Crisis on Wall Street as Lehman Totters,
Merrill Is Sold, AIG Seeks to Raise Cash

Fed Will Expand Its Lending Arsenal in a Bid to Calm Markets;
Moves Cap a Momentous Weekend for American Finance

By CARRICK MOLLENKAMP, SUSANNE CRAIG, SERENA NG and AARON LUCCHETTI
September 15, 2008 12:15 p.m.

NEW YORK -- The American financial system was shaken to its core on Sunday. Lehman Brothers Holdings Inc. filed for bankruptcy protection, and Merrill Lynch & Co. agreed to be sold to Bank of America Corp.

It was a gut-wrenching weekend for Wall Street, with Lehman Brothers headed toward possible liquidation, Merrill Lynch about to be taken over and AIG facing shareholder wrath. WSJ's Dennis Berman and Matthew Karnitschnig look at what's ahead.

The U.S. government, which bailed out Fannie Mae and Freddie Mac a week ago and orchestrated the sale of Bear Stearns Cos. to J.P. Morgan Chase & Co. in March, played much tougher with Lehman. It refused to provide a financial backstop to potential buyers. Without such support, Barclays PLC and Bank of America, the two most interested buyers, walked away. Barclays said Monday it pulled out of the potential deal after deciding it wasn't in the best interest of shareholders.

Early Monday morning, Lehman filed for protection under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York. Lehman said none of the broker-dealer subsidiaries or other subsidiaries of LBHI will be included in the Chapter 11 filing and all of the broker-dealers will continue to operate. Customers of Lehman Brothers, including customers of its wholly owned subsidiary, Neuberger Berman Holdings LLC, may continue to trade or take other actions with respect to their accounts, Lehman said.

On Sunday night, Bank of America struck an all-stock deal to buy Merrill Lynch for $29 a share, or $50 billion. (See related article.)

Bank of America Chief Executive Ken Lewis said on Monday that he felt "no pressure" from federal government regulators to sign a deal to acquire Merrill Lynch.

Merrill Chief Executive John Thain said he began to look for an acquisition partner for Merrill after exploring "the implications for a Lehman bankruptcy."

Though the Federal Reserve steered clear of a bailout, it is expected to take new steps to stabilize the broader financial system. These steps, expected to be temporary, would make it easier for banks and securities firms to borrow from the central bank by using a wider range of collateral. Bankers say these financial institutions might need short-term funds as they unwind their many trading positions with Lehman. (See related article.)

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The Lehman board authorized the filing of the Chapter 11 petition in order to protect its assets and maximize value, the firm said. In conjunction with the filing, Lehman intends to file a variety of first-day motions that will allow it to continue to manage operations in the ordinary course. Those motions include requests to make wage and salary payments and continue other benefits to its employees.

However, employees at the Lehman units that filed for insolvency in the U.K. may not be paid, said Tony Lomas, a partner at PricewaterhouseCoopers assigned to help manage the proceedings for four Lehman companies there. The four companies in administration are: Lehman Bros International Europe, Lehman Brothers Ltd, Lehman Brothers Holdings plc and Lehman Brothers UK R.E., which holds real estate assets, he said.

Not in administration and continuing to function are Lehman Brothers Europe and Lehman Brothers Asset Management, Mr. Lomas told a news briefing Monday. There are dozens of PricewaterhouseCoopers people inside the Lehman building on Canary Wharf trying to come to grips with the company's affairs, he said.

"When we were appointed this morning, quite bluntly there was no cash because of the group treasury function," Mr. Lomas said, adding that his team would tell employees as soon as possible "whether or not there are funds enough to pay." Mr. Lomas said "a couple of dozen" of Lehman employees in London have been told definitely that they no longer have jobs. The rest should know by Wednesday, he said. The Lehman insolvency will be "larger and more complex" than similar proceedings for Enron and MG Rover, Mr. Lomas said.

