Street Prepares for Worst As Lehman Deal Stalls

In a sign that Wall Street is preparing for the worst — a possible bankruptcy filing by Lehman Brothers after Barclays PLC walked away from a deal to purchase the troubled Wall Street investment bank — brokers Sunday afternoon were streaming into their offices and a special trading session for credit default swaps was called.

Oliver P. Quilla for CNBC.com

CNBC also has learned that Bank of America has pulled out of negotiations to buy Lehman Brothers and has set its sights on Merrill Lynch & Co, Inc. The bank also has offered to take the other side of Lehman’s swap trades — essentially insurance that Lehman had provided for the bonds of other companies.

"Right now all the firms are preparing for an orderly bankruptcy," said one Wall Street executive involved in the negotiations.

Of course, a last minute deal could be reached, with all sides in this drama compromising and Barclays, or some other firm coming in to purchase Lehman. But as of now, reaching a deal appears remote because the federal government will not provide assistance to help Barclays or some other suitor purchase Lehman cleansed of its bad real estate assets.

Meanwhile, the big Wall Street firms are balking at a plan to buy the bad debt because they say they don't have the money and are worried that they may be called on again to bail out another firm.

For that reason, Wall Street traders headed back to their offices this afternoon to prepare for the market impact of a pre-package bankruptcy and the unwinding of Lehman's balance sheet of approximately $700 million. One Wall Street trader involved in the discussions with officials from the Federal Reserve said every firm had determined their exposure to Lehman by this morning, and were preparing for some Fed help in unwinding the trades.

But officials from the Federal Reserve said they won't be involved in any such unwind — they told the Wall Street firms to work among themselves to determine how best to settle trades with Lehman.

Such a move adds another level of uncertainty to the markets as it braces for the growing possibility that Lehman will file for bankruptcy. Many traders expect massive selling pressure if Lehman does declare bankruptcy beginning when the Asian markets open.

Still others can't believe there won't be a last minute compromise.

"I can't believe people won't give a bit," said one trader involved in the negotiation. "I don't see why this is happening."

One person with knowledge of Sunday's deliberation's called it "a big game of chicken" with all sides digging in their heels.

Meanwhile, officials at one of Lehman's most highly prized assets, asset manager Neuberger Berman, were hoping to find out their fate this afternoon, but were told to simply stay by their e-mails for an announcement that may or may not come.

Bank of America

Bank of America sent a note to derivatives traders Sunday saying "Banks, brokers started netting Lehman trades from 2 p.m. today … trades netted are contingent on Lehman bankruptcy by midnight." The note continued "If no Lehman bankruptcy, netting of trades to be cancelled," meaning Bank of America's assumption of Lehman’s side of trades would end.

"It’s a way of lessening the pressure before Wall Street opens up tomorrow. The more they can reduce the total brokerage book for Lehman, the less heart-ache there will be for counterparties if Lehman files," Carlos Mendez, senior managing director of ICP Capital in New York.

The International Swaps and Derivatives Association called a special session from 2 p.m. to 4 p.m. but traders said that was purely symbolic. They intended to trade through the night.

The cost of insuring the bonds of investment bankers blew out in trading on Sunday.

Barclays Pulls Out

Earlier in the day, Barclays of Britain pulled out of talks to buy Lehman Brothers , raising the possibility that a deal to rescue the embattled investment bank may not happen today.

Bank of America is still involved in the talks, according to several reports, but the situation remains fluid.

Barclays, which was considered the lead candidate to buy Lehman, reportedly was unable to agree on credit guarantees to shield them from potential losses.

One person with direct knowledge of the negotiations told CNBC they don't think a deal will get done Sunday, though the situation could change at a moments notice.

Top Wall Street executives arrived Sunday morning for another round of talks to resolve the Lehman crisis, and sources said the group continued to work on how to handle the possibility of a deal not getting done before Monday.

By mid-morning, Federal Reserve Chairman Ben Bernanke was said to have been involved in several conversations by phone from Washington with officials meeting at the New York Federal Reserve. In addition, Bernanke was said to have made several calls already to foreign central bankers who are monitoring the proceedings carefully.

New York Federal Reserve President Tim Geithner and Treasury Secretary Hank Paulson were already at the New York Fed by the time executives from top Wall Street firms began to arrive.

Work went on through the night on a deal drafted Saturday to have a consortium of banks backstop Lehman's bad assets and sell off the rest of the bank to Bank of America and Barclays. But sources said key parts of the deal remained controversial Sunday morning. As reported, the banks backstopping the bad loans were said to be balking at the amount of capital required of the banks and the sense that they were supporting a good deal for Barclays and Bank of America.

The larger group has been broken up into several working groups to devise responses to different possible outcomes.  Among those, how markets can prepare for the possibility that Lehman might not find a buyer before Monday.

Sources said the possibility of some kind of deal being struck this weekend still existed.

—Reuters contributed to this story

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