Investors who bet Lehman Brothers wouldn’t default on its debt are, unsurprisingly, looking at a hefty bill. Sellers of credit default protection on the bankrupt New York brokerage firm will have to pay 91.38 cents on the dollar later this month to settle with the buyers of Lehman credit default swaps. The price was set in an auction Friday whose results were posted on Creditfixings.com.

The Lehman price fixing is below the level implied by bond market trading. Lehman bonds recently fetched 13 cents on the dollar, Bloomberg reports. The auction is being closely watched because it offers a test of an unregulated marketplace that grew at a rapid clip for years before the credit bubble burst last year. Still, it’s not completely clear what the final settlement of the Lehman trades, due in two weeks, will mean for the rest of us.

The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven’t heard of and even fewer understand. Fortune recently wrote about the threat of credit default swaps, noting these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market in just over a decade.

TheDeal.com reported Thursday that uncertainty tied to the Lehman credit default swaps was responsible for some of the fear that swept through the markets this week, as banks hoard cash to make sure they have enough to settle CDS trades. But Bloomberg notes that some observers are skeptical. “Fears surrounding the Lehman auction settlement are overblown,” Bank of America credit strategist Jeffrey Rosenberg wrote in a note to investors. “The economic impact of the Lehman bankruptcy through CDS contracts has for the most part already occurred.”

Lehman Brothers (LEH) chief Richard Fuld hasn’t been terribly visible since the 158-year-old brokerage firm filed early Monday morning for Chapter 11 bankruptcy protection, but that may soon change.

U.S. Rep. Henry Waxman, the California Democrat who runs the House Committee on Oversight and Government Reform, said in a press release Tuesday he has invited Fuld to testify at a hearing next Thursday that will “examine the regulatory mistakes and financial excesses that led to the bankruptcy filing by Lehman Brothers,” and “explore the impacts of the bankruptcy on financial markets and the United States economy.”

Lehman didn’t immediately return a call seeking comment, though it surely wouldn’t be good form for Fuld to decline the invitation. His colleague in brokerage-firm insolvency, former Bear Stearns chief Alan Schwartz, appeared before Congress in April in the wake of Bear’s collapse, to the edification of no one.

Schwartz told senators that Bear’s bad bets on souring mortgage securities, its failure to secure adequate long-term funding and its poor relations with other big brokerage firms were far from the only reasons for its collapse. As Fuld has done on occasion, Schwartz pointed the finger at short-sellers, who bet against a company’s stock.

“I would just say as an observer of the market, it looked like more than fears,” Schwartz told the Senate Banking Committee in testimony April 3. “There were people that wanted to induce a panic.”

Fuld, who thundered this past spring that he wanted to make the shorts feel pain, made his last public appearance on a conference call last week to announce a now-aborted plan to split off some commercial real estate assets and do other things to slim Lehman’s balance sheet. Now, of course, it’s Lehman’s rank-and-file that’s feeling the pain: After taking home nearly half a billion during his 15 years atop Lehman, Fuld let the firm slip into bankruptcy - in a move that will surely lead to thousands of layoffs - after he declined the tough terms being offered by prospective partners. We may soon learn whether he views that as the shorts’ fault too.

Assuming Bank of America (BAC) completes its planned purchase of Merrill Lynch (MER) as scheduled in the first quarter of 2009, Merrill chief John Thain will have had one of the shortest runs as the CEO of a top financial firm on record. The question now is whether the CEOs of two other struggling firms - Robert Willumstad of AIG (AIG) and Alan Fishman of Washington Mutual (WM) - will end up beating Thain’s record.

In this way, at least, time is on the execs’ side. Willumstad took over at AIG in June after his predecessor, Martin Sullivan, was ousted for his failure to warn investors of the insurer’s massive losses on derivatives contracts tied to the plunging mortgage market. Fishman joined WaMu just last week, after the Seattle-based thrift forced out longtime head Kerry Killinger amid worries about the bank’s holdings of souring adjustable-rate mortgages. By comparison with Fishman and Willumstad, Thain is a grizzled veteran at Merrill, having taken over last November following the ouster of Stan O’Neal.

With investors racing to reduce their exposure to mortgage-related holdings in the wake of the collapse of Lehman Brothers, WaMu and AIG are under intense pressure to raise capital or find big partners. AIG shares were down 37% in early trading, on top of their 60% plunge Monday, as the company remained silent for a second day on any plans to bring in new money. The outlook was dimming on a rescue of the firm after it suffered several ratings downgrades Monday afternoon - moves that could force the cash-strapped firm to produce as much as $19 billion in new collateral and other funds, analysts estimate.

“The downgrades are just the latest development placing pressure on AIG’s liquidity,” Morgan Stanley analyst Nigel Dally wrote Tuesday. “When we layer in additional mark-to-market losses, other contingent liabilities, likely investment portfolio losses, and other items, we estimate near-term capital
and liquidity needs to be in the range of $45-50 billion.”

