The history of the financial meltdown

Like the butterfly flapping its wings in Patagonia and causing a storm in Paris, the global banking crisis had humble beginnings.

In 2005, Mr and Mrs America could get a mortgage from their bank very cheaply. The economy was booming, jobs were plentiful and the property market was unstoppable. They probably couldn't afford that dream house. But, hey, the offers were great.

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Competition among lenders was intense, with so-called teaser discount rates luring in people from the hitherto unloved sub-prime underclass.

These people weren't Ma and Pa from Main Street. These were people with bad debts. These were people with low-paid jobs. These were people who shouldn't have been getting on the property ladder, given their patchy, at best, credit histories. These people were taking a massive bet. And America's lenders were funding the habit sweeping the country.

But like any gambler putting all his chips on black only to watch the wheel coming up red, the banks and lenders have lost out spectacularly – and last week was among the most catastrophic seven days in financial history.

The collapse of Lehman Brothers into administration and the folding of Merrill Lynch into Bank of America brought the number of banks and lenders that have fallen victim to the sub-prime crash to a staggering 284 worldwide.

Some 51 hedge funds managing more than 80 individual funds worth billions of pounds have also gone under, as the claws of the bear have sharpened.

Previous masters of the universe like the team behind Polygon or the men at SRM, who have made catastrophic losses betting on Northern Rock, edge closer to intensive care, or worse.

How has it come to this?

The crisis dates back to the end of 2006, but it only featured in the consciousness of the average Brit in March 2007 when HSBC, Europe's biggest bank, had to issue its first profit warning in its 142-year history.

Losses from the bank's US lending business came in at $10.5bn (£5.8bn) – a massive figure that has since been dwarfed by others.

Just weeks later across the Atlantic, New Century, one of the biggest lenders of sub-prime mortgages, filed for Chapter 11 bankruptcy protection – America's equivalent of administration.

Then, in June, the crisis at Bear Stearns, a cornerstone of the US bank clearing system, became apparent when it was revealed that it had been forced to spend $3.2bn bailing out two of its hedge funds exposed to sub-prime – the biggest rescue of its type in more than a decade.

Goldman Sachs – which, according to some reports, remains in a precarious state this weekend after its shares tumbled in trading last week – would similarly be forced to bail out its once stellar-performing Alpha hedge fund to the tune of $3bn.

In Britain, Northern Rock came to a grinding halt in September and would eventually lurch into nationalisation months later.

In America, the House of Representatives passed the Predatory Lending and Mortgage Protection Act, enshrining in legislation the need for lenders to make sure their customers can afford their mortgages.

It was all rather too late, though, with Goldman Sachs predicting at the time that sub-prime losses in the financial sector would come in at more than $400bn – roughly the size of America's entire budget deficit.

The Freddie Mac and Fannie Mae fiasco – which earlier this month ended in their effective nationalisation following the rescue operation mounted by US Treasury Secretary Hank Paulson – began in November 2007. That was when the former put aside a modest $1.2bn to cover bad debts. Weeks later, it would have to sell $6bn worth of shares to cover the losses.

Citigroup, at the time the world's biggest bank, posted huge losses of $9.8bn in January this year – a figure that was soon eclipsed when Merrill Lynch wrote off more than $14bn linked to sub-prime assets.

The hedge funds Peloton Partners and Carlyle Capital would fold in March, but just days later the extent of the downward spiral became clear when Bear Stearns finally hit the buffers.

As with Northern Rock months before, a lack of liquidity forced the bank under. Investors simply lost faith in its ability to pay back its most short-term loans overnight – overnight borrowing being a vital ingredient in any bank's survival.

As its chief executive Jimmy Cayne played golf, Bear Stearns burned, with its web of complex, interlinked transactions sending a huge ripple through global banking. As one trader put it at the time: "As far as Wall Street was concerned, Bear Stearns wasn't too big to fail – it was too interconnected to fail."

In stepped JPMorgan and the Federal Reserve with a plan to save the bank which would see JPMorgan picking up the carcass for a song, while the Fed agreed to finance $30bn of the most toxic Bear Stearns assets.

It worked.

