Lehman Files for Biggest Bankruptcy as Suitors Balk

By Yalman Onaran and Christopher Scinta

Sept. 15 (Bloomberg) -- Lehman Brothers Holdings Inc., the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.

The 158-year-old firm, which survived railroad bankruptcies of the 1800s, the Great Depression in the 1930s and the collapse of Long-Term Capital Management a decade ago, has filed a Chapter 11 petition with U.S. Bankruptcy Court in Manhattan today. The collapse of Lehman, which listed more than $613 billion of debt, surpasses WorldCom Inc.'s insolvency in 2002 and Drexel Burnham Lambert's failure in 1990.

Lehman was forced into bankruptcy after two suitors, Barclays Plc and Bank of America Corp., abandoned takeover talks yesterday and the company lost 94 percent of its market value this year. Chief Executive Officer Richard Fuld, who started working for the New York-based firm in 1969 and turned it into the biggest underwriter of mortgage-backed securities at the top of the U.S. real estate market, joins his counterparts at Bear Stearns Cos., Merrill Lynch & Co. and more than 10 banks that couldn't survive this year's credit crunch.

``There is likely to be a domino effect as other firms and individuals who relied on Lehman for financing feel the effects of its meltdown,'' said Charles ``Chuck'' Tatelbaum, a bankruptcy lawyer with Lauderdale, Florida-based Adorno & Yoss and former editor of the American Bankruptcy Institute Journal. ``The whole thing is frankly frightening for the U.S. economy.''

The filing is by Lehman's holding company and won't include any of its subsidiaries. Lehman's largest unsecured creditors are Citibank N.A. and The Bank of New York Mellon Corp. as trustees for bondholders owed $138 billion. The bank listed $639 billion of assets.

Barclays, Bank of America

Barclays, which had emerged as a leading candidate to acquire Lehman, pulled out first yesterday, saying it couldn't obtain guarantees from the government or other Wall Street firms to protect against potential losses on Lehman's assets. Bank of America withdrew about three hours later, before saying it would acquire Merrill Lynch. Banks and brokers sought yesterday to consolidate trades linked to Lehman to minimize the impact of a bankruptcy filing.

Founded in 1850 by three Jewish immigrants from Germany, Lehman has managed to avert previous potential disasters and was among the handful of U.S. financial firms that had endured for more than a century.

Fuld, the longest-serving CEO on Wall Street, attempted to shore up the firm's finances in the second quarter by raising $14 billion of capital, selling $147 billion of assets, increasing cash holdings and reducing reliance on short-term funding to create a buffer against a bank run.

Historic Loss

Lehman last week reported the biggest loss in its history and said it planned to sell a majority stake in its asset- management unit, spin off real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence. The efforts failed to stem speculation that the firm's mortgage holdings would lead to more losses. Lehman fell 77 percent last week in New York trading.

The U.S. Treasury and the Federal Reserve negotiated with Wall Street executives for the past three days in New York, trying to strike an agreement that would prevent the investment bank from failing before markets open today. Treasury Secretary Henry Paulson indicated that he didn't want to use U.S. taxpayer funds to ease a sale of the company.

Fuld, 62, is exploring the sale of its broker-dealer operation and continues to hold talks on the sale of its asset- management unit, including fund manager Neuberger Berman, the company said today in the statement.

SIPC Role

The U.S. Securities and Exchange Commission said customer accounts at Lehman are protected and agency staff will remain at the brokerage firm in the coming weeks.

Securities rules require segregation of Lehman's securities and cash, and accounts are covered by insurance provided by the Securities Investor Protection Corp., the Washington-based agency said last night. SEC employees working inside the broker's office will continue that assignment, the agency said.

``We are committed to using our regulatory and supervisory authorities to reduce the potential for dislocations from recent events, and to maintain the smooth functioning of the financial markets,'' said SEC Chairman Christopher Cox in a statement yesterday.

Brokerage units that fail usually are handled by the SIPC, which appoints a trustee to liquidate the business and protect its customers. Lehman's customer accounts may also be farmed out to other firms that could protect cash and securities, on the model of the failed junk-bond firm Drexel Burnham Lambert, which filed for bankruptcy in 1990.

`Big Mess'

Lehman's trades in commodities, derivatives and other financial instruments could be unwound by the bank's counterparties, said Andrew Rahl, co-head of bankruptcy in New York at law firm Reed Smith LLP and a specialist in financial companies.

A liquidation of the brokerage unit might be ``a big mess'' if Lehman used customer accounts to raise cash, and sale and repurchase agreements had to be unwound, Rahl said.

The trigger for SIPC to take over the Lehman brokerage would be a freezing of customer accounts, or a Chapter 11 filing that implied the unit was insolvent and its customers might not be able to access their property, the official said.

`Chaos' at First

``First there will be chaos and then an adjustment process as losses distribute themselves through the market,'' said Gilbert Schwartz, a former Federal Reserve attorney and now a partner at Schwartz & Ballen LLP in Washington. ``There won't be any lasting turmoil. Treasury and the Fed have determined that markets have adjusted to the situation since Bear Stearns. If every time a big institution went bust the markets expected the government to step in, no one would ever adapt.''

Ladenburg Thalmann & Co. analyst Richard Bove wasn't as sanguine.

``We will be entering uncharted territory,'' he said. ``Forcing liquidation will set off problems in other companies and markets everywhere.''

Rival banks and brokers today held a session for netting derivatives transactions with Lehman to reduce uncertainty in the derivatives market. That move means canceling trades that offset each other, the International Swaps and Derivatives Association said in a statement. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the U.S. and abroad.

Damage Test

Fed officials sought a solution that didn't involve a government bailout of Lehman. Barclays, the U.K.'s third-biggest bank, said in a statement that it walked away after failing to obtain guarantees to protect against potential losses at the U.S. securities firm.

Any sale of Lehman's investment management units would be subject to court approval and creditor scrutiny if Lehman goes into Chapter 11, Tatelbaum said.

``Bankruptcy severs all counterparty contracts, and therein lies the systemic risk,'' said David Kotok, chief investment officer of Vineland, New Jersey-based Cumberland Advisors Inc., which manages $1 billion. ``This would be the first time we've tested how much damage will be done by a bankruptcy.''

Lehman's filing was made by lawyers from New York's Weil Gotshal & Manges LLP led by Harvey Miller.

The case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net; Jef Feeley in Wilmington, Delaware at jfeeley@bloomberg.net