Greece and the investors who bought its national bonds were close to a deal over the weekend. The investors would swap their bonds for replacements with half the face value.
Greece needs the deal to secure a crucial installment of bailout loans and avoid missing an upcoming bond payment. But the deal has been in the works for weeks and could still fall apart.
The Dow Jones industrial average was down 72 points to 12,588 as of just before 1 p.m. EST, a drop of 0.6 percent. Financial stocks were the worst performers in the broader market, with Bank of America down 3.3 percent.
Borrowing costs for European countries with the largest debt burdens shot higher. The two-year interest rate for Portugal's government debt jumped to 21 percent from 14 percent last week.
U.S. Treasury yields sank to their lowest level this year as traders parked cash in the safest assets. The yield on the 10-year Treasury sank to 1.83 percent. It was trading above 2 percent just last week.
The euro dropped 0.6 percent against the dollar, and European stocks sank. French and Spanish stocks closed down 1.6 percent, Italian stocks down 1.2 percent and German stocks down 1 percent.
The focus on Greece has shifted attention away from what's going well in the U.S., said Jack Ablin, chief investment officer at Harris Private Bank. Companies have reported stronger quarterly earnings, and hiring has picked up.
"Our collective breath has been held for so many months," Ablin said.
While the market is waiting on an agreement to cut Greece's debt and contain a wider European debt crisis, even a messy default could eventually lead to a stronger U.S. stock market, he said.
"If it finally happens and the world doesn't fall apart, maybe we'll have a reason to take risk again," he said. "Once you pull off the Band-Aid, it feels better."
An agreement between Greece and its creditors could serve as a blueprint for other European countries with heavy debt burdens. Dan Greenhaus, chief global strategist at BTIG, pointed to Portugal's soaring bond yields in a note to clients.
"At this rate, Portugal is going to move from the back to front burner in very, very short order," he said.
European leaders are also gathering in Brussels, focusing on how to stimulate economic growth when huge government spending cuts threaten to push many countries back into recession.
The latest data showed Spain's economy shrank in the last three months of 2011.
In other trading in the United States, the broader Standard & Poor's 500 index fell nine points, or 0.7 percent, to 1,307. The Nasdaq composite lost 12 points, or 0.4 percent, to 2,804.
The Commerce Department said Americans' income rose in December by the most in nine months. That's slightly better than what economists expected.
Among stocks making big moves Friday:
— The fast food chain Wendy's dropped 2 percent. The Wendy's Co. said Monday that a key measure of earnings dropped 30 percent in the fourth quarter. Charges for selling Arby's offset the effects of a jump in sales.
— PharMerica Corp. plunged 12 percent. The Federal Trade Commission said it was suing to block rival pharmacy company Omnicare Inc. from completing its $457 million takeover of PharMerica. The agency said a merger of the country's two largest long-term care pharmacies would raise the cost of Medicare prescription plans covering drugs for nursing home residents. Stock in Omnicare Inc. inched up less than 1 percent.
— Thomas & Betts Corp. soared 22 percent on news that Swiss engineering group ABB Ltd. agreed to buy the maker of power lines and other electrical products for $3.9 billion in cash.