The Bear rally began with bourses around the world shooting up. If governments were prepared to underwrite banking failure, then where was the risk? Moral Hazard was in play.

Against the backdrop of the events that were playing out in the US, Britain's banks were convulsing. But Royal Bank of Scotland, HBOS, Barclays and Bradford & Bingley all took their medicine, shoring up their balance sheets with a mix of rights issues and other new capital to the tune of more than £20bn.

"We believe this [raising £4bn in a rights issue] is the prudent thing to do and we will be proven right in three years' time when the worst of this is over," said HBOS's chief executive, Andy Hornby, back in May. Events were soon to overtake him.

A largely benign summer would come to a crashing end in September.

Fannie Mae and Freddie Mac may sound like a couple of dance partners from the 1930s, but together the two government-sponsored companies indirectly advanced billions of dollars to US homeowners.

Fannie Mae was set up in the 1930s in the wake of America's Great Depression, when mortgage funds were scarce and millions faced eviction from their homes. Freddie Mac was created 40 years later to provide competition.

If Bear Stearns wasn't expendable, this pair certainly weren't. So just two weeks ago, as they edged towards oblivion, the US government stepped in, offering trillions of dollars in guarantees to the company that would secure its future.

As Fannie and Freddie were bailed out, Dick Fuld, the long-time chief executive of Lehman Brothers, one of America's most august investment banks, must have been staring ruefully out of the window of his Times Square office.

With one of the most fragile balance sheets on Wall Street, Lehman had long been talked about as a potential victim of the crunch. Back in 1998, as Russia's government defaulted on its debts, and the hedge fund Long Term Capital Management crashed to earth, Lehman came close to failure.

Traders were told not to answer phones. Credit lines were cut. Rumours flew.

But it survived. Management instituted a radical overhaul of the way in which the bank funded itself and the future suddenly looked very rosy indeed.

"We came close to the edge," Lehman's European boss, Jeremy Isaacs, said later. "People were walking into my office and asking if they should still go ahead and buy the new house they wanted. I told them there was nothing to worry about."

Lehman went on to prosper, with its European base generating annual sales of £3bn. In America the story was even better, as the firm's profits soared on the back of its exposure to mortgage-backed securities.

But as the sub-prime crisis began to unfold and Joe Public began defaulting on his mortgage payments, fears for Lehman's long-term safety grew.

In an interview given in the summer of 2007, Mr Fuld said: "Do we have some stuff on the books that would be tough to get rid of? Yes. Am I worried about it? No. If you have some re-pricing of these things, will we lose some money? Yes. Is it going to kill us? Of course not."

But perhaps he knew the game was up back in the spring when he was reported to have approached Korean investors about taking a 50 per cent stake in the bank. The Korean Investment Corporation walked away.

In August the Koreans, this time from the Korean Development Corporation came back, but with an offer price that Mr Fuld deemed too low. Lehman would soldier on.

Until 12 September when, days after the Fannie and Freddie bailout, talk of the bank's collapse began to surface.

As Lehman's workers walked out of their office on the Friday night, the talk was that a carve-up had been agreed and details would be announced at a press conference on the Saturday night. Leh-man Brothers was too big to fail after all.

But the Fed thought differently. Lehman was expendable both commercially and politically; outside Wall Street, it was little known. And if Barclays and Bank of America didn't want to take it, then nobody would.

Word quickly got out that the unthinkable was about to happen. Staff at Goldman Sachs in London were summoned to their desks near Fleet Street on Sunday as the potential fallout from the collapse was digested.

Mr Fuld, the physically imposing chief with a penchant for weightlifting, would be forced to retreat to his million-dollar mansion in Florida.

Nobody could call John Thain, the chief executive of Merrill Lynch who took over from the dismissed Stan O'Neal last year, physically imposing. The man who has ploughed hundreds of thousands of his own cash into supporting John McCain's tilt for the Presidency cuts rather a geeky figure.

But during his time at the helm of the New York Stock Exchange, Mr Thain garnered an enviable reputation. Indeed, it took a $15m golden hello and one of the most generous chief executive packages on Wall Street to persuade

him to lead the bank known as "The Thundering Herd", with its famous bull logo.

