By Christian Plumb and David Lawder

Lehman's bonds also dropped ahead of what is expected to be a series of frantic calls this weekend between Lehman, U.S. regulators and potential bidders. Bank of America Corp is widely seen as a leading contender, with British bank Barclays Plc also considered a possibility.

The Financial Times reported that BofA, the No. 2 U.S. bank by assets, was considering a joint bid for Lehman along with private equity investor JC Flowers and sovereign wealth fund China Investment Co. Lehman declined to comment.

Lehman shares, the most traded on the New York Stock Exchange, were down as much as 19 percent in afternoon trading.

"I think they're going to have to draw a line at some point," Rose Grant, managing director of Eastern Investment Advisors in Boston said of Washington regulators. "This could be the point."

The credit maelstrom is threatening other financial companies, including leading brokerage Merrill Lynch & Co Inc and American International Group Inc , once the world's largest insurer by market capitalization. AIG lost as much as a third of its value, while Merrill slid 11 percent.

Credit protection costs also rose for AIG, Lehman and JPMorgan Chase & Co , with investors paying $715,000 to protect $10 million of Lehman debt, and $1.2 million to protect the same amount of AIG debt.

Lehman's 6.875 percent notes due in 2018 fell to 83.5 cents on the dollar, down from 84 cents at Thursday's close.

WORKING THE DEAL

Adding doubts about the possibility of a quick rescue for Lehman, a source familiar with U.S. Treasury Secretary Henry Paulson's thinking said he was "adamant" that no government money be used in any deal.

U.S. Sen. Richard Shelby, the top Republican on the Senate Banking Committee, told CNBC that the Treasury and the Fed were trying to work a deal that involved no U.S. government money but said he couldn't guarantee it wouldn't be needed at some point to prevent Lehman from collapsing.

"I'm hoping that some big firm will want them more than the Fed wants them," Shelby said.

The investment bank is struggling to find a solution to the worst crisis of its 158-year history. Lehman wrote down its assets by $5.6 billion in the third quarter, triggering a second straight quarterly loss of $3.9 billion.

Lehman has so far failed to attract investors to shore up its capital position, weakened this year by its outsized exposure to commercial real estate and residential mortgage assets hard hit by the continuing credit crunch.

The government's reluctance to intervene has raised concern about the possibility of a bankruptcy filing at Lehman, which employs 25,935 people worldwide.

If Lehman did go under, the effects could be devastating to world markets, resulting in a fire sale of the firm's troubled assets, which could depress bond and mortgage markets, among other areas.

Standard & Poor's analyst Scott Sprinzen said on Friday he did not expect Lehman to fail and said its near-term liquidity was satisfactory.

But S&P analyst Tanya Azarchs, asked about S&P's concerns about overall counterparty and systemic risks, said concerns are "very, very high" because of skittish market conditions and tight liquidity.

A Fitch analyst said the failure of Lehman to reach a deal would result in a ratings cut in the "near term." If Lehman's credit ratings were cut, as Moody's, S&P and Fitch are considering, it could be forced to post as much as $2.9 billion in collateral to counterparties, according to research from independent firm CreditSights.

The investment bank, until recently the nation's fourth-largest, is the latest casualty of the year-long mortgage crisis, which has led to billions of dollars in write-downs for banks, a credit crunch, and the loss of thousands of banking jobs.

MOST LIKELY SUITOR

Bank of America, the largest U.S. bank by market value, has emerged as the most likely suitor for Lehman, according to various reports and analysts. BofA declined to comment.

"I believe that Bank of America will win the auction for Lehman Brothers. There is a natural fit between the two companies," veteran analyst Richard Bove said in a note.

HSBC Plc has also been linked with Lehman, but in recent weeks executives at the London-based bank have distanced themselves from a possible deal.

By buying Lehman, BofA would get access to one of the best fixed-income trading desks, Bove said. "It immediately becomes a first-rank player in the equity investment banking sector ... it gains access to customers around the world in the capital markets arena."

But a takeover by BofA, which took on a huge restructuring burden in troubled mortgage giant Countrywide earlier this year, was far from a sure thing.

In a sense, the Charlotte, North Carolina-based banking company could snag Lehman for a bargain price; Lehman's market cap now stands at $2.7 billion, according to Reuters data, less than investment banks that were once much smaller than Lehman, such as Raymond James Financial and Jefferies Group Inc.

THUMBS DOWN

But BofA and other bidders were said to be concerned about potential losses on Lehman's $45.8 billion of mortgage and asset-backed securities.

Lehman Chief Executive Richard Fuld, who had vowed to never sell the firm in his lifetime, has been trying to unload just a part of the company rather than the whole thing, sources familiar with the situation said.

But investors gave a thumbs-down to revival plans unveiled by Lehman on Wednesday, saying they lacked real progress. It prompted fears that clients and trading partners might take their business to more stable firms. Major Wall Street firms have said they continue to do business with Lehman.

(Additional reporting by Dan Wilchins, Joseph A. Giannone, Dena Aubin, and Juan Lagorio in New York, Karey Wutkowski in Washington and Jamie McGeever in London; writing by Steve Slater, Lincoln Feast and Ian Geoghegan; editing by Jeffrey Benkoe and John Wallace)