Geithner, in this morning's speech, offered his response to Volcker: that the Fed's actions to sh.o.r.e up Bear Stearns and sell it to Jamie Dimon were sound and justified.

"The Fed made the judgment," he said, "after very careful consideration, that it was necessary to use its emergency powers to protect the financial system and the economy from a systemic crisis." He explained that they had done this "with great reluctance," but that it had seemed "the only feasible option" to avert the crisis. "Our actions," he continued, "were guided by the same general principles that have governed Fed action in crises over the years."

What came next were mostly statements followed by hedges, and a.s.sertions carrying qualifiers. He threw a bone to the moral hazard crowd-"the management of the firm and the equity holders" at Bear Stearns "suffered very substantial consequence"-and then called "for a comprehensive rea.s.sessment of how to use regulation to strike an appropriate balance between efficiency and stability," so the Fed and Treasury were not ginning up bailouts, weekend to weekend. Then he immediately walked away from this bit of "forewarned is forearmed" good sense to say that such a task would be "exceptionally complicated" and that "poorly designed regulation" might well "make things worse."

That last line-in 2008 and onward-would widen into Geithner's overarching dictum, a twist on Hippocrates and his doctor's oath: "first, do no harm."

After the speech-attended by a host of notable economists who were friends of Wall Street, including Martin Feldstein and Columbia Business School head R. Glenn Hubbard, chief of George W. Bush's Council of Economic Advisers-a wide delegation from Wall Street was slated to meet with Geithner in a closed session to discuss credit derivatives.

As a prelude of sorts to that gathering, Geithner finished his speech, arguably the most important of his career, with a final qualifier about the limits of what any public official could do about the ultimate issue: "Confidence in any financial system," he said, "depends in part on confidence in the individuals running the largest private inst.i.tutions. Regulations cannot produce integrity, foresight or judgment in those responsible for managing these inst.i.tutions."

Shortly after 2:00 p.m. he proceeded to the Fed's stately Liberty Room with executives from seventeen firms that represented more than 90 percent of credit derivatives trading, a market now with a nominal value of $68 trillion. Mentioning this meeting in his luncheon speech an hour earlier, he said they'd "outline a comprehensive set of changes to the derivatives infrastructure."

The meeting was attended by Geithner's full staff, along with executives from all the major banks. The New York Fed chief laid out his agenda for the group. Bullet point number one: The establishment of a central clearinghouse for credit default swaps.

This sounds like more than it was: a clearinghouse is just a place where, at each day's end, the swaps can be valued, as when someone goes to the closing on the purchase of a house. But clearinghouses tend to demand that counterparties in a swap put up collateral, or show the clearinghouse, like a casino, that they can cover their bets. A central clearinghouse for CDSs is not so much a solution to regulation of the wildly profitable and potentially destructive world of derivatives as it is merely a good start.

After the session finished, the Fed released a terse overview of the group's findings and commitments. There was no more mention of clearinghouses.

The waters were rising throughout the United States in the summer of 2008. Defaults on mortgages, car loans, and credit card payments were rising faster than they had at any point since the 1982 recession. Americans of every income level were quickly realizing that when bills are greater than income and credit gets scarce, the ground beneath your feet begins to liquefy.

The Obama campaign had scheduled an event to discuss this very issue for June 12, in Cedar Rapids, Iowa, when the water there began to rise, literally. Over the years, the Cedar River had been known to swell with heavy rains, but its hard red clay sh.o.r.eline always held back the churning rapids. No one much bothered to sell flood insurance. Fire, yes; liability, of course. But everyone knew that the Cedar River rarely crested its bank.

Until now.

In her corner office overlooking the Harvard Law School quad, Elizabeth Warren watched the Iowa flood reports confirmed on Weather.com and CNN. She was supposed to be flying there the next day, but as dusk fell on the eleventh, she got the call: Cedar Rapids was out. The city was underwater.

