NEW YORK ( TheStreet) -- U.S. stocks plummeted by more than 3% Wednesday as investors feared that a worsening debt crisis in Europe was dragging Italy into the mix.

The market's selloff deepened in the afternoon, although stocks finished off their session lows. The Dow Jones Industrial Average lost 389 points, or 3.2%, to 11,781 after falling more than 410 points earlier. The S&P 500 closed down 47 points, or 3.7%, at 1229, while the Nasdaq settled 106 points, or 3.9%, lower at 2622.

Worries over the fate of Europe's third largest economy shook the market after Italy's borrowing costs topped a new record. The sharp downturn came even as Prime Minister Silvio Berlusconi offered to resign yesterday, suggesting that investors are skeptical that new leadership can steer the country out of its debt troubles. Furthermore, Greece was still stuck in a chaotic debate over who will replace its own outgoing prime minister.

Leading the losses on the Dow were the materials, financial, energy and technology sectors. Banks stocks JPMorgan Chase ( JPM) and Bank of America ( BAC) lost 7% and 5.7%, respectively. Morgan Stanley ( MS) plunged 9%, while Goldman Sachs ( GS)closed down 8.2%.

Two negative headlines may have helped push stocks further in the afternoon-- Bloomberg cited a report by German business newspaper Handelsblatt, saying German Chancellor Angela Merkel wants to allow countries to exit the euro. Also, Reuters reported that Germany and France have explored the possibility of overhauling the European Union, further suggesting that the two nations are growing weary of bearing responsibility for their debt laden neighbors.

While equities rallied Tuesday after news of Italian prime minister Silvio Berlusconi's planned resignation, by Wednesday, investors were questioning whether a shift in government would really change Italy's fiscal fate. The European Central Bank has sent clear signals that it cannot help boost Europe's emergency rescue fund. In the meantime, pressure has dialed up on the International Monetary Fund to step in and intervene.

Political uncertainty in Italy, combined with a move by clearinghouse LCH.Clearnet to hike the initial margin required to trade Italian bonds mobilized a snowball effect that helped trigger soaring yields before the open. Italian 10-year yields surged by 65 basis points to 7.4%, breaching a crucial 7% threshold that increases the risk of possible Italian default.

"Some are even saying that Italian bond yields have become the new fear index, like the VIX," said Charles Reinhard, deputy chief investment officer at Morgan Stanley Smith Barney, of Wednesday's record yields.

"Just when it seemed safe to assume that the path of least resistance for the euro was more likely located in a northerly direction, an increase in LCH.Clearnet margin on Italian government bond trading has tripped up the unit," noted Miller Tabak economist Andrew Wilkinson.

Worries over Italy trumped expectations that China may introduce economic stimulus measures as the country's annual inflation rate slowed to 5.5% in October from 6.1% in September.

London's FTSE lost 1.9% and Germany's DAX plunged by 2.2%. Japan's Nikkei Average finished 1.2% higher and Hong Kong's Hang Seng advanced 1.7%.

In corporate news, General Motors ( GM) lost 10.9% after the company said weakness in the European market may cause it to miss profit targets this year. Its third-quarter profit beat estimates of 96 cents per share but still fell 15% to $1.7 billion, or $1.03 a share.

Adobe Systems ( ADBE) tumbled 7.7% after the company said it plans to eliminate 750 jobs, or roughly 8% of its work force, as part of a restructuring plan. The graphics software maker said it still sees revenue of between $1.075 billion and $1.125 billion, for the fiscal fourth quarter, in line with consensus estimates.

In U.S. economic news, inventories fell 0.1% in September amid weak sales, the first dip since Dec. 2009, according to the Commerce Department. Economists had expected a 0.5% increase.

Separately, Federal Reserve Chairman Ben Bernanke, speaking at a small business and entrepreneurs conference, told the audience that policymakers should provide more support to small businesses and entrepreneurs as part of the plan to mobilize job growth.

Oil prices snapped a five-day winning streak. The December crude oil contract was down $1.06 to settle at $95.74 a barrel. A stronger dollar also hit other commodities including gold. December futures lost $7.50 to $1790.90 an ounce.

The benchmark 10-year Treasury was up 1 2/32, diluting the yield to 1.97%. The euro lost 2%, sinking to $1.355, while the dollar soared 1.7% against a basket of currencies.

--Written by Chao Deng in New York.

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