As the maelstrom raged through financial markets last week, Jim Mills was waist-deep in a tranquil Scottish river wondering what to do. News was coming through on his BlackBerry of the latest crisis.

That Thursday morning HBOS, one of Britain’s biggest banks, was being rescued by Lloyds TSB. Other banks were under pressure. Mills, a private-equity millionaire, was reeling, mainly from the shock.

Should he carry on fishing, or attend to business? Mills waded out, called his broker and decided it was time to head for the hills.

“I’m trying to get my cash into gilts,” he said. “RBS [Royal Bank of Scotland] could be next. At the moment you just don’t know.”

These were uncharted waters. “No fish either,” he muttered with gallows humour.

Mills knowsthe City,has made millions in recent years and saw trouble coming long ago. But he didn’t expect it to be this bad.

In the space of a few days the financial world was being upended and torn apart. Lehman Brothers, one of the four remaining investment-bank titans of Wall Street, had gone bust. Merrill Lynch, another giant, had sought rescue. The world’s biggest insurance company, AIG, was having to be salvaged by the US government. It was, said the budget director of the White House, “an economic 9/11”.

And now some of the biggest banks on Britain’s high street were under pressure. It seemed incredible that such a large and venerable institution as HBOS, formed from the merger of Halifax and Bank of Scotland, could be in difficulty - but it was.

Across the country, brokers, bankers, bricklayers, hedge fund managers and housewives were wondering: “What the hell is going on?” and, if only quietly to themselves, “Is my money safe?”

Mills is no alarmist, but he had cash in the bank far beyond the £35,000 guaranteed by the government. Though the authorities surely wouldn’t, couldn’t allow high-street banks to fail, nothing seemed certain any more amid the worst financial crisis since the 1929 crash brought the Roaring Twenties juddering to a halt.

While Mills (not his real name) sought sanctuary in government bonds known as gilts, others piled money into National Savings and Investments. Many others stayed put, reasoning, quite rightly, that panic would only make matters worse and for all they knew their bank was as safe as any.

From London to New York and well beyond, central banks began pouring $300 billion (£165 billion) into the financial system to stave off an even greater meltdown.

So serious is the threat that this weekend governments are thrashing out plans for the biggest financial bail-out in history, hiving off up to one trillion dollars - that’s $1,000,000,000,000 - of bad debts incurred by private institutions into new, government-controlled entities.

The aim is to stop an implosion of the financial system. It will give more time to manage the mountainous bad loans and dodgy assets, but the final cost, as yet unknown, will land on taxpayers. The 1980s bail-out of US savings banks ended up costing taxpayers nearly $300 billion at today’s prices - and this crisis is much worse.

On Friday, however, hopes of success stabilised markets. Shares rebounded in the belief that the immediate threat to banks was past. The FTSE 100 index of leading companies posted its largest single-day rise, soaring by 8.8%.

Gordon Brown, rushing to take credit for helping to save HBOS, said: “We will continue to act quickly and decisively to safeguard the stability of our financial system over the weeks and months ahead.”

Others are more doubtful of the longer-term prospects. “We are not out of it all,” said George Soros, the billionaire trader who has long warned of disaster. “In some ways we are still walking into the storm rather than out.”

Either way, there is no denying the epochal scale of events. Even if the bankers escape with their yachts and mansions, the financial system that fuelled huge bubbles in housing and credit faces structural change and new regulation. The impact on the wider economy and our daily lives is only just beginning.

In Britain one investment bank predicted this weekend that if the credit crisis continues, unemployment could rise by 1m over the next 18 months. Economists also suggested that government borrowing could reach £100 billion. As recently as March, Alistair Darling, the chancellor, said it would be less than £40 billion. Drastic cuts in spending or big tax rises are bound to follow.

After 16 years of growth, it raises big questions. Are the good times at an end? And where will all this turbulence lead?

AS THE credit crunch continued to bite hard this summer, optimism still levitated Lehman Brothers, an investment bank that epitomises how the boom has turned to bust. Its boss, Dick Fuld, was a “master of the universe”. Fuld didn’t believe he and his bank could ever be swallowed by a black hole. When he took the helm of the bank in 1993 it was a lightweight; by last year it was a behemoth with revenues of $19 billion.

Under Fuld, whose career as an air force pilot ended after he got into a fist fight with his commander, the bank expanded aggressively using “leverage” - in simple terms, other people’s money - and new financial instruments that ratcheted up risk and reward. He was such a big, swinging Tarzan that he became known as the Gorilla of Wall Street.

