Aug. 15 (Bloomberg) -- Countrywide Financial Corp., the biggest U.S. mortgage lender, fell 13 percent, the most since the 1987 stock-market crash, after Merrill Lynch & Co. raised the possibility of bankruptcy.

``Effective insolvency'' would result if creditors force Countrywide to sell assets at depressed prices or investors lose confidence in its ability to raise cash, Kenneth Bruce, a Merrill analyst in San Francisco, said in a research note today.

Shareholders shouldn't ``understate the importance of liquidity,'' Bruce wrote. ``If liquidations occur in a weak market, then it is possible for CFC to go bankrupt,'' said Bruce, who downgraded Countrywide to ``sell'' from ``buy.'' The Calabasas, California-based company trades under the ticker CFC.

Countrywide's shares have lost almost half their value this year on concern a credit crunch in the mortgage industry will erode profit. KKR Financial Holdings LLC, Scottish Re Group Ltd. and other companies tied to the mortgage industry dropped today on speculation earnings will be hurt by the crisis.

Bankers have curtailed lending to mortgage providers and demanded more collateral, forcing more than 70 companies to seek buyers or shut since the start of last year.

Countrywide dropped $3.17 to $21.29 in New York Stock Exchange composite trading at 4 p.m. It reached $19.25 earlier today.

Commercial Paper

The stock extended its decline after CNBC reported that Countrywide's 30-day asset-backed commercial paper is being quoted by securities dealers at a 12.54 percent yield. The company previously borrowed at 15 basis points, or 0.15 percentage point, over the London interbank offered rate, the cable-television network reported. Libor, as the rate is known, currently is about 5.57 percent for 30-day borrowings.

Countrywide's overnight corporate commercial paper was quoted today at 6 percent and 6.5 percent for 30 days, according to Denise Latchford, director of money funds for American Century Investments, in Mountain View, California.

KKR Financial, which said it lost $40 million on the sale of $5.1 billion of mortgage loans, dropped 31 percent, or $4.75, to $10.52.

Scottish Re said it was evaluating risks in its $3.1 billion of bond holdings backed by subprime and so-called Alt-A mortgages, or those made to borrowers who don't qualify for prime loans. Shares of the company declined 90 cents, or 24 percent, to $2.79.

Newcastle, Thornburg

Newcastle Investment Corp. fell 4.8 percent to $14.64 after Lehman Brothers Holdings Inc. cut its ratings on shares of the real estate investment trust.

Thornburg Mortgage Inc. rose 39 percent to $10.56 after the company said it's moving closer to getting funding and has no plans to file for bankruptcy.

The perceived risk of owning Countrywide's bonds increased, according to credit-default swap prices. Countrywide five-year credit swaps climbed 225 basis points to 600 basis points, according to broker Phoenix Partners Group in New York. A rising price indicates more skepticism about a company's solvency.

Last week, Countrywide said it had access to about $187 billion in credit. Chief Executive Officer Angelo Mozilo assured investors that the company has enough cash to cope with the market turmoil, and said it may even benefit as competitors are forced out of business.

`Expensive' Steps

``We continue to think the company can survive a period of secondary market instability,'' Bruce said in his note. ``However, the steps that it would take to preserve shareholder value would be expensive, likely leading to further share price declines from here.''

Amber Cousins, a spokeswoman for Countrywide, didn't return calls seeking comment. Carrie Gray, a spokeswoman for Merrill Lynch, declined to make Bruce available for comment.

``Any talk of bankruptcy is grossly exaggerated,'' said Edwin Walczak, who manages $600 million at Vontobel Asset Management in New York and owns 182 million Countrywide shares. Walczak said he's been buying Countrywide shares amid the turmoil in part because most of Countrywide's new mortgages qualify to be bought by Fannie Mae and Freddie Mac, so they are ``easily securitized.''

Bruce said in his report that the ``severe contraction'' in liquidity is surfacing in almost every type of asset. He cited Coventree Inc., the Canadian investment bank that yesterday sought emergency funding after investors declined to buy its debt. The company later said it found buyers for C$600 million ($557 million) of the securities.

Coventree's problem may spread to the U.S., Bruce said.

``We hesitate to use the word contagion, but this market is feeling awfully similar to the fall of 1998,'' he said, referring to the market crisis that resulted from Russia's debt default and the collapse of hedge fund Long-Term Capital Management LP.

To contact the reporter on this story: Elizabeth Hester in New York at ehester@bloomberg.net.

Last Updated: August 15, 2007 18:10 EDT