Letting Lehman Brothers go bust must have seemed like a good idea at the time. Or at any rate, the least evil of the options available to the US financial authorities, all of which were bad. Mindful of the potential systemic risk of what would be the biggest bankruptcy in history, America's leading financial public servants trod carefully. A special Sunday trading session of the derivatives market, ISDA, was even arranged in order that exposure to Lehman's hundred of billions of dollars of debt by other institutions could be minimised.
But when, at 5.30am EST on Monday, 15 September, the official Chapter 11 announcement was made, it rapidly became apparent that attempts to minimise the impact of the failure of the world's fourth-largest investment bank had come spectacularly unstuck. In the course of the following couple of weeks, the Lehman's collapse would come to be seen as the point at which the credit crunch suddenly became orders of magnitude more severe, morphing into a full-scale financial crisis with the potential to be as bad, said the Jonahs, as the Great Depression of the 1930s.
The news triggered a vertiginous fall on the New York stock exchange that morning, with the Dow Jones index losing 504 points, thanks to panic selling on a scale not seen for a generation. The authorities' efforts to manage the situation may even have made things worse - braced for bad news as they were by the events of the previous few days, the markets raced downhill out of the blocks that morning like Usain Bolt hearing the starting gun. As share prices plunged, asset values evaporated and tight credit markets dried up completely, it looked alarmingly like the entire global financial system was beginning to unravel.
It was the bursting-point of a bubble that began to inflate five years ago, says John Kay, economist and commentator whose book on the subject, The Long and the Short of It, will be published in January. 'Banks became more cavalier about lending as the securities market became the new bubble. But the elaborate structure of that market meant no-one could discover the exact nature of their liabilities.'
In other words, increasingly large volumes of bad loans were made, just to provide debt that could be packaged up and sold on the booming - and unregulated - securitised debt markets. The subprime crisis, often fingered as the root of our current problems, was by this analysis merely a symptom rather than the disease itself.
The banks, says Kay, were in effect playing a huge game of pass-the-parcel, with the financial equivalents of chunks of toxic waste covered in shiny paper - the CDOs, CDSs et al of which we have heard so much recently. In the end, even the institutions that sold these deliberately baffling constructs couldn't figure out who was going to owe what and to whom when the music stopped and the last layer of wrapping was removed. 'The securitised debt market should never have existed in the first place,' he says. 'We certainly shouldn't try to revive it.'
Across the Atlantic in London that Monday, events were hardly less dramatic. Footage of staff at Lehman Brothers' London office being sent home prompted the BBC's Jeremy Paxman to remark tartly that it must be hard for them to keep thinking of themselves as masters of the universe when they were toting their personal possessions in a cardboard box.
The following day, Tuesday the 16th, the world's largest insurer, AIG, effectively went bust, rescued by an $85bn pledge from the US treasury, and Washington Mutual - a retail bank this, with billions of dollars of citizens' savings on deposit - had to be saved by JP Morgan Chase. By the end of the week, the once-mighty US i-banks were all but gone, acquired by corporate giants like Bank of America and Mitsubishi UFJ. Only Goldman Sachs managed to remain independent.
The FTSE crashed as the shockwaves spread, and bank shares were particularly badly hit - HBOS, the country's largest mortgage lender, lost 30% of its value two days running. Fears of a Northern Rock-style run on a terrifyingly large scale prompted a Government-brokered emergency takeover by arch-rival Lloyds TSB, concluded in record time by 9.30pm on Wednesday the 17th. Short selling, thought to be a prime cause of the run on bank stocks, was temporarily banned in the UK and the US in an effort to stop the slide in their share prices. It didn't make much difference. Markets yo-yo'd wildy, swinging hundreds of points in the space of hours as investor confidence vanished. This wasn't London catching cold after New York sneezed, this was more like a case of sudden multiple organ failure, on an international scale.
It was all bound to end in tears, says Kay. 'The system we have at present is like a utility attached to a casino. The utility is the functional banking system, lending to and taking deposits from real businesses and real people. The casino is the rest of it.' This needs to change, he adds. The gamblers in the casino cannot be allowed to continue speculating with funds generated by the utility. 'What ordinary businesses and people want is a banking industry that serves a proper economic function, providing sensible, old-fashioned banking where loans are made against deposits taken.'
This is the so-called 'narrow banking' model - essentially the way banks used to operate before the market deregulation of the '80s opened up a vast new range of opportunities to them. But while it sounds great in theory, the difficulty lies in the painful process of getting there from where we are now. A massive amount of debt, debt insurance and associated speculative finance will have to work its way slowly and destructively out of the system. There is a risk that the cure could be worse than the disease.
