The reckoning - domino effect that reshaped global economy

The week started with shocking news of a Wall Street giant collapsing - and ended with euphoria and a record market surge. So have the bankers avoided financial catastrophe?

Capitol Hill is a five-minute drive down Pennsylvania Avenue from the US Treasury and it was here as dusk fell in Washington on Thursday that the US treasury secretary, Henry Paulson, arrived for talks with leading members of Congress. Shown into the suite of offices of Nancy Pelosi, the speaker of the House of Representatives, it was here on a sticky September day that the deal to save the American financial system from calamitous meltdown was done.

In the room with Paulson were the most powerful central bankers in the world, Ben Bernanke, chairman of the Federal Reserve; Christopher Cox, the chairman of the Securities and Exchange Commission, and the key movers and shakers on Capitol Hill - Charles Schumer and Barney Frank.

Schumer let the cat out of the bag to reporters ahead of the meeting. It had been called, he said, to discuss a plan whereby the US government would buy up the bad debts of America's banks -hundreds of billions of pounds of them - and put them in a state-owned asset management company.

The remark flashed on to dealing screens just before the closing bell on Wall Street's stock market trading floor and the impact was immediate. Amid wild cheering, the Dow Jones Industrial Average took off in a rally which saw it gain more than 400 points in the last few minutes of trading.

The recovery moved across the Pacific to Asia overnight and then rippled round to Europe. By the close of business in London last night, the FTSE 100 Index was more than 400 points higher. When traders went home from Canary Wharf a week earlier, on Friday September 12, the FTSE stood at 5416.7. When they left last night, the FTSE stood at 5311.3. The modest fall of 100 points or so gave no indication of quite what a momentous week it had been.

At the meeting in Pelosi's office, called at the request of Paulson and Bernanke, the mood was tense if business-like. After the most traumatic week on Wall Street since the Great Depression, Paulson said something had to be done to shore up confidence in the financial system. Only two of America's investment banks - Morgan Stanley and Goldman Sachs - had survived the week and there were doubts about the future of both.

Paulson and Bernanke said the selling threatened to get out of control. What had started as a problem in one segment of the American mortgage market was in danger of becoming a global contagion. In Russia, the Kremlin had shut down the stock market. In Britain, the government had helped orchestrate a rescue of Britain's mortgage lenders. Gold prices had shown their biggest ever one-day rise. The rush for safe havens had pushed the interest rate on US treasury bonds negative for a brief period, suggesting that investors were willing to pay the government for the privilege of assured security.

Bernanke and Paulson knew it would be something of a hard sell. Wall Street is not popular in the US after the excesses of recent years. Ordinary Americans have seen their incomes stagnate as the masters of the universe have seen theirs soar. There was little appetite on Capitol Hill for burdening the budget with extra debt, especially if it meant raising taxes. But the treasury secretary and the Fed chairman insisted there was no alternative.

The Bush administration had tried bailing out banks. It had tried letting them fail. It had tried mergers. None had worked. All that was left was to establish a Resolution Trust Fund, of the sort that had been used when the American savings and loans industry had imploded in the late 1980s. Thursday's meeting was told that this crisis was of a different magnitude. They needed to agree to set up an RTC and they needed to set it up quickly - before Congress broke up for the November elections. Forget party point-scoring, Paulson said, this is bigger than politics.

Schumer and Pelosi agreed with the need for urgent action, but they told Paulson that the price would be reform, serious and deep-rooted reform of Wall Street.

When Paulson went in front of the cameras yesterday he kept his side of the bargain. "This crisis demonstrates in vivid terms that our financial regulatory structure is sub-optimal, duplicative and outdated." Once the crisis is over, Wall Street has been served notice that it will face the sort of clean-up not seen since FDR took big finance to task after 1933. In the presidential race, the sense that the Republicans have been the party of deregulation and the party of the well-off has changed the complexion of the race, putting the economy centre stage and boosting the fortunes of Barack Obama.

The Democratic candidate for the White House was not the only one to try to seize the moment. Battered in the polls, railed against by uneasy backbenchers, dismayed at the impact of looming recession on his economic legacy as chancellor, Gordon Brown grabbed the political lifeline presented by the tumbling markets. He announced on Thursday lunchtime that he would clean up the City and the first leg of the reform programme was unveiled six hours later when the Financial Services Authority, the City's watchdog, slapped a temporary ban on short selling. The FSA, under its new chairman, Lord Turner, will be given the task of making London's light-touch regulatory regime a bit more hard edged.

