Talks with Britain's Barclays Bank and the Bank of America over the weekend faltered after the potential buyers said they were not convinced that Lehman, which last week announced a loss of $3.9bn in just three months, would be a good buy for shareholders.
Within hours of the collapse of those talks, details emerged of a deal by Bank of America to takeover Merrill Lynch - the third largest investment firm - and the expected sale of assets by American International Group, the world's largest insurance company.
Asian markets dropped by up to 3.6 per cent amid fears of an imminent collapse of Lehman, while US markets fell sharply at the opening bell of the New York Stock Exchange, dropping more than 3 per cent.
Lehman's Chapter 11 file will not include its broker-dealer operations and extra units.
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"The ordinary course of financial change has winners and losers"
Alan Greenspan, former US Federal Reserve chairman
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The bank aims to sell its broker-dealer operations and is still involved in talks with potential buyers over its investment management division.
Al Jazeera's Matthew Moore, at the London Stock Exchange, said: "Henry Paulson, the US treasury secretary, was adamant that this time around, no money would be spent on bailing out yet another investment bank.
"Just over a week ago they put in billions to prop up Fannie Mae and Freddie Mac, but those are two crucial mortgage giants which also have a bearing on how foreign investors treat the United States and how they treat the dollar."
Some analysts believe a Lehman collapse could trigger a shake up of the entire US financial system, which has been stuck in the economic doldrums since the mortgage crisis hit more than a year ago.
Safety Measures
The US Federal Reserve and a banking consortium have announced measures to offset a further credit crunch.
The consortium of 10 global commercial and investment banks had said earlier that it would provide $70bn "to help enhance liquidity and mitigate the unprecedented volatility and other challenges affecting global equity and debt markets".
Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, and UBS, said in a joint statement that they agreed to create a "collateralised borrowing facility" of $70bn, with each bank contributing $7bn, to help ease access to credit.
"These actions reflect the extraordinary market environment," the banks said.
The Federal Reserve, meanwhile announced new steps to ease access to emergency credit for struggling financial companies by broadening the collateral to be used for central bank loans.
The end of bidding for Lehman prompted a rare emergency trading session on Sunday, which market sources said was initiated by the US Federal Reserve with the aim of reducing risk associated with any Lehman bankruptcy.
The lack of a government guarantee to resolve the Lehman crisis is the main reason Barclays decided to exit the negotiations, according to a person familiar with the talks.
So far this year, the government has bailed out mortgage giants Freddie Mac and Fannie Mae, and saved Lehman rival Bear Stearns from going under by extending it cheap loans and allowing its forced sale to another rival, JPMorgan Chase.
Merill Lynch purchase
Bank of America, meanwhile, announced early on Monday that it was to buy Merill Lynch for $50bn, creating the world's largest financial services company in the process.
Merrill Lynch has cut thousands of investment banking jobs this year, and its stock values were sliding just last week.
Ken Lewis, chairman and CEO of Bank of America, said in a statement: "Acquiring one of the premier wealth management, capital markets, and advisory companies is a great opportunity for our shareholders.
"Together, our companies are more valuable because of the synergies in our businesses."
Adding to investor worries was a report that American International Group Inc, one of the world's largest insurers, had asked the US Federal Reserve for a $40bn bridge loan.
Over the weekend Alan Greenspan, the former US Federal Reserve chairman, projected the failure of "other major financial firms" but added that this did not need to be a problem.
"It depends on how it is handled and how the liquidations take place," he said on US broadcaster ABC.
"And indeed we shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers."