Stocks dropped sharply on Thursday as fears grew that deteriorating credit market conditions may deal a blow to economic expansion.

In a sign of the credit shortage in the mortgage industry, Countrywide Financial Corp., the biggest U.S. mortgage lender, said it had to draw all of an $11.5 billion credit line to fund its operations after it was essentially shut out of other credit markets. Its stock tumbled 13 percent.

Companies' ability to raise capital and stay liquid is being questioned, said Owen Fitzpatrick, head of U.S. equity group at Deutsche Bank Private Wealth Management in New York. What we're going to see here is companies that need to borrow are going to be challenged.

The Dow Jones industrial average was down 84.22 points, or 0.65 percent, at 12,777.25. The Standard & Poor's 500 Index was down 9.11 points, or 0.65 percent, at 1,397.59. The Nasdaq Composite Index was down 12.54 points, or 0.51 percent, at 2,446.29.

For a time in the early moments of trading, both the S&P and Nasdaq were trading 10 percent below their respective 52-week highs from mid-July. That is a threshold professional investors define as a market correction.

Inconsistent comments from government officials were also adding to markets' disarray. U.S. Treasury Secretary Henry Paulson told the Wall Street Journal he expects the financial markets' turmoil to extract a penalty on the growth of the U.S. economy. But St. Louis Federal Reserve President William Poole told Bloomberg that the turmoil had not undermined the economy and saw no need for a rate cut at present.

Problems in the U.S. subprime mortgage market have triggered a tightening of credit and forced investors to unwind risky, high-yielding trades.

In a sign investors are fleeing risk, the Japanese yen extended broad gains again major currencies.

Adding gloom on the housing front was a government report that showed home construction starts fell to their lowest in nearly 10 years in July, while building permit activity dropped its lowest in nearly 11 years.

Countrywide shares fell $2.86 to $18.43.

Shares of luxury home builder Hovnanian Enterprises Inc. fell 10.3 percent to $11.48. Builder Lennar Corp. was down 5.8 percent to $28.30 on the NYSE.