Lehman’s size and profits soared, bringing huge rewards for Fuld and the bank’s staff. During his tenure Fuld cashed in $450m from the business, quite apart from having many millions more still tied up in the bank’s shares. He graced numerous boards and had grand homes in Manhattan, Florida and elsewhere. In his contract was a clause that he should be paid $240m for “involuntary termination”; if he became disabled or died, he or his heirs were entitled to $430m.

As part of his drive for ever bigger profits, however, the bank began making loans to riskier borrowers, creating on top of them a vast edifice of contracts known as derivatives, struck with all sorts of trading partners. All was hunky-dory while prices kept rising, but when house prices began to collapse last summer and the credit crunch hit, the value of these assets grew more and more doubtful. They were simply no longer worth the billions that the bank had claimed.

This is at the heart of the crisis besetting global markets: a deep loss of confidence in the value of many assets created by modern financial methods.

Investors began to sell Lehman shares, which a year ago stood at more than $60 (£33) apiece. By May they were below $50. Then the rout really began, the price plummeting to below $20 by September. Fuld, to his bitter chagrin, had to seek help, wherever he could find it.

He even held talks with Korean investors. The Koreans to buy Lehman, one of the great names of US capitalism? Fuld couldn’t bring himself to strike a deal.

In London last week, one employee of the bank, a middle-ranking executive who asked to be identified only as David, described the chaos: “The whole crisis suddenly went from amber to red when it emerged the Koreans weren’t interested. If you’re talking to them, you’re up shit creek. Then they say no. You’re dead.

“We watched here, staggered, as the share price went beneath the all-important psychological level of $10 to $7.

“We brought forward results, unveiled a strategic review, which frankly was a half-arsed plan. They were talking about selling a 55% interest in the asset management. What’s the point? Sell the whole f***ing thing. It was total arrogance and misunderstanding of how serious it was.

“Then on Thursday [September 11] the share price went down to under $4, and that was effectively game over.”

In London and New York, the state authorities were horrified at the prospect of Lehman and Merrill Lynch, an even bigger Wall Street bank, collapsing - yet reluctant to save private bankers from their recklessness. Early on Friday evening nine days ago, Wall Street’s finest were summoned to a meeting at the New York Federal Reserve Bank.

Timothy Geithner, president of the NY Fed, told them: “There’s no political will for a federal bail-out. Come back in the morning and be prepared to do something.

In London, Lehman staff, including David, were told to go home and keep their BlackBerrys on. “All day Sunday I had the BlackBerry on; nothing happened,” he said. “Then en famille [he has a wife and children] we were watching Tess of the D’Urbervilles on the BBC, BlackBerry on. Nothing. Then on came the 10pm news - boom! Lehman, America’s fourth largest investment bank, files for bankruptcy.

“My wife was really shocked. She kept saying: ‘You see; you see - I told you. You showed blind faith and they’ve done nothing but shit on you. What does it mean?’”

“I said, ‘I don’t know - maybe we’re f***ed.’ She’s hideously worried, but I’m an optimist. Sometimes there’s a pretty strong clash.”

Lehman reckoned it had liabilities of $613 billion and assets worth $639 billion. But nobody trusted the quality of those assets. Without a buyer and strapped for cash, it had been forced to make the biggest bankruptcy filing in US history, an extraordinary humbling of both Fuld and Wall Street.

Like David, thousands of bankers feared for their jobs. In an internal memo to staff, Fuld said: “I know that this is very painful on all of you, both personally and financially. I feel horrible.”

In a jarring mix of corporate-speak and reality he added: “The past few months have been extraordinarily challenging.”

Staff were not impressed. “People are furious,” said David. “I heard that Dick Fuld has been seen in the New York office with bodyguards - as well he might.”

Naveed Chaudhry, an Oxford graduate who joined the bank 15 months ago, said: “I guess there was a feeling that success was something we had a right to. That attitude has gone for ever now.”

Merrill Lynch had been luckier, managing to strike a last-minute rescue deal with the giant Bank of America. It didn’t solve Merrill’s problems with billions of dollars of dubious assets - but it at least gave it breathing space.

To many ordinary people, the crisis seemed mostly a matter of shiny-suited bankers getting their comeuppance. So what if some overpaid, overweening City types fell to earth, they thought. Sainsbury’s was still there. Strictly Come Dancing was on the telly. Cristiano Ronaldo was back playing for Manchester United. Normal life would go on.

The great financial unwinding, however, was about to hit much closer to home.

IN Downing Street the collapse of Lehman intensified the fears of Brown and Darling that another Northern Rock was in the making. For weeks they had been fretting that HBOS, one of the biggest names on the high street, was at risk of crumbling under the credit crunch.

