Wall Street banks were preparing for one of the most dramatic shake-ups in the finance industry's history last night as it emerged that Lehman Brothers, an investment bank with a 158-year history, was working on a plan to declare bankruptcy.
As a marathon session of weekend talks went into its final hours, an even bigger rival, Merrill Lynch, also assembled its board to vote on a takeover offer. With the opening of Asian markets as a deadline, the signs were that two of the most powerful corporations in global finance could disappear. Insiders said other financial institutions were examining the creation of a massive fund, perhaps as large as $50bn (£28bn), which would be used to prop up other firms that get into difficulty.
Whatever the exact shape of the deal, it was clear that it would have profound – and unpredictable – consequences for the world economy. The events represent a crescendo for the year-long credit crisis, which has wiped out half-a-trillion dollars in investments held by Wall Street's biggest firms, forced governments to nationalise once-proud financial institutions and has made it ever harder for ordinary people and businesses to get loans. Failure to end the crisis soon could tip the world into a severe recession, say economists.
For that reason, the Federal Reserve, the US central bank, had called in the chief executives of Wall Street's biggest banks for crisis talks over the future of Lehman Brothers on Friday night, but few expected such dramatic action would be necessary.
One by one, the major players revealed that the credit crisis had so weakened their finances that they would not be able to fund a rescue deal for Lehman. When the UK bank Barclays walked out of negotiations to buy the company yesterday, there seemed no option left but a liquidation of Lehman.
Fears grew over the weekend that Lehman's failure could trigger a crash when Asian markets resumed trading. The Fed and the US Treasury refused to hand over government money to prop up firms brought low by their own bad mortgage investments.
There were signs, however, that the Fed was considering taking some action to aid markets by loosening conditions for lending money to Wall Street firms.
The question is whether a once-in-a-generation shake-up on Wall Street will bring stability and help restore confidence, or presage a new leg-down in the credit markets that are the lifeblood of the global economy.
It is certain to throw thousands more bankers out of work. Lehman employs 25,000 people around the world, including 4,500 in London, where it has its European headquarters.
Coming on the heels of the fire sale of the government-backed Bear Stearns in March, the disappearance of Lehman Brothers and Merrill Lynch would mean the Big Five investment banks will become just two.
Bank of America was cajoled by the Fed into talks to buy Merrill Lynch after walking away from negotiations with Lehman Brothers yesterday. It will pay $40bn, but not in cash, issuing Merrill Lynch investors instead with new BofA shares. If the takeover is consummated, it will spare Merrill Lynch, one of the most famous brands on Wall Street, from the ignominious fate of Lehman Brothers, which declined to accept cut-price offers to refinance the firm earlier in the year, only to find that its value continued to plummet and its business began to wither.
Dealers across Wall Street were called in for an unprecedented shadow trading session, supervised by the derivatives industry regulator, aimed at reducing exposure to Lehman. The trades would only go into effect if Lehman filed for bankruptcy before midnight, NY time.
Such a liquidation has not been tried since the explosion of derivatives trading, which meant the collapse of one institution could mean unpredictable losses elsewhere. Bill Gross, of Pimco, one of the most outspoken fund managers, predicted an "immediate tsunami" if Lehman fails.