Lehman failure looms as British bank says it won’t bid

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From Times staff writers Walter Hamilton and Tom Petruno:

Barclays PLC dropped out of negotiations to buy Lehman Bros. Holdings Inc. today, and Wall Street began to prepare for the liquidation of the crumbling investment bank -- a move that could shake global financial markets.

Separately, the Wall Street Journal reported that Bank of America Corp. was in talks to buy Merrill Lynch & Co. A deal for Merrill could lessen the fallout from Lehman’s demise, because Merrill had been viewed as the next weakest investment bank after Lehman.

Lehman’s situation appeared increasingly hopeless, and the firm was expected to file for bankruptcy protection as early as this evening. Major brokerages began trying to work with each other to close out some of the trades they have with Lehman in so-called derivative securities, a multitrillion-dollar market.

Barclays, Britain’s third-largest bank, had emerged Saturday as the leading contender to acquire Lehman amid marathon negotiations in New York between federal regulators and Wall Street chiefs.

But all along, Barclays and U.S. banking firms reportedly had been pressing for some kind of aid package from the U.S. Treasury or the Federal Reserve to share the pain of dealing with Lehman’s potentially toxic real estate-related investments.

Barclays abandoned its bid after the government refused to financially guarantee any of Lehman’s troubled assets, according to a person familiar with the matter.

Likewise, Bank of America, which last week had appeared to be the most likely U.S. buyer for Lehman, indicated this morning that it wouldn’t bid without government help, the Wall Street Journal reported.

Barclays had hoped to buy Lehman’s viable assets -- the ‘good’ bank -- while shunting billions of dollars in troubled loans and securities into a ‘bad’ bank, as a separate legal entity.

One plan had called for other major investment banks to back the Lehman bad bank with a multibillion-dollar capital infusion.

But many U.S. financial giants are worried about shoring up their own balance sheets as defaults on real estate loans continue to rise, and so wanted the government to guarantee that a Lehman bad bank wouldn’t become a black hole for the rescuers.

However, the Treasury and the Federal Reserve have been adamant that they wouldn’t provide government aid to save Lehman, a 158-year-old Wall Street institution. The government drew a line in the sand after committing up to $200 billion last weekend to keep mortgage giants Fannie Mae and Freddie Mac solvent.

Although meetings continued in New York, it wasn’t clear whether the government and Wall Street could agree on some other plan that would result in the sale of Lehman or a breakup of the company that wouldn’t involve bankruptcy.

The clock was ticking because Asian financial markets open in late afternoon Pacific time, and those markets could react violently if investors fear that the U.S. financial system faces another serious hit.

The Journal’s early report on talks between Bank of America and Merrill had few details. But a deal for Merrill could be crucial to shoring up confidence on Wall Street because of deepening fears late last week that Merrill could follow Lehman into a financial crisis.

With a Lehman collapse now a serious possibility, the International Swaps and Derivatives Assn. said securities dealers were meeting in New York to begin ‘netting out’ derivatives trades they have with Lehman. In other words, a dealer on one side of a bet with Lehman -- say, on the direction of interest rates -- would try to find another dealer with the opposite bet with Lehman, and the two would then effectively consider those trades to be with each other rather than with Lehman.

The ISDA said that if Lehman didn’t file for bankruptcy by midnight tonight, the netted trades would be canceled.

It’s conceivable that Lehman could liquidate itself in an orderly manner as long as other Wall Street banks continue to trade with it, and with the help of short-term loans from the Federal Reserve -- a facility opened to brokerages in March after the demise of Bear Stearns Cos.

But the collapse of Lehman could wreak havoc with other financial firms that investors perceive to be in a weakened state, including insurance titan American International Group. AIG was said to be planning a major restructuring announcement for Monday.