As the week ended, three separate conclusions were being drawn. The first was that the financial landscape had changed - probably for ever. After the high-profile cull, there would undoubtedly be fewer banks and the ones that survived would operate differently. The second was that the era of deregulation would be replaced by re-regulation. Schumer suggested that the US was starting to look like France, and it wasn't meant as a compliment.

Finally, while the measures taken this week may mark the beginning of the end of the financial crisis that erupted in August 2007, the economic effects will be felt for months if not years. "These are the most difficult circumstances since the Great Depression," said Mark Gertler, a professor of economics at New York University. "The landscape is changing." In the UK, hedge fund dealers and short-sellers found themselves pilloried by the tabloids. It was, in short, a week like no other.

It is often said how ordinary a day seemed, even as extraordinary events were about to unfold and so it was on Monday in New York, a gloriously sunny morning that gave no clue of the storm about to be unleashed on Wall Street.

Lehman Brothers, the fourth largest investment bank, had filed for bankruptcy in the early hours after frantic talks to find a buyer had failed over the weekend. The firm, which was 158 years old, had made losses of $3.9bn in the third quarter alone after writing down bad investments in mortgages and commercial real estate.

Paulson spent the weekend trying to broker a takeover of Lehman, but intensive talks with Barclays and Bank of America fell apart because of the refusal of the US government to offer any kind of guarantee for the liabilities on the investment bank's books. Having rescued Bear Stearns in March, the message was that some banks were not too big to fail after all.

The Fed had agreed to absorb $29bn of losses to avoid the bankruptcy of the Bear and the government had also stepped in with a $200bn bailout of the mortgage finance giants, Fannie Mae and Freddie Mac just a week before Lehman faced bankruptcy. But Paulson had decided that enough was enough: the political will to risk any more taxpayers' money had temporarily evaporated and Lehman was left to go to the wall, the biggest bankruptcy in American history.

For chief executive Richard Fuld, who had been with the firm for his entire career and who bragged that he bled green - the Lehman corporate colour - it was a personal disaster. The date was emblazoned on a digital screen fixed to the front of Lehman's glass and steel tower, September 15; the day the world changed. "Nobody in the office thought we would go bankrupt," said one London trader at the firm.

The trading screens on the floor of the New York Stock Exchange were lacerated with red. Panic set in and the Dow Jones Industrial Average, the index of leading shares, plummeted 504 points, the biggest one-day fall since the first day of trading after the terrorist attacks seven years earlier. In the UK, the chancellor, Alistair Darling, knew that the collapse of Lehman and the hastily arranged shotgun wedding between Bank of America and Merrill Lynch meant trouble. The Treasury knew that the gale would blow across the Atlantic and batter a big British bank and they had an inkling that that bank would be HBOS (Halifax Bank of Scotland) - heavily exposed to the plunging UK housing market and unable to access finance through the ossified wholesale money markets. Darling was right; as the markets tanked on Monday, HBOS was one of the biggest casualties.

The next stage of the drama began on Monday night, when Brown met Sir Victor Blank, chairman of Lloyds TSB, at a party hosted by Citigroup. Both men had seen a 17% fall in the share price of HBOS that day. Both knew a crisis was brewing at Britain's biggest mortgage lender. Words were exchanged; Lloyds was, in effect, being given clearance by the government to buy HBOS and to bypass the competition authorities.

An outline of the plan had been worked on for weeks by two of Brown's closest aides - Jeremy Heywood, the permanent secretary at No 10, and business minister Lady Vadera. On Tuesday morning, as HBOS shares plunged again, falling 40% at their worst point, Eric Daniels, Lloyds TSB's chief executive, phoned Downing Street.

HBOS's submission was inevitable. Its pleas that its capital position was "strong" had been ignored by the market. Worse, savers were beginning to withdraw money. At least £1bn had been taken out on Monday, a small fraction of HBOS's total deposit base, but alarming nonetheless.

The task of Andy Hornby, chief executive, was to secure the best possible price for his shareholders. The bank had raised £4bn from its shareholders in June at 275p, so a take-out price below that level would be a humiliation for HBOS. Hornby and his chairman, Lord Stevenson, set themselves the goal of 300p-a-share, a price Lloyds initially appeared to be prepared to pay. Markets, once again, intervened. On Wednesday morning, HBOS's shares fell heavily, hitting 80p at their lowest point. The horrible prospect of a run on the bank was now a real possibility. Officials at No 10 decided the secret negotiations had to be made public immediately. The BBC broke the story soon after 9am and named a price of 300p. Official confirmation, via the Stock Exchange, came only at 1.25pm.

Key members of the two banks' board agreed to meet. Daniels and Blank argued that 300p was too high a price for Lloyds to pay. Soon after 9pm, the deal was signed. With little negotiating power, Hornby and Stevenson had agreed to sell HBOS for 232p-a-share, or £12.2bn.

