As Lehman Brothers raced to find a buyer on Saturday, federal officials and Wall Street chieftains mapped out options to prevent an abrupt collapse of the crippled bank and arrest the downward spiral threatening other financial companies.
Several possibilities began to emerge as top Wall Street executives met under the guidance the Federal Reserve and Treasury Department. One would involve major banks and securities firms providing a financial backstop to facilitate a sale of Lehman. Another option would involve an agreement among Wall Street players to keep trading with Lehman as the bank seeks an orderly liquidation.
Those briefed on the talks said the situation was still fluid and other options could emerge.
Adding urgency to the discussions were growing concerns that other big financial institutions like the insurance giant American International Group and Merrill Lynch might face a similar crisis and also need billions of dollars in capital to strengthen their businesses.
The spreading troubles were the latest sign that even the government’s extraordinary interventions into private enterprise during the last year have not been enough to halt the unraveling of the financial system.
As the trading week ended, top officials from the Federal Reserve and the Treasury Department called an emergency meeting in Lower Manhattan with the heads of major Wall Street firms to insist that they find a way to rescue Lehman because their own companies might be next. The meetings, which involved top executives from Goldman Sachs, Morgan Stanley, JPMorgan Chase, Citigroup and other financial companies, continued on Saturday.
The group was working on two main contingency plans in case Lehman is unable to strike a deal to sell itself to one of several suitors — Bank of America or two British firms, Barclays and HSBC. Under one possibility being discussed, major financial firms would jointly inject new capital into Lehman, allowing it to spin off its portfolio of troubled securities into a separate company.
Under another option, Lehman would start an orderly liquidation of its assets on Monday. Its major competitors would agree to keep doing business and trading with Lehman as it unwound its business and portfolio.
The Fed’s call for Wall Street institutions to support one of their own comes at a time when many of them are also short on capital. And yet entities that do have cash ready to invest, namely private equity firms, are not at the table.
Regulators do not want those firms, which borrow money to buy companies, controlling major financial institutions that provide the financing for their acquisitions. Many foreign investors, for their part, are reluctant to buy now after having seen earlier investments drop sharply in value.
For months, Lehman and other companies assured investors that they had a handle on troubled assets tied to real estate. But those assets turned out to be worth less than the firms had thought.
As a result, many investors are no longer sure what such financial companies are worth, and they do not want to invest in them until they do. Many hedge fund managers and other traders have profited handsomely from bets that these stocks would fall in value.
Companies that took the biggest risks and used debt aggressively to build their businesses stumbled first, and now healthier companies are coming under pressure. Loans that were considered far better than the subprime mortgages, which kicked off the panic, turned out to be only marginally safer.
“You have to think of this like there is an epidemic going on — an epidemic of capital destruction,” said James L. Melcher, president of the hedge fund Balestra Capital, who has been bearish on the stock market.
The federal government has taken an unusually activist role in the crisis. This spring, the Federal Reserve arranged a hasty rescue for Bear Stearns, the wobbly investment bank. Then last week, federal regulators took over the country’s two largest mortgage finance companies.
At every turn, officials hoped they had done what was needed to restore confidence in the markets, only to be greeted with another crisis.
Policy makers have signaled that they are not willing to provide financial support for a takeover of Lehman, as they did with Bear Stearns. Unlike Bear Stearns, which lost many clients and its access to money markets in just a few days, Lehman has been able to finance its business, especially after investment banks were allowed to borrow directly from the Fed. The problems that bedevil Lehman are more thorny questions about the quality of the securities it owns.
The decision by policy makers sets up a crucial test for the financial system: Can the market resolve the panic by pairing Lehman with a willing and strong suitor?
There is a growing consensus on Wall Street that the government may not be able to save every big firm whose failure would pose a risk to the system.
“The too-big-to-fail mantra or concept or government policy is in my opinion off the table and we have to deal with that,” said David H. Ellison, president and chief investment officer at the FBR Funds. “They are not going to save these companies.”
So far, the market has struggled to correct the excesses of the recent credit boom on its own.
Analysts say many financial companies, including the insurer A.I.G., need to raise capital. But every time their stock prices fall, raising capital becomes harder. And when that happens, bondholders and credit rating companies start worrying, too. Stock prices fall even further — and the whole cycle repeats again.
On Friday afternoon, for example, Standard & Poor’s warned that it might lower A.I.G.’s credit rating because the drop in the company’s share price — 45.7 percent last week alone — could make it even harder for the company to raise capital.
That partly explains why markets in general, and financial shares in particular, are gyrating ever more. Even after the Bush administration took control of the mortgage finance giants Fannie Mae and Freddie Mac last week, a step many thought might calm investors, trading volatility kept rising.
“Investors are like hyperactive first graders playing musical chairs,” said Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research.
The government, for all its activism, has been unable to stabilize the markets for long — though policy makers would argue that their interventions have prevented failures from cascading through the financial system.
After the Federal Reserve arranged the emergency sale of Bear Stearns to JPMorgan Chase in March, the stock market rallied and many strategists and executives on Wall Street declared that the deal was a turning point.
At the time, Richard S. Fuld Jr., the chairman and chief executive of Lehman Brothers, said that the Fed’s decision to lend directly to investment banks like his had eliminated the problems that felled Bear Stearns. Now, Mr. Fuld is expected to sell Lehman at a fire-sale price.
Stocks also rallied on Monday, after the Treasury Department and federal regulators took over Fannie Mae and Freddie Mac, only to sink the next day as concern over Lehman, A.I.G. and Washington Mutual spread.
At the end of the week, the broad stock market was up modestly, but financial shares closed down 2.5 percent.
Downturns are typically more volatile than the booms that precede them, strategists say. Investors try to anticipate the recovery, though the actual turning point is often visible only in hindsight. But after a lot of bad news, some investors usually dive in, believing that the markets have reached a cathartic moment.
“There are lots of investors that don’t want to miss the absolute bottom,” said Allen Sinai, a former chief economist at Lehman Brothers who now has his own research firm, Decision Economics. “Unless you are a professional trader, and even then, it’s a very dangerous philosophy.”
Many of the fundamental forces in the economy remain worrying. Home prices are still falling, though their rate of decline appears to have slowed in recent months. And defaults on all kinds of loans are rising. In the broader economy, the unemployment rate is rising and consumer spending has been faltering.
The losses created by rising defaults have impaired the ability and confidence of banks to lend to one another and to consumers. As financial institutions rein in risk-taking to protect themselves and preserve their dwindling capital, interest rates go up, lending standards tighten and credit lines are capped or severed.
“Every time there is another problem, it causes lenders to become that much more conservative, which then puts the squeeze on someone else,” said David A. Levy, the chairman of the Jerome Levy Forecasting Center, a research firm in Mount Kisco, N.Y.
Many analysts believe that for the downward spiral to be broken, home prices must fall to a level that can be supported by factors like household income that have traditionally had a strong relationship to prices. Also, the government has to determine how it will restructure Fannie Mae and Freddie Mac, which own or guarantee half of the nation’s home loans, said Thomas F. Cooley dean of the Stern School of Business at New York University.
“We have to hit the bottom in housing prices,” he said, “and we have to just sort out how housing will be financed in future.”