Sept. 13 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson and New York Federal Reserve Bank President Timothy Geithner urged the heads of Wall Street's biggest firms to find a solution to the plight of Lehman Brothers Holdings Inc., signaling their reluctance to use government funds to bail out the investment bank, people familiar with the talks said.

Talks between the government and the banks continued today, New York Fed spokesman Andrew Williams said. Yesterday's meeting, convened by Geithner, began at 6 p.m. with Kendrick Wilson, a former Goldman Sachs Group Inc. executive whom Paulson tapped last month as an adviser, helping lead discussions. An agreement may be reached as early as tonight, the Wall Street Journal reported today, citing unidentified people with knowledge of the discussions.

Geithner and Paulson presented two scenarios at last night's meeting, people briefed on the talks told Bloomberg News. The first was a forced liquidation of New York-based Lehman, which they said could spread turmoil in the markets and lead investors to flee other investment banks.

The scenario preferred by Geithner and Paulson was for other companies to contribute money to a so-called bad bank to assume Lehman's devalued real-estate assets. That approach is similar to one Lehman presented to investors this week, which the company said would cost $5 billion to $7 billion. By assuming the ``bad'' assets, firms would help ease a sale of the rest of Lehman to Barclays Plc or Bank of America Corp., the people said.

Decision Required

Geithner and Paulson presented the scenarios and took questions, and none of the Wall Street CEOs offered opinions, the people said. The executives agreed to work over the weekend and determine what they were willing to do. A decision was required before the markets opened on Monday, according to the people.

Citigroup Inc.'s Vikram Pandit, JPMorgan Chase & Co.'s Jamie Dimon, Morgan Stanley's John Mack, Goldman Sachs Group Inc.'s Lloyd Blankfein, Merrill Lynch & Co.'s John Thain and Credit Suisse Group's Brady Dougan were among the CEOs at the meeting, according to the people.

Robert Kelly, CEO of Bank of New York Mellon Corp., Robert Wolf, chairman of UBS AG in the Americas, and Christopher Cox, chairman of the U.S. Securities and Exchange Commission, also participated, the people said, who asked not to be identified because the meeting wasn't public. Bank of America CEO Kenneth Lewis didn't attend because his company is a potential bidder for Lehman, one person said.

Bank of America

Bank of America, the biggest U.S. consumer bank, and Barclays, the U.K.'s third-biggest bank, are among the firms weighing acquisition of some or all of the 158-year-old investment bank after it reported its worst quarterly loss this week and the shares plummeted 77 percent in the past five days, according to people familiar with the situation who declined to be identified because the negotiations are confidential.

HSBC Holdings Plc, Europe's largest bank by market value, is also considering a bid, the Wall Street Journal reported today, without saying where it got the information. Goldman Sachs, the largest securities firm, is interested in Lehman's real-estate portfolio, the Journal said. HSBC spokesman Richard Lindsay said in an interview from London that the company doesn't comment on market speculation.

Spokesmen for the New York Fed and the SEC confirmed that yesterday's meeting took place with ``senior representatives of major financial institutions,'' and declined to comment further. Treasury is ``in regular contact'' with market participants, spokeswoman Jennifer Zuccarelli said yesterday.

Without Backing

A sale may be possible without government backing, an analysis of Lehman's distressed mortgage assets shows. In a worst-case scenario -- with the assets discounted more deeply than in recent distressed sales -- a buyer could write off almost half of Lehman's $50 billion in mortgage holdings and still have $7 billion of equity left in company, based on figures the investment bank disclosed when it reported third- quarter financial results this week.

``The firm should be worth something even after the troubled assets are taken out at a massive discount because Lehman has a good franchise,'' said Corne Biemans, a Boston- based senior portfolio manager at Fortis Investments, which oversees about $200 billion. ``There are distressed asset buyers who should be interested in this stuff at such serious haircuts.''

Mortgage-Related Assets

Lehman had $50 billion of mortgage-related assets at the end of August, marked down to between 29 cents and 85 cents on the dollar. Reducing valuations further to between 5 cents on the dollar for collateralized debt obligations and 35 cents for European mortgages would result in $21 billion of further writedowns. Shareholders' equity was $28 billion at the end of firm's fiscal quarter in August.

Merrill Lynch sold subprime CDOs for 22 percent of their value in July. UBS AG sold bonds backed by subprime and Alt-A mortgages for 68 cents on the dollar in May. Alt-A loans are made to people with better credit scores than subprime borrowers, though they're not considered as high quality as prime.

Paulson doesn't want to put up money to help fund any Lehman acquisition, a person familiar with his thinking said yesterday. Unlike when the Fed committed $29 billion to help JPMorgan Chase take over Bear Stearns Cos. in March, Lehman has access to a lending facility for brokers that would permit an orderly process for unwinding the firm, the person said.

