Stocks tumbled about 2 percent on Tuesday, tracking a sell-off in global equities, on worries over Europe's banking sector and as short-term funding costs soared.

European markets were on edge after three-month dollar Libor rates rose to their highest level since July as banks became more wary of lending to European institutions after the Spanish government's rescue of a local bank over the weekend.

The euro fell to an 8-1/2-year low against the yen and neared a 4-year trough versus the dollar, while safe-haven U.S. Treasuries rallied.

Big banks and industrial stocks tumbled on fears that Europe's debt crisis might derail a global economic recovery. Caterpillar Inc fell 3.4 percent to $57.20, and Bank of America Corp fell 3 percent to $14.95.

Chevron Corp was off 2.7 percent to $71.42 as oil futures were caught up in a commodities sell-off, falling 3 percent to just above $68 per barrel.

The contagion has really dragged our markets down, I think somewhat excessive from where we are in the crisis. It's become more of a panic, said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco. The impact on the U.S. economy is getting a bit overplayed here.

The Dow Jones industrial average <.DJI> dropped 198.00 points, or 1.97 percent, to 9,868.57. The Standard & Poor's 500 Index <.SPX> fell 21.20 points, or 1.97 percent, to 1,052.45. The Nasdaq Composite Index <.IXIC> lost 48.35 points, or 2.18 percent, to 2,165.20.

North Korea's threat of military action against the South helped send local shares to a 15-week closing low as the government in Seoul convened an emergency session, rattling investors around the globe. The threats followed the sinking of a South Korean warship, allegedly by the North, in March.

The S&P 500, a broad gauge of big-cap U.S. stocks, briefly fell below February's intraday bottom of 1,044.50, reaching its lowest point since early November 2009.

The index is down about 14 percent since late April. Some traders said they were looking for a 20 percent correction, which would mark a technical bear market.

In one bright spot, U.S. consumer confidence rose for the third straight month in May to the highest in more than two years. But that was countered by a report showing single-family home prices dropping in the first quarter on renewed price pressure as federal aid faded away.

(Reporting by Edward Krudy; editing by Jeffrey Benkoe)