Jeremy Warner's Outlook: Wall Street and the City get their comeuppance

As the credit crunch enters a new and more lethal phase, all prediction has become essentially worthless. The events of the last 48 hours are without precedent on Wall Street and in the City. Nobody knows how they are going to pan out.

If you had said even a year ago, by which time Northern Rock had already gone cap in hand to the Bank of England, that Lehman would collapse, that Merrill Lynch would be forced to succumb to a rescue takeover, that numerous others would have to be bailed out by their shareholders or the sovereign wealth funds of the developing world, or that the share price of HBOS would drop more than 30 per cent in a single day, as it did yesterday, you would have been thought mad.

In any case, many of the instant judgements already being made off the back of this weekend's events are likely to prove as misguided as those that followed the immediate aftermath of 9/11, when it was widely said that people would never fly again, or work in tall buildings. The only thing that can be said with any certainty is that the latest bombshells don't bode well, not well at all.

In its 158-year history, Lehman Brothers has survived numerous economic contractions and financial crises, including the Great Depression. But not this one.

In finishing off one of Wall Street's most venerable names, a crisis that had its origins in American sub-prime mortgage lending has succeeded where countless decades of war, pestilence and economic catastrophe have failed.

The tragedy of it all is that Lehman and its fellow investment banking goliaths only have themselves to blame. Hank Paulson, the US Treasury Secretary, spoke last night of the need to cleanse the financial system of past excesses so it could begin afresh. A decade of greed- fuelled hubris has brought Wall Street's "masters of the universe" to their knees.

The crisis might have claimed Merrill Lynch, too, had not its chief executive, John Thain, realised that the game was up and agreed to sell to Bank of America while he still could. It's a humiliating end for the "thundering herd", but not nearly as bad as the one that has befallen Lehman. By selling up, Mr Thain salvages at least something for the shareholders while at the same time creating a fire break that will hopefully prevent the inferno spreading further through the banking landscape.

Mr Thain knew only too well that, after the markets had finished with Lehman, it would be him next. Unlike his opposite number at Lehman, Dick Fuld, Mr Thain was not about to hang around to find out whether the bank was strong enough to withstand the pummelling. Sell early, sell fast, has been one of the big lessons of the financial maelstrom.

Will Wall Street's "bloody Sunday" do the trick in providing the explosion necessary to quell the wider fire? As I say, nobody can really know. In times past, the wider collateral damage inflicted by the collapse of even a very substantial wholesale bank might have been limited. There's no depositor base to be harmed, and the likelihood is that other creditors would be widely spread.

Many will in any case think that the financiers are only getting their just rewards. There was something faintly obscene about the world's most high-paying organisations being repeatedly bailed out by the taxpayer.

Had investment banks been factories filled with blue-collar workers, they would have been sent to the knacker's yard long ago, with the investment bankers cheering from the sidelines as they preached the virtues of the creative/destruction of capitalism.

The prevailing wisdom about banks, on the other hand, is that they cannot be allowed to fail because of the damage this would inflict on the wider economy. Infuriatingly, bankers manage to reap the rewards in the good times and then make the taxpayer bankroll the losses in the bad.

The calculation made by Hank Paulson, in allowing Lehman to sink, is partly political. There's a presidential election coming up, and the last thing the Republican administration wants is a reputation for bailing out its rich friends on Wall Street.

The other bit of the calculation is that Lehman's collapse had been reasonably well flagged. The fact that everyone was half expecting it makes the likely damage less severe than if it had come out of a clear blue sky. Unlike Fannie Mae and Freddie Mac, or even Bear Stearns, which has a major position in US local government finance, Lehman is not that important to the US economy.

There was a feeling in the US Treasury that at least one major bank had to be allowed to go under, if for no other reason than pour encourager les autres. Lehman has been allowed to die, but the next most vulnerable, Merrill Lynch, has been saved.

Allowing Lehman to fold may even come to be seen as politically and economically quite clever. Mr Paulson appears to have drawn a line in the sand which answers allegations thrown at the federal authorities of creating moral hazard. Yet it's a big gamble. The US Treasury knows no better than you or I what the consequences might be.

At the last count, Lehman had some $729bn of positions out there in the capital markets, which now need to be unwound. That's an awful lot of counterparties. The chances of multiple defaults through the financial system would seem quite high.

To ease the pain, central bankers have again injected huge amounts of extra liquidity into the system. There's also to be a $70bn liquidity pool set up by ten of the world's leading commercial and investment banks. Whether these lifeboats will be sufficient to support a system once assumed to be as unsinkable as the Titanic is anyone's guess.

In most of us non bankers, there is a puritanical streak that welcomes the sight of mammon receiving its punishment. Yet we are not going to be quite so pleased once it starts to affect our own pockets, as now inevitably it must. Some financial crises have little or no effect on the real economy – the crash of 1987 and the collapse of Long Term Capital Management in 1998 immediately spring to mind. Regrettably, this does not look like one of them.

For a start, it is much bigger and more global than either of those two. The mere sight of so much financial destruction has hit business and consumer confidence. For the London and New York economies, there is also the trickle- down effect of so many highly paid professionals losing their jobs.

Yet the bigger effect is on the creation of credit, which has been one of the main dynamos of growth these past 15 years. The motors of credit creation, the banks, have now been put into reverse gear. Balance sheet expansion has been replaced by balance sheet contraction. The belief that there would be unlimited, and always-on, quantities of wholesale funding available to banks to lend has been shattered. Scarcity has taken the place of excess.

The effects of this can be seen most immediately in the present mortgage famine, but there is also growing evidence of the credit squeeze being applied more generally to the consumer and small business sectors. Less credit equals less money equals less business.

I've said that prediction is futile, so I should stop myself before I start. Yet we already know that Wall Street has been changed for ever by the events of the last year, and that what the markets have begun the regulators will finish. Bankers can in future expect a more tightly regulated environment that will severely restrict their freedom of action. Mr Paulson referred last night to "major regulatory change".

Yet though Mr Paulson thought that it was the "archaic" nature of much financial regulation which is at fault, it is perhaps the lack of it which has been the real problem.

The abandonment in the late 1990s of the Glass-Steagall Act, which among other things enforced a rigid separation in the United States between commercial and investment banking, rounded off an unprecedented period of liberalisation in the affairs of financial markets. They have not used their new-found freedoms well.

This may always have been inevitable. Putting together the bonus-driven rainmakers and financial innovators of Wall Street and the City with the balance sheet strength and lending abilities of the commercial banks looks with the benefit of hindsight to have been a recipe for disaster. Quite how vicious the regulatory backlash proves to be depends on how bad the consequences become for the taxpayer and the real economy. We'll see.