"Dagummit," she whispered, her go-to epithet-not considered one of the more satisfying ones; a holdover from her "no cussin' allowed" Oklahoma upbringing. But she really was irked, since she had been looking forward to the trip for a while. Finally she would get to spend some substantive time with the candidate who had so piqued her curiosity and enthusiasm: Barack Obama.

The senator had had close friends at Harvard Law, such as Charles Ogletree, the esteemed African American law professor who had taught both him and Mich.e.l.le. But with regard to Warren, the sense of connection to Obama was more a matter of shared interests, a mutual fascination with how the law affected people on society's bottom rungs, who might not know, off the top of their heads, just how many justices sat on the Supreme Court. At least it seemed to Warren that they shared this fascination. After two years spent working as a community organizer in South Side Chicago, Obama had attended law school in 1988, "to see," as he later explained, "how power really operated in America."

He found out-then spurned the road most took after law school, the well-worn path whereby a precious Harvard degree was traded in for a portion of that very power. Students such as Obama, the top students from top schools, generally went on to clerk for federal and appellate judges, the very best for Supreme Court justices. A few became professors, and an overwhelming majority took big salaries at corporate law firms. Obama instead returned to Chicago, armed with another credential to round out his core narrative as the wayward, loner kid who managed to rise up and seize one of the great prizes of the professional cla.s.s: becoming editor of the Harvard Law Review. In Chicago, he started writing an autobiography-truly audacious for a thirty-three-year-old-and began his well-known journey in public life.

Thirteen years Obama's senior, Warren was a bit further along on her own unlikely journey, which she began as the lone daughter of a down-on-their-luck Oklahoma family, the Herrings, who lost everything in the Depression and never quite recovered. The route from there to her professorship at Harvard Law was anything but conventional: her first child at nineteen; the better part of a decade following her husband, a high school beau, from job to job; a Rutgers law degree picked up along the way; then single motherhood in Houston after leaving her husband.

But the really unlikely part, the bit that started Warren down the path to becoming a household name, came in 1979, when as a professor at the University of Houston she started researching how bankruptcy law was going to be reshaped in a federal legal overhaul that same year. She set out to prove what the business community was, at that point, incensed about: people gaming the system, irresponsibly running up debts and then discharging them in court.

The reality she found, however, traveling from one courthouse to the next, was altogether different from the one she'd expected, and far more complex: the filings came overwhelmingly from working people who had suffered from mishaps and bad luck-illnesses, deaths of family members and spouses, divorces, and economic downdrafts that often swallowed communities whole. Page after page, Warren started to recognize the shadows of a past she had long ago left behind, that of her own struggling family and the families she grew up with in Oklahoma. As with Obama, Warren's past and future suddenly came together in a powerful integration. Elizabeth Warren was once again Betsy Herring, native of Oklahoma City, up the hard way, now asking the country's judges and legal barons a tougher set of questions about the nature and cause of financial ruin.

That was how Warren got her start. Thirty years hence, she was one of the leading bankruptcy experts in America, and certainly the most visible.

But at this point, in June 2008, with Bear Stearns escaping a true meltdown, and the particulars of the coming crisis wholly foreign to most Americans, an expertise in bankruptcy law and consumer lending was not the sort of thing to get you a national soapbox. So Warren hoped to get her message out behind the scenes-and to one person in particular.

By midday on June 12, the crowd that had gathered at the Illinois Inst.i.tute of Technology, a smallish sprawl of aluminum and gla.s.s on Chicago's South Side, was almost all reporters. One hundred and fifty of them, mostly with the traveling press, there to watch Obama and Warren chat with three Chicagoans in varying degrees of credit h.e.l.l.

This was the event that the Obama campaign threw together in a matter of hours, as downtown Cedar Rapids slipped beneath the water.

One by one, each citizen told a story-they were surprisingly conventional stories of people overwhelmed by debt-as Obama listened patiently, asking a question or two.

