By Dan Wilchins and Glenn Somerville

The emergency talks involving the Treasury Department, Federal Reserve, Securities and Exchange Commission and the bankers started on Friday night and were continuing in a bid to find a way to save Lehman and stabilize financial markets.

The Wall Street Journal said a deal could come as early as Saturday, although it said it was not clear how much progress had been made in clearing the biggest hurdle -- government funding for any plan.

Lehman was until recently Wall Street's fourth largest investment bank. But Treasury Secretary Hank Paulson is adamant that federal funds not be used for a bailout, a source familiar with his thinking said on Friday.

The Fed has also made it clear it doesn't want to see taxpayer funds committed to a rescue of the bank, which employs some 25,000 people worldwide.

The Journal said the banks were looking at two solutions -- liquidation, or an industry-driven solution that may involve Wall Street firms providing financing to remove Lehman's real estate assets.

The New York Times reported that at Friday's meeting, Federal Reserve Bank of New York President Tim Geithner -- flanked by Paulson and Securities and Exchange Commission Chairman Christopher Cox -- told the banks that if they didn't work together on a Lehman solution, their own banks could be the next victims of the credit crunch.

The CEOs of Goldman Sachs Group Inc, Merrill Lynch & Co Inc, JPMorgan Chase & Co and Citigroup Inc were all at Friday's meeting, in a scene reminiscent of the 1998 bailout of hedge fund Long-Term Capital Management, two sources familiar with the situation said.

Officials at Goldman Sachs, Citigroup, Merrill and Morgan Stanley declined to comment while spokespeople for JPMorgan and Lehman were not immediately available.

BAD BETS

With Long-Term Capital, major banks each contributed to a $3.65 billion bailout of the hedge fund, allowing it to be wound down in an orderly way.

This time, though, the capital of many top banks is already strained by the credit crisis, making them reluctant to fork over funds to help Lehman, whose problems are largely a result of bad bets on the mortgage market before the housing bust eviscerated the once lucrative business.

Also, while Long-Term was a client of most Wall Street firms, Lehman is a competitor.

"I'm not sure why Goldman Sachs would want to keep Lehman in business," said Charles Peabody, analyst at independent research firm Portales Partners in New York.

Underscoring the markets' fragility on Friday, Merrill's shares tumbled 12 percent and while those of insurer American International Group Inc fell more than 30 percent.

Both have varying degrees of exposure to the mortgages and other toxic assets that appear to have been Lehman's undoing.

One key source of pressure on Lehman is its debt ratings.

All three rating agencies said ratings cuts for Lehman were a possibility, as confidence in the firm erodes.

Moody's Investors Service said on Wednesday that Lehman must enter a "strategic transaction with a stronger financial partner" to avoid having its ratings cut to near-junk levels.

Such a ratings cut would make it difficult for Lehman to compete in businesses such as long-term interest-rate derivatives. Ratings downgrades could force the firm to post more collateral with its trading partners.

Media reports said Lehman was in talks to sell itself to banks including Bank of America Corp, the No. 2 U.S. bank by assets, and Barclays and HSBC, respectively Britain's third biggest and Europe's biggest bank.

But all three are reported to be reluctant to acquire the 164-year-old investment bank without government backing similar to that received by JPMorgan when it took over former rival Bear Stearns in March.

EUROPE WORRIES

"It's going to be very difficult to get something done without the government putting in some money," said Bill Fitzpatrick, equity research analyst for financials at Optique Capital Management in Milwaukee Wisconsin. "I don't see why you'd pay anything for Lehman otherwise."

Germany's finance minister said on Saturday he expected a solution for Lehman by Monday, as European policymakers worried about the market impact of the firm's woes.

"The news from the United States is bad," Peer Steinbrueck told reporters, referring to the financial market turmoil stemming from trouble in the U.S. subprime mortgage sector.

Worries about Lehman were also heard on the U.S. presidential campaign trail, where top economic advisers to Democratic candidate Barack Obama and Republican candidate John McCain argued for a private solution to Lehman's problems.

"Senator Obama believes we should have a private solution to Lehman's problem," said his adviser, Jason Furman.

"And, unlike Bear Stearns, the Federal Reserve now has a special lending facility in place that could prevent a wider run on the market."

"I have not heard of any proposal for taxpayer money (to be used) ... and obviously that would be something that is not anyone's first choice," Douglas Holtz-Eakin told Reuters.

(Additional reporting by Megan Davies in New York, Jeff Mason, Caren Bohan and Richard Cowan in Washington and Paul Carrell in Nice, France)

(Writing by Christian Plumb; Editing by Ted Kerr)