Sept. 15 (Bloomberg) -- Lehman Brothers Holdings Inc., the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create in the biggest bankruptcy filing in history.

The 158-year-old firm, which survived railroad bankruptcies of the 1800s, the Great Depression in the 1930s and the collapse of Long-Term Capital Management a decade ago, filed a Chapter 11 petition with U.S. Bankruptcy Court in Manhattan today. The collapse of Lehman, which employs about 25,000 people and listed more than $613 billion of debt, dwarfs WorldCom Inc.'s insolvency in 2002 and Drexel Burnham Lambert's failure in 1990.

Lehman was forced into bankruptcy after Barclays Plc and Bank of America Corp. abandoned takeover talks yesterday and the company lost 94 percent of its market value this year. Chief Executive Officer Richard Fuld, who turned the New York-based firm into the biggest underwriter of mortgage-backed securities at the top of the U.S. real estate market, joins his counterparts at Bear Stearns Cos., Merrill Lynch & Co. and more than 10 banks that couldn't survive this year's credit crunch.

``There is likely to be a domino effect as other firms and individuals who relied on Lehman for financing feel the effects of its meltdown,'' said Charles ``Chuck'' Tatelbaum, a bankruptcy lawyer with Adorno & Yoss in Florida and former editor of the American Bankruptcy Institute Journal. ``The whole thing is frankly frightening for the U.S. economy.''

Shares, Bonds

Lehman shares plunged 93 percent at 12:41 p.m. in New York trading to 25 cents from their $3.65 close on Sept. 12. U.S. stocks tumbled, erasing almost $400 billion in market value. American International Group Inc. sank 51 percent as the biggest U.S. insurer sought capital, while Bank of America Corp. slumped 16 percent after agreeing to buy Merrill Lynch & Co. for $50 billion.

Benchmark gauges of corporate credit risk rose by a record in Europe, and traded near an all-time high in North America, driven by a rise in Goldman Sachs Group Inc., Morgan Stanley and AIG. U.S. two-year Treasuries climbed, pushing yields below 2 percent for the first time since April, as investors sought the relative safety of government debt.

Since the collapse of the subprime home-loan market last year, the world's biggest banks and brokerages have reported more than $510 billion of writedowns and credit losses on securities tied to mortgages. Lehman still had a $50 billion stockpile of the investment at the end of August. Falling housing prices and fear of a U.S. recession have eroded prices for the holdings.

Leverage Ratios

Lehman's leverage -- the ratio of total assets to shareholders' equity -- was 31 last year when the mortgage market collapsed. That compares with 33 at Morgan Stanley and 32 at Merrill Lynch. Only Goldman Sachs had a lower ratio, at 22.

Lehman bondholders may get about 60 cents on the dollar if the investment bank is forced into liquidation, analysts at CreditSights Inc. said. The filing is by Lehman's holding company and won't include any of its subsidiaries. Lehman owes its 10 largest unsecured creditors more than $157 billion, including debts to bondholders totaling $155 billion.

The largest single creditor listed in today's filing is Tokyo-based Aozora Bank Ltd., owed $463 million for a bank loan. Other top creditors include Mizuho Corporate Bank Ltd., owed $382 million, and a Citigroup Inc. unit based in Hong Kong owed an estimated $275 million, according to the filing.

Aozora Bank

Aozora, controlled by U.S. investment firm Cerberus Capital Management Ltd., said in a statement today that its exposure to Lehman is ``significantly less'' than the filing shows, thanks to ``risk-management instruments.'' New York-based Citigroup and the Bank of New York Mellon Corp. are among trustees for bondholders who Lehman owed about $155 billion.

Lehman listed $639 billion of assets in the filing, or $26 billion more than its liabilities, a fact Lehman executives have pointed to in recent days to argue that the company was solvent.

Yet opening for business today would have pushed the company toward bankruptcy within days, said Sanford C. Bernstein & Co. analyst Brad Hintz.