When Warren finally spoke up, she recounted the first time she'd met the senator-then an Illinois state senator-at a 2003 fund-raiser in Cambridge and how "he had me at 'predatory lending,' " a sure-laugh line. Then she and Obama ran through an array of the typical traps buried in deceptive credit card agreements: teaser rates in the low single digits that suddenly jump to 30 percent, the arbitrary lowering of cardholders' credit limits in order to charge over-the-limit fees. Obama even appeared to know more than Warren about the details of one practice, called the "fair-play rule." Warren looked on at the senator in amazement.

"In the interest of full disclosure," he admitted quietly, "I've gone through this. I've had credit cards."

Ears p.r.i.c.ked, the reporters crowded in close. Throwing his lot in with those sitting around the table was a risky gambit. Their stories were the stories of millions across the country, but traditional judgment still looked down on those who took on debts they couldn't repay. But Obama, and Warren beside him, were a pair of winners, those who had risen from humble beginnings and managed to overcome obstacles and mishaps, and maybe even errors. It was a bold and empathetic statement, challenging a censorious culture: Don't be too swift to judge.

"We've just heard three examples of what I think most people would say is grossly unfair," Obama said, citing the three partic.i.p.ants. "But this is not atypical." For good balance, he acknowledged the merits of the other side. "Part of why our debt crisis is so bad," he continued, "is that some folks are making reckless decisions-racking up big credit card bills by purchasing flat-screen TVs and other luxury goods that they know they can't afford." The qualifier, as always with Obama, was there to help him earn his conclusion-a nod at both sides' reasonableness in order to justify his authority in arbitrating between them. Here he was looking to redefine the basic notion of fairness. No mean task.

Warren, too, threw her weight behind a new framing. "We have a bunch of regulators in Washington," she explained, "who see their job as protecting banks and see you folks as little profit centers for them."

Then there was talk of Obama's proposal for a Credit Card Bill of Rights and his 2005 opposition to a bankruptcy bill, which had given banks additional advantages and taken away consumers' rights. All to the good, in Warren's book, but then, the true lines of advantage and disadvantage were tough to draw. During the thirty-year credit binge, who in power hadn't made money? Penny Pritzker, Obama's national finance chair, had run Superior Bank, a Chicago-area savings and loan that had been among the pioneers in predatory lending. Since Jim Johnson's resignation from Obama's vice presidential search committee a week before, the McCain campaign had been busy talking about his special mortgage deals with his friend Angelo Mozilo, the man responsible for running Countrywide into the ground.

Warren knew all this, and she also knew, from years of battle, how difficult it was to frame arguments for debtors' rights. No one had forced them to take money they couldn't pay back. How could you blame the creditor, filling people's desire for cash, even if it was just to set the interest hook into the debtors? Warren had come to view the whole system more elementally, in terms of its fundamental power imbalances. The average bank was strong, well funded, and skillful; the average consumer, much less so. Who was looking out for the little guy? No one, really.

But gazing now at Obama, who talked warmly, sympathetically, with those facing fiscal ruin, Warren couldn't help but wonder if the country might soon have a president who would fight, really fight, for the little guy. After bidding the day's three roundtable partic.i.p.ants farewell, Obama called Warren over. He explained that he had another event, a speech at a nearby junior high school, but that he wanted to talk with her for a minute before he rushed off. Everyone kept their distance as the two spoke, leaving a wide perimeter.

"I want to thank you for doing this," Obama began. Then he looked at Warren intently. "So how did you think it went?"

She sighed, smiling. It had gone fine-better than fine. Would he not know that? She supposed he was really asking about how she thought he had connected with the guests in their distress.

"Frankly," Warren said, "I can't believe you understood all of this so well-what they felt each day and the stresses they faced, and really esoteric stuff, some things I barely know about how they get trapped in credit h.e.l.l and can't get out."

Obama smiled. "I was talking to Mich.e.l.le last night about what we were going to do today and I said, 'You know, we've been there. We walked through this when we were young and trying to get ahead. This is not stuff from the streets. This is something middle-cla.s.s people face.' " He paused, as a thought seemed to take shape. "I haven't been living in this bubble very long," he said softly. "I'm in it now, but not that long ago I had a real life."