Initial efforts to tackle the crisis in the US certainly seemed to assume that this de-leveraging medicine was too bitter to take, and aimed instead at trying to restore business as usual. US Treasury secretary Hank Paulson's $700bn plan to buy up toxic debt, presented as a fait acompli towards the end of that first week, was rejected by angry American politicians, and even after being eventually passed on 3 October was subject to considerable revision. Conceived in haste, it was not only the wrong plan, it was also politically unacceptable only a few weeks away from the US presidential election.
Washington made it plain that Wall Street wasn't going to get its blank cheque from the taxpayer without more serious guarantees that they wouldn't just go out and get into the same mess all over again. 'The US position looked initially like that of the indulgent parent who says to their wayward child: "I'll bail you out so long as you promise not to go into the casino again." But they will of course,' says Kay.
By the middle of the second week, around 24 September, some commentators were optimistically opining that the worst might be over. But there was plenty more grief to come - Bradford & Bingley's catastrophic buy-to-let mortgage book was nationalised on Sunday the 28th, while its £22bn savings business went to Spain's Santander. The following week, banks in Belgium, Ireland and even ultra-conservative Germany failed as the dominoes of dodgy assets and securitised debt products continued to topple.
The Russian stock market was suspended for three days in a row as foreign money dived for cover. Iceland - whose shattered banks' debts are six times their nation's entire GDP - is testing to destruction the old adage that a country cannot go broke. This left savers and investors in the UK hanging out to dry - not to mention various local councils and even the Audit Commission, red in the face at being caught with millions in Icelandic banks. Now the Asian markets are in trouble too, and the hope that they might be de-coupled from the troubles further west has been dashed. Recession is upon us.
But as we approach the two-month anniversary of that fateful Monday in September, there are a few cautiously positive signs among all the carnage. Remarkably swift, bold and co-ordinated international action has been taken to address the banking crisis - led by our own PM Gordon Brown, whose personal reputation has been salvaged, albeit probably only temporarily, as a result. The equivalent of £2trn has been pledged by governments and central banks across Europe and the US to shore up the financial system and recapitalise banks in return for equity stakes - from which the taxpayer stands a decent chance of making a good return in the end.
The Bank of England continues to work hard to free up the credit markets with huge liquidity injections and easier loan provisions. And we're all getting used to the dramatic changes in our national circumstances - the smell of outright fear that characterised those first few weeks is in abeyance, replaced by a dawning realisation that we are all going to have to knuckle down to cope with the hard times ahead.
Of course, the big question mark hanging over those of us who don't work in financial services is what the effects of the crisis will be in the so-called 'real' economy. Back in the summer - only three months ago, but a world away now in terms of sentiment - more optimistic commentators were suggesting that the slowdown would remain just a slowdown, and if it wouldn't all be over by Christmas we could be out of the worst of it by mid-2009.
Now most of the classic indicators of full-blown recession are there. Growth has stalled, manufacturing output is down, unemployment is rising at its fastest rate for 16 years, and oil, energy and commodities prices are all in steep decline.
'Problems in the financial sector don't have to be reflected in the real economy, but this collapse is so severe that they are and will continue to be,' says Jon Moulton of Alchemy Partners. 'We are probably in recession already - high-end retail, estate agents and the car business are in a shocking state. It's hard to see how the public-sector deficit will be less than £150bn next year - that's worse than it was during world war two.'
Recruitment, that traditional bellwether of economic health, is taking a big hit, with signs that hiring is being slashed by many corporates. And, of course, the City jobs market is especially badly off. 'I'm running out of superlatives at the moment,' says one boutique financial headhunter, who prefers to remain nameless for fear of scaring his already-spooked clients even more. 'A lot mid-tier recruiters will see their revenues fall by 25%-30% over the next few months. The likes of Hay are saying that conditions are unprecedented in 25 years of recruiting. No-one seems to know whether we're in the eye of the storm or the worst is yet to come. It's roll-your-sleeves-up time.'
The immediate banking crisis may have been averted, but we're not out of the woods yet, or anywhere near. There are signs that the interbank lending market may have shifted into a permanently more cautious mode, as Libor remains stubbornly high despite the Bank of England's strenuous attempts to get it closer to the base rate. And rescuing the banks may simply divert the effects of deleveraging, perhaps to the insurance sector, whose capitalisation is coming under scrutiny, or to currency runs on the pound and the dollar.