Taxpayer Money

At yesterday's meeting, Paulson indicated he wants to avoid putting taxpayer money behind Lehman the way the government stepped in to guarantee the debt and mortgage-backed securities of home-loan financing companies Fannie Mae and Freddie Mac, said the people. The government also wants to avoid a collapse of Lehman, which might disrupt financial markets.

Banks and brokers called into the meeting may be asked to contribute money to back Lehman long enough to unwind its trades, the people said. The Wall Street firms were reluctant to do so unless Barclays, Bank of America or any other buyer also agrees to contribute significantly, which they may not be willing or able to do, one of the people said.

Long-Term Capital Management

Such an arrangement would be similar to the rescue of hedge fund Long-Term Capital Management LP, which failed in 1998 as Russia defaulted on its debt, roiling global markets. Spurred by the New York Fed, Wall Street firms including Lehman contributed cash to prop up LTCM.

CEO Richard Fuld, who participated in the LTCM talks and built Lehman into the biggest U.S. underwriter of mortgage securities during his four decades at the investment bank, was pushed toward a forced sale this past week after talks about a cash infusion from Korea Development Bank ended, eroding investor confidence and the company's market value.

Potential buyers demanded some sort of government protection in the Bear Stearns case because of the mortgage- related assets the firm owned, which had plummeted in value. Since the collapse of the subprime mortgage market last year, banks have reported more than $510 billion of writedowns and credit losses on such assets.

If the government's resistance to fund the purchase lowers the price offered for Lehman, Fuld could balk as well, said Brad Hintz, an analyst at Sanford C. Bernstein & Co.

``We might have a Mexican standoff, with two guys holding guns to each others' heads but nobody firing,'' Hintz said.

Investment Unit

Lehman said Sept. 10 it would sell 55 percent of the investment unit as part of Fuld's plan to keep the firm independent. The company received bids for the unit yesterday from private-equity firms including Bain Capital LLC and Clayton Dubilier & Rice Inc., people familiar with the situation said.

The bids value the unit, which includes the Neuberger Berman fund business, private-equity funds and a brokerage firm serving wealthy individuals, at about $5 billion, said the people, who asked not to be named because the auction is private. KKR & Co. LP, which was weighing an offer, hadn't made a bid by a 5 p.m. deadline in New York yesterday, the buyout firm told people involved in the process.

Bank of America is considering a joint bid for the company with J.C. Flowers & Co. and China Investment Corp., the Financial Times reported yesterday, citing people it didn't identify.

Reviewing Books

Bankers from several firms were reviewing Lehman's books this week, according to people with knowledge of the situation, and a deal may be announced before Asian markets open Sept. 15, one of the people said. The investment bank announced the biggest loss in its 158-year history on Sept. 10, as devalued real estate assets led to $5.6 billion of writedowns in the third quarter.

``Fuld decided to take execution risk and demand more than the marketplace was willing to bear,'' Charles Peabody, an analyst at Portales Partners LLC, said in a Bloomberg Radio interview. ``And he presented that plan to the investor community, which said, `We don't have faith in your ability to bring about the plan.'''

Lehman dropped 14 percent to $3.65 in New York Stock Exchange composite trading yesterday. The shares have lost almost 95 percent of their value this year. Bank of America rose 68 cents, or 2 percent, to $33.74.

Most-Likely Buyer

Ladenburg Thalmann & Co. analyst Richard Bove said in a note to clients this week that Bank of America is the most likely buyer for Lehman. The Charlotte, North Carolina-based company would gain ``one of the best'' fixed-income desks in the U.S. and boost its research and capital markets businesses, Bove said.

Bank of America may team up with Barclays Plc and private equity firms to make an offer for Lehman, analysts at MF Global Securities Ltd. said.

When Bear Stearns collapsed in March, the Fed opened a lending facility for brokerages, including Lehman. The decision, along with the funding provided to facilitate the sale, prompted warnings from current and former regulators, who said the central bank was creating a so-called moral hazard by encouraging firms to take on excessive risk in anticipation of government aid in the event their bets fail.

``What would be best is to alter the precedent with Bear Stearns,'' said former Fed governor Laurence Meyer, who is now vice chairman of Washington-based Macroeconomic Advisers LLC.

Lehman had advanced discussions about a deal with state- owned Korea Development Bank, which offered as much as $6 billion for a 25 percent stake in the firm, or about $26 a share, people briefed on the talks said last week. Goldman Sachs, the biggest U.S. securities firm, has no plan to buy Lehman without financial backing from the Fed or Treasury, a person briefed on the matter said Sept. 10.

To contact the reporters on this story: Bradley Keoun in New York at bkeoun@bloomberg.net; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.

Last Updated: September 13, 2008 14:37 EDT