Elizabeth Warren would think about that man-in-a-bubble conversation all the way back to Cambridge and many times since. She would go on to become the country's top consumer advocate, and Obama its president. He would preside over the worst financial crisis in generations, one that would develop, in large part, because financial firms and other creditors had retooled their business models to bleed the country's consumers dry. But it would be a long time before Warren saw Obama again. He would go on to meet with hundreds of people in the meantime-financiers, bankers, Wall Street CEOs-but not her. And she would wonder, replaying that last conversation in her head, if it was really about the bubble or the character of the man inside the bubble, and if in Chicago she had seen what she hoped to see, rather than what was really there.

The pressurized bubble Barack Obama had entered by June 2008 demanded some seasoned tending. After Hillary Clinton's formal withdrawal that month from the race, professional managers were on their way.

Lawrence Summers had at this point been in exile from public life since his 2006 ouster from the Harvard presidency. In this last major job, he'd managed to lose the confidence of the university and its directors, most notably over comments suggesting that he held a discriminatory att.i.tude toward women. At a meeting of the National Bureau of Economic Research in January 2005, Summers had opined that women's underrepresentation in the advanced sciences might be due to "innate gender differences." In the fallout that ensued, it looked suddenly like more than a coincidence that, during his time in office, Summers had overseen the tenure appointment of just four women to Harvard's Faculty of Arts and Sciences, out of thirty-two total appointments.

This flap would generally be cited as the cause of his dismissal, but the real story was a bit more complicated. Other Harvard presidents, after all, might have survived the incident. But then, most would also have been familiar with the many studies on the so-called stereotyped threat, the faulty seeing-is-believing tendency that's been shown to have a tightening effect at the highest ends of academic disciplines. Whether Summers knew about this research or not, in those comments at the NBER meeting for which he would later apologize, he certainly never mentioned it.

But this has been a pattern with Summers: to a.s.sume that his opinions in areas well outside his expertise are nonetheless sound. He trusts his a.n.a.lytical capacities to a remarkable degree, his ability to frame both sides of an argument and then decide which side is right. Many would say he trusts them to a fault. As he has aged, he has grown less troubled by being uninformed. This is at least what his friends say, while all the same pointing to his overall brilliance. His enemies-a substantial community by 2008-are less charitable. They point to the many instances in which Summers has marshaled powerful arguments for actions and policies that turned out to be disastrously wrong.

In an odd way, Summers's extraordinary self-confidence would grow both harder and more brittle as he spent time in the public sphere. The architecture of his personality, in this way, recalls that of Nixon and Henry Kissinger, or, more recently, d.i.c.k Cheney-all men who blurred the line between ends and means. On issues of domestic policy and economics, Summers has long been rising to a similar status.

"Like Rome," an old friend of Larry's said, "he has spread himself too thin and must ever be on guard to put down even the slightest challenge or insurrection in intellectual territories which he claims but can't hold."

By most accounts, Summers exhibited less of this pomposity at earlier stages of his career, when he was still on the upward thrust of his meteoric ascent. As the child of two economists, with two n.o.bel laureate uncles in the field, Summers was primed for a life among the top economic minds of academia. He spent the first five years of his life in New Haven, Connecticut, while his father taught at Yale, then moved with his family to Philadelphia when his father got a professorship at Penn. As a teenager, in the span of just two years, Summers would see his uncles Kenneth Arrow and Paul Samuelson each win the n.o.bel Prize in Economics.

The lofty standard set by his family threw Summers full tilt into a scramble up the academic meritocracy. During his adolescence, when left home alone, he would get a math problem from his parents. If they forgot to leave a problem for him, he would chase after them demanding one. He matriculated at MIT at age sixteen, starred on the debate team, got his PhD in economics from Harvard by his midtwenties, and received tenure at the tender age of twenty-eight, becoming one of the very youngest tenured professors in Harvard's 350-year history.