Moulton offers hardnosed advice to managers in such turbulent times. 'Change what you are aiming for from prosperity to survival. It's a different mindset. Manage cash as your key priority - put the cashflow statement on the first page of the management accounts instead of the P&L. Do better forecasting, control debt, cut back on product development, capex, costs, salaries. It's unpleasant, but the only way.'
Even so, there will be casualties he says - especially among firms acquired during the private-equity boom of a couple of years ago.
'It's hard to see how the position of these firms could be worse, to be honest,' confides Moulton. Plenty of them are in the position where 90% of cashflow is going to service their debt. 'That's a very bad place to be right now. Even the companies that survive will be competitively disadvantaged because of the impact on their capitalisation. It's the end of the LBO (leveraged buyout), at least for the time being.'
The flipside to this, of course, is that there will be opportunities for well-managed, prudently financed and tightly run firms to do well. The tortoise will overtake the hare.
Despite the chequered history of financial supervision - the poachers have generally been a long way ahead of the gamekeepers in recent years - much closer regulation of the banks' activities is also on the cards. FSA chairman Lord Turner has fired his first shot, warning that 'the era of light-touch regulation is over'.
Then there's the ever-emotive issue of executive pay, control of which has been made a prerequisite of the UK banks' rescue package. It's an easy and popular target, but not the right one, says Kay. 'I don't much like the idea of Bob Diamond (Barclay's investment banking boss) being paid £20m, but I don't want to regulate against it. I just want to make sure that none of my money is in his pay packet.'
The question also remains of more heavyweight justice. How are the guilty financial whizzkids who got us into this mess to be punished? Some big bankers - Fred Goodwin of RBS for one - have already fallen on their swords - although his £580,000 severance deal may seem a funny kind of reprimand. More scalps could follow. In America, Dick Fuld tops the unofficial 'former Wall Street titan most likely to face the slammer' league table.
So what, if anything, can be done to limit the chances of a repeat of Black September anytime soon? Kay offers some characteristically waspish advice. 'This is the second bubble we have had in a decade, and unless we protect the real public interests of businesses and individuals, there will be another in five years' time.
'What we need is a lot less respect for financial services. Our attitude should go back to the way it was 50 years go, when it was an activity regarded as profitable but somehow shameful and ridiculous. Like being a bookmaker - which is essentially what it is.'
Now that's a real regulatory poser for the FSA to grapple with...
THE FALLEN 'MASTER OF THE UNIVERSE' LEHMAN BROS BANKER
I suppose it all started going wrong for us in February/March of this year. Lehmans wasn't exposed to any of the worst sub-prime stuff and other toxic assets. We didn't carry it on the balance sheet, just traded it. But we undid the good work when our boys in New York took the view that the dip in commercial property wouldn't be severe or long and so they loaded up. Bad news.
As the storm gathered, Bear Sterns went down, and then we were the next-smallest. We had the equity issue, convertible issues and then another equity issue. We got into a massive fight with a hedge fund. Then we made a massive loss and writedowns, and things started to look really bad. Dick Fuld was convinced he'd got us through the Russian crisis and he was going to do it again. He was sure he could trade his way out and spent the summer trying to fix it.
He consistently overplayed his hand, always after a better deal. This was typical of his style: sitting there, all powerful in an executive suite surrounded by those who licked his arse all day long. Fuld was a cult leader, but no walker of the floors. He didn't live in the real world.
By September, the final throes were terrible. As soon I saw in the final week that we were talking to the Koreans, I knew we had had it. When you're talking to the Koreans you are really scraping the barrel. Fuld wouldn't take their offer but he had no Plan B, nothing in his back pocket. Bank of America got Merrill but we were too much in the way of 'moral hazard'. Paulson lost patience with Fuld and let us go. Pretty galling that he found $85bn to bail out AIG the day after.
I got the call that it was all over on the Sunday evening. Going into administration is the most unpleasant business. It's a mix of extreme fear and disappointment. We all gathered at 8.30am on the Monday and were told that we had no jobs by the end of the day. One colleague was personally in the hole for £15,000 of expenses he'd run up on a trip to Hong Kong. I knew I had to get another job fast. I put the calls into headhunters and waited to pull the trigger.
I had done well in banking. In the best years I made between one and two million but I'd financed myself conservatively. Although I don't have a seven-figure mortgage like some colleagues, everything was up for grabs. I had a big house in Essex, two kids in private school and a very anxious and upset wife. The nature of the job is that I never see them get up or go to bed. I leave at six and was rarely home before 10. I'm not complaining - that's the sacrifice you make.
I don't doubt the validity and value of what I do. I give good advice and that is worth a lot. People ask me if I understood the full intricacies of some of those derivative products. Well, I did, but I didn't understand how far they had got. Like all clever things, they just got pushed too far.
