It turned out that Wall Street's most profitable institutions stood on the shakiest of foundations, writes Denis Staunton

WALL STREET traders have long been early risers but few are used to starting their working day at 3am - as they did in the days following the collapse of Lehman Brothers last September. The traders were at their posts in the middle of the night to watch the European markets opening, often heralding another dreadful day in New York.

It has been a year when Wall Street has been turned upside down and reshaped as never before, leaving all five big investment banks either gone or transformed, while other financial institutions were taken under government control.

The lightning flashed in the second quarter of 2007, when two mortgage funds operated by Bear Stearns went bankrupt and the market for mortgage securities seized up. The US housing bubble had already burst and, as home values fell, mortgage defaults rose, driving prices down further.

The first serious rumble of thunder was heard on Wall Street in March, when Bear Stearns itself narrowly escaped collapse by agreeing to a shotgun marriage to JP Morgan Chase. The deal valued Bear's shares, which had been worth more than $150 each a year earlier, at just $10.

Bear Stearns had been among the pioneers of mortgage-backed collateralised debt obligations (CDOs) - complicated securities based on pools of mortgages. CDOs were often constructed with the help of ratings agencies so that they received AA or AAA ratings - suggesting they were as safe as treasury bonds.

As property prices soared in the first half of this decade, investment banks loaded up on CDOs - ignoring the fact that many of the mortgages that backed them were issued to "subprime" borrowers with poor credit histories. When subprime borrowers - some of whom had mortgages known as "liar loans" that required no proof of income - started to default, big US home loan companies like Washington Mutual and Countrywide saw their shares slide.

On September 7th, the federal government seized control of Fannie Mae and Freddie Mac, government-chartered companies that hold or guarantee more than half the mortgages in the US.

A week later, however, Treasury Secretary Hank Paulson refused to rescue Lehman Brothers, a 158-year-old investment bank that was leveraged at a ratio of more than 30 to one.

The same weekend, federal officials arranged for Merrill Lynch to step under the wing of Bank of America and a week later, Goldman Sachs and Morgan Stanley agreed to become commercial bank holding companies. By the end of September, the age of investment banking on Wall Street was over.

Lehman's collapse caused the credit markets, which were already tight, to seize up completely and the US government was forced to put together a $85 billion rescue package for insurance giant AIG. Washington Mutual was seized by federal regulators and Wachovia was pushed into a merger with the healthier Wells Fargo.

Paulson, himself a former Goldman Sachs chairman, decided that what Wall Street needed was a $700 billion federal bailout. His plan was for the government to buy up the most toxic securities from the financial institutions, with a view to shoring up the banks' balance sheets and getting credit moving again.

The US public was outraged at the idea of bailing out the Wall Street buccaneers who had helped to create the financial crisis by taking irresponsible risks with other people's money. Despite heavy lobbying from the White House and the grudging support of both presidential candidates, the bailout was rejected by the House of Representatives on September 29th, sending stock markets into a tailspin.

Public opinion shifted dramatically in the days that followed the vote, as the Dow Jones plunged by almost 800 points. As they watched their retirement savings melt away on the stock market, Americans were persuaded that something had to be done and, in the first week in October, Congress passed the Troubled Asset Relief Programme (Tarp).

By now, Paulson had second thoughts about buying up troubled securities and he instead used the bailout funds to recapitalise the leading banks by taking equity stakes in them.

President-elect Barack Obama has promised to review the Tarp to make sure that banks that receive government help start lending again to businesses and consumers. He has also pledged to toughen the financial regulatory system in an effort to ensure that, once the current crisis passes, Wall Street cannot return to its old, reckless ways.