Lehman said it is exploring the sale of its broker-dealer operations and, as previously announced, is in advanced discussions with a number of potential purchasers to sell its Investment Management Division. Lehman said it intends to pursue those discussions as well as a number of other strategic alternatives. Neuberger Berman LLC and Lehman Brothers Asset Management will continue to conduct business as usual and will not be subject to the bankruptcy case of the parent company, and its portfolio management, research and operating functions remain intact. In addition, fully paid securities of customers of Neuberger Berman are segregated from the assets of Lehman Brothers and aren't subject to the claims of Lehman Brothers Holdings' creditors, Lehman said.

The damage on Wall Street is the latest consequence of a storm that began last year with the sharp decline in American housing prices and losses on loans and other assets tied to home values. Massive capital infusions have failed to stem write-offs and losses, and financial firms are running out of options to escape the damage.

Regulators and others were preparing for a hectic Monday. The New York Stock Exchange prepared contingency plans over the weekend to reassign the approximately 200 blue-chip stocks that Lehman's specialist unit trades, according to people familiar with the matter. If Lehman is forced into liquidation, the exchange will likely transfer the stocks to one or more of the remaining specialist firms, most likely using the same technology and staff that currently trade the stocks.

Dozens of Wall Street desks have trades with Lehman. As word spread that the Barclays deal was falling apart, worries that the company could be thrown into bankruptcy mounted, and traders labored to get out of those contracts.

At approximately 2:30 p.m., government officials hosted a call, and a trading session was opened to ease fears. One trader said it was agreed that other brokers would pick up contracts that trading desks have with Lehman. If Lehman does open on Monday, the deals struck on Sunday, often at a worse price, would be void. "It is utter chaos here," the trader said.

At many Wall Street firms, traders of credit-default swaps -- contracts that act as insurance against debt defaults -- were told to come to work immediately. Concerned investors were rushing to buy swaps tied to other brokerages and corporations, sending the cost of protection on investment banks such as Goldman Sachs and others sharply higher.

In a statement Sunday, the International Swaps and Derivatives Association, a trade group whose members include many large dealers, said a "netting trading session" took place between 2 p.m. and 6 p.m. on Sunday. The idea was to allow firms to try to unwind their derivatives transactions with Lehman by finding other parties to step into Lehman's shoes.

"The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy filing," it said. It added that trades conducted during this period "are contingent on a bankruptcy filing on or before 11:59 p.m. New York time" on Sunday. If no filing takes place, the trades will be canceled, ISDA said.

Some traders said it was difficult to find new counterparties for many of their outstanding trades with Lehman. The snags included different terms and maturity dates on derivatives contracts, and market prices changed rapidly Sunday afternoon. "People were screaming at each other over the phone, asking: How can this work?" one trader said.

William Gross, chief investment officer at bond-fund giant Pacific Investment Management Co., said very few Lehman trades were offset. "There's an immediate risk related to the unwind of these positions," he said.

Many Wall Street firms concluded that a liquidation of Lehman's assets likely would proceed in an orderly fashion, people familiar with the situation said. That means other firms could quickly buy real estate, securities and other investments, preventing the assets from flooding the market. Because of that, these people said, some participants in the New York Fed talks decided that liquidation was no worse an option than selling Lehman to a buyer such as Barclays.

"There will be an orderly wind down," said one banker involved in the matter. "This was the default option. It happens when you have no buyer."

The outside firms decided that instead of making guarantees for Barclays or some other purchaser of Lehman, they would prefer to pool their resources and buy the assets themselves, taking on the risks and carrying costs, along with the possibility of profiting down the road.

Those firms would likely then buy assets such as mortgage-backed securities, leveraged loans, private-equity positions and investments in real estate or hedge funds.

Roger Freeman, a nine-year Lehman employee who analyzes brokerage firms, spent the weekend gathering cellphone numbers and email addresses from colleagues who also are likely to lose their jobs. He plans to clean out his desk Monday morning. "We worked long hours here, we've made some of our best friends here. We're suddenly being ripped apart," he said. "It's just unbelievable."

--Jon Hilsenrath, Jeffrey McCracken, David Enrich and Jeanne Whalen contributed to this article.

Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com, Susanne Craig at susanne.craig@wsj.com, Serena Ng at serena.ng@wsj.com and Aaron Lucchetti at aaron.lucchetti@wsj.com