Do I feel guilty? Well, all bubbles burst. The absurdities of the real-estate market are no great advert for what we do. But politicians were complicit - they encouraged home ownership and make it feel like a citizen's right. We're not the only ones who made money. Clearly, hair shirts are the order of the day, but they'll come off in time, when someone finds a new way to make money. Ours is a creative industry.
The City is a transparent place: you make a lot of money for your company and get paid a lot of money. Bonuses will have to be more long-term, but any attempt to legislate on City salaries is doomed to failure. At Lehmans, we were good at that. The employees owned - and lost - 30% of the company. I lost a very large sum of money, but we were bought by Nomura and I'm thankful for that.
And Dick Fuld? He'll go to jail. The mood is very ugly in the States at the moment and the American public won't be happy until they see him in an orange boiler-suit.
THE ACCOUNTANT ON THE UP - Tony Lomas, PWC administrator Lehman Bros, london
'I got the call on the Saturday night, 13 September, to come to the board meeting Sunday lunchtime. At that meeting, I was told to begin at eight on Monday morning - from a standing start. The only thing I've done that was in any way analogous to Lehmans was winding up Enron's European business. And you'd have to scale it up many times to get this level of complexity. But that's the closest analogy anybody in my profession would have.
We've got 200 people from PWC in here, and we'll have a significant presence for a serious amount of time. The process of agreeing claims here is going to be far more complex than in any other significant insolvency, just because of the complexity of the relationships Lehmans had with all its counterparties. The whole project could well last 10 years.
The first few days involved massive shock and surprise. Everything freezes - until the employees get a bit more clarity about their circumstances. It was 15 September, and pay was due at the end of that week. So the employees' concerns were: am I going to get paid? Am I going to get a bonus? For some people, who may have had the opportunity for a golden hello elsewhere, it was: should I go out and look, or should I wait around to see if I have a job here?
Lehmans' management team found it difficult to interact with their staff - not because they feel any guilt, but because they know them as people. I try to avoid sounding like an automaton: to be as frank as I can, without being brutal, and as open and informative as I can, without breaching confidentiality. It's a fine balance.
I don't have to worry that I've never managed the insolvency of an investment bank before. The act of recovering value is not like shelling peas, but it's no different in concept to handling MG Rover, for example. With supreme confidence in your team, you can work through the challenges in a structured, orderly way. Pragmatism - that's what it is.
I'm not fazed by the pressure. I'm used to dealing with crises not of our own making. That's important: no-one is blaming us for anything. There are personal sacrifices. I do end up working through the night, but I've been doing this for more years than I care to remember. Approach it on the basis that you work hard and play hard, and you can keep some balance in your life. I am a Spurs fan - I've been so distracted by this that I've been able to forget their disastrous results.
REALITIES OF RECESSION: TRENDS FOR 2009 AND BEYOND
The return of the greenback. When times are hard, cash is king. The businesses that will be best placed to survive and even prosper in the coming recession will be those that act now to conserve their cash and to manage cashflow. Reserves of the folding stuff will mean competitive advantage.
- Tortoises are the new hares. The stars of the downturn will be cautious, careful and risk-averse companies operating in unspectacular but consistently profitable sectors like booze, food and FMCGs. Exactly the same companies that the City has been, until very recently, putting the boot into for their lacklustre growth, in fact.
- A chance for leaders to shine. Tough times are when good leadership can really make a difference. Apprehension and uncertainty knocks staff performance in a downturn. Empathetic, experienced and decisive leaders can get them back on top of their game.
- The rise of sovereign wealth. Companies that saved up their pennies during the boom times may well start picking up fire-sale bargains. So look out for Chinese and Middle Eastern funds going on buying sprees - as well as the Norwegians, of course. Unlike the UK, these careful Scandinavians banked their North Sea oil money and now have nearly $400bn to play with.
- Costly credit. The price of borrowing is likely to stay high, whatever happens to baseline interest rates. Banks need higher margins, and not just to recapitalise; they have belatedly realised that the cheap-loans model of recent years doesn't actually make them any money.
- Opportunism. As the recession bites and budgets are slashed, many of the old sources of revenue that firms have come to rely on will dry up.Finding replacements for at least some of this income will require ingenuity, energy and a willingness to chase down business wherever it can be found.
- Breach-of-covenant bankruptcies. Companies that loaded up on cheap debt in the good times and have yet to get rid of it will form the majority of the first wave of business failures, as they fail to meet the terms of their loans. Even those that are trading well will suffer badly because of the punitive cost of servicing their debt.