate cut being priced in

By Natsuko Waki

LONDON, Sept 16 (Reuters) - Investors dumped equities and oil as the financial meltdown spread on Tuesday, a day after Lehman Brothers collapsed, driving the yen and government bonds higher and unleashing a panic rush to secure short-term cash.

A day after Lehman filed for bankruptcy protection and Bank of America agreed to buy Merrill Lynch , concerns about the global financial system deepened as fears grew American International Group could be the next financial giant to tumble.

Third-quarter earnings results from Goldman Sachs and an interest rate decision from the Federal Reserve ECON top the day's agenda with a panic scramble in the interbank money market threatening to trigger a fresh liquidity crunch.

The cost of borrowing dollars overnight rose to 10 percent , five times the benchmark Fed rate of 2 percent. Interest rate futures FEDWATCH were pricing in a more than 90 percent chance the Fed would cut rates to 1.75 percent later.

Asian and European central banks flooded money markets with cash as they sought to prevent the upheaval on Wall Street from clogging the pipes of the global financial system.

"There's a smell of cordite in the air. It's like the day after the explosion. People are still extremely nervous. They're wondering what happens next," said Justin Urquhart Stewart, investment director at Seven Investment Management.

"Investors are looking at what other companies have weak balance sheets. Now we need a bit of leadership from the central banks and the regulators."

The MSCI main world equity index .MIWD00000PUS fell 1.2 percent, its lowest since June 2006, on top of a 3.6 percent tumble on Monday.

The FTSEurofirst 300 index fell 1.7 percent while Asian stocks .MIAPJ0000PUS fell more than 4 percent.

AIG, thrown a $20 billion lifeline by New York state, came under renewed pressure as ratings agencies downgraded the insurer's debt.

PANIC SCRAMBLE IN MONEY MARKET

There were signs that the deepening financial crisis is freezing up activity in the interbank money market. Overnight dollar deposit rates rose to 10 percent, according to Reuters data, five times the benchmark Fed interest rates.

"The interbank market is dead because people are not willing to take up positions or not willing to provide liquidity for other banks," said a fixed income trader in London.

"Banks do have liquidity but they don't want to share with other banks because they don't know what is going to happen overnight. They don't want to come into the office and see who is looking for Chapter 11."

The low-yielding yen extended its steep rise, with the currency hitting a four-month high of 103.70 per dollar . On Monday, the dollar suffered its biggest one-day drop against the yen in nine years.

The dollar .DXY also fell against a basket of major currencies.

Safe-haven government bonds surged around the world, with the December bund future FGBLc1 rising 76 ticks.

The broad sell-off in risky emerging assets, already under pressure from slowing global growth, gained new momentum. Emerging sovereign spreads 11EMJ blew out to 395 basis points over U.S. Treasuries, their widest level since May 2005.

Emerging stocks .MSCIEF fell 3.4 percent, their lowest since October 2006.

U.S. light crude CLc1 extended losses, falling 3.6 percent to $92.32 a barrel as investors extended across-the-board deleveraging, taking oil more than $50 off its record high set in July.

Gold fell to $775.80 an ounce.

(Additional reporting by Brian Gorman and Ian Chua; Editing by Ruth Pitchford)