By Heather Landy and Neil Irwin

Washington Post Staff Writers

Monday, September 15, 2008; 12:05 PM

NEW YORK, Sept. 15 -- Lehman Brothers filed for bankruptcy early Monday morning, becoming the largest financial firm to fail in the global credit crisis, after federal officials refused to help other companies buy the venerable investment bank by putting up taxpayer money as a guarantee.

The failure of the nation's fourth-largest investment firm offers a profound test of the global financial system, and government and private officials had been bracing Sunday night for an upheaval in a range of financial markets that have never before experienced the bankruptcy of such a large player. To keep cash flowing normally through these markets, the Federal Reserve announced new lending procedures, while 10 major banks combined to create a new $70 billion fund.

The aftershocks were already being felt. Major European and U.S. stock indexes dropped sharply in morning trading. Major Asian exchanges were closed for a holiday, but markets in India, Taiwan, Singapore and Australia all dropped sharply. Financial regulators in South Korea, where institutions hold over $700 million in investments in Lehman brothers, had called an emergency meeting for Tuesday, when markets reopen.

Central banks around the world issued statements to try to calm an uncertain situation, with the Bank of England saying it stood ready to "stabilize those markets" that need help, and the Bank of Australia freeing extra cash to bolster local banks.

U.S. stock futures pointed to initial losses of as much as 300 points, or nearly 3 percent, for the Dow Jones industrial average.

The filing by Lehman Brothers Holdings, Inc., also touched off a scramble to determine who might be on the losing end of the company's meltdown. On the Paris exchange, shares of insurer Axa SA plummeted after the company was listed as a major Lehman shareholder, Bloomberg news service reported. The company later clarified that the shares were held by clients of an investment subsidiary, not the company itself, Bloomberg reported.

After a marathon series of negotiations over the weekend, Federal Reserve and the Treasury stepped aside to allow a wrenching transformation of Wall Street to proceed. Having galloped to the rescue of other major financial institutions in recent months, the federal government drew the line with Lehman Brothers, ignoring pleas from would-be buyers of the company who insisted on receiving federal backing for its troubled assets.

The grim sense of urgency was underscored this weekend by news that two other major financial firms were seeking lifelines. Venerable investment banker Merrill Lynch will be purchased by Bank of America, and insurance giant American International Group was scrambling to come up with a sweeping restructuring plan.

In refusing to offer federal backing for Lehman, leaders of the Federal Reserve and Treasury Department decided that the firm was unlike the investment bank Bear Stearns, whose sudden collapse in March threatened the world financial system, or Fannie Mae and Freddie Mac, whose potential insolvency did the same.

By betting that Lehman could be allowed to fail without catastrophic consequences, New York Federal Reserve President Timothy F. Geithner, Fed Chairman Ben S. Bernanke, and Treasury Secretary Henry M. Paulson Jr. were making it clear that struggling financial firms cannot count on a bailout.

The decision not to intervene carries the risk that the ripples of Lehman's failure will prove impossible to contain. What worries regulators and Wall Street is a massive, multitrillion-dollar lattice of interlocking financial instruments known as derivatives. The most worrisome to bankers are "credit default swaps," in essence a form of insurance against corporate failures. If the financial firms themselves fail, the value of the insurance they have written will be tested as never before.

So would the market for "triparty repo" -- a form of debt that funds all sorts of financial firms and is held in the money market mutual funds of ordinary Americans -- which is also looking at potential losses from the Lehman bankruptcy.

It was that fear that led the Fed specifically to broaden the types of collateral it will accept at its lending window for investment banks, so that cash can keep flowing through the repo market. Even with that move, they are were steadying themselves for a tumultuous week in that market.

The steps the Fed announced last night, Bernanke said in a statement, "are intended to mitigate the potential risks and disruptions to markets."

"Bankruptcy is a perfectly natural thing, but you hope that the firm is in a position so that it can be an orderly bankruptcy and not cause other problems," said Susan Phillips, dean of the George Washington University School of Business and a former Federal Reserve governor.

