Sept. 15 (Bloomberg) -- Lehman Brothers Holdings Inc., once the fourth-largest U.S. investment bank, will file for bankruptcy after potential buyers abandoned talks and the U.S. government declined to fund a takeover of the crippled firm.

Lehman, last year's biggest underwriter of mortgage-backed securities, plans to file a Chapter 11 petition in the U.S. Bankruptcy Court for the Southern District of New York, the firm said in a statement today. The filing will be by the holding company and won't include any of its subsidiaries, Lehman said.

Barclays Plc, which had emerged as a leading candidate to acquire Lehman, pulled out first yesterday, contending it couldn't obtain guarantees from the government or other Wall Street firms to protect against potential losses on Lehman's assets. Bank of America Corp. withdrew about three hours later, before announcing that it would acquire Merrill Lynch & Co. Banks and brokers sought yesterday to consolidate trades linked to Lehman to minimize the impact of a bankruptcy filing.

``In the short term, there will regrettably be losers including creditors, investors and the capital markets,'' said Martin J. Bienenstock, a New York bankruptcy lawyer representing several Lehman creditors.

Founded in 1850 by three Jewish immigrants from Germany, Lehman has managed to avert previous potential disasters and was among the handful of U.S. financial firms that had endured for more than a century.

Chief Executive Officer Richard Fuld, who joined Lehman in 1969 and is the longest-serving CEO on Wall Street, attempted to shore up the firm's finances in the second quarter by raising $14 billion of capital, selling $147 billion of assets, increasing cash holdings and reducing reliance on short-term funding to create a buffer against a bank run.

Historic Loss

Lehman last week reported the biggest loss in its history and said it planned to sell a majority stake in its asset- management unit, spin off real-estate holdings and cut the dividend in an effort to shore up capital and regain investor confidence. The efforts failed to stem speculation that the firm's mortgage holdings would lead to more losses. Lehman fell 77 percent last week in New York trading.

The U.S. Treasury and the Federal Reserve negotiated with Wall Street executives for the past three days in New York, trying to strike an agreement that would prevent the investment bank from failing before markets open today. Treasury Secretary Henry Paulson indicated that he didn't want to use U.S. taxpayer funds to ease a sale of the company.

Fuld, 62, is exploring the sale of its broker-dealer operation and continues to hold talks on the sale of its asset- management unit, including fund manager Neuberger Berman, the company said today in the statement.

SIPC Role

The U.S. Securities and Exchange Commission said customer accounts at Lehman are protected and agency staff will remain at the brokerage firm in the coming weeks.

Securities rules require segregation of Lehman's securities and cash, and accounts are covered by insurance provided by the Securities Investor Protection Corp., the Washington-based agency said last night. SEC employees working inside the broker's office will continue that assignment, the agency said.

``We are committed to using our regulatory and supervisory authorities to reduce the potential for dislocations from recent events, and to maintain the smooth functioning of the financial markets,'' said SEC Chairman Christopher Cox in a statement yesterday.

Brokerage units that fail usually are handled by the SIPC, which appoints a trustee to liquidate the business and protect its customers. Lehman's customer accounts may also be farmed out to other firms that could protect cash and securities, on the model of the failed junk-bond firm Drexel Burnham Lambert, which filed for bankruptcy in 1990.

`Big Mess'

Lehman's trades in commodities, derivatives and other financial instruments could be unwound by the bank's counterparties, said Andrew Rahl, co-head of bankruptcy in New York at law firm Reed Smith LLP and a specialist in financial companies.

A liquidation of the brokerage unit might be ``a big mess'' if Lehman used customer accounts to raise cash, and sale and repurchase agreements had to be unwound, Rahl said.

The trigger for SIPC to take over the Lehman brokerage would be a freezing of customer accounts, or a Chapter 11 filing that implied the unit was insolvent and its customers might not be able to access their property, the official said.

`Chaos' at First

``First there will be chaos and then an adjustment process as losses distribute themselves through the market,'' said Gilbert Schwartz, a former Federal Reserve attorney and now a partner at Schwartz & Ballen LLP in Washington. ``There won't be any lasting turmoil. Treasury and the Fed have determined that markets have adjusted to the situation since Bear Stearns. If every time a big institution went bust the markets expected the government to step in, no one would ever adapt.''

Ladenburg Thalmann & Co. analyst Richard Bove wasn't as sanguine.

``We will be entering uncharted territory. The company has $600 billion in assets and $550 billion in debt outstanding. Forcing liquidation will set off problems in other companies and markets everywhere.''

Rival banks and brokers today held a session for netting derivatives transactions with Lehman to reduce uncertainty in the derivatives market. That move means canceling trades that offset each other, the International Swaps and Derivatives Association said in a statement. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the U.S. and abroad.

Damage Test

Fed officials sought a solution that didn't involve a government bailout of Lehman. Barclays, the U.K.'s third-biggest bank, said in a statement that it walked away after failing to obtain guarantees to protect against potential losses at the U.S. securities firm.

Any sale of Lehman's investment management units would be subject to court approval and creditor scrutiny if Lehman goes into Chapter 11, said Charles Tatelbaum, a Florida-based bankruptcy lawyer and a former vice president of the American Bankruptcy Institute.

``Bankruptcy severs all counterparty contracts, and therein lies the systemic risk,'' said David Kotok, chief investment officer of Vineland, New Jersey-based Cumberland Advisors Inc., which manages $1 billion. ``This would be the first time we've tested how much damage will be done by a bankruptcy.''

To contact the reporters on this story: Yalman Onaran in New York at yonaran@bloomberg.net; Jef Feeley in Wilmington, Delaware at jfeeley@bloomberg.net

Last Updated: September 15, 2008 01:40 EDT