The crisis caused by the loss of confidence in derivatives had led to banks refusing to lend money to one another. Yet most lenders rely on this “wholesale funding” for part of their business.

HBOS depended on it more than most. It had about £456 billion in loans to customers and £258 billion in deposits from customers. That left a “funding gap” of £198 billion. In normal circumstances HBOS would raise this money in the wholesale money markets, but the credit crunch was making it increasingly difficult.

The bank had already struggled to find £4 billion to shore up its capital base. Property prices were still subsiding. The problems were getting worse. Lehman’s collapse crystallised the need for action.

On Tuesday morning Darling chaired a hastily convened summit in the ground floor sitting room of No 11 Downing Street with Mervyn King, the Bank of England governor, Callum Mc-Carthy, chairman of the Financial Services Authority, the City regulator, and his successor Adair Turner, due to take over as chairman later this month.

Their officials reported that “short-selling” in the stock market - traders trying to make money by driving down share prices – had added to HBOS’s difficulties, but was not the main cause of its woes. The bank’s business model meant it would be vulnerable as long as the credit markets remained tight.

They concluded that the struggling mortgage giant no longer had a future as an independent entity. It was too big to let fail and, they thought, too big to bail out. There was only one answer: a deal with another, stronger bank, Lloyds TSB, which had been mulling over a takeover for weeks.

“It was a big decision to authorise such a deal because of the competition considerations,” said one source familiar with the talks. “But at the same time they were clear there could be no Northern Rock-style bail-out. The Lloyds plan was the only one on the table."

Darling contacted John Hutton, the enterprise secretary, who oversees the Competition Commission. Hutton has a reputation as an abrasive figure who often clashes with cabinet colleagues, but he instantly saw the need to act.

There was near-panic in Whitehall when news of the “merger” talks broke early on the BBC on Wednesday morning. “We did not leak anything,” a Treasury source said. “It was in our interests to keep this tight. But once it was out, there was a race against time. Alistair knew a deal had to be concluded by that night otherwise there would be a run on the bank.”

The spectre was of people queuing round the block, as with Northern Rock, to get their money out - which would precipitate the very collapse they feared. Mayhem, contagion, more banks under siege. It didn’t bear thinking about. This time Darling and the bankers did not delay.

For even as the fate of HBOS was being decided, news reports were coming in of chaos at American International Group (AIG), a giant insurance and financial services company with tentacles all over the world - including a £56.5m sponsorship deal with Manchester United (which all helps to pay Ronaldo’s wages). Fears that it might go bust had sent AIG customers scurrying to its offices, some trying to cancel or cash in policies. A run was in the making.

Like so many others, AIG had chased profits through derivatives that were now imploding. Facing the need to stump up $14 billion, it was desperate for cash. According to one estimate, further downgrades to its assets meant that the following week it might need $250 billion to meet liabilities.

The US authorities, only days after refusing to bail out Lehman, were now confronted by a crisis on a far greater scale. This time they couldn’t take the risk of letting AIG go bust: the fallout would be utterly devastating. They caved in and rapidly agreed to prop up the firm with an injection of $85 billion.

Still the uncertainty spread like wildfire. Shares were plunging so crazily in Russia that the authorities closed the market. Dmitry Medvedev, the president, ordered a 500 billion rouble (£10.7 billion) rescue package to support Russian companies.

In the UK, RBS shares were hit by rumours over the bank’s “funding gap” of £160 billion, though it was in the end seen as able to cope.

Also in the cross-hairs was Morgan Stanley, as sellers turned on its shares with a vengeance. So frenzied was the market that one former trader, now a Cambridge researcher, suggested that cortisol, a natural steroid produced by the body, played a part in the mania.

His studies have shown that in volatile markets the level of cortisol in traders’ bodies can rise by 500%. Cortisol affects behaviour by reducing the appetite for risk: it may encourage selling.

As panic gripped the market, fear gripped Morgan Stanley’s staff, as an employee in the London office, who asked not to be named, described last Thursday. “I don’t know what the future is,” he said. “The market is being stoked by panic, and panic destroys confidence - and confidence is the key to financial services.

“I can’t really tell you where Morgan Stanley is going. I mean, we produced some great figures this week, profits better than Goldman [Sachs, a Wall Street rival], liquidity of $180 billion - that’s probably bigger than some African countries. But there’s panic and it erodes any common sense. You have very great difficulty trying to argue against it.”

Why the lack of confidence? Why did people no longer believe banks and their figures? The staffer then made comments that illuminate another key factor in this crisis: not everyone has been honest.

