Some 30 of the finest minds on Wall Street, the super-remunerated chief executives of the country's biggest finance houses, had been huddled all weekend in the Manhattan fortress that is home to the Federal Reserve's New York offshoot. There, they had tried to come up with a solution to the tottering of Lehman Brothers, a bank brought to the brink of insolvency by its multibillion-dollar losses on mortgage derivatives.
Hank Paulson, the brick-built secretary of the US Treasury, a former head of Goldman Sachs, had bailed out Wall Street twice before, cajoling the Fed into backstopping a takeover of Bear Stearns in March. Earlier this month, he had signed off on the nationalisation of Fannie Mae and Freddie Mac, two mortgage finance giants, at a cost to the US taxpayer that could run into tens, if not hundreds, of billions of dollars.
Simplistic critics said he was "bailing out his friends on Wall Street". That was never his intention. Right or wrong, he believed that what happens on Wall Street doesn't stay on Wall Street. Home-buyers and businesses large and small rely on the banking system for the loans that make the economy go round. The calculation on Sunday night, though, was that Lehman Brothers was not "too big to fail", no matter that it was a party to millions of financial contracts and billions of dollars of trades which could be paralysed by a bankruptcy. This was the right moment, said Mr Paulson and Ben Bernanke, chairman of the Fed, to make Wall Street pay for its years of excess. It was a bold gamble – and it was clear within hours that it had gone very wrong.
They've let it fail. They've actually let it fail. When Wall Street's traders, bankers and hedge-fund managers poured out of the New York subway on Monday morning, they walked just perceptibly faster towards their desks. There is a part of every one of them that is exhilarated by large events, by the mega-deal, by the world-changing economic shock, whatever: everything is an opportunity for profit. Yet this was something quite extraordinary, and quite terrifying.
The US government had actually let Lehman Brothers go bust. Merrill Lynch, suddenly aware that the Treasury and the Fed were unwilling to keep funneling loans to keep them afloat, sold itself to Bank of America. On Friday there had been four major investment banks; now they were two. The former Fed chief Alan Greenspan called the failure of such an institution as Lehmans "probably a once-in-a-century type of event". It turned out to be more of a once-a-day sort of event.
Stock markets around the globe plunged, the FTSE 100 down 4 per cent and the Dow Jones Industrial Average in the US slipping further and further as the day wore on. The worst of the chaos was in the credit markets, where Lehman had been such a pivotal player, and where the knock-on consequences were creaming another giant corporation. This time it was AIG, the world's largest insurer, which had written guarantees on $440bn (£240bn) of mortgage derivatives – guarantees which banks, pension funds, municipal governments and countless investors all relied upon. Mr Paulson and a cabal of advisers pored over some computer models. If AIG went under next, they showed, the damage could be a multiple of that inflicted by the Lehman bankruptcy, and could be catastrophic for the financial system.
There was no end in sight, and the chill winds crossed the Atlantic. First came the sight of Lehman Brothers' employees leaving the firm's London offices bearing cardboard boxes filled with the detritus of their careers. But another tale was unfolding behind the scenes. Lord Stevenson, the chairman of HBOS, made the gentlest of overtures to Sir Victor Blank, his counterpart at Lloyds TSB. Gordon Brown wasn't going to see another episode like the run on Northern Rock finally wreck his premiership. He was briefed and, at a dinner that night hosted by Citigroup at Spencer House in London, presented an opportunity for Mr Brown and Sir Victor to reach some understandings about the importance of a rescue. The Prime Minister made plain the Government's determination, this time, to place financial stability ahead of any other considerations. Late that night Lord Stevenson and his executive still believed they might be able to ride out the storm, and told No 10 officials as much; that further talks with Sir Victor would be welcome, but privately hoping for the best. It was not to be.
Throughout the day HBOS shares plumbed ever lower depths. The talks between HBOS and Lloyds TSB became more serious. As confidence in HBOS ebbed away, Lloyds TSB came closer to securing its prize.
A similar story was unfolding across the Atlantic. Tim Geithner, the chairman of the Federal Reserve in New York, is normally a robust participant in the central bank's meetings to set US interest rates. But as 10 men and women gathered in Washington for their latest session, which would debate whether to give Wall Street a rate cut it wanted to ease the pain of the past few days (they decided not to), Mr Geithner was absent. What could be more important? Trying to prop up AIG, that's what.
The insurance giant's position was worsening by the hour. On Monday night, Bob Willumstad, just four months into his job at AIG's helm, had been pleading for a $40bn bridging loan from Mr Geithner to tide the company over until it could sell off chunks of itself to raise cash. By first light, the money needed was more than $70bn. A credit rating downgrade overnight triggered new cash demands on the company from hundreds of its trading partners.
Hank Greenberg, the company's former chairman and still a large shareholder, went on television to call AIG a "national treasure" that should be propped up by the government. AIG's regulator, David Paterson, the governor of New York, went on television to say he was ripping up decades of rules in order to let AIG dip into the pots of cash held by its subsidiaries – money the companies use to pay out on motor insurance claims, life insurance policies and other staples of ordinary life. Little wonder, within hours, that AIG's policyholders were jamming phone lines to try to cancel their business.
