As I write, it’s about 5pm Sunday in Manhattan, and it’s been another long day at the New York Federal Reserve headquarters in Liberty Street, around the corner from Wall Street, as the regulators and Wall Street play chicken over Lehman Brothers.

The next 24 hours will be one of the most decisive and significant in our lifetimes.

Bankers in black town cars began arriving at Liberty Street early in the day yesterday and at 7.30am three bags of Dunkin Donuts were delivered. On Saturday there had been 15 hours of donuts and coffee; yesterday was the same.

On Saturday afternoon, Barclays Bank of the UK pulled out of a plan to buy the Lehman “good bank” because it couldn’t get indemnities.

But in any case, the matching plan for US banks to continue trading with the “bad bank”, which contain all of Lehman’s toxic mortgage exposures, was already in trouble.

The question remains: who will step up? Who will throw capital away buying an insolvent institution for zero dollars without taxpayers’ money making up the gap? Nobody will — or can.

The three men trying to orchestrate the rescue of Lehman are Treasury secretary Hank Paulson, Fed chairman Ben Bernanke (who has stayed in Washington) and New York Fed boss Tim Geithner.

But for them the moral hazard problems are now enormous. Having put taxpayers money into guaranteeing Bear Stearns’ worst assets and then bailing out Fannie Mae and Freddie Mac, they have to draw the line.

If Lehman goes, then so do Washington Mutual, and then American International Group, each of which is already teetering. Today’s emergency, though, is Lehman.

And no one wants to buy Lehman for a positive price, or even zero, unless there is a public subsidy — that is, taking the most toxic assets out of the picture. In fact Barclays didn’t even want to deal on the good assets without a guarantee.

Pictured arriving yesterday in Liberty Street were Robert Wolf of UBS Americas, Stephen Black of JP Morgan Chase, Vikram Pandit of Citigroup, so we know they are involved in the talks. Others made it through without being photographed.

Early on Saturday there seemed a chance that Bank of America would step up to the plate, but it, too, was insisting on government support.

Paulson, Geithner and Bernanke, meanwhile, are holding out. They were trying to play Bank of America and Barclays off against each other but that strategy has now failed, and now they are just jawboning the others – telling them that if they do not put their capital on the line and continue to trade with Lehman this week, they would also suffer devastating counterparty runs this week and would lose more capital if they did not do it. In other words they all are playing chicken.

If someone does not blink tonight New York time, which is our daytime, then it looks like Lehman will crash before dinner tonight.

The Wall Street Journal has reported this morning that Lehman has hired law firm Weil, Gotshal and Manges LLP, a bankruptcy specialist, to prepare a Chapter 11 filing.

Meanwhile Bloomberg has reported that banks and brokers held a session a few hours ago for netting derivatives transactions with Lehman, or cancelling trades that offset each other, in case the New York-based firm files for bankruptcy before midnight New York time.

There was a statement from the International Swaps and Derivatives Association:

The purpose of this session is to reduce risk associated with a potential Lehman Brothers Inc. bankruptcy filing. The ISDA includes 218 banks, brokerages, insurance companies and other financial institutions from the US and abroad.

ISDA confirms a netting trading session will take place between 2pm and 4pm New York time for over-the-counter derivatives. Trades are contingent on a bankruptcy filing at or before 11:59pm New York time, Sunday, September 14, 2008. If there is no filing, the trades cease to exist.

If there is a bankruptcy today, then Lehman’s brokerage units would have to file Chapter 7 liquidation, in which a court-appointed trustee would take over and liquidate its assets, so the broking customers could get back their money.

Lehman’s lenders would immediately withdraw all lines of credit, since Chapter 11 would be a default event.

There would then be a scramble to see how many of Lehman’s credit default swaps trades could be offset, with new counterparties found.

Nobody knows how much Lehman has in CDS contracts because this trade is not disclosed, but in a survey last year, Fitch Ratings listed Lehman among the top 10 largest CDS counterparties. If it fails, then, as the ISDA statement above implies, a huge number of CDS contracts will be worthless unless new counterparties can be found.

Australian municipal councils and others who bought CDOs from Lehman will also be watching events unfold with close interest.

Lehman was one of the counterparties to about 70 per cent of what was sold to the councils. It was a counterparty or guarantor in one capacity or another. It is also understood to be a reference company in more than 50 per cent of the CDOs.

So in the first instance, the failure of its debt would be a credit event for those CDOs (most of which also reference Fannie Mae and Freddie Mac — and for that matter AIG, Merrill Lynch and Washington Mutual) and this would push those CDOs towards loss.

The other problem with a Lehman bankruptcy is that its assets — stock, property and mortgage securities — are likely to hit the market in a firesale, forcing prices even lower and then, next quarter, forcing further mark-to-market write-downs by other banks and investment banks.

In fact it’s unlikely to be a slow-motion train wreck this time. With Lehman in liquidation, and Washington Mutual and AIG on the brink, the credit market would likely shut down entirely and interbank lending would cease.

In his newsletter yesterday, Nouriel Roubini wrote:

What we are facing now is the beginning of the unravelling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank (with now only a small group of them having access to the limited and conditional and thus fragile support of the Fed).

The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure so far as plugging and filling one hole at the time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.

It is hard to imagine what that might be.