Irish banks and building societies are effectively semi-nationalised under the bank guarantee scheme and recapitalisation programme

There is almost nothing good to say about Irish banking in 2008. The industry began the year, with a push from the tail of the Celtic Tiger as one of the most profitable in Europe, but ended it in disgrace, with desperate recapitalisations of the three biggest institutions and the promise of more government intervention to come.

The banks and building societies are now effectively semi-nationalised under the twin structures of the bank guarantee and the recapitalisation programme. And they are facing probably three years of serious financial pain as nasty property-related write-downs wreak havoc on their balance sheets. How did this happen? Who is to blame?

The year even started on a bum note, as Irish Nationwide chief executive Michael Fingleton celebrated a bittersweet 70th birthday that marked both the end of his role on the board and the unsuccessful conclusion of a demutualisation-and-sale process that left members hoping for large windfalls but getting nothing. Nobody wanted Irish Nationwide at a price acceptable to Fingleton – reportedly somewhere between €1.5bn and €2bn. Thus the paradigm for the year was set: there are the prices bankers believe in and then there are the prices the market sets.

The market was relatively kind to Irish banks for the first quarter at least. Even though the Iseq was the worst-performing index in the word for financials in 2007, there was some resilience in share prices in the first two months of the year. But the clouds were gathering.

In February Bank of Ireland trimmed its earnings forecasts and AIB admitted it was monitoring 8% of loans to developers for defaults. The banks were peeking into the abyss. Then came the plunge.

Many commentators point to the Lehman Brothers collapse in mid-September as the signal event in the financial crisis. However for Irish banks the real distress became evident when Bear Stearns nearly went to the wall as nervous depositors fled the investment bank over liquidity fears. Bear was ultimately rescued by the Fed and JP Morgan, but not before unleashing a worldwide panic over bank shares. This was the Paddy's Day Massacre, so-called not only because it fell on 17 March, but because Irish banks were most severely punished.

The biggest victim was Anglo Irish Bank – then still under the guidance of chairman Seán FitzPatrick and chief executive David Drumm – which shed nearly a quarter of its value in a sustained sell-off as shareholders decided the bank's property-lending exposures no longer warranted long-term investment.

Anglo maintained it was the victim of malicious hedge fund rumours and goaded the Financial Regulator into a Potemkin investigation. That investigation has so far yielded absolutely nothing, and seven months on, it looks like the Saint Patrick's Day bears were absolutely correct about the Irish banks while the senior executives were blowing smoke.

Thus the pattern was set for the summer: the stock market would go into convulsions about the bleak future of Irish banks and executives would reassure all and sundry, with the help of politicians and civil servants, announcing the "fundamentals were sound". But no matter how many times Pat Neary, the head of the Financial Regulator, or John Hurley, the governor of the Central Bank, made soothing noises, the market blocked it out like background noise.

That 'sound fundamentals' mantra seemed more and more like a desperate prayer as the summer wore on and banks delivered their interims. Profits fell as bad debt expectations rose. AIB chief Eugene Sheehy was moved to talk reporters through the worst-case stress tests to prove that a) things could never get so bad and b) AIB was ready if they did.

The Lehman bankruptcy finally shattered these illusions. The failure of the Wall Street behemoth devastated confidence in the capital markets and froze funding to the banks. Within two weeks Irish banking was on its knees begging the government for assistance. Finance minister Brian Lenihan was left with little choice but to do something – anything – as Sheehy and his Bank of Ireland counterpart, Brian Goggin, paid him a visit in Government Buildings one night and told him deposits were fleeing the country at a rate of billions per week. The sector had less than a day to live unless the state guaranteed deposits and funding. Hence the guarantee scheme.

Though the funding issue was solved, the problem remained. The forecasts for bad loans over the next three years were getting worse all the time, making a mockery of predictions – such as AIB's – made only a couple of months before. By November it was clear Bank of Ireland wouldn't make a profit going into 2009. Irish Life & Permanent, though capitally sound, was so overstretched on wholesale funding that chief executive Denis Casey was doing virtually no new mainstream mortgage business.

Then early this month Anglo came out with a king-size loan loss provision of nearly €750m, along with the promise of similar bad debt charges to come for years. All hope that Irish banks would be able to avoid taking government money disappeared. After three weeks of seeming indecision and near-panic, the government took the plunge and committed an initial €5.5bn to the top three listed banks: AIB, Bank of Ireland and Anglo.

So where do we go from here? The biggest clients of the banks – developers and construction firms – are half-broke. That well is tapped. The SMEs are hurting badly after being starved of credit for months and many, even the good customers, may not make it out of the first quarter of 2009. More and more homeowners are strapped as unemployment rises, wages stagnate and taxes rise.

The government is insisting that the banks increase lending to first-time buyers and SMEs, but everything points to painful deleveraging over the next year at least. That means little new business apart from fulfilling existing commitments. Meanwhile, delinquencies and defaults are sure to mount as the economy goes through its worst single-year contraction in decades. With no fresh income and a legacy of bad debt, the banks' balance sheets look likely to get worse before they improve.

All signs indicate the crisis is not over yet. Next year could be even worse.