Sept. 20 (Bloomberg) -- The U.S. stock market posted the steepest two-day rally since the aftermath of the 1987 crash as government efforts to bolster banks helped the Standard & Poor's 500 Index rebound from its biggest losses in seven years.

Financial shares in the S&P 500 plunged 13 percent in the first three days of the week as Lehman Brothers Holdings Inc. filed for bankruptcy, Merrill Lynch & Co. sold itself and the government seized American International Group Inc., sending the market to its steepest declines since the 2001 terrorist attacks. Government plans to purge banks of bad assets and curb bets on share declines sparked a 24 percent rally in lenders and brokerages in the final two trading sessions and left stocks little changed for the week.

``It's been a roller coaster, and the investors would like to get off the ride if they could,'' said Bruce McCain, the Cleveland-based chief investment strategist at Key Private Bank, which oversees about $30 billion. ``Lehman may be gone, Merrill may be gone, but the government has taken a basic step to solve the crisis by being a buyer of last resort. That offers the hope we really will put this part of the crisis behind us.''

The S&P 500 rose 0.3 percent to 1,255.08, its second straight weekly advance. The Dow Jones Industrial Average lost 0.3 percent to 11,388.44. The Russell 2000 Index of small- company stocks added 4.7 percent to 753.74.

929 Points

The Dow average rose 929 points from its low of the week and markets from the U.K. to China advanced the most ever yesterday. U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke ignited the rally by proposing to shore up banks' balance sheets and guaranteeing money-market mutual funds, while the Securities and Exchange Commission banned short sales of financial firms.

The proposal from Paulson and Bernanke is aimed at isolating devalued mortgage-linked assets at the root of the worst credit crisis since the Great Depression. Congressional leaders said they aim to pass legislation soon.

``There's been a lot of news coming very fast, and investors have probably had a hard time absorbing it,'' said John Carey, a Boston-based money manager at Pioneer Investment Management, which oversees about $300 billion. ``We've had news about a possible federal bailout of the whole financial industry, and that's extraordinary, unprecedented and also a little bit worrisome.''

Biggest Bankruptcy

The S&P 500 tumbled 4.7 percent twice earlier in the week and is down 15 percent this year, poised for its first annual decline since 2002. Until yesterday, financial companies led the retreat as losses stemming from the first nationwide drop in home prices since the 1930s surpassed $500 billion.

Lehman was the fourth-largest U.S. investment bank before it filed the biggest bankruptcy in U.S. history on Sept. 15, succumbing to the subprime-mortgage crisis it helped create. The firm was forced into bankruptcy after Barclays Plc and Bank of America Corp. abandoned takeover talks and the company lost 94 percent of its market value this year.

Merrill Lynch agreed to be bought by Bank of America after its shares plunged 36 percent the prior week. Merrill led gains in the in the S&P 500, climbing 73 percent to $29.50.

Goldman Sachs Group Inc. and Morgan Stanley, the only remaining independent brokerages on Wall Street after Lehman's bankruptcy and Merrill's sale, climbed after earlier enduring their steepest one-day sell-offs ever as the nation's three largest pension funds stopped loaning shares to investors betting on the firms' declines. Goldman dropped 16 percent to $129.80 for the week and Morgan Stanley fell 27 percent to $27.21.

Washington Mutual

Financial stocks gained 7.4 percent overall. Washington Mutual Inc., the largest U.S. thrift, surged 56 percent to $4.25 on the government's rescue plans and reports four potential bidders may be interested in buying pieces of the company.

AIG fell the most in the S&P 500, losing 68 percent to $3.84. The biggest U.S. insurance company was taken over by the government after mortgage-related losses led to credit-rating downgrades that drove the company to the brink of insolvency. The government said it will receive a 79.9 percent stake in return for an $85 billion loan that analysts said may be repaid by liquidating the company.

The Federal Reserve kept its benchmark interest rate at 2 percent on Sept. 16, citing risks to growth and inflation. The central bank agreed to the AIG loan hours after the decision.

Energy stocks in the S&P 500 advanced 3.6 percent, the second-biggest gain after financials, as oil staged the steepest three-day rally in almost a decade on speculation the government's plan to resolve the bank crisis will spur the economy and bolster petroleum demand. The fuel climbed 3.3 percent for the week to $104.55 a barrel. ConocoPhillips, the third-biggest U.S. oil company, increased 6.7 percent to $78.31.

Treasury Yields

Yields on three-month Treasury bills sank to the lowest since World War II on Sept. 17 as investors sought the relative safety of government debt, and a measure of corporate borrowing costs surged above the level seen during the crash of 1987. Treasuries rebounded yesterday, sending two-year note yields up the most in 26 years, as the government's plans helped stem a collapse in confidence.

Investors paid up for protection from losses. The Chicago Board Options Exchange Volatility Index jumped 25 percent for the week to 32.07. The VIX, as the index is known, measures the cost of using options as insurance against declines in the S&P 500. It closed at 36.22 on Sept. 17, the highest since October 2002.

To contact the reporter on this story: Eric Martin in New York at emartin21@bloomberg.net.

Last Updated: September 20, 2008 08:00 EDT