Faced with this firestorm, Mr Paulson and Mr Geithner performed an extraordinary U-turn. Within 48 hours of letting Lehman Brothers go to the wall, they began discussing ways to use Fed money to prop up AIG. It had to be money with menaces. Republicans, including the presidential candidate John McCain, were loudly demanding that there be no more government bailouts for Wall Street. But Mr McCain had not seen the financial models that Mr Paulson had been poring over that morning, and had not been inundated with calls from the chief executives of the world's biggest banks warning that AIG's fall would knock dominoes throughout global finance. At 8pm, the government's powerbrokers signed off an $85bn loan to AIG, and under its onerous terms they took over 80 per cent of the company – in effect nationalising it – and sacked the hapless Mr Willumstad. A glance at his severance package cushioned the blow. He will get $7m.
There were some unequivocal winners amidst the maelstrom. At Lehman Brothers' Times Square headquarters, a bullish figure strode in to address the employees. "You have a new partner," he announced. The man was Bob Diamond, swashbuckling head of Barclays' US investment banking division, who would have bought Lehman at the weekend if only the US government had taken responsibility for its most toxic mortgage investments. A quirk in the US bankruptcy laws allowed him to return to the table to cherry-pick the best assets just a day later, paying $1.75bn and transforming Barclays into one of the most powerful players in investment banking.
Meanwhile, Lloyds TSB, Barclays' old foe from the UK high street, was getting closer to a prize of its own.
The end came quickly for HBOS. The bank's shares were in all but freefall within half-an-hour of the market opening at 8.30am. Then the word came through, via Downing Street. At 9.16am the BBC's business editor, Robert Peston, semi-official messenger to HM Government, told the world that Lloyds TSB was in "advanced" talks to buy its beleaguered rival, at a price "nearer 300p a share", against the previous night's close of 182p, and the intra-day low of 88p reached a few minutes before. It was certainly a surprise to the two banks' negotiating teams; Downing Street had, in effect, bounced them into a deal, a high-risk tactic that worked.
An avalanche of investors trying to buy and sell HBOS shares during the morning left online dealing services frozen. More significantly a trickle of customers withdrawing their funds from Halifax savings accounts was prevented from turning into a Northern Rock-style flood. Whoever made money out of HBOS that day, it wasn't anyone using an online broker. As the day wore on, the "advanced" talks become more definite, though one rumour, that HBOS shareholders would get nothing from the deal, briefly sent HBOS shares tanking again at midday. By the evening the deal was all but official, and at a price of 232p, payable in Lloyds TSB shares. HBOS was history.
Stock market traders met the rescue of AIG in a pattern typical of their reactions at pivotal moments of the credit crisis over the past year: Hooray the government has bailed us out. Oh my god the government has had to bail us out.
As early morning euphoria gave way to panic-selling, the Dow Jones ended down 450 more points. Desperate investors pulled their money out of anything remotely risky and bought gold, which had its biggest one-day price rise in history. Then, they went on a witch hunt for the next likely victim. This was the day that Morgan Stanley and Goldman Sachs came close to collapse.
It was also the day that John Mack swung into action. Known around the industry as Mack the Knife for his unsentimental approach to cutting costs, Mr Mack has led Morgan Stanley for the past three years and he was not going to let it go down without a fight. The company had rushed out some great figures the previous night, to reassure the markets, but the markets ignored them. Indeed, the situation looked so dire that Mr Mack received calls from the bosses of some of America's biggest banks, asking to buy the company, and he did agree to explore talks with a few. But what he really wanted was to stop the panic, not simply respond to it.
In mid-afternoon, he placed a call to Christopher Cox, chairman of the Wall Street watchdog, the Securities and Exchange Commission, demanding he do something to curb the speculators who were driving down the share price and threatening to ignite a crisis of confidence that could overwhelm the firm. Lloyd Blankfein, Mr Mack's mild-mannered opposite number at Goldman Sachs, echoed the call.
Quickly Mr Cox agreed to work on new restrictions and penalties that could be announced in the morning. It was speedy work for Mr Cox, whose relentless inactivity over many years had allowed the credit derivatives market to mushroom without oversight to the point at which it could bring down the entire system. Whether it would be enough to stop the downward spiral, however, no one was confident, least of all the Bank of England. Having only a week before told MPs that the Bank's Special Liquidity Scheme would close as planned on 21 October, Mervyn King, the Governor, announced it would, after all, stay open until 31 January next year. HBOS was rumoured to have been a heavy user of the scheme.
The official news of the HBOS-Lloyds TSB merger was released at 7am, before the London stock market opened. It helped bolster confidence, but not half as much as the ban on short-selling in financial stocks announced by the Financial Services Authority after the market closed. Not a few pondered why such a ban hadn't been imposed after the last raid on HBOS shares, in March.
