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Stocks close in the red amid looming fears of a US debt default

Stocks finished in the red on Monday, with the Dow hitting a one-month low, as the government shutdown dragged on for a second week amid investor worries that lawmakers might not be able to increase the debt ceiling, potentially leading to a default.

The Dow Jones Industrial Average fell 136 points, or 0.9 percent, dragged by American Express and Visa. The blue-chip index had initially tumbled 150 points, touching a one-month low, during morning trading.

The S&P 500 also fell and the Nasdaq closed almost 1 percent down. The CBOE Volatility Index (VIX), widely considered the best gauge of fear in the market, spiked more than 12 percent to trade near 19, hitting a fresh three-month high.

Most key S&P sectors closed in the red, dragged by energy and financials.

"We're off session lows -- people are not going to be driven into a state of panic over this [gridlock in Washington]," said Keith Bliss, senior vice president at Cuttone & Co. "We've seen an orderly pullout in the market, and some sort of deal will eventually get done."

As the government shutdown entered into a second week with no clear resolution in sight, investors remained nervous as the Oct. 17 deadline to raise the nation's borrowing limit loomed closer.

On Sunday, Treasury Secretary Jack Lew said that Congress was "playing with fire," and warned the U.S. could default in just over a week.

(Read more: So what if there's adefault? 5 things to remember)

Republican House Speaker John Boehner warned he did not have a sufficient majority to pass legislation on raising the $16.7 trillion borrowing limit without spending cut conditions attached. Speaking to ABC television over the weekend, he added that the U.S. was on the path to a credit default.

However, the chief executive of credit rating agency Moody's Investors Service ruled out the prospect of a default, even if an agreement on the debt ceiling is not reached next month.

"It is unlikely that we go past October 17 and fail to raise the debt ceiling, but even if that does happen, then we think that the U.S. Treasury is still going to pay on those Treasury securities," Moody's CEO Raymond McDaniel told CNBC.

(Read more:Wall Street gets ready to trade defaulted US debt)

"We started out with great anxiety -- the weekend brought a bit more venom and vitriol...But now we haven't had any heads popping up on the TV screen and pointing at one another and making harsh claims," said Art Cashin, director of floor operations at UBS Financial Services. "And people are beginning to analyze a little bit better what the situation is -- that on the 17th, we don't necessarily see the Capitol dome turn into a pumpkin."

This week, the shutdown is likely to continue to disrupt the flow of official economic data, meaning third-quarter earnings may garner extra attention as a means of gauging the state of the recovery.

On the economic front, consumer credit rose by $13.63 billion in August to $3.04 trillion, according to Federal Reserve data. Economists polled by Reuters had expected consumer credit to rise $12 billion after a previously reported $10.44 billion increase in July.

For the third-quarter, S&P 500 earnings are expected to increase 3.12 percent year-over-year, according to the latest data from S&P Capital IQ.

(Read more: Debt ceiling flashback: Remember how bad 2011 was?)