If Lehman collapses expect a run on all of the other broker dealers and the collapse of the shadow banking system

It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

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Fed, Street Draft Deal To Buy Lehman's Bad Assets

By Charlie Gasparino On-Air Editor | 13 Sep 2008 | 06:58 PM ET

A deal has been drafted to buy Lehman Brothers' bad assets and clear the way for an eventual sale of the troubled firm, CNBC has learned.

Under the terms of the proposal, which could still blow up, all the major Wall Street firms would pitch in $30 billion total to purchase Lehman's bad real estate assets and create what's knows as a "bad bank."

The proposal is being drafted Saturday night and will be discussed Sunday morning, according to sources close to CNBC. If Wall Street agrees on the terms, which would amount to around $3 billion per firm, it would clear the way for the sale of Lehman Brothers itself to one of several suitors, including Bank of America, Barclays Plc and HSBC.

Executives remained less than pleased with the proposal as they left the New York Federal Reserve around 6 p.m. to convene again Sunday morning. Contingency planning for no deal getting done, potential bankruptcy and defaults continues as Lehman continues its search for a buyer.

"Why should we give up capital so Barclays and Bank of America can buy a clean bank," said one Wall Street executive.

Despite the grumbling, those in the know expect the deal to get done Sunday, with Barclays in the lead to buy the rest of Lehman, including Neuberger. No price has been set just yet.

One Wall Street executive involved in the meetings put it this way: "I'm thinking logically; if they do nothing it's Armageddon. That means they do a deal. It will be announced at 6 p.m. (ET) Sunday."

Most people think the deal will come together sometime between 2 p.m. and 4 p.m. ET Sunday, though the structure is fluid, so the deal could change.

Barclays, along with Bank of America, HSBC and private equity firms have all expressed interest in purchasing Lehman Brothers, though far below the $70 share price that Lehman enjoyed earlier in the year.

Executives from these outfits have met with company officials who began to shop the firm after it became clear that a recent plan to add more capital wouldn't be enough to strengthen the firm, which holds around $40 billion in bad real estate assets on its books.

But with firms like Bank of America and Barclays refusing — at least so far — to budge on their position that they will only buy Lehman without the beaten down real estate assets, and the street balking on the government plan, which calls on the big firms to chip in a total of around $3 billion to purchase the Lehman assets, people with direct knowledge of the meeting say a deal may not get done.

Another problem: officials from the Federal Reserve and the Treasury were holding fast to their position that the government won't guarantee any of Lehman's bad assets, as they did with Bear Stearns, a move that allowed JP Morgan to purchased that troubled brokerage firm in March.

But the Fed's stance might soon soften — as might the position of Wall Street — because the consequences are so dire.

Without a deal, many market analysts predict Lehman will have to file for bankruptcy. Already, there is a near uprising at the firm. Top executives are saying they won't show up to work on Monday. It's unclear if other firms on the Street will continue to trade with Lehman and if Lehman can get loans from major financial players to fund its operations.

Making matters worse, if Lehman does file for bankruptcy, top Wall Street executives involved in the meetings with government officials say they fear another financial firm may be next. All eyes have been on Merrill Lynch, which, despite a recent plan to strengthen its balance sheet, still has exposure to bad assets.

Merrill, of course, is much more diversified firm than Lehman. It has the largest brokerage salesforce of any Wall Street firm, and a major investment in money management powerhouse, Blackrock.