As I write this, according to the Financial Times (here), some of my former colleagues are shuffling out of their offices at Lehman Brothers’ Headquarters on 7th Avenue in New York. The Internet is swarming with news suggesting that Lehman Brothers may be filing for bankruptcy tonight, marking the end of an era for a great firm, who also happens to be my first employer.

Only on a weekend when my hometown of Clear Lake (a suburb of Houston) was hammered by the biggest hurricane of my lifetime and my great-aunt passed away, could the news of Lehman going bankrupt be the third worst piece of news I have received over the last few days.

The failure of Lehman is not only sad because of the fact that so many of my friends and former colleagues will likely be unemployed tomorrow, but it is also scary because it has massive implications for the various different financial players who have contracts with Lehman as a counterparty.

As I noted here in January: The Fan, the risk of a major CDS counter-party failing has been my biggest fear about the credit crisis since I first started blogging about all of this last summer.  This post explains CDS: CDS = Crazy Derivatives Stuff.

Thankfully, the Federal Reserve appears to have orchestrated an emergency trading session today (Derivatives Market Trades on Sunday to Cut Lehman Risk) in an attempt to avert disaster Monday morning.

However, given the fact that the various players in this market were unable to anticipate Lehman’s failure, how can we have confidence that they will be able to anticipate the wide-ranging implications that Lehman’s bankruptcy will have?

It is hard to imagine that it was only last week that the government decided that it would be necessary to bail out Fannie and Freddie: Government Bails Out Fannie Mae and Freddie Mac

Apparently Mr. Paulson and the SEC orchestrated meetings with all of Wall Street’s leading players on Friday and over the weekend in an attempt to find a savior for Lehman. That no one was willing to step up to the plate only indicates how dire the situation truly has become.

If I had to guess, I would imagine that the challenge of estimating the potential liability associated with Lehman’s massive balance sheet in addition to the challenges in valuing its large real estate portfolio were stumbling blocks.

However, the larger reason why no one saved Lehman may be because no one could. Although some commentators at the WSJ speculate that Potential suitors were selfish in their analysis, the more likely reality is that any potential buyer is facing large challenges of their own today.

Remember, the Federal Government, the buyer of last resort, has already been tapped to support the entire real estate market through its support for Fannie and Freddie, suggesting that another Treasury backed purchase is not only impractical but likely infeasible. Furthermore, Goldman, Morgan Stanley and the other Wall Street players have billions of dollars of illiquid assets and untold counterparty risks of their own to wrestle with.

Apparently, Bank of America may be swooping in to save Merrill Lynch from the backdraft from Lehman’s implosion, but even this move is not without a large degree of risk for the largest domestic retail banking institution who has already taken on the risk associated with its Countrywide purchase last fall.

And if all this news isn’t bad enough, AIG is also on the brink of a downgrade which may force it to tap the Fed for up to $40B in loans as it seeks to avoid Lehman’s fate (AIG Seeks $40B Bridge Loan). As an insurer, AIG’s failure would have even broader implications for the derivatives markets than Lehman’s failure will.

I hope that by some miracle we wake up tomorrow and Lehman is still standing with no bankruptcy filing in hand. (Update: Just after Midnight EST Lehman confirmed that the holding company is filing for Chapter 11). I sincerely believe Lehman is a great firm filled with brilliant and good people, which is what makes its failure all the more difficult to stomach.

Unfortunately, it is also a product of a system that has collectively overestimated its ability to predict the future and assess risk. The collective machine that is our financial markets was ruled by hubris and incentives that created innovation and leverage based on a worldview that turned out to be flawed.

And as we continue to witness the unwinding of this leverage, which unfortunately still has a long way to go, we will unfortunately continue to see more failures and losses borne by individuals who are a product of this system that is beyond anyone’s control.

This was a sad weekend. Let’s hope for a brighter tomorrow.