But for all his academic success, Summers did less well in his leadership roles. In the Clinton administration, he only really stepped out of Bob Rubin's shadow at the end of that president's second term. He then managed, in his own brief tenure as Treasury secretary, to preside over perhaps the most disastrous piece of deregulatory legislation since the Great Depression: the Financial Services Modernization Act of 1999 (also known as Gramm-Leach-Bliley), which, in undoing a major provision of Gla.s.s-Steagall, directly precipitated the "too big to fail" crisis nine years later. But it was as Harvard president that Summers provoked the most acrimony. Along with his knack for the public faux pas, he succeeded in antagonizing his bosses behind closed doors, specifically through meddling in the university's investment strategy for its multibillion-dollar endowment. In addition to championing Gramm-Leach-Bliley in 1999, Summers played a central role, that same year, in making sure the burgeoning derivatives market was left unregulated. When he became president of Harvard a few years later, his faith in derivatives was so great that it was all but indistinguishable from his expertise in how the products actually worked.

The result of this particular overreach came with merciless speed when Harvard lost nearly one-third of its endowment, largely because of investments in interest rate swaps and other derivatives. Summers had talked in 2003 about overseeing a period of expansion at Harvard "not unlike the growth of the early Renaissance." By 2005 the wildly overcommitted university was freezing professors' salaries, cutting support staff, and canceling construction projects left and right.

It all boils down to the cla.s.sic Larry Summers problem: he can frame arguments with such force and conviction that people think he knows more than he does. Instead of looking at a record pockmarked with bad decisions, people see his extemporaneous brilliance and let themselves be dazzled. Summers's long career has come to look, more and more, like one long demonstration of the difference between wisdom and smarts.

Not that Summers himself would admit this-or admit to having been wrong in more than a public relations sense. His disastrous foray into private investing at Harvard might have sidelined a lesser man, but by 2007, Summers was signed on at the hedge fund DE Shaw as an absentee consultant. Despite spending just one day a week at the fund, Summers was paid $5.2 million in his second year with Shaw, according to a report in the New York Times. He had now fulfilled one key goal he set for himself after leaving Harvard: to make money. Now it was time to burnish his image.

The idea of retiring from public life at age fifty-three, of receding into the private sector to make money hand over fist, was not enough for Summers. As the Bush era lurched to its ign.o.ble end and a troop of resurgent Democrats took the field, Summers began putting considerable energy into writing columns for the Financial Times. They were state-of-the-world renderings, most of which looked at the global economy and the challenges it presented. The columns were artfully crafted bids for reappraisal, for the world to take another look at Larry Summers. He wanted back in the game.

But Obama already had a formidable team of economic advisers, several of whom claimed long, troubled histories with Summers dating back to the Clinton years. They knew him and they understood him too well. Yet somehow, in the ensuing shakeout, Summers would wind up with a coveted spot as head of the National Economic Council.

The real antecedent to Summers's blazing return to prominence was Obama's decision, in the week that Hillary conceded, to appoint Jason Furman as head of the campaign's economic team. It was a job that Obama's friend and adviser Austan Goolsbee had wanted, and this fateful decision would open the door through which those Rubinite economists such as Summers would slowly slip back in. In his new role, Furman became the bottleneck between Obama and his other economic advisers, the gatekeeper deciding whom the senator spoke to. For Summers, the appointment could not have been more propitious. Furman had been a teenage phenom and Summers had known him for years. Now, with Furman advising Obama, Summers saw his opening.

According to those on the staff at the time, Furman and Summers had conversations to the effect that Furman could get Summers access to Obama's economic circle, but Summers would have to do the rest.

No problem. This was Summers's strong suit: conference calls-free-form, wide-ranging, and loosely organized. No one had Summers's rhetorical command, the skills of argument and persuasion he had been honing since his days on the MIT debate team. Summers would work his magic on the president-to-be, and in spite of all those trusted economic advisers on the team-such as Volcker, Goolsbee, and Wolf-Obama came slowly to invest confidence in what amounted to a Clinton-era redux, with Summers's brash voice carrying high above the rest.