Unlike Lehman, Merrill, which employs hordes of brokers across America's 52 states, has a place in the country's heart. But like Lehman, Merrill has long been on the sick list.

When a Lehman collapse was first mooted, sources close to regulators said Merrill was the one they were most fearful of following suit. Since the start of the crisis, it has written off around $50bn worth of assets linked to sub-prime and sought investment from sovereign wealth funds like the Korean Investment Corporation, Kuwaiti Investment Authority and Mizuho Corporate Bank of Japan.

As Lehman fell into the mire, Ken Lewis's Bank of America was thought to be the likely buyer, but failure to do a deal meant it was Mr Thain instead who was pushed into the arms of the straight-talking Mr Lewis.

Bank of America, which earlier in the year bought the ailing Countrywide financial group for a relative song at $4bn, agreed to pay $50bn for Merrill, fulfilling Mr Lewis's long-held desire to have a more sizeable investment banking presence.

"I long ago predicted that commercial banks would own investment banks," he said. "But I was a little ahead of my time."

By contrast, time was running out for Robert Willumstad, chief executive of AIG. Parachuted into the role just three months before, he was having to contemplate the unthinkable: bankruptcy for, until recently, the world's biggest insurance company.

Like Lehman and others, its problems came from securitisation and the mortgage-backed market. It didn't trade in these products but insured holders of the assets against default. Given the high level of defaults, it was little wonder AIG was on the brink.

It helped to save Bear Stearns. It rescued Fannie and Freddie. It ignored Lehman. But the Federal Reserve was once again called into action. And this time it would give AIG an $85bn cash package in return for a near 80 per cent stake in the firm and the sacking of the management, albeit with hefty severance packages.

There was a collective sigh of relief in the global insurance and financial markets, and the forced sell- of AIG's assets has presented a huge opportunity for rivals. Prudential, for example, may well be eyeing up AIG's juicy Asian assets.

The bailout of AIG should have calmed nerves and brought a degree of normality back to the markets. Sadly it hasn't.

Morgan Stanley, whose offices are next to the emptying Lehman building in Canary Wharf, is in talks with US bank Wachovia, although the sale of a 49 per cent stake in the company to the sovereign wealth fund China Investment Corporation looks more likely.

And last Wednesday, Washington Mutual, the once-giant US savings institution that has been on its knees since the spring, appointed Goldman Sachs to conduct a sale.

That move came after TPG, the private equity group that invested $7bn in the bank in June and that also tried and failed to buy a stake in Bradford & Bingley in Britain, waived its so-called dilution rights an so allowed the size of its stake in the company to be reduced.

Suitors lining up to take the bank include JPMorgan, Wells Fargo and HSBC.

Back in Europe another sovereign wealth fund was bailing out a once-august Western institution. Bank of China bought a 20 per cent stake in Compagnie Financière Edmond de Rothschild, the company behind the Rothschild banking group in Britain.

How Andy Hornby of HBOS must have hoped his own white sovereign knight could have come galloping to the rescue last week as the company's share price went into freefall – purportedly on the back of the actions of short-sellers, although there is scant evidence to prove this.

Instead, a government-brokered tie-up with Lloyds TSB – that conservative institution known for doing little more than paying a hefty dividend to its shareholders – was agreed.

Lloyds chairman Sir Victor Blank and chief executive Eric Daniels, a much-derided duo, were having the last laugh as the hunted became the hunter.

Normal competition rules would have precluded the merger of Lloyds and HBOS on the grounds that the combined group would have more than 35 per cent of the current account, savings and mortgage markets. But a political and regulatory will made the deal possible.

Whether the marriage is one made in heaven seems unlikely. Concerns about the long-term wholesale funding problem that has dogged HBOS for the last year aren't going to go away.

When Mr and Mrs America got a mortgage three years ago, only to struggle to make their repayments, few could have believed the impact it would have on the world in 2008. Last week everything changed.

It will take a brave man or woman to guess where we go next, though these markets have shown that guesswork is something we have in abundance.

If Hank saves the US economy, it will be through gritted teeth

Henry "Hank" Paulson is the man many believe can keep the US economy afloat.

Nicknamed "Hank the Hammer" because of his toughness on the football field, he got an MBA at Harvard in 1970, before working as a staff assistant, first to the Assistant Secretary of Defense and then to the President.

