Volkswagen froze talks over a merger that could bail out its majority owner Porsche SE

, leaving the luxury carmaker scrambling to reassure investors a deal to unite the two was still alive.

Porsche insisted the talks to create a sweeping automotive empire were still on and that it faced no short-term financing issues, but the standoff heightened market concern about how it would fund its 9 billion euro ($12.1 billion) debt pile -- sending its shares down more than 9 percent at one stage.

A Porsche source confirmed a report it had sounded out state bank KfW on whether it could qualify for 1 billion euros in loans. Porsche said it had not applied for state aid.

With nerves already stretched after VW called off merger talks set for Monday, a source close to Volkswagen Chairman Ferdinand Piech told Reuters that a meeting scheduled for Wednesday was also canceled. Discussions could only resume if Porsche sheds more light on its finances, the source said.

The news focused attention on the potential financial risk posed by Porsche's complex web of derivative contracts, which have undermined its attempts to forge closer ties with conservatively funded VW.

We must get a clear idea of the true state of affairs at Porsche. We need absolute transparency with regard to the present situation, Volkswagen Chief Executive Martin Winterkorn wrote in a letter to staff seen by Reuters.

It is in the interest of all concerned, our employees, all shareholders and our customers to ensure there is no threat to Volkswagen's financial stability and autonomy.

Porsche SE amassed debt while building a 51 percent voting stake in Europe's largest carmaker. Porsche's accounts show that cash flows at its healthy sports car business are sufficient to make interest payments but not pay off the principal.

One way for Porsche to get rid of its debt would be to cash in its cash-settled call options which are estimated to cover 20 percent of Volkswagen voting shares.

A Porsche spokesman said the company had no intention to unwind cash-settled call options related to Volkswagen shares and that Porsche could refinance itself to the end of June.

DOWNSIDE RISK

The potential downside risk to VW ordinary shares has led some analysts to recommend switching into VW preferred stock , whose valuation was never influenced by takeover speculation.

Sal Oppenheim, which downgraded Porsche preferred stock to sell from reduce this month, said the company was sliding toward disaster and cut the stock's fair value to 20 euros from 30 euros per share.

The longer Porsche waits with the announcement of the rights issue the more Porsche pref shares will fall and the higher the number of shares Porsche will have to issue, the bank wrote on Monday.

Porsche SE's non-voting stock fell as much as 9.3 percent and traded 1.8 percent lower at 40.50 euros by 1418 GMT. Its ordinary shares are held by members of the Porsche and Piech clans, which met on Monday to try to resolve their strategy.

Senior Porsche labor leader Uwe Hueck said during a pause in the family talks that Porsche Chairman Wolfgang Porsche and Hans-Michel Piech -- brother of the controversial VW supervisory board head -- had assured him that the family could guarantee the independence of the Porsche AG sports car unit.

He spoke as more than 6,000 Porsche staff marched to insist VW not be allowed to take over the maker of 911 sports cars.

($1=.7422 Euro)

(Reporting by Christiaan Hetzner and Edward Taylor and by Hendrik Sackmann in Stuttgart and Jan Schwartz in Hamburg)

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