“Other banks have had difficulties and I think probably have not been as straight with the market as they should have been,” he said. “It’s part of the loss of confidence.

“I don’t get that sense when people talk of Morgan Stanley. We are confident of our asset valuations. If we thought they were going to fall, we took the full hit. But that is clearly not the case with some other banks - and even not some banks that are continuing right now.” In other words, some people have lied and are still lying.

ON THE face of it, the caped crusaders swooped down from government heights and came to the rescue. From the steps of the White House on Friday morning, Hank Paulson, the US treasury secretary, announced plans for the government to guarantee $50 billion of money market funds (a common investment hitherto thought safe) and to take some $800 billion of troubled mortgage and other debt assets off the hands of the banks.

“The federal government must implement a programme to remove these illiquid assets that are weighing down our financial institutions and threatening our economy,” intoned Paulson, promising the programme would be large enough to “have maximum impact”.

Stock markets soared in relief. Newspaper front pages hailed the “big bounce”. Kapow! Bad debts knocked out. Okay, folks, the show’s over. Everything’s back to normal.

If only it were that simple. The humbling of the banks means that credit is not going to be free and easy again for a long time. On Friday, in fact, a British mortgage provider called First National raised interest rates by 0.8% for people borrowing less than 80% of the value of a house and by 1.6% for those borrowing more. Others are likely to follow.

Meredith Whitney, a prominent US analyst, predicted that tighter credit will mean even bigger falls in house prices: “The impact of lower liquidity will surely be lower home prices . . . we believe peak-to-trough levels will be far worse than 33%.” In other words, house prices will fall more than a third from their peak.

Roger Bootle, head of Capital Economics in London, said: “It is difficult to believe that the outlook has materially improved . . . the decisiveness of the policymakers’ actions is a reflection of the gravity of the ongoing problems in the financial sector.

“What news there has been on the real economy continues to worsen. As such, we remain distinctly concerned over the outlook for the UK economy.”

The ratings agency Standard & Poor’s predicts that a further wave of massive losses from sub-prime loans - potentially double the level previously forecast - will hit banks in the next few months. “The second half of 2008 may prove to be the most difficult test yet for the battered global financial sector,” it said in a report published last week but largely overlooked in the chaos.

Britain is particularly vulnerable because its housing bubble has been one of the biggest and financial services have grown to be such a significant part of its economy. Unemployment is rising and growth slowing. Government borrowing is out of control.

Despite the rescue plans, the dangers are still grave in the eyes of Nouriel Roubini, an American economics professor known for his doom-laden predictions - many of which have proved correct.

“There is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt,” he warned last week. Hundreds of US banks are at risk, he believes, because US households have been swamped by debt and now the value of their assets is falling. The only way out of the downward spiral, he says, is a massive government programme that leads to “significant debt reduction” for ordinary people.

The advantage governments have, unlike banks, is time. Backed by the ordinary taxpayer, who has little opportunity for escape, they can take on and manage debts over the long term and, hopefully, muddle through. Optimism and ingenuity will find a way. In the end they may even make a profit in some areas.

Willem Buiter, a professor at the London School of Economics, believes that the US government struck a tough deal over AIG that could eventually make money. He also suggests that losses on mortgages through Fannie Mae and Freddie Mac, two giant companies that have also had to be rescued by the government, could be contained if correctly managed.

“It depends what [the US] Congress makes them do,” he said. “If they could hold these assets to maturity, the taxpayer ought to do all right.” But in Buiter’s view, if the government bails out homeowners too much, the bill will have to be met “through spending cuts or higher taxes”.

As for the bankers: are they getting away with it?

For all the talk of Wall Street never being the same again, some characteristics appear to have survived the fallout. Shareholders of Barclays may reflect this weekend on its decision to put aside $2.5 billion in order to pay the salaries and bonuses of the Lehman Brothers employees in New York that it bought in a fire sale of the collapsed bank last week.

Some critics say the vast government bail-out is “socialism for the rich”. The bankers keep their bonuses; the taxpayer picks up the losses.

Brown clearly knew what message he wanted to put across on Friday. He used the word “decisive” three times in the space of a couple of sentences about the government’s role in the HBOS rescue. But he and other politicians are under pressure to exact a price to match the taxpayers’ investment in saving the financial system, which is likely to be tougher regulation.

Last week John McCain, the Republican presidential candidate, railed at Wall Street for “corruption” and “greed”, and Barack Obama, the Democratic candidate, talked of the need for tax cuts for ordinary households rather than the rich, who were favoured under President Bush. The crisis seemed to swing polls in Obama’s favour. From trailing at the beginning of the week, he had a two-point lead over his rival by the weekend, surveys suggested.