The news is only slightly more upbeat at WaMu, which rose modestly Tuesday on the latest report - this time in a U.K. paper - that the firm is in advanced talks to sell itself to JPMorgan (JPM). Analyst Betsy Graseck at Morgan Stanley wrote Sunday that a deal would be a strategic positive for JPMorgan, though she stressed that she believes it’s unlikely a deal is imminent. “First, working through the Lehman situation likely takes precedence for JPM,” she wrote. “Second, other banks are suggested to be interested in WM. Third, WM has a new CEO who presumably is interested in remaining independent.” WaMu rose 35 cents to $2.35.

By Katie Benner

Shareholders aren’t the only ones getting whacked in the chaos roiling Wall Street. Big buyers of bonds, among them mutual fund managers Pimco, Vanguard and Franklin, could face $86 billion in losses stemming from the collapse of Lehman Brothers, Bloomberg reports.

According to the story, Pimco et al. held more than $143 billion of Lehman bonds as of June 30. In a bankruptcy, bond investors recover different amounts of their principal based on where they are in the capital structure. While it is possible that Lehman bondholders could be made whole, the market is saying that the once-vaunted investment bank’s debt is worth very little. Bloomberg said that Lehman senior debt was trading for as little as 35 cents on the dollar. Senior debt holders are typically the first in line to collect when a company declares bankruptcy.

This is in marked contrast to bondholders who were reimbursed when Bear Stearns collapsed and Freddie Mac and Fannie Mae were rescued by the government. The fact that Lehman bondholders will lose money on the company’s downfall is “VERY important from a moral hazard perspective, as the debt holders were made whole with Bear, Fannie and Freddie,” noted value investor Whitney Tilson of T2 Partners in an e-mail to investors late Monday. “This was not an equity bubble, but a debt bubble, so there will be sobering implications of this.”

Added Ciaran O’Hagan, a credit strategist at Societe Generale, in a Bloomberg interview: “The losses look set to be widespread, hurting the public through their mutual and pension funds. It’s clearly a disaster for public confidence.”

Vanguard spokesman John Woerth told Bloomberg that his firm holds Lehman bonds among the $450 billion of fixed income it manages, but would not elaborate. An outside spokeswoman for Pimco in London declined to comment for the story. Bloomberg could not reach a Franklin spokeswoman.

In other Lehman investor news, hedge fund king George Soros may have also lost big on the bank – but on the stock side. According to a recent SEC filing, Soros Fund Management owned about 9.5 million shares as of June 30; and most of those shares were bought in the second quarter of this year. Representatives from Soros Fund Management did not respond to an e-mail seeking comment Tuesday.

Shares of Lehman plunged 80% in early trading Monday, dropping below a dollar a share, as investors realize their shares are likely to be worthless. It was just last week that Lehman chief Richard Fuld announced a plan to reduce the brokerage firm’s mortgage-related risk - a plan that was rejected in the market as the latest instance of making promises rather than taking action, however painful.

Further complicating the picture for AIG and other financials is the wave of writedowns that’s likely to result from Lehman’s collapse. “Due to the liquidation of an unprecedented scale, we expect a broad-based decline in marks on asset values within the financial markets,” Oppenheimer analyst Meredith Whitney wrote late Sunday. “The liquidation of LEH’s assets will force the other brokers to mark down their assets accordingly and therefore pressure all capital ratios.” She adds, a propos of the steep decline of the stock futures markets early Monday, that she expects financial markets “to be under unprecedented strain over the next several days as players respond to outsized industry deleveraging.”

A very senior Lehman Brothers (LEH) executive tells Fortune’s Roddy Boyd that all else equal, management’s favorite suitor is Bank of America (BAC) - BofA chief Ken Lewis’ crack about having had all the fun he can stand in investment banking notwithstanding.

The thinking goes like this: BofA would have the most jobs to offer to displaced Lehman sales, trading and banking staff. And it would have the balance sheet to ride out future storms. What’s more, there is hope that with two competitors off the Street - Bear Stearns and, presumably soon enough, Lehman - when good times return, there will be plenty of business to be had.

“There is absolutely no denying that BofA is a commercial bank culture,” says the Lehman officer, touching one of the perpetually raw nerves of investment bankers and traders working at large commercial banks. Traditionally, bankers at J.P. Morgan or the old Citibank looked at investment bank executives as capital-consuming gamblers intent only on maximizing their annual bonus checks; the investment bankers scorned commercial bankers as stodgy throwbacks unable to adapt to a changing global dynamic.

It’s a toss-up as to who’s right in this market cycle: Lehman appears to be following in the footsteps of Bear, but Washington Mutual (WM) and Wachovia (WB) are looking none too robust themselves.
 