But Downing Street had extracted a pound of flesh. Lloyds could avoid a competition inquiry but it had to give the government something in return. The formal announcement on Thursday morning made the deal clear. Lloyds' new mortgage lending would "continue at least at current levels and will expand as market conditions improve". In addition, the "management focus is to keep jobs in Scotland," said the announcement. Savage cost cuts from a government-brokered takeover in his own backyard as the Labour party conference began would have been difficult to contemplate.

While the race was on to save Britain's biggest mortgage lender, AIG, the world's largest insurance group and sponsor of Manchester United, was scrambling for financial help. Its shares fell 61% in a single day as the Fed worked to raise a $75bn loan from the private sector. AIG had in recent years expanded rapidly into insurance contracts to investors who bought the complex mortgage debt securities. It was determined that a collapse of the firm would be catastrophic, setting off a deadly chain reaction because it was so deeply rooted in the financial system.

AIG failed to find a white knight and time was running out. At 6.30pm on Tuesday, Paulson and Bernanke met with House and Senate leaders on Capitol Hill to deliver the bad news. After initially refusing to put more taxpayer money on the line, the Fed had reversed course, taken control of the firm and injected $85bn.

Hyan Song Shin, professor of economics at Princeton, said the level of government intervention had reached astonishing levels. "We have run out of superlatives. But it does show quite an adaptability and a pragmatism, which is actually quite refreshing."

Uwe Reinhardt, also at Princeton, was less kind. "This fiasco may conceivably trigger a major shift in American, and possibly British, popular beliefs. Gone will be the mindless belief in the mantra that the private sector will always do what's best for America and is self-regulating. How could one still defend that proposition?"

Wall Street appeared calmer but the banks were paralysed with fear. The cost of overnight lending, the short-term loans that oil the financial markets, rose to unprecedented levels as banks became even more wary of each other, despite the central banks pumping billions more into the system.

By Wednesday the Dow was plummeting again, 449 points. "It is just total chaos and uncertainty," said one trader, the next day. "With the AIG bailout, you would think the market should be up." The pace of events still didn't slow. The savings bank Washington Mutual put itself up for sale. It also emerged that Morgan Stanley was in talks to merge with the commercial bank Wachovia and other potential partners, as its shares fell to 10-year lows, leaving Goldman Sachs as the sole remaining independent investment bank.

By the end of the week, analysts were trying to work out what will happen next. Some changes looked glaringly obvious. The practice of short-selling, betting that a share price will drop, the "spivs" and "speculators", in the words of Scotland's first minister Alex Salmond, was temporarily banned on both sides of the Atlantic.

There were also fears for the wider impact on the twin capitals of finance. About 5% of the jobs in New York are in financial services but they account for about a quarter of wages. Even before the events of the weekend NY had lost 11,000 banking jobs and London some 20,000. In London, there has been a boom in building new office space, some 80% of which is speculative and now could be left empty.

"In my view, the kindest thing one could say about American bankers, and their copycats at UBS etc, is that they were reckless," says Reinhardt. "Our financial sector has arguably visited more harm on our economy than bin Laden could ever have dreamt of inflicting."

Just who is to blame for this mess?

· Alan Greenspan The alleged grandfather of the credit binge that gave rise to the current crisis.

· Ben Bernanke Raised interest rates so fast and so far that it triggered millions of home repossessions.
· The Bush government Allowed huge mortgage boom with little regulation.

· Short-sellers Hedge funds that bet against the survival of banks.

· Henry Paulson US treasury secretary may have wielded big bucks in recent weeks, but he bet last year that Wall Street could sort out its own mess.

· Bob Diamond Head of Barclays investment banking business. His decision to buy parts of Lehman Brothers is seen by some as catastrophic.

· Sir Fred Goodwin Chief executive of RBS who masterminded the £48bn takeover of ABN-Amro, almost breaking his own bank

· Sir Howard Davies Ex-chairman of the FSA and architect of "light touch" regulation in the City.

· Mervyn King (pictured)Bank of England boss who failed to see the need for drastic action.

· Adam Applegarth Former chief executive of Northern Rock.

· Dick Fuld Former Lehman Brothers boss who refused to sell the bank at a low price before it went bust.

· Jimmy Cayne Former chairman of Bear Stearns, he was attending a bridge tournament just as the bank was owning up to its losses.

· Gordon Brown Sanctioned "light touch" regulation in the City as chancellor.

· Alistair Darling Dithered when Northern Rock savers needed guarantees to stop a run on the bank. Also failed to back sale of the Rock to Lloyds TSB.