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TOKYO, Sept 30 (Reuters) - The dollar fell to a four-month low against the yen on Tuesday as investors fled risky positions after U.S. lawmakers refused to pass a $700 billion bank bailout plan, sparking the biggest Wall Street stock sell-off since 1987.

But the dollar quickly recovered ground against the yen, as Asian stock markets trimmed some of their earlier losses.

The U.S. House of Representatives on Monday unexpectedly rejected a plan to buy toxic assets from struggling banks in an effort to revitalise strained lending markets.

The move hit the dollar by dashing hopes for a comprehensive solution to the credit crisis that has claimed a variety of major financial institutions such as Lehman Brothers this month, stirring worries of a deeper economic downturn.

"There are many dollar-selling factors such as a slowing economy, possible Fed rate cuts and an outlook for worsening fiscal conditions for the U.S. government as it is expected to spend money to rescue banks," said Osamu Takashima, chief currency analyst at Bank of Tokyo-Mitsubishi UFJ.

But the euro and sterling have also suffered as banks in Europe succumb to the widening crisis fallout, prompting investors to rush for currencies seen as a safe-haven during the turmoil, such as the yen and Swiss franc.

"The simple way to understand all the developments is that the yen is an alternative choice as a safe haven, with the euro and dollar shunned due to the credit crisis," said a senior trader at a Japanese trust bank.

The rejection by U.S. lawmakers of the bailout package caused panic among investors, with the Dow Jones industrial average <.DJI> suffering its biggest one-day point drop ever. Asian markets tumbled as well, with Japan's Nikkei average falling nearly 5 percent at one stage.

The Nikkei later recouped some losses and was down 3.7 percent in late trade.

The dollar struck a four-month low of 103.50 yen on trading platform EBS before recovering to 104.45, up 0.4 percent.

Despite the dollar's recovery, traders expect it to weaken against the yen as risk aversion is expected to spread after trade moves to Europe and the United States.

The dollar is also vulnerable because more investors are betting the Federal Reserve will cut interest rates from the current 2.0 percent in an effort to limit the economic fallout from the worst financial crisis since the Great Depression.

The dollar fell 4.3 percent against the yen during September, when problems in the U.S. financial sector went from bad to worse.

Earlier this month, the U.S. government took control of troubled mortgage finance giants Fannie Mae and Freddie Mac and bailed out insurer AIG, while Lehman Brothers filed for bankruptcy.

The euro fell 0.2 percent to $1.4391, after falling to a low of $1.4338 earlier on Tuesday. The single currency was 2.2 percent below where it was at the end of August.

The euro was up 0.1 percent at 150.24 yen, off an earlier low of 148.84 yen. It hit a two-year low earlier in the month.

On Monday, the credit crunch claimed new victims -- Wachovia Corp as well as many European banks -- showing the financial crisis is spreading from the United States to Europe.

Banks in Britain, Belgium, Russia, Iceland and the United States were rescued by authorities over the weekend, prompting mammoth injections of cash into the global banking system by central banks to relieve frozen money markets.

But interbank rates stayed painfully high, showing the efforts of global central banks have not succeeded in easing credit tightness.

"Funds are not reaching financial firms that need money as a sense of panic continues to dominate markets," said a trader at a big Japanese bank. "It is reaching a point where financial markets, including the forex market, are not functioning."

(Additional reporting by Chikako Mogi; Editing by Michael Watson)

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