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These greedy bankers have cost us billions

'I see nothing in the present situation which is either menacing or warrants pessimism ... I have every confidence that there will be a revival of activity in the spring and that, during this coming year, the country will make steady progress.' In fact, 1930 turned out to be the year in which the Wall Street Crash was followed by the slump. Mellon's forecast, which proved so mistaken, was probably as good an economic forecast as could have been made at the time. Mellon was no fool.

We cannot now be sure whether last week's crash in world stock markets will prove to be a healthy correction after a period of inflationary finance or the start of a more profound and dangerous readjustment, possibly even a slump. We know many financial institutions, ranging from international banks to speculative hedge funds, have lost a great deal of money. We know that the world stock markets have fallen sharply. We know this has affected the confidence of the world banking system. But we do not know what to expect next. On the face of it, the world economy is still in flourishing shape. That was the official line in 1930, the view of President Herbert Hoover as well as of Secretary Mellon. Yet the world's bankers have made some quite remarkable misjudgments.

The underlying mistake of the bankers in 1929 and again in 2007 was bad lending leading to 'defaults', cases of people not repaying loans. In 1929, the excess lending was in Wall Street stockbrokers' loans to people speculating in shares. The defaults occurred when the speculators could not repay these loans because the shares they had bought had collapsed in value. In 2007, the bad lending has been on sub-prime mortgages — loans to borrowers who were poor or had bad credit histories — in America, and the defaults are appearing in the form of mortgaged properties being repossessed.

As is usually the case in human affairs, bad judgment has played an important role. The world of finance has always had a sheeplike quality; if the leading ram thinks it's safe to go to the water trough, the subservient ewes will follow.

In the old days, a phrase that refers to years as recent as the Nineties, prudent bankers did not want to lend money to people who were unlikely to repay them. Why did they suddenly acquire such an unwholesome enthusiasm for doing just that? They had discovered that they could sell these loans to someone else and make a profit out of doing so. The market for collateralised debt opened a new way of doing the banking, but selling on the risk. This was the first mistake and the worst.

The original mortgage banks thought they could safely take on what they knew to be bad risks because they intended to sell them to someone else. The ultimate purchasers of these mortgages relied on the underlying value of the houses, not of the creditworthiness of the borrowers, of whom they knew little or nothing.

That goes against a principle of good banking: bankers should look to the borrower and his future ability to pay, not primarily to the security. No bank wants to be forced to foreclose on the security, let alone to acquire the tens of thousands of houses in America that are subject to sub-prime mortgages. Some banks may find themselves the reluctant owners of scattered estates of lowgrade homes. After the event, everyone can see the flaw in the original argument. The banks seem to have forgotten the high interest rates on sub-prime mortgages reflected the high risk of default. High yield relates to high risk. There is indeed no free lunch.

The world banking system treated these securities as a proper basis for further lending. Banks sold their loans to hedge funds ñ though not all hedge funds joined in this game ñ and then lent money to private equity funds, who used it to finance the purchase of slow-moving companies, such as Boots. Either through hedge funds or private equity, the money reached the stock exchanges and that supported share prices. It is wrong for banks, who are money professionals,to sell high-cost mortgages to poor people who are likely to default when interest rates rise. Responsible banking involves a duty of care to clients. Banks dealing with other banks are dealing as professionals with professionals and are entitled to assume a measure of judgment and competence. American mortgage banks have lost a lot of money, to the point where the solvency of some of them is in doubt. Some hedge funds have also lost money and look more like incompetent speculators than prudent investors. The flow of funds for private equity purchases has almost dried up, particularly for large deals. The stock markets of the world have fallen sharply, which has damaged pension and life assurance funds. Whatever the long-term effects, there is a lot of immediate reputational damage.

In its origins, this shock has been a disorder of the financial sector. Mellon's optimistic views in January 1930 were based on a similar contrast between the healthy state of American trade and industry, and the panic that had overtaken the stock market. Governments and central banks are now working to confine the damage to the financial sector. So far they seem to be doing so successfully, but these are early days.

There are a number of ways in which the financial shock could lead to a broader recession in the world economy. The first is the direct impact of more limited lending. Private equity funds and hedge funds have purchased stock that supported stock markets. The free availability of debt encouraged industrial expansion and private consumption. Conversely, the limitation of lending can be expected to have a deflationary effect.

A second negative impact will come from the stock market falls, though there will be fluctuations and an eventual recovery. The third impact may come in falls in house prices, certainly in the US and perhaps in Britain. Lower house prices could lead to a general reduction in American consumption.

Wal-Mart has already given a mild profit warning. American consumption is huge and is a dominant factor in determining the level of world trade.

I still have some confidence that 2007, like the panic year of 1987, will be remembered as a difficult year in a prosperous time, not as the year that stopped the clocks. I do not feel sure.

But I do believe the world's banks need to get back to basics. Bankers are not there to be too clever; they should remember they depend on their clients who trust and need them as honest advisers as well as financial intermediaries.

Lord William Rees-Mogg is a veteran British journalist. This article first appeared in the Mail on Sunday