“But when the credit cycle turns,” the exec adds, “there is probably going to be a lot of need for the sort of trading and banking expertise Lehman has traditionally excelled at.”

Which is better than nothing, one supposes.

Fortune’s Shawn Tully notes that the latest drop in Lehman Brothers (LEH) shares - they fell 12% in early afternoon action Friday, to $3.70 - takes the stock back to the level it traded at in its first day as a public company in its current configuration, nearly 15 years ago.

On May 11, 1994, Lehman - newly spun off from American Express (AXP) - opened at $16.51 before rising in moderate volume to close at $16.75. Adjusted for dividend payments and stock splits, shares closed that day at $3.74. So investors who got Lehman shares when AmEx distributed its stake in the brokerage and held on through thick and, more recently, thin are back to break-even, a decade and a half later.

Fuld, of course, has done a bit better. Though a report in The New York Times Friday notes that the value of options Fuld holds have dropped by some $900 million since the stock peaked last year, the paper also puts his cash take during his CEO tenure at $466 million. It was nice while it lasted.

The roster of potential losers in an expected fire sale of Lehman Brothers (LEH) reprises many of the firms that were hit hard in last weekend’s government takeover of Fannie Mae (FNM) and Freddie Mac (FRE).

The biggest holder of Lehman as of June 30, going by the latest data, was AllianceBernstein - the New York-based investment unit of France’s Axa SA (AXA) that also took a big hit on its holdings of Fannie and Freddie. AllianceBernstein had 65.6 million Lehman shares at last count, according to LionShares.com, giving it a 9.5% stake in the brokerage firm.

Other big Lehman holders include ClearBridge Advisors and Fidelity Investments, each with 5.6%, and Barclays, with 3.9%. ClearBridge, as it happens, is a unit of Legg Mason (LM), the mutual fund shop whose chief investment officer is Bill Miller. While other investors were fleeing Freddie Mac shares during their yearlong plunge to penny-stock status, Miller was furiously dollar-cost averaging into the mortgage company. His fund was down by a third over the past year at last count. 

One other likely casualty when the Lehman mess sorts itself out will be Wellington Management of Boston. The firm was the fifth-biggest holder of Lehman at June 30, with a 3.7% stake, but the Boston Globe points out that Wellington was also among the biggest purchasers during the second quarter of Freddie Mac, Fannie Mae and another financial name that has been in free fall, Washington Mutual (WM).

The distress at Lehman Brothers (LEH) has lured private equity investor Christopher Flowers to the table. The Financial Times reports that Flowers, along with Bank of America (BAC) and China Investment Co., is considering a bid for Lehman, the struggling investment bank that is expected to try to sell itself between now and the open of Asian securities markets Sunday evening. Citing people familiar with the matter, the FT says U.K. bank Barclays (BCS) is also interested.

Flowers’ interest is noteworthy because he was reportedly trying to line up financing to bid for Bear Stearns before that brokerage firm collapsed in March into the arms of Fed-backed suitor JPMorgan Chase (JPM). As with Bear, the price in any sale of Lehman is expected to give shareholders only token compensation, and the FT reports the BofA group’s bid “may involve losses for holders of the debt as well as shareholders.”

Whether Lehman’s able to find a buyer at any price may boil down to whether Treasury Secretary Hank Paulson, Fed chief Ben Bernanke and New York Fed President Timothy Geithner are willing to provide a backstop for the buyers, or whether they are willing to step aside and let Lehman fail. Reuters reported Friday that Paulson is “adamant” that no taxpayer funds go to support Lehman, but history shows the government has changed its tune on these questions before. Lehman shares dropped 12%.

Stocks of companies with big mortgage exposure and questions about their capital standing continue to plunge in early trading. Lehman Brothers (LEH) dropped 45% for the second time in three days, suggesting investors aren’t taken with the brokerage firm’s plan to slim its balance sheet. Washington Mutual (WM) dropped 19%, marking its fourth straight double-digit decline and sliding below $2 for the first time since 1991, just days after a CEO change and agreement with regulators. American International Group (AIG), the giant insurer that’s expected to outline a restructuring of its own in two weeks’ time, dropped 14%.

AIG’s decline is the smallest of the three, but it could have an outsized effect on the insurer’s efforts to repair the damage to its balance sheet. CEO Bob Willumstad may consider selling the company’s consumer finance and reinsurance units to raise new money, Bloomberg reported Thursday. Some analysts are saying the company will need to raise $20 billion to $25 billion to stem the bleeding from its derivatives business, on top of the $20 billion AIG raised earlier this year.

Unlike Lehman and WaMu, whose shares have dropped into the low single digits, for the moment AIG still seems to have the option of selling common shares to raise new money. But given the pace of the stock’s plunge since the government took Fannie Mae (FMM) and Freddie Mac (FRE) into conservatorship this past weekend - AIG has lost a third of its value since then - that opportunity may soon vanish, making Willumstad’s choices even harder.