The housing market took a sharp turn for the worse in September as prices tumbled and sales of previously owned homes fell to a record low, battered by rising foreclosures and tighter lending standards.

Sales of existing homes dropped 8 percent to a 5.04 million unit annual pace in September, the lowest on record dating to 1999, the National Association of Realtors said on Wednesday.

The drop, from a downwardly revised 5.48 million rate in August, was steeper than Wall Street had expected, and pushed inventory to record levels.

The national median price for both existing single-family homes and condominiums dropped 4.2 percent from a year ago to $211,700 and was down 5.7 percent from August.

It is clearly well below expectations and it is also interesting that prices have declined sharply on a month-to-month and year-on-year basis, said David Sloan, an economist with 4cast Ltd in New York. The question was, Is the housing decline going to continue at this pace or even moderate or accelerate? This suggests that the decline is accelerating and that the downside risk is certainly significant.

Stocks tumbled on the housing data and on a report by Merrill Lynch (MER.N) of its first loss in nearly five years as a result of write-downs related to mortgage market problems, but pared most losses on a rumor the Federal Reserve would imminently cut its discount rate, the rate it charges banks for loans. A Fed spokesman declined to comment on the rumor.

The Fed's next policy meeting is scheduled for October 30-31. Markets widely expect the U.S. central bank to cut the benchmark interbank federal funds rate by at least a quarter-percentage point to 4.5 percent.

Treasuries rallied on the weak housing data but came off session highs in afternoon trading as stocks pared losses. The dollar was off slightly against a basket of currencies.

The National Association of Realtors pinned September's sales weakness on a tightening of credit in August, which was sparked by concerns over rising foreclosures on U.S. subprime mortgages extended to borrowers with spotty borrowing histories.

Mortgage problems were peaking back in August when many of the September closings were being negotiated, and that slowed sales notably in higher-priced areas that rely more on jumbo loans, said Lawrence Yun, an economist for the realty trade group, adding that mortgage availability has improved in recent weeks.

The slower pace of existing-homes sales -- both single-family homes and condominiums -- helped drive up the inventory of unsold homes on the market by 0.4 percent to 4.4 million last month. That marks a 10.5-month supply at the September sales pace, the highest since NAR data began combining sales of single-family homes and condos in 1999.

Single-family home sales fell 8.6 percent in September to a 4.38 million-unit annual pace, close to a 10-year low, from 4.79 million in August.

Sales were down in all regions, the association said.

MORTGAGE APPLICATIONS UP JUST SLIGHTLY

A separate report on Wednesday showed U.S. mortgage applications edged up only marginally last week, even as interest rates sank to their lowest levels since May.

The Mortgage Bankers Association said its index of mortgage applications, which includes both purchase and refinance loans, crept up by 0.03 percent to 656.5 in the week ended October 19. The slight gain reflected the difficulty borrowers face obtaining loans in the face of tightened lending standards.

Prospective borrowers have been filing multiple applications to obtain a single loan, which economists say has been skewing the mortgage application data in recent months.

Mortgage applications last week were 11.5 percent above their year-ago level, even though existing- and new-home sales are both down sharply.

The deep slump in the housing market has led many U.S. lawmakers to look for ways to help Americans who have found themselves in homes they cannot afford.

Fed Governor Randall Kroszner cautioned Congress on Wednesday against taking any action that might restrict credit availability and adversely impact the ability of lenders to repackage loans as securities for resale to investors.

Mortgage Merrill Lynch