Still, more importantly, the US authorities proved determined not to repeat their mistake when the credit crunch began a year ago; this time they would offer practically unlimited funds to the banking system in an international show of strength. After a week of fighting fires in New York, Mr Paulson returned to Washington to marshall a fire prevention strategy.
An infusion of $180bn into the financial markets, courtesy of Federal Reserve loans to its fellow central banks, including the Bank of England, the European Central Bank and the Bank of Japan, was was still not enough to restore normality. With commentators beginning to wonder whether the Fed's coffers would run dry, and with the stock market continuing to gyrate wildly, Mr Paulson calculated that politicians would be sufficiently panicked that they could be galvanised into action. He was right. Nancy Pelosi, Speaker of the House, said they might even agree to work beyond the scheduled end of the session, which is due to close next Friday.
George Bush made his first appearance of the week, dropping his usual refrain that the economic fundamentals are "strong" and instead insisting that his administration would do all it could to respond to "challenges". Inside the White House, Mr Paulson lifted the lid on the Treasury's plan, a scheme that was first examined earlier in the month but dismissed for fear it would turn into an exercise in election point-scoring. In order to free up the banking system to start lending again, the idea would be to create a new federal government agency to which Wall Street could sell the toxic mortgage investments that have wrecked their finances; investments ultimately backed by the millions of homes that have plunged in value across the country. At the fag end of an administration ideologically committed to free-market solutions; under a Treasury secretary with impeccable laissez-faire credentials, the federal government is going to end up as the nation's biggest homeowner.
As news of the plan leaked and amid signs that the US may soon follow the UK's lead in banning short-selling altogether in some stocks, the Dow Jones staged a powerful rally.
And at 7pm, the talks. Shortly after, the photo op. The party leaders, the chairmen of the most powerful congressional committees, Mr Paulson himself, and Mr Bernanke lined up to take questions, to promise swift action, even to suggest that legislation could be drawn up next week, if the government and Wall Street could agree details. "Let's hear from the Bernankes and the Paulsons and the rest what their view of it is," said Ms Pelosi. "Let's hear from the private sector. How these captains of the financial world could make millions of dollars in salary, and yet their companies fail and then we have to step in to bail them out."
"There will be ample opportunity to debate the origins of the problem," said Mr Bush. "Now is the time to solve it." He was flanked by the three men who had reshaped the world's financial system – Mr Paulson, who an hour earlier had unveiled the biggest package of government intervention in the markets in modern times; Mr Cox, who followed the UK's lead and banned short-selling of financial company shares; and Mr Bernanke, who loosened the Fed's purse strings one more time.
Behind the scenes, a small cabal of Treasury advisers had beavered through the night on a string of emergency measures to insure money market funds and to buy distressed mortgage assets – measures that sent 10,000 volts through the financial markets around the world. The FTSE 100 surged by more than 400 points, its biggest one-day rise. The Dow was also vastly higher. Shares in Morgan Stanley were double their value 24 hours earlier. The traders panicking now were the ones who had been betting on a financial meltdown, which appears a much less likely outcome at the end of this extraordinary week than it did at the start.
For Mr Paulson, though, there can be no time for relief. There are devilish details to plan, congressional cats to be herded, and some of the hardest negotiators on Wall Street to deal with before these plans will actually come to fruition. These are uncharted waters, and we have sighted land. But we have not reached harbour. Another long weekend of work is in prospect.
The questions on everybody's lips
Where does the American government find all this money to bail out the banks?
Vast quantities of US government debt will be created, probably the largest issuance since the Second World War. It will be bought, on the whole, by China, with the Gulf states and the Russians taking their share too. One day, sooner or later, it will need to be repaid. It will need to be serviced from day one. That will mean higher taxes and lower US government spending.
If my bank fails will they write off the mortgage?
If only. Your mortgage will be transferred to the new owners or sold to another lender; you and your repayments are valuable assets. They will not be forgotten.
What is capital and what is liquidity?
Great buzzwords of the moment. It's simple. Imagine you are very rich indeed; lots of shares, houses, racehorses, a yacht or two, a collection of classic cars and the rest, with no debts attached to any of them. You have lots of capital, and a strong balance sheet; like some banks. But one day you find yourself in a cafe and unable to find the £2 for the cup of coffee you just drank because you forgot your wallet. Then you have a liquidity problem: you are unable to pay your obligations as they fall due – like some banks. If no one around will lend you £2, then you are in real trouble. Like some banks...
Does it matter if an investment bank is nationalised?
None have been yet; if they were then they wouldn't really be investment banks any more, because they do things – like take huge risks, pay obscene salaries – that taxpayers tend to dislike.
Is the panic over?
For now, yes, if only because we're running out of banks to trash.
Is my money safe?
Yes. The Financial Services Compensation Scheme will look after the first £35,000 of any savings in a single institution. However, you may have to wait for your cash, and you may also judge that if a couple of truly large banks are threatened with collapse then there won't be enough funding left in the system to pay you off. The example of Northern Rock, however, now featuring an unlimited state-backed guarantee on its deposits, suggest that the Government would rather nationalise a bank than see depositors lose their cash.
Sean O'Grady, economics editor