If the opposite of certainty is doubt, humility must lie somewhere between the two. By August 2008, as hundreds of financial professionals gathered for their annual meeting in Wyoming, humility had finally begun to set in-albeit too little, too late.

Within a month, the financial system would begin its free fall, and those prudential voices that had urged caution and humility through the years would get, for their trouble, I-told-you-sos they'd just as soon have gone without. Hindsight is twenty-twenty, of course, but the truth of the 2008 crisis was that some had seen it coming a mile away. Foresight had not been wanting; it had been ignored. And though the early critics would be cast as outliers, if they were it was largely for having been shouted down by an arrogant, self-congratulatory consensus.

As Fed chairman Ben Bernanke stepped to the podium, in the shade of the nearby Teton Range, it was all too clear that the market in certainty had begun to correct.

"The financial storm that reached gale force some weeks before our last meeting here in Jackson Hole has not yet subsided," Bernanke said, opening a speech t.i.tled "Reducing Systemic Risk." The chairman continued: "Its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment."

This was hardly news to the attendees by this late date of August 22. After the past year-to say nothing of the past few months-it would not have been at all odd to see these staid central bankers trading their light beer and Chablis for a few stiff shots. The conference's same-time-next-year spirit was now clouded with uncertainty. How many of those now in attendance would be here next time around, and what sort of financial storm, at what battering force, would they be discussing then?

One audience member, a Wharton professor by the name of Gary Gorton, thought he had a pretty good idea.

It was Gorton's first time at the Jackson Hole conference, and though he had been invited as a guest presenter, he was there now as a Jeremiah.

The night before, he had spotted Bernanke at the c.o.c.ktail reception and sidled up. The ever-polite Fed chairman nodded attentively as Gorton introduced himself. He wanted to alert Bernanke, to warn someone with power and sway, about what he had found in his research. But he wasn't quite sure now how to broach the topic.

Fishing for the right way in, Gorton heard himself say, "You're doing a great job for the country, and we're all behind you." Bernanke took the compliment graciously and listened as Gorton explained who he was. He managed to touch briefly on the journey that had brought him there, and thought he'd succeeded in piquing Bernanke's interest, one academic to another, but other revelers had crowded in before he could get to his main point: repos.

For a decade, Gorton had been studying the growth of the repo market and had become increasingly troubled by what he found. Firms were funding more and more of their operation with repos, often basic expenses and even salaries. The size of the repo market alone remained a mystery. Gorton and his colleague Andrew Metrick, a Yale professor who had that summer drawn Gorton from Wharton to a professorship in New Haven, estimated it could be a whopping $12 trillion, slightly more than all the bank lending in the United States. But repos were not the province of just banks, or mostly banks. Anyone with cash could do it. The largest repo vendors were the huge fund companies, such as BlackRock, Fidelity, and Pimco. Industrial companies did it, too (even if they didn't have large finance subsidiaries, as General Electric or General Motors did), as did manufacturers with significant cash flow. Everyone had become a bank. What concerned both men, though, was that any slight disruption-any small loss of confidence-threatened sweeping consequences for this so-called shadow banking industry. This was exactly what had happened to Bear Stearns, which found itself with no money to do business when confidence in the company flagged and its repo market dried up.

Especially worrisome was the way repos allowed companies to fund their off-balance-sheet activities. Repos made possible the vast world of shadow banking-a realm of operations and transactions hidden from the public and from shareholders. In shadow banking, firms had found a way to shift risky activities and liabilities off their books. With the ready spigot of repo money, they could then tailor their cash flows and balance sheets to create the illusion of health and stability. And as liabilities disappeared from their books, the amount of leverage the firms could operate with increased.

The prevalence of repos and their undisclosed nature meant it had become impossible to a.s.sess the country's financial stability. But even with Bear Stearns-toward the end, "dialing for dollars" each morning to fund its operation-regulators still did not seem to understand the severity of the situation. One whole point of repos was, after all, to escape notice: the agreements were typically made on a bilateral or tripart.i.te basis, meaning the deal was struck and known about by just the two firms involved (borrower and lender) and occasionally a third, middleman firm. But Gorton and Metrick had an inside track.

