Nightmare on Wall Street

To lose one major investment bank in the course of a weekend, to paraphrase Oscar Wilde, might be considered a misfortune. To lose two looks dangerously like a catastrophe.

By Sunday night, after a tumultuous weekend of round-the-clock negotiations orchestrated by the US Federal Reserve and the Treasury, it looked likely that Lehman Brothers and Merrill Lynch, two of America’s most famous financial names, would cease to operate as independent institutions at the opening of business this morning.

That would mean Wall Street may have just had its most extraordinary weekend in at least the last 50 years, with the worry that even worse may still be to come.

How did we get here? There are two answers to this basic question:

The immediate explanation is that the US government decided that it simply could not afford - in the interests of prudential supervision - to rescue yet another bank. Someone had to be shown to be not too big to fail, and it looks like it was Lehman.

In March, the Federal Reserve helped JP Morgan acquire Bear Stearns, a controversial decision that could cost the authorities almost $30bn. The Fed defended the move as essential to saving the whole US financial system from going down.

But having dipped its hands in the blood of the financial markets the Fed decided it simply could not do so again without in effect committing itself to a completely open-ended guarantee of every financial institution that found itself in trouble.

The second, deeper explanation, is that this is merely the most dramatic symptom yet of the disease that continues to ravage the US financial system.

The balance sheets of too many US banks are awash in toxic assets. Most of them can be traced back to wildly negligent investment decisions made during the boom in house prices and other assets in the last five years. In the last eighteen months US house prices have fallen by more than at any time in the last 70 years and a whole host of assets that were backed by that market have become worthless.

This may be more than just another catastrophic end to another financial cycle, however. It could be the end of a whole financial model - investment banking itself.

“It’s probably no exaggeration to say we are witnessing the end of an era’ said one seasoned financial executive watching events unfold at the weekend.