Government officials drew a sharp contrast with the threat posed by the difficulties of Bear Stearns. In that situation, in March, Fed and Treasury leaders were convinced that its abrupt demise would have caused extensive damage across the financial system resulting in economic distress in the United States and beyond. For that reason, senior federal officials strongly encouraged J.P. Morgan Chase to buy Bear Stearns and backed $29 billion worth of its risky assets to make the deal happen.

Several firms, especially Bank of America and the British bank Barclays, wanted control of Lehman's investment banking and asset management businesses. However, they wanted no part of billions in shaky real estate and other investments on Lehman's books, and wanted either taxpayers or other financial firms to assume part of that risk.

But other companies decided they didn't want to take over the distressed assets, leaving only the good ones for Bank of America or Barclays. They concluded that they would rather risk potential problems in the financial markets on Monday than plow their limited cash into a venture that would be expected to have poor returns. And the Fed and Treasury refused to make government money available.

On Capitol Hill, key lawmakers either declined to comment on the Lehman's fate or did not return calls. A spokesman for Sen. Charles E. Schumer (D-N.Y.), for whom the day's events represent a hometown crisis, said Schumer, who chairs the Joint Economic Committee, was withholding comment until the status of Lehman Brothers became clear.

Lehman confirmed early Monday that its holding company intends to file for Chapter 11 with the U.S. bankruptcy court for the Southern District of New York, and will make motions that would allow the firm to continue to pay employees and to keep its operations running.

Lehman also said it is exploring a sale of its broker-dealer operations, and confirmed it remains in advanced talks with "a number of potential purchasers" for its investment-management division, which includes Neuberger Berman and Lehman Brothers Asset Management. Those two subsidiaries will conduct business as usual and will not be subject to the bankruptcy case, Lehman said. Customers of Lehman and Neuberger Berman can continue to trade in their accounts, the company said.

Lehman's rank-and-file employees were unsure what they would find when they went to their offices Monday morning. "There's no word. It's not clear what's happening or what's going to happen," said a Lehman bond trader who spoke on condition of anonymity because of the sensitivity of the situation. On Friday, "we thought the options were clear, that either we got bought or we got sold off in small pieces. Nobody thought it was actually going to go to bankruptcy."

Lehman's dissolution has been gradual, over several months. If Bear Stearns experienced a run on the bank, Lehman has experienced a walk on the bank. That means that its various business partners have had time to bolster themselves for potential losses, and, in the view of these government officials, the risks to the system as a whole are therefore less.

It likely means the end of a Wall Street titan, a firm with 24,000 employees and 158 years of history. Lehman Brothers dates back to 1850, to a general store that Henry Lehman and two siblings opened in Montgomery, Ala. The brothers accepted cotton for cash and started a trading business on the side.

A century ago, the firm helped arrange financing for Sears Roebuck. It expanded globally through the twentieth century and became one of the top investment banks. A decade ago, chief executive Richard S. Fuld Jr. faced down rumors that the firm was on the brink of insolvency and put Lehman on an aggressive expansion course. In 2001, with its trading floors destroyed by the terrorist attacks in New York, he regrouped quickly, and the firm managed the first initial public offering to come to market after the attacks.

Fuld's aggressive and competitive nature is not uncommon on Wall Street, but friends and rivals have said the intensity with which Fuld expresses those traits are unmatched.

Lehman, which was outmuscled in merger advising and other traditional investment banking businesses, seized on the mortgage market as an area it could dominate in recent years.

Lehman, the number one underwriter of mortgage-backed bonds last year, amassed a giant portfolio of properties and mortgage-related securities. But the value of the assets began to sink last year amid a spike in mortgage defaults by homeowners with subprime credit.

Lehman shares have fallen from a high of $86.18 in February 2007, when the company's stock market value was approaching $50 billion, to Friday's closing price of $3.65, which left the firm with a market capitalization of $2.5 billion.

"Six months to the day since Bear Stearns went under, I'm viewing our experience in a whole new light," said John Ryding, a former Bear Stearns economist. "We were lucky to be first. We got out with $10 a share, which looked really bad at the time, but it looks a whole lot better than what Lehman shareholders are likely to get."

Staff writers Binyamin Appelbaum, David Cho, Lori Montgomery and Howard Schneider contributed to this report.