Lehman Brothers Again Hit by Credit Fears

Paulson told legislators that "financial institutions must be allowed to fail" to ensure market discipline.

"To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions," Paulson said. "These authorities should be flexible, and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing."

Lehman last month reported a $3 billion loss for its second quarter, leading to the dismissal of its CFO and COO. The firm has been the target of short-seller Greenlight Capital's David Einhorn, who has accused it of masking losses.

The firm also was not helped by Fannie and Freddie, both of which were plummeting amid mounting concerns about their viability. Weakness in the mortgage market will continue to weigh on financial firms like Lehman who hold significant structured finance products tied to mortgages that already have declined sharply in value and have proven difficult to trade during the credit crunch.