At the begining of last year a City reception at the Mayfair ancestral home of Diana, Princess of Wales, would have symbolised the height of the boom times. The pink champagne and lashings of easy money fuelled merger deals that turned Britain’s chief executives into billionaires.

The gold-encrusted ceilings and Roman murals of Spencer House were looking as opulent as usual on Monday when Citigroup hosted a gathering of the City’s great and good. Yet the financial picture was dire. This year the deal of the night was a hurried rescue of Britain’s biggest mortgage and savings bank — and possibly the political life of the Prime Minister.

In normal circumstances the merger of Sir Victor Blank’s Lloyds TSB with HBOS would never have withstood the rigours of regulatory scrutiny, and rivals would have been up in arms. But these were no ordinary times. The shares of HBOS, one of Britain’s biggest mortgage banks, were plunging fast and Mr Brown knew that his political future — not just the future of HBOS — was at stake.All banks were being hurt by the storm pulverising the financial markets, but HBOS was much more vulnerable than its peers because of the way it ran its business. Hours earlier on Monday, with dealers already reeling from the collapse of Lehman Brothers, two events in the internal workings of the City helped to seal the fate of HBOS.

First, the price of borrowing money in the financial markets, known as Libor, or the London Interbank Offered Rate, leapt, as news of the Lehman rescue became apparent. HBOS needs billions of pounds a day to carry out its business but as the Libor spiked, it became more and more difficult for it to get cash. Secondly, Standard & Poor’s, the agency that rates the balance-sheet health of thousands of companies, said HBOS was “less well positioned” than its peers to cope with deteriorating financial conditions.

Rightly or wrongly, shareholders were stampeding to sell their HBOS stock because of these doubts, and opportunistic hedge funds were said to be piling on the agony by taking big bets that the price would fall further. Whether HBOS was so weakened in reality didn’t matter ultimately: the worst fears of the market were in danger of becoming self-fulfilling.

As Mr Brown and Sir Victor stood in the 18th-century mansion, they sketched out a deal. Mr Brown told the Lloyds chairman that he would pass special legislation to prevent British regulators from referring the mammoth takeover to the Competition Commission in Brussels. With that guarantee, Sir Victor said he would play ball.

The next morning, Mr Brown had a scheduled meeting at No 10 with Alistair Darling, the Chancellor, and Mervyn King, the Governor of the Bank of England. He told them of his conversation with Sir Victor and it was decided to call an emergency meeting of the tripartite authorities — the Bank, the Treasury and the Financial Services Authority — to press ahead with the rescue plan. All the while HBOS shares continued their downward spiral, falling at one point by 67 per cent.

At midday a cohort of some of the City’s most powerful men arrived at No 11. They included Sir Callum McCarthy, the outgoing chairman of the FSA who had been criticised widely a year earlier for his failure to spot the troubles at Northern Rock. His replacement, Lord Turner of Ecchinswell, was also present, as was Hector Sants, the FSA’s youthful chief executive — a former banker who had already seen to the rescue of Alliance & Leicester and Bradford & Bingley. Mr King attended too. The subject of the meeting was clear cut. To carve out a path, free of red tape, that would enable Lloyds to enter into takeover talks with HBOS as soon as possible. Mr Sants was to propose the merger formally and lead discussions with the two banks. The meeting was over by 2pm and Mr Sants got down to business quickly. He telephoned Sir Victor and gave him assurance that the regulatory issue was in hand. talks began and continued late into the night and again the next day.

It was, of course, the panic in the markets that finally killed it for HBOS as an independent bank. But the seeds of its destruction go back years. Since the 2001 takeover of Halifax by the Bank of Scotland, the board had chosen to alter the philosophy of the business. Out went what was seen as an old-fashioned obession with prudence, a hangover from Halifax’s old building society days. In came a more shareholder-focused approach that was all about creating “value”.

Out went the focus on funding itself by attracting small savers. Instead, HBOS began to shift more of its fund-raising to financial money markets, where banks lend money to each other for their daily business.

In the good times, HBOS also picked up some bad habits. Along with dozens of other banks, it started packaging mortgages into bundles and selling them on to investors, using the houses as guarantees. It was a way to raise billions of pounds quickly and it was much cheaper than the laborious business of taking small deposits over the counter from millions of small savers. The treasury operations within HBOS were massively expanded. Like many financial institutions, it was also tempted to buy up fancy instruments, supposedly backed by solid mortgages. It ended up with £7 billion of so-called Alt-A American mortgages, sometimes known as sub-prime-lite. That’s toxic waste to you and me.

Finally, HBOS relaxed its own rules on lending in Britain. It began to tolerate borrowers putting up smaller deposits. It started to push more deeply into buy-to-let lending. It decided to lend more without asking for any proof of income — a riskier corner of the mortgage market known by its practioners as “self-cert” and by the more sceptical as “liars’ loans”.

In the first half of this year, it was advancing more in net lending to these unconventional borrowers than in traditional home loans, S&P noted disapprovingly on Tuesday as it drove one of the final nails in the bank’s coffin by downgrading its credit rating.

By the spring the board had recognised the error of its ways. It was tightening lending criteria, seeking new depositors and raised £4 billion in fresh capital over the summer. But the return to its more cautious roots had come too late.

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive