Lehman may face failure, Merrill may be bought

By Dan Wilchins and Glenn Somerville

NEW YORK/WASHINGTON (Reuters) - The ruptured U.S. financial system was facing an unprecedented shakeup on Sunday that could lead to the failure of Lehman Brothers, the takeover of Merrill Lynch & Co Inc and big asset sales by big insurer American International Group.

The developments may indicate Wall Street and Washington are accepting that massive triage is necessary in the face of the 13-month old credit crisis and destructive U.S. housing bust.

"The U.S. financial system is finding the tectonic plates underneath its foundation are shifting like they have never shifted before," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey. "It's a new financial world on the verge of a complete reorganization."

The focus on Sunday had initially been on whether talks between regulators and Wall Street's top bankers could lead to the sale of Lehman, which until recently was the fourth-largest U.S. investment bank.

However, those talks faltered when Britain's Barclays Plc, which had appeared to be front-runner to take over Lehman -- excluding its toxic mortgage-related assets -- said it had pulled out of the bidding.

That triggered expectations the investment bank is heading into bankruptcy and prompted a rare emergency trading session on Sunday to allow Wall Street dealers in the $455 trillion derivatives market to reduce their exposure to the firm.

The Lehman news pushed U.S. stock index futures sharply lower on Sunday, with the S&P500 futures down 36.40 points at 1222.10, and the U.S. dollar tumbled in early trade in New Zealand, with the euro jumping to 1.4306/10 at 2214 GMT compared with $1.4225 in late U.S. trade on Friday.

Within hours of Barclays withdrawal, the New York Times was reporting that Bank of America was in advanced talks to acquire Merrill for at least $38.25 billion in stock, citing people briefed on the negotiations.

And then, the Wall Street Journal said that AIG, which was until recently the world's largest insurer by market value, is expected to sell off assets, including a profitable aircraft leasing arm.

REAL ESTATE WOES

Merrill, AIG and Washington Mutual, which was the subject of conflicting reports on Friday about whether it was in advanced talks for a sale to JPMorgan Chase & Co all face similar problems because of their ownership of real-estate related assets that have fallen sharply in value.

A perception among investors that the losses they have disclosed are far from enough, and that they will have difficulty in raising new capital, has driven their share prices sharply lower.

One of the catalysts for this weekend's events was the stance of U.S. Treasury Secretary Henry Paulson.

He was strongly opposed to using government money in any deal aimed at resolving the Lehman crisis, a source familiar with his thinking reiterated on Sunday.

The lack of such government guarantees was the main reason Barclays decided to exit the negotiations to buy Lehman, according to a person familiar with the matter.