July 11 (Bloomberg) -- Lehman Brothers Holdings Inc., once the biggest U.S. underwriter of mortgage bonds, fell the most since Bear Stearns Cos. collapsed in March on speculation home loan-financing companies Freddie Mac and Fannie Mae might fail.

Lehman, which has lost about 37 percent of its market value this week, dropped $2.87, or 17 percent, to $14.43 at 4:01 p.m. in New York Stock Exchange composite trading, even after Treasury Secretary Henry Paulson said federal regulators are backing Fannie Mae and Freddie Mac ``in their current form.'' The Amex Securities Broker/Dealer Index of 11 companies including New York-based Lehman declined 2 percent.

Fannie Mae and Freddie Mac fell more than 40 percent today before Paulson's remarks, which signal the administration's intent to keep them as shareholder-owned companies. Placing the firms under government control would wipe out equity holders.

The companies face pressure to raise more capital amid a credit contraction that has saddled banks with $410.1 billion of writedowns. A government takeover of one or both of them was among options that could be weighed by the White House, said Joshua Rosner, an analyst with Graham Fisher & Co., who met with Bush administration officials in Washington.

``It is impossible to contemplate all of the negative events that will occur if Fannie and Freddie go under,'' said Richard Bove, an analyst at Ladenburg Thalmann & Co.

`Pall Over Everyone'

Fannie Mae fell $2.95 to $10.25 as of 4:01 p.m. after closing at the lowest level in 17 years yesterday. Freddie Mac slid 25 cents to $7.75.

Fannie and Freddie's problems ``cast a pall over everyone. If they have problems, everyone else has to deal with that perception,'' said David Hendler, an analyst at CreditSights Inc. in New York. ``It's going to be difficult without more definitive government support,'' he said, adding that Paulson's statement ``is a step in the right direction.''

Goldman Sachs Group Inc., the biggest U.S. securities firm, declined 4.5 percent to $162.48. Morgan Stanley, the No. 2 firm, dropped 7 cents to $33.44, while Merrill Lynch & Co. fell 3.8 percent to $27.61. All the firms are based in New York.

``This is the ruboff from Freddie, Fannie as people are worried about the values of mortgage bonds if those two go down and Lehman still owns a lot of those securities,'' said Bruce Foerster, who was a managing director at Lehman before starting advisory firm South Beach Capital in Miami. ``It also shows we're not as close to the end of this mess as we thought earlier. This is real fear.''

Credit-Default Swaps

Credit-default swap contracts on Lehman jumped 38 basis points to 363 as of the close of trading in New York, according to broker Phoenix Partners Group. That's the highest since the week the Federal Reserve backed an emergency sale of Bear Stearns to JPMorgan Chase & Co. to prevent a bankruptcy. Credit- default swaps typically rise as investor confidence deteriorates.

The record share price decline hasn't damaged Lehman's liquidity, funding or client business, Standard & Poor's said today in a statement.

``The firm's management continues to successfully implement a number of measures -- including strengthening its funding platform, reducing exposure to troubled assets, and increasing capital -- to ensure the maintenance of sound liquidity and the ability to meet funding obligations,'' S&P said.

British Banks

Royal Bank of Scotland Group Plc, the U.K.'s second-biggest bank, led a decline among British banks in London trading today on concerns Fannie Mae and Freddie Mac capital woes may trigger new credit writedowns.

RBS fell 8.6 percent to 182.7 pence and Barclays Plc fell 5.9 percent to 267.75 pence, the lowest in almost 10 years for both companies. Standard Chartered Plc fell 7.8 percent to 1,341 pence, the most in almost seven years. The eight-member FTSE 350 Banks Index fell 5.2 percent.

Without a government bailout, the biggest U.S. finance companies may have to sell ``prime'' mortgage securities, triggering a cut in the price of mortgage-backed assets worldwide and further credit writedowns among U.K. lenders, MF Global Securities Ltd. analysts said today.

`Have to Be Rescued'

``They have to be rescued,'' said London-based Simon Maughan. ``If Fannie Mae and Freddie Mac have to sell their mortgage securities, the value of prime mortgage assets will fall dramatically. That could wipe out huge chunks of the banking sector.''

Fannie Mae, based in Washington, and McLean, Virginia-based Freddie Mac own or guarantee almost half the $12 trillion in outstanding U.S. home loans.

``I didn't get a real strong sense one way or another from Paulson's statement,'' said Jack Ablin, chief investment officer at Chicago-based Harris Private Bank, which oversees $65 billion. ``I don't think anyone in the investing world believes that the government is going to let either of those entities fail.

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules. The fair value of Fannie Mae's assets tumbled 66 percent to $12.2 billion and may be negative next quarter, former St. Louis Federal Reserve President William Poole said in an interview.

Lehman shares have plunged 78 percent this year after the company reported the first quarterly loss in its history and sold $6 billion of stock to shore up funding. Lehman has also been hurt by speculation that some of its biggest customers had ceased doing business with the firm, which the clients denied.

``It's getting to be tough for them to manage their own situation,'' Hendler said. ``Even when a lot of investors are saying they're trading with them, it doesn't seem to matter. They're going to need to take more dramatic strategic action. They're going to have to sell at a dilutive price or else it's going to get more dilutive.''

To contact the reporter on this story: Josh Fineman in New York at jfineman@bloomberg.net.

Last Updated: July 11, 2008 17:03 EDT