Stocks fell on Friday after data pointed to more deterioration in the economy and the largest loss in insurer American International Group Inc's history signaled the worst was far from over for the beleaguered financial sector.

Benchmark indexes sank to session lows after two widely watched surveys indicated U.S. consumer sentiment was at its lowest in 16 years and Midwestern business conditions were the weakest in more than six years.

Shares of financial companies led the decline, dragged by AIG, whose stock tumbled more than 5 percent, making the insurer the top drag on both the Dow and the S&P 500. Shares of Bank of America Corp, the No. 1 U.S. bank by market value, lost 2.1 percent.

A report by CNBC television saying that an effort to rescue troubled bond insurer Ambac Financial Group Inc has hit a snag over the amount of capital banks would inject into the company added to the negative tone. Ambac shares slid 8.2 percent.

People are positioned poorly. They got long thinking the bottom was in and went long. Now they're paying the price. The flight to quality is in, said Joe Saluzzi, co-manager of trading at Themis Trading in Chatham, New Jersey. The hope earlier in the week was that the insurer bailout was coming ... but we are stuck in a quagmire.

The Dow Jones industrial average was down 167.22 points, or 1.33 percent, at 12,414.96. The Standard & Poor's 500 Index was down 19.34 points, or 1.41 percent, at 1,348.34. The Nasdaq Composite Index was down 31.24 points, or 1.34 percent, at 2,300.33.

AIG shares dropped to $47.28 on the New York Stock Exchange after the world's largest insurer posted a $5.29 billion fourth-quarter loss late on Thursday, hurt by write-downs of securities linked to bad mortgage bets.

Shares of Bank of America declined to $40.67 on the NYSE, while those of JPMorgan Chase & Co, the No. 3 U.S. bank, fell 2.03 percent to $41.60.

The latest signs of weakness came from a report that showed U.S. Midwest business activity contracted sharply in February.

The National Association of Purchasing Managers-Chicago also said even the areas of the country least affected by the boom-bust housing cycle are feeling ripples from the crisis.

The Reuters/University of Michigan Surveys of Consumers showed that sentiment slumped to a 16-year low in February, hitting levels that usually sound alarm bells for recession.

Shares of home builders also took a beating, sending the Dow Jones home construction index down 3.5 percent.

Toll Brothers, a luxury home builder, fell 2.5 percent at $21.94. Ambac declined to $11.05, while rival MBIA Inc declined 5.4 percent to $13.30.

(Editing by Kenneth Barry)