Turmoil on Wall Street

By Francesco Guerrera in London, Krishna Guha in Washington and Greg Farrell in New York

Wall Street is in turmoil tonight as Merrill Lynch rushed to find shelter in a $35bn-plus takeover by Bank of America and Lehman Brothers appeared to be running out of options to save itself from becoming the biggest victim yet of the credit crunch.

The moves cap a weekend of high drama which could lead to one of the most radical reshapings in Wall Street’s history.

Markets’ reaction on Monday to the weekend’s dramatic events will be closely watched by regulators and banking executives to gauge investors’ sentiment towards the credit crunch that wreaked on the financial sector for over a year.

BofA’s rapid U-turn, which saw it abandon talks to buy Lehman and turn to Merrill in the space of just a few hours, will throw the spotlight on Morgan Stanley and Goldman Sachs, which could soon become the only two independent investment banks in the US.

Top Wall Street executives last night were still locked in increasingly desperate talks with US Treasury Secretary Hank Pailson and Tim Geithner, president of the New York Federal Reserve in an effort to save Lehman from bankruptcy.

However, bankers familiar with the discussion said a rescue plan for Lehman had become increasingly difficult after its two suitors, Barclays of the UK and BofA had walked away.

Barclays pulled out of the talks in the afternoon after the US government refused to provide a guarantee to enable Lehman to continue trading until a deal had been completed.

Regulators prepared the ground for a Lehman bankruptcy by asking its derivatives counterparties to settle trades between themselves in an extraordinary trading session on Sunday afternoon.

Merrill’s decision to enter talks with BofA, which has long coveted its rival’s large retail brokerage business, came after it became apparent that Lehman’s woes could spread to the rest of the investment banking sector in the coming weeks.

John Thain, Merrill's chief executive who was attending the Lehman crisis talks, approached a number of rivals asking them whether they would be interested in bidding for his firm.

People close to the situations said that Morgan Stanely, BofA and several foreign banks were contacted but many of them declined to pursue the talks because they had insufficient time to pore over Merrill’s complex trading books. Merrill, Morgan Stanley and BofA declined to comment.

Bankers familiar with the discussions said BofA had proposed an all-stock takeover that would value Merrill at around $25-$30 per share. This is a sizeable premium to Friday’s close of $17.05 but Merrill’s shares have fallen nearly 70 per cent since the beginning of the year.

A takeover of Merrill would be a victory for Ken Lewis, BofA’s chief executive, who had long wanted to combine the lender’s commercial banking operations with Merrill’s large retail brokerage.

However, a deal could saddle BofA with more troubled assets. The bank bought the stricken mortgage lender Countrywide last year and a purchase of Merrill would force it to clean up the investment bank’s trading books, which has already cost Merrill billions of dollars in writedowns.

People close to the Lehman situation said that, after nearly three days of talks in the headquarters of the New York Fed, the discussions had come down to whether Lehman’s rivals wanted to fund the purchase of about $80bn (£44.6bn) of its troubled assets.

The uncertainty and concerns surrounding Lehman’s portfolio of bad assets prompted bankers to revise the value of the assets to be included in the planned “bad bank” from just over $30bn on Saturday to about $80bn by Sunday morning.

The “bad bank” plan, first revealed by FT.com, was aimed at facilitating a sale of the rest of Lehman, which includes its highly regarded investment banking and asset management operationsunits. Failure to agree a rescueplan for the 158-year-old investment bank by Monday this morning could cause severe strain in financial markets and put further pressure on other financial firms such as the insurer AIG, Washington Mutual, a US lender, and other investment banks such as Merrill Lynch and Morgan Stanley.

Credit rating agencies have threatened to downgrade Lehman unless it quickly finds a buyer - a move that could deepen its plight by forcing it to put up billions of dollars in collateral to continue trading.

The main stumbling block has been the banks’ reluctance to fund a Lehman rescue without a government guarantee on at least some of the losses on its bad book, which includes more than $30bn in troubled commercial real estate assets.

HoweverRegulators have repeatedly told Wall Street executives that said there would be no government intervention along the lines of the $29bn guarantee offered when JPMorgan Chase bought Bear Stearns in March.

The latest round of talks, which opened at around 9am in New York, are following the pattern of the previous two days with bankers meeting among themselves and then holding periodic conversations with Mr Paulson, Mr Geithner and Chris Cox, chairman of the Securities and Exchange Commission