* US stocks sink deeper in bear market, Dow at 12-year low
* Bonds rise in flight to safety buying as stocks slide
* Oil falls below $39 a barrel on weak demand outlook
* Dollar strengthens in safe haven bid, yen declines (Recasts with close of U.S. markets)
By Herbert Lash
NEW YORK, Feb 23 (Reuters) - U.S. stocks fell deeper into bear territory on Monday, with the Dow sliding to 12-year lows, as doubts grew about Washington's plans to bolster beleaguered banks and investors fled to the safety of government debt.
The Dow shed 250 points, marking another downturn for heavily battered equity markets. European shares closed at nearly six-year lows.
U.S. Treasuries prices clambered higher as sinking stocks revived the appetite for safe-haven U.S. government debt. For details, please see [ID:nN23461556] and oil fell below $39 a barrel on worries about a weakening economy. [ID:nSYD321505]
The dollar, which has benefited from the safe-haven rush to U.S. government debt, rose to a near-three month high versus the yen [ID:nN23360038], but gold futures fell as investors took profits ahead of option expirations. [ID:nN23544904]
Driving stocks lower were reports that Washington may convert its stake of preferred shares in Citigroup Inc nto common stock, a move that investors fear is a step closer to nationalization. [ID:nN23336737].
"It is generally a market 'no' vote to what we're getting from Washington," said Hank Smith, chief investment officer at Haverford Trust Co in Philadelphia, referring to the market's reaction to the Citigroup news.
Citigroup rose 9.7 percent to close above $2 a share. It and Bank of America Corp, which rose 3.2 percent, were the only two stocks in the 30-component Dow to rise.
Driving bonds higher and stocks lower is uncertainty over government policies, especially regarding the battered U.S. banking system, said Keith Wirtz, president and chief investment officer at Fifth Third Asset Management.
The financial sector has become politicized, and the sharp increase in government largess is worrisome, Wirtz said.
"The survival of many of our well-known financial companies (depends) on the generosity of the U.S. government, which is not something capitalists would want to see," Wirtz said. "The financial center of the universe may no longer be New York, it may be Washington, D.C."
The Dow Jones industrial average is now down 18.9 percent for the year, while the broader Standard & Poor's 500, which closed less than 2 points higher than its November closing low, is down 17.7 percent year to date.
The Dow Jones industrial average tumbled 250.73 points, or 3.40 percent, to 7,114.94. The Standard & Poor's 500 Index dropped 26.71 points, or 3.47 percent, to 743.34. The Nasdaq Composite Index skidded 53.51 points, or 3.71 percent, to 1,387.72.
Concerns that demand might be less than robust for this week's sale of $94 billion in new Treasury securities eased in the face of investors' preference for the least-risky assets.
"People act as if supply matters. Why does it matter when there's ample demand for risk-free assets?" said Thomas Higgins, chief economist at Payden & Rygel in Los Angeles.
The benchmark 10-year U.S. Treasury note rose 2/32 in price to yield 2.79 percent, while the 30-year U.S. Treasury bond rose 21/32 in price to yield 3.54 percent.
Markets reversed course after an initial warm reception to rising expectations that the U.S. government will increase its stake in Citigroup, and not fully nationalize it.
Regulators pledged to provide more capital to banks as needed and keep large institutions viable through a program to "stress test" banks, to be launched Wednesday. [ID:nN23331722]
But investors' euphoria soon waned.
"The market initially saw it as 'glass half full,' but the other way of looking at it is Citi taking one huge step toward public ownership," said Richard McGuire, head of rates strategy at RBC Capital Markets in London.
The fall in European shares to nearly six-year lows was spearheaded by banks. The FTSEurofirst 300 index of top European shares closed off 0.9 percent at 729.39 points, and is now down 12 percent this year after plunging 45 percent in 2008.
UBS was down 9 percent and Deutsche Bank
The dollar rose against a basket of major currencies, with the U.S. Dollar Index up 0.84 percent at 87.319. Against the yen, the dollar gained 1.57 percent at 94.59.
The euro fell 1.11 percent at $1.2697.
The euro surrendered gains against the dollar after European Central Bank president Jean-Claude Trichet said the euro-zone financial system is under severe strain.
Oil prices settled down. U.S. front-month crude settled at $38.44 a barrel, down $1.59. [ID:nSYD321505]
London Brent crude dropped $1.32 to $40.57 a barrel by 3:02 p.m. EST (2002 GMT).
"Overall, the weakness in the economy is still what's dictating direction for oil prices," said Phil Flynn, an analyst at Alaron Trading in Chicago.
Gold futures ended lower as investors took profits ahead of option expirations. [ID:nN23544904]
Gold for April delivery settled down $7.20 at $995.00 in New York. (Reporting by Rodrigo Campos, Ellen Freilich, Rebekah Kebede and Vivianne Rodrigues in New York; writing by Herbert Lash, Editing by Kenneth Barry)