The Wall Street banks purchased the mortgages and used pools of the loans to back complex bonds, many of which were sold overseas. But heavy defaults beginning in late 2006 triggered the crisis that has brought some financial firms to the brink of extinction. Wall Street firms have written down the value of their mortgage-related holdings by more than $500 billion, giving many of them a need to raise capital.
Lehman's fate was sealed last week when an expected capital infusion by a South Korean state bank failed to materialize. Lehman sought to reassure investors by hurriedly rolling out a restructuring plan to dump soured assets and sell a stake in its prized money-management unit.
The most immediate risk from a Lehman bankruptcy filing is that it could result in the unloading of its portfolio of mortgage-related assets at fire-sale prices, spurring another painful round of write-downs on Wall Street.
"That's where the meltdown scenario comes into play and that's not a happy one," said Dan Alpert, managing director at Westwood Capital, a New York-based investment bank.
Large Wall Street firms have failed during past crises, such as Drexel Burnham Lambert after the insider-trading scandals of the late 1980s.
However, the crumbling of one firm -- Lehman -- and buyout of two others -- Bear and Merrill -- take the current crisis to a new level.
"It is unprecedented," said Sam Stovall, chief investment strategist at Standard & Poor's Corp. "When you look back to other periods of market turmoil, while you had single companies that did go out, you really didn't have the financial community crumble like a house of cards."
The Fed's actions announced Sunday night are designed to ensure that short-term funding will be readily available to Wall Street firms during trading Monday and the rest of this week.
When markets are functioning normally, that kind of funding is usually provided by big institutional investors. But starting with the subprime debacle last summer, these investors have become more and more leery about providing those funds, leaving banks and financial firms without adequate amounts to function.
That leeriness is sure to increase with Lehman's demise, which could leave companies with loans to Lehman short of cash and those that did not do business wondering about the health of the firms they have relationships with.
In the wake of the March collapse of Bear Stearns, the Fed expanded whom it would lend to from just banks to most of the country's major financial firms. But it required borrowers to put up highly rated bonds as collateral, and generally restricted the loans to six months. No firms have borrowed under its so-called primary dealer credit facility since July.
Now, securities firms will be allowed to put up stocks and even junk bonds as collateral, making borrowing more appealing.
In addition, the Fed expanded a separate lending program, its so-called term securities lending facility, by agreeing to accept all types of highly rated bonds, not just government bonds, and increasing the amount available for lending from $175 billion to $200 billion and the frequency of auctions for the money to weekly from every two weeks.
In conjunction with the Fed action, a group of the 10 biggest financial players in the country, including Bank of America, announced that they would each contribute $7 billion to a pool from which any of the 10 can borrow funds if they run into financing problems.
Each firm would be limited to a maximum withdrawal of about $25 billion, although that amount may increase as other banks are admitted to the pool and make contributions, according to a statement issued on behalf of the group by Morgan Stanley.
In addition to Bank of America and Morgan Stanley, other companies involved are Barclays, Citigroup Inc., Credit Suisse, Deutsche Bank, Goldman Sachs Group Inc., JPMorgan, Merrill Lynch and UBS.
Hamilton reported from New York, Gosselin from Washington. Times staff writer E. Scott Reckard in Orange County contributed to this report.
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Largest securities firms in the U.S., by assets in latest quarter
Goldman Sachs: $1.09
Morgan Stanley: $1.03
Merrill Lynch: $0.97
Lehman Bros.: $0.64
Sources: The companies