Though a professor of finance at Wharton for nearly two decades, Gorton had been a regular consultant for AIG since the late 1990s. There he'd developed some of the models the firm used-and, in cases, misused-in its investment decisions, and he happened to be on AIG's trading floor on August 9, 2007, just a week after Barack Obama got his all-points alert from Robert Wolf, when the rest of the financial world saw a full-blown credit crunch unfold. Gorton saw the traders' shock and fear firsthand. It was palpable and frightening, and all driven by the shifting winds of confidence.

Gorton had left shaken. He returned to Wharton, put on his professorial robes, and began to cast a hard, cold eye at what had beset the financial markets. It was at this point that Metrick entered the picture. He, too, was an academic with a window on the inner operations of the finance industry. His father, Richie, was the deputy and so-called other brain to Alan Schwartz, the head of Bear Stearns at the end of its run. Andrew had spent Bear Stearns' final chapter visiting regularly with his father.

A "financing dilemma"-in Wolf's parlance-is the specific cause of death for Bear Stearns. As fears about the company's exposure to toxic CDOs grew in January and February of 2008, its repo book began to tighten. The repo deals Bear Stearns struck were with every type of company, financial and otherwise. If corporate treasurers have excess cash, they lend it as a repo, and then purchase it back. Their money gets parked in a repo, as opposed to being put in a bank, where the $100,000 of federal insurance-fine for an individual, and, after the coming crash raised to $250,000-is so small for a company as to be no insurance at all. The lender of a repo gets a tiny percentage of short-term interest, in the area of .03 percent a month, as well as collateral, which the recipient has to post. If there's a default on the repurchase, there's someone to call.

And there was no doubt, since 2005, that they'd pick up. That last part is a crucial addition to the repo equation. After many years of sustained lobbying, the financial industry pushed through a key provision in the 2005 Bankruptcy Act, which overhauled the U.S. bankruptcy system. All repos and swaps, like those soon-to-be-fatal credit default swaps, were exempt from bankruptcy's famous "automatic stay"-the defining provision, really, of bankruptcy, where all a.s.sets and liabilities are frozen as a company seeks the protection from creditors that bankruptcy court provides. Creditors then get in line at the court, with the most secure, or senior, creditors first, then unsecured creditors, and so forth. Repo and swap contracts, though, are exempt from the stay. They must be honored, even if a company goes bankrupt. That makes them the safest item on any balance sheet-safer, even, than cash accounts, which are frozen in a bankruptcy like everything else. In terms of debt, safe means cheap. Repos, thereby, became the cheapest, safest funding source available, and repo growth was dramatic after 2005.

In the specific case of Bear Stearns, the firm was using repos to fund many operations and most of its special investment vehicles-the legal vessels not noted on the company's balance sheets and which held CDOs and other exotic investments. This is the sort of creative license that repos offered financial engineers across corporate America, helping them craft earnings, especially at the end of each quarter, to hide losses, pump up their share price, or, maybe, make certain stock optionbased compensation packages. .h.i.t their strike points. An odd twist on the repo market that both Gorton and Metrick discovered is that repos, inexplicably, become more expensive at the end of each quarter-something both men feel is worth investigating. It might indicate that their prime value is in obfuscating a company's public disclosures, which would be fraud.

But even with the bankruptcy exemption, fears about Bear Stearns' condition tightened its repo "durations" dramatically as March 2008 approached. In the week of Bear Stearns' collapse, Metrick watched his father suppress panic as the firm's traders were rolling over a stunning $50 billion a night in repos. On Thursday night, March 13, 2008-three days before the Fed sold off the collapsing Bear Stearns to JPMorgan-Andrew's father and Alan Schwartz called Geithner's office to say that the firm needed to declare bankruptcy. They couldn't roll over their repo book by morning. Geithner told them to hold out one more day, and New York Fed officials made sure Bear got the overnight infusions it needed.

