* Investors flee for safety after Lehman files for Chapter 11

* High-grade debt, gold, yen in demand on bank industry storm

* Focus turns to Fed policy decision on Tuesday (Repeats to additional subscribers with no change to text) (Updates prices, details)

HONG KONG, Sept 15 (Reuters) - Stocks and the U.S. dollar fell sharply on Monday after Lehman Brothers filed for bankruptcy protection, sending safe-haven Treasury debt and gold prices soaring as the financial system bent under severe pressure.

U.S. stock market futures SPc2DJc2NDc2 were down around 3 percent, pointing to sharply lower open, while major European markets were set for falls of between 3.5 to 4 percent STXEc1FDXc1FCEc1.

Rapid-fire developments on Wall Street, only a week after the U.S. government bailed out Fannie Mae and Freddie Mac, left some analysts literally speechless and sent shockwaves through almost every asset class. The dollar plunged 1.9 percent against the yen, on track for its biggest decline since February 2007, as investors’ willingness to take risks evaporated. [ID:nLF649266]

“It’s a pure flight to quality right now,” said Adam Donaldson, head debt strategist at Australia’s Commonwealth Bank.

“The big concern is how Lehman and other banks unwind their credit default contracts,” he added. “Nobody knows how that will play out.”

The price of insurance against default on debt soared, pushing up the iTRAXX Asia ex Japan high-yield index ITAHY5Y=IE, a measure of credit market stress, to match record highs reached in the runup to Bear Stearns' collapse in March.

While a lack of confidence felled Lehman, a lack of short-term funding was hurting one of the world's largest insurers American International Group Inc AIG.N. The firm was asking the Federal Reserve for a bridge loan of $40 billion, according to the New York Times, an unprecedented move that further battered the dollar and knocked down two-year U.S. government debt yields to a five-month low.

For more stories on Lehman, click on [ID:nN13574113]

ASIAN STOCKS TUMBLE

Stock markets in Australia, Singapore and Taiwan all dropped 3 to 4 percent, Indian stocks .BSESN fell 5 percent.

Holidays in most major Asian markets kept volume thin though price action belied a desire to seek safety first and ask questions later.

“The exact ramifications of the liquidation process and the unwinding of positions pertaining to the Lehman situation remain unclear. Hence, over the next 48 hours at least, financial markets are likely to be volatile and tense,” said economists with United Overseas Bank in Singapore in a note.

The Swiss franc and yen, currencies associated with stability in times of duress, strengthened, especially against the dollar, which reeled as some in the market speculated the Federal Reserve may have to cut interest rates on Tuesday to shore up the economy from financial fallout.

The U.S. dollar dropped 1.9 percent against the yen at 105.88 yen JPY= and was off 1.2 percent against the Swiss franc to 1.1165 francs CHF=.

The euro rose by more than a cent against the dollar to $1.4380, up 1.1 percent from late Friday in New York.

In the spot market, gold rose 2 percent to $778.85 an ounce XAU=.

FED SUPPLIES LIQUIDITY, NOT CONFIDENCE

The Fed on Monday said it would begin accepting equities as collateral for emergency loans for the first time as it tried to ease the spiralling crisis. The steps would likely help surviving financial institutions to find cash but may not do much to boost global confidence in the U.S. financial system.

“The mere fact that they are forced to do this -- and they may still yet do some more -- indicates the breadth and depth of the trouble that the system is in,” said V. Anantha Nageswaran, head of investment research, Asia-Pacific with Bank Julius Baer in Singapore.

In addition, 10 of the world’s biggest banks agreed to establish a $70 billion borrowing facility to bolster liquidity.

U.S. Treasury yields, which move in the opposite direction of prices, fell sharply in early Asian trade on Monday and 3-month eurodollar futures <O#ED:> surged as dealers priced in the possibility of lower Federal Reserve benchmark interest rates.

The yield on the policy-sensitive two-year Treasury note US2YT=RR hit a five-month low of 1.90 percent. The 10-year yield US10YT=RR was also at the lowest since April, at 3.52 percent compared with 3.72 percent late on Friday.

Bank of America BAC.N said it would acquire Merrill Lynch & Co Inc MER.N for $50 billion in yet another development that realigned Wall Street. The deal was significant not just because of its price but it showed how the private sector will have to sort itself out and not depend on backing of the U.S. government.

“For many, but not all, this is an impossible lesson to learn in the middle of the worst financial storm since the Great Depression,” said Alan Ruskin, chief international strategist with RBS Greenwich in Greenwich, Connecticut.

Australia's benchmark S&P/ASX 200 index .AXJO fell 1.8 percent, weighed by shares of the country's top banks such as Commonwealth Bank of Australia CBA.AX and Macquarie Group Ltd MQG.AX.

Taiwan's TAIEX .TWII, the only stock market open in north Asia, dropped 4.1 percent to the lowest since November 2005.

Singapore's Straits Times index .FTSTI was at the lowest since September 2006, down 2.9 percent.

“The financial sector in the region is very volatile now and we don’t expect investors’ confidence to recover quickly in just a few days or one week,” said Alex Huang, a vice president at Taiwan’s Mega International Securities.

While the fate of the U.S. financial system loomed in investors’ minds around the world, initial reports that Hurricane Ike had not severely damaged infrastructure in Texas knocked benchmark oil prices fall to a six-month low below $99 a barrel. [ID:nN14450042]

Oil CLc1 fell $2.10 to $99.08 a barrel after falling as low as $98.46 -- the lowest since February 26 -- adding to a steady downward trend in prices since mid-July's peak of over $147 a barrel as evidence mounts that high energy costs and a weakening economy are cutting into fuel consumption. (Additional reporting by Baker Li in TAIPEI and Wayne Cole in SYDNEY; Editing by Lincoln Feast)