Moody's Investors Service last week threatened to downgrade Lehman's debt unless it reached a strategic deal. With lower ratings and no support from trading partners, Lehman would bleed cash and become insolvent quickly, Hintz said in a report today.

``It was unlikely that counterparties would accept settlement risk,'' Hintz said. ``Therefore, the company would be forced to pre-fund its trades.''

Moody's Rating

Moody's today cut its ratings for Lehman by 10 notches to B3 today due to the bankruptcy filing, bringing it down to junk bond level from investment grade overnight.

PricewaterhouseCoopers LLP, the administrator asked by Lehman to oversee the liquidation of businesses in the U.K., said the failure of the company underlined ``the massive importance of market confidence.''

``Once that's gone and no one wants to trade with you, you're in big trouble,'' said PricewaterhouseCoopers partner Tony Lomas at a press conference today in London.

London-based Barclays, which emerged as a leading candidate to acquire Lehman, pulled out first yesterday, saying it couldn't obtain guarantees from the U.S. government or other Wall Street firms to protect against losses on Lehman's assets.

Bank of America Corp. withdrew about three hours later, before saying it would acquire New York-based Merrill Lynch. Brokers sought yesterday to consolidate trades linked to Lehman to minimize the impact of a bankruptcy filing.

Lehman Founders

Founded in 1850 by three 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.

Fuld, 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.

Instability in the financial and credit markets left Lehman officials struggling to keep the firm afloat, Ian Lowitt, the firm's chief financial officer, said in a court filing in the bankruptcy case. Liquidity problems plagued Lehman earlier this year, he said.

``This loss of liquidity created a chain reaction of adverse economic consequences,'' Lowitt said.

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.

`Uncertainty' Trap

``The uncertainty, particularly among the banks through which the company clears securities trades, ultimately made it impossible for the company to continue to operate its business,'' Lowitt said in the filing. The firm had sought about $4 billion for the asset-management unit, he added.

The U.S. Treasury and the Federal Reserve negotiated with Wall Street executives for the past three days in New York, trying to strike a deal 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.

Account Protection

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.

The bankruptcy proceedings will likely mean the speedy sale of stocks, bonds and derivatives on Lehman's books, said Oppenheimer & Co. analyst Meredith Whitney.

``Due to the liquidation of unprecedented scale, we expect a broad-based decline in marks on asset values,'' Whitney wrote in a report. That ``will force the other brokers to mark down their assets accordingly, and therefore pressure all capital ratios.''

SIPC coverage

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 may protect cash and securities, on the model of the failed junk-bond firm Drexel Burnham Lambert, which filed for bankruptcy in 1990.

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

Adjustment Process

``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 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,'' he said. ``Forcing liquidation will set off problems in other companies and markets everywhere.''

`Netting' Session

Rival banks and brokers yesterday held a session for netting derivatives transactions with Lehman to reduce uncertainty in that 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.

In the U.K., the Financial Services Authority asked banks to disclose their exposure to Lehman, spokeswoman Teresa La Thangue said in a statement today.

Any sale of Lehman's investment management units is subject to court approval and creditor scrutiny under bankruptcy rules, according to Tatelbaum.

``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.''

Lehman's filing was made by lawyers from New York-based Weil Gotshal & Manges LLP, led by bankruptcy lawyer Harvey Miller. The case was assigned to U.S. Bankruptcy Judge James Peck, according to court records. Peck was sworn in as a judge in January 2006. Before taking the bench, he served as co-chair of business reorganization at Schulte Roth & Zabel, and prior to that was a partner at Duane Morris, according to the court's Web site.

The case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

To contact the reporters on this story: Christopher Scinta in U.S. Bankruptcy Court for the Southern District of New York in Manhattan at cscinta@bloomberg.net; Yalman Onaran in New York at yonaran@bloomberg.net.

Last Updated: September 15, 2008 12:43 EDT