In the midst of the drama last week, one trader declared: “The world is on the brink. The market is puking all over us.”

It was hyperbolic but apt. Whether recovery is relatively swift or protracted is not yet clear. But the bankers’ lavish feast of recent years is over, for now at least, and it’s the waiters, the kitchen staff and the ordinary passers-by who will have to clear up the mess.

Additional reporting: David Smith, Jonathan Oliver, Brendan Montague and Tony Allen-Mills in New York

Watch out, everyone - the Chinese are not happy

As the axis of the world economy tilts towards Asia, China’s reaction to last week’s events is worrying, writes Michael Sheridan.

Its stock markets plunged but more concerning was the emergence of a popular backlash against investing its growing wealth abroad.

Ferocious criticism from leftists and unofficial market commentators has turned public opinion against such ventures after ill-timed Chinese investments in Morgan Stanley, Barclays, the private equity firm Blackstone and the US mortgage giants Freddie Mac and Fannie Mae.

“Some of that has gone up in smoke,” said Guo Quan, a professor at Nanjing University. “Our foreign reserves are the fruit of the Chinese people's sweat and toil - who should be responsible for these losses?” There have already been calls for an investigation by the National People’s Congress, China’s usually docile parliament, into China Investment Corporation, the finance ministry and the central bank for their handling of the country’s dollar reserves.

"Why did China increase its bondholdings just on the eve of the sub-prime mortgage crisis?" demanded Liu Menxiong, a member of a political consultative body.

Last week the media reported prominently that several Chinese banks held bonds from Lehman Brothers, which has now gone bust.

Many analysts say China has so many investments at stake that it must help to support the United States, whose debts have long been funded by foreign investors. But if that sentiment changes, more trouble looms.

Why the short-sellers were not to blame

When John Mack, chief executive of Morgan Stanley, the beleaguered American investment bank, attacked short-sellers last Wednesday “for driving our stock down” it gave the financial tragedy the villain it needed, writes Kate Walsh.

No longer would commentators have to rely on complex banking models to explain the financial crisis, they could point to people - and very rich ones at that.

By Thursday morning newspapers were filled with pictures of hedge fund managers who had previously “shorted” HBOS stock - a way of making money when share prices go down, which in theory tends to make them go down even further.

Phil Falcone, the multi-billionaire founder of Harbinger Capital Partners Funds and poker-playing David Einhorn of Greenlight Capital, were singled out because their respective hedge funds had been “short” on HBOS last June when the bank was undertaking a rights issue to raise money.

A hue and cry ensued, with Alex Salmond, the Scottish first minister, denouncing the “spivs and speculators” who had brought down the bank.

This weekend, however, evidence emerged that Salmond and the others who blamed the short-sellers had got it wrong.

The practice of short-selling needs owners of a firm’s shares to lend them out to speculators, who then sell them and try to buy them back later at a cheaper price. By finding out the proportion of a company’s stock that is out on loan at any time, a good assessment can be made of how much short-selling is taking place.

In the case of HBOS, just 2.75% was on loan last Monday, according to Dataexplorers.com, which monitors shareholdings. Similarly, with Morgan Stanley only 2.9% was on loan just two days before Mack declared war on short sellers.

With such a small amount of shares available to them, the short-sellers would not have been able to influence the decline in the banks’ stocks that was witnessed last week. That was the result of simple lack of confidence. “It was fear driving the shares down,” said a senior hedge fund manager. “It wasn’t the ‘evil hedge funds’ shorting the life out of something.”

Indeed, this weekend Hector Sants, head of the Financial Services Authority, the City’s regulator, admitted that short-sellers were not to blame for HBOS’s fall.

Bubbles

Are inflated prices and pay in these areas the next to go pop?

Art Prices for some contemporary art have jumped by 55% in a year. Last week Damien Hirst sold 218 works for £111m at auction, a record for a sale by one artist.

Football In August Frank Lampard became Britain’s highest-paid footballer when he signed a new contract with Chelsea worth £140,000 a week. Three weeks later Brazil’s Robinho signed for £160,000 a week at Manchester City.

Fine wine Prices for top vintages from classic estates, including Château Lafite Rothschild, have nearly doubled in two years.

Explore UK News

• Crime News

• Education News

• Health News

• Science News

• Scotland News

Times Recommends

• Sarah Brown says 'no thanks' to veal at G8 - twice
• Stockton-on-Tees is obesity capital of Britain
• Stores blame poor sales on Murray factor