Wall Street was in turmoil on Monday after Lehman Brothers filed for bankruptcy protection and Merrill Lynch agreed a $50bn takeover by Bank of America.

Confidence in financial institutions around the world was shaken as central banks introduced a series of emergency measures to ease the crisis in the global financial system.

Equity markets fell heavily and debt spreads widened as banks, investment managers and insurance companies came under heavy selling pressure. By mid-morning in New York, the S&P 500 had fallen 2.9 per cent to 1,215.89. led by a 3.8 per cent drop in financials.

BofA’s bold bid for Merrill came as the world’s top banks abandoned efforts to save Lehman and set out to build a firewall against further financial chaos with a $70bn liquidity pool to support other vulnerable institutions.

George W. Bush, US president, acknowledged on Monday that the changes had been painful but remained focused on the health of the financial system as a whole. “In the long run I’m confident that our capital markets are flexible and resilient and can deal with these adjustments,” he said.

The moves capped a weekend of high drama that could lead to one of the most radical reshapings in Wall Street history.

The Federal Reserve said it was making it easier for financial institutions to access Fed liquidity by easing terms on its borrowing facilities and accepting a much wider range of assets as collateral. The Fed meets to decide on interest rates on Tuesday.

It widened the set of assets eligible as collateral for loans of Treasuries to include all investment grade paper, and raised the size of these Treasury loans to $200bn.

The Fed also suspended rules that prohibit banks from using deposits to fund their investment banking subsidiaries.

The Fed’s intervention was followed on Monday by the European Central Bank and the Bank of England.

The ECB allotted €30bn ($42.04bn) in one-day liquidity at a marginal rate of 4.30 per cent and an average rate of 4.39 per cent. Altogether 51 banks bid €90.27bn.

Meanwhile, the Bank of England said it would offer extra reserves to help stabilise conditions in sterling money markets. The Bank said it would auction £5bn through an exceptional fine tuning open market operation.

The weekend’s dramatic events undermined confidence in financial stocks across Europe. Banks and insurance companies were the heaviest fallers on Monday while gold prices jumped higher as investors sought the safety of the precious metal.

The Markit iTraxx Crossover index, which measures the cost of insuring European junk-rated credit derivatives, widened 17 per cent on Monday to 640 basis points as the likelihood of defaults was perceived to be higher.

Monday’s market reaction will be closely watched by regulators and banking executives to gauge investor sentiment towards the credit crunch that has wreaked havoc on the financial sector for more than a year.

BofA’s rapid U-turn, which saw it abandon talks to buy Lehman and move to Merrill in the space of a few hours, will throw the spotlight on Morgan Stanley and Goldman Sachs. The two could soon become the only independent investment banks in the US.

Merrill’s board voted on Sunday night to approve BofA’s takeover all-stock bid, which was pitched at $29 a share. That is a premium of 70 per cent on Friday’s closing price of $17.05. Merrill’s shares have fallen nearly 70 per cent this year.

The sudden turn of events came at the end of a weekend which saw top Wall Street executives locked in increasingly desperate talks over the future of Lehman and the state of the financial sector with Hank Paulson, US Treasury secretary, and Tim Geithner, president of the New York Federal Reserve.

However, bankers familiar with the talks said a rescue plan for Lehman had been seriously undermined after suitors Barclays of the UK and BofA, had walked away. Barclays pulled out in the afternoon after the US government refused to provide a guarantee to enable Lehman to continue trading until a deal had been completed.

Lehman said during the New York night that it would file for bankruptcy.

The filing is likely to cause thousands of job losses among Lehman’s 25,000-strong staff. On Sunday night a number of employees were seen leaving Lehman’s Manhattan headquarters with boxes stacked with their possessions, stationery and even some paintings.

In a separate move, regulators had prepared the ground for a Lehman bankruptcy by asking its derivatives counterparties to settle trades between themselves in a special trading session in the afternoon.

Merrill’s decision to enter talks with BofA, which has long coveted its rival’s large retail brokerage business, came after it became apparent that Lehman’s woes could spread to the rest of the investment banking sector in the coming weeks.

John Thain, Merrill's chief executive, who was attending the Lehman crisis talks, approached some rivals asking them whether they would be interested in bidding for his firm, according to people close to the situation.

Morgan Stanley, BofA and some foreign banks were contacted but many of them declined to pursue the talks because they had insufficient time to pore over Merrill’s complex trading books, they added. Merrill, Morgan Stanley and BofA declined to comment.

A takeover of Merrill would be a victory for Ken Lewis, BofA’s chief executive, who has long wanted to combine the lender’s commercial banking operations with Merrill’s army of retail brokers.

However, a deal could saddle BofA with more troubled assets. The bank bought the stricken mortgage-lender Countrywide and a purchase of Merrill would force it to clean up the bank’s trading books, which have already cost Merrill some $52bn in writedowns and credit losses.

Mr Thain, the former Goldman Sachs executive and former head of the New York Stock Exchange who joined Merrill last year after the departure of Stan O’Neal, is almost certain to leave the firm if the BofA takeover goes through.

He is a fervent supporter of John McCain, the Republican presidential candidate, and some experts expect him to seek a political career.

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