After 24 years at Goldman Sachs, eight as chairman, he was nominated for the role of US Treasury Secretary by George Bush and took up the job in July 2006.

Paulson, himself a Republican though married to a Democrat, has surprised colleagues by calling for reform in social security and healthcare, narrowing the wealth gap, improving global trade and introducing a sustainable energy policy.

Saying he is fanatical about the environment and wealth distribution, he has announced he would like his $500m fortune to go to charity.

In recent months, he has become central to the futures of Bear Stearns and Fannie and Freddie. In July he said he would not let the companies fail, but did not want to use taxpayers' money to prop them up; the deal to bring Fannie and Freddie into government conservatorship was said to be done through gritted teeth.

When Lehman Bros looked like going under on Sunday, Paulson pleaded with Barclays to buy it out. The bank said no, leaving him with little choice but to let it fail.

'This is the time I think we could go for the jugular'

Ken Lewis, the chief executive of Bank of America and saviour of Merrill Lynch , has developed a taste for banks weakened by the credit crunch. Earlier this year he bought the US mortgage lender Countrywide.

The 61-year-old Mr Lewis was born in Mississippi and raised in Georgia. The son of a nurse and an army sergeant, he worked as a shoe salesman to pay his way through Georgia State University. He is also a graduate of Stanford University's executive programme.

He had his first taste of banking as an aide to Hugh McColl, the former marine who built the first coast-to-coast American bank through a string of deals, culminating with the 1998 merger of his Charlotte, North Carolina-based NationsBank with the San Francisco-based Bank of America. Mr Lewis replaced Mr McColl in 2000.

Bank of America's investment banking business is tiny by comparison with its giant US consumer arm, but its record there is dismal and has been the scene of several management shake-ups.

Last year, the combative Mr Lewis told a gathering of top bankers that worsening market conditions were ripe with opportunity. "This is the time we could go for the jugular," he said. "[We can] really be disruptive and take market share."

'It's my job to execute' – but it was his bank that got the bullet

Dick Fuld, the 62-year-old chief executive and chairman of Lehman Brothers, always said he would never sell the company. However, it turned out that he couldn't rather than wouldn't.

Last weekend he and Hank Paulson tried to save the 158-year-old bank by offering it up to every bank from Barclays to Morgan Stanley. The former picked up a small rump, but the business is now bankrupt.

Until then Mr Fuld was one of the big stars of global banking, nicknamed "the gorilla" for his no-nonsense attitude.

After becoming chief executive in 1993, a year before Lehman was spun off from American Express, he built the group up from a narrowly focused corporate bonds company into a financial services major.

It's a sad ending to such a distinguished career at the bank he loved – Mr Fuld joined Lehman in the 1960s – and makes a mockery of words he uttered publicly just three months ago.

After posting a $2.8bn quarterly loss, Mr Fuld, a former international squash player for America, insisted: "We've made a number of changes. It's my job to make sure that we execute."

Unfortunately, he quite clearly failed. And despite admitting that the earlier loss was his "responsibility", Mr Fuld now blames the short-sellers for the bank's failure.

The meteoric rise and then the fall to earth

Andy Hornby was once tagged the "golden boy" of banking. But now he is blamed for the woes at HBOS after the UK's biggest mortgage lender announced £2.8bn of treasury losses and a "funding gap" of £198bn.

Hornby is expected to keep his £2m-a-year job and will make a further £2m from his own personal investment in HBOS when the takeover goes through.

In his own defence, he has said: "I became chief executive two years ago and no one prophesied what was going to happen to markets."

He has also been backed by HBOS chairman Lord Stevenson, who described him as one of the "most decisive chief executives of any bank in the world".

Hornby was educated at Clifton College Preparatory School in Bristol, and lived there with his father, the headmaster. After English at Oxford, he did an MBA at Harvard and then joined the corporate world. He worked for Blue Circle Industries, moving on to join Asda as director of corporate development. He joined the Halifax in 1999 as its head of retail and chief executive a year later aged 39, making him the youngest person in such a role at a British bank. He was given a bonus scheme worth £2m to stop him taking the top job at Boots.