NEW YORK (Reuters) - U.S. and British officials intervened to restore confidence in battered global financial markets on Thursday, helping Wall Street bounce back to its best day in six years.

U.S. Treasury Secretary Henry Paulson shopped a plan to create a fund that would mop up toxic debt, and Paulson and Federal Reserve Chairman Ben Bernanke were to meet with congressional leaders Thursday night, sources said.

Meanwhile, British officials moved to crack down on short selling of banks.

“It’s very good news, generally speaking,” said Haag Sherman, co-founder and managing director of Salient Partners in Houston. “I think it will start to provide a floor to asset values and allow institutions to work through this in a systematic manner. They won’t have to rush into the arms of suitors to avoid collapsing.”

Morgan Stanley and rival Goldman Sachs Group Inc, the largest surviving independent Wall Street investment banks, have been facing concerns that the credit crunch could constrict the short-term funding they need to do business.

BOUNCE BACK

Paulson’s plan would be similar to the creation of the Resolution Trust Corp (RTC), which was used to clean up bad debts from the savings and loan crisis in the late 1980s at a $400 billion cost to taxpayers.

The U.S. housing bust of the past two years has created hundreds of billions in toxic debt that has plagued bank balance sheets and led to the credit crisis.

In recent weeks, the government has stepped in to rescue three massive financial institutions: American International Group Inc, Fannie Mae and Freddie Mac, while opting to allow another, Lehman Brothers Holdings Inc, to fail.

On Thursday, battered U.S. financial stocks bounced back. After plummeting 42 percent, investment bank Morgan Stanley ended up nearly 4 percent. Beaten down banking shares like Wachovia Corp and Washington Mutual Inc flipped from massive losses to gains of 59 percent and 49 percent, respectively.

Volatility was the name of the game. The Dow Jones industrial average fell as much as 150 points at one point, finally closing up 410 points.

U.S. Treasury debt prices tumbled, with the benchmark 10-year debt slid 31/32, its yield rising to 3.54 percent.

Despite the revived markets, there were still signs of major stress at U.S. financial institutions. Washington Mutual Inc, the largest U.S. savings and loan, has failed to attract formal offers despite being shopped around to larger banks like JPMorgan Chase & Co and Wells Fargo according to sources familiar with the situation.

Morgan Stanley is in talks to sell a larger equity stake to China Investment Corp, sources said. Also, Wachovia Corp, the fourth-largest U.S. bank, has also emerged as a leading candidate to pair up with the investment bank. A source familiar with Morgan’s plan said negotiations between the two had advanced to a more formal stage.

There was concern the companies might be acting too hastily to strike merger deals in the wake of the bankruptcy filing of Lehman Brothers Holdings Inc and Merrill Lynch & Co Inc’s shock decision to sell itself to Bank of America Corp.

WaMu shares slid 13 percent in extended after-hours trading after rallying 49 percent in the main session.

‘I AM WATCHING’

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In other moves to restore confidence to markets, Britain’s Financial Services Authority said it would bar investors from taking new short positions amid signs of a growing backlash against those who bet on price declines.

Also, New York Attorney General Andrew Cuomo started a wide-ranging probe into possible illegal short selling.

“I want the short-sellers to know today that I am watching,” Cuomo said on a conference call with reporters. “If it is proper and legal then there is nothing to worry about.”

U.S. authorities have already spent $900 billion to prop up the financial system and housing market.

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The U.K. ban on short selling came after the U.S. Securities and Exchange Commission introduced rules under which short sellers and broker-dealers must deliver securities by the close of business on settlement day, three days after the sale.

Morgan Stanley Chief Executive John Mack told employees at a town meeting he thought U.S. regulators were starting to understand the systemic risk posed by short sellers.

Meanwhile, in a sign of the growing political blame game arising from the crisis, Republican presidential hopeful Sen. John McCain called for the resignation of SEC Chairman Christopher Cox, a fellow Republican.

And a key U.S. lawmaker asked chief executives of Lehman and AIG to provide internal documents in preparation for an upcoming hearing on the collapse of both companies.

COORDINATED MOVE

In his first remarks about the crisis since the government’s $85 billion takeover of AIG earlier this week, U.S. President George W. Bush expressed concern about the turmoil, and said his administration was prepared to take further measures to strengthen and stabilize markets.

“The American people are concerned about the situation in our financial markets and our economy, and I share their concerns,” he told reporters in a two-minute statement outside the Oval Office.

Shares of major trust banks slid on concern about potential losses in their investment portfolios. State Street Corp closed down 9 percent, leading the decline, after tumbling 55 percent at one point.

Following its near-collapse and bailout, insurance giant American International Group Inc was replaced in the index by Kraft Foods Inc, best known for products like Cheez Whiz.

Earlier, the U.S. Federal Reserve announced coordinated moves with five of the world’s major central banks to inject up to $180 billion in liquidity into global money markets.

That gave some reassurance to panicked investors, and slashed overnight money rates to 2 percent from 8.5 percent.

As an indication of the demand for liquidity, the Bank of England said it received bids of 202 billion pounds ($365 billion) for the 66 billion pounds on offer in its weekly open market operation.

TOO HASTY?

British bank Lloyds TSB Group Plc took advantage of the market turmoil to achieve a long-held ambition by scooping up the country’s biggest mortgage lender, HBOS Plc, in a $22 billion all-share deal.

HBOS shares, which had slumped due to fears about its funding, soared 40 percent, and the British government promised to rewrite competition laws to let the deal go through. ($1=.5612 pound)