When Gorton and Metrick huddled before Gary's trip to Jackson Hole, and began to talk about the latest wave of fears rippling through the investment markets, their concerns deepened.

Repos, both men felt, had grown into the equivalent of demand deposits for lots of American businesses, especially those on Wall Street. If confidence in the ability of firms to make good on their repos dipped, creditors would all clamor for their money back at the same time, as in a cla.s.sic bank run. The firms, which had invested in long-term, illiquid a.s.sets, would not have enough money at that point to pay back their borrowing. When Roosevelt saw that this had happened in regular old consumer banking, he created the Federal Deposit Insurance Corporation in 1935, to resolve failing banks and guarantee deposits. In the world of Big Finance, however, there's no equivalent, nothing half so st.u.r.dy, backing up a forbidding mountain of debtor commitments.

Gorton had written a ninety-page paper over the summer, which he intended to present the next day at Jackson Hole. The paper, t.i.tled "The Panic of 2007," investigated the causes of that crisis in more depth than just about any other doc.u.ment. The dynamic it described was like a glimpse into the future. Precipitating the crisis, he found, was a drop in the ABX, a newish index put together to get a handle on the CDO market. As the ABX began falling in early 2007, because so many CDOs had been funded by repos or used as collateral in repo transactions, fear spread quickly to the repo market.

If the collateral behind a loan loses its value, the loan suddenly becomes much riskier. In this way, as the CDOs lost value, the repo market dried up and companies began demanding greater collateral as security against a given repo. This meant firms needed to sell off lots of a.s.sets to get cash for basic needs, which drove down the market they were selling into even further.

This tightening in the repo market lasted through the fall of 2007, but somehow, by the next summer, it was still widely unrecognized as a central contributor to the year-end contraction in economic activity. When the much larger crisis of 2008 hit, only weeks later, the role of repos would again go underappreciated. Had they relied on repos less, the investment banks would surely have better weathered a crisis of confidence. Lehman's distinguishing feature-what would set it apart in sickness-was its bloated repo book.

Bernanke gave his speech that morning, August 22, and then left. Gorton went next.

"I thought my talk went badly," he recalled. "I just went up there with no notes and talked until time ran out-explaining modern capital markets, but not explaining why it was that way. I stopped abruptly because I ran out of time. The audience was people who had focused on inflation and interest rate policy for the last few decades. I must have seemed like an alien landing."

Gorton felt panic rising inside of him as he watched the attendees sit blithely through his Ca.s.sandra turn. He wanted to scream at them-or maybe just scream.

Afterward, as central bankers chatted and mingled, Gorton spotted Austan Goolsbee. He cornered him, mincing no words: "Obama should stand up and say, 'Look, everybody can't own a home-sorry. We have to do something about Freddie and Fannie right away, and here's what we plan to do.' "

Goolsbee nodded gamely, but he was busy. They never got to the "here's what we plan to do" part. Then Larry Summers walked by, a group of acolytes in tow, hanging on his every word.

Gorton followed the posse to a lunch with Mario Draghi, governor of Italy's central bank and a man on the short list to eventually head the European Central Bank. Draghi, the luncheon speaker, was talking generally about how to sh.o.r.e up regulations to better support financial stability. Summers asked him some questions, Gorton recalled, "with a kind of dismissive pomposity, like a sniffing English don."

At that point Gorton made for the door. He had had enough. As he booked a flight back east, he vowed to himself never to waste his time going to Jackson Hole again.

5.

The Fall.

On Wednesday, September 10, John McCain woke up feeling confident. Finally his campaign was picking up the kinetic energy it needed if he hoped to topple the Obama juggernaut. The polling looked auspicious. Obama's summer lead had been eradicated. Of the first fifteen polls covered that month by Real Clear Politics, Obama was ahead in just four of them. McCain had shown ruthless, all-in political savvy selecting Sarah Palin as his running mate, and he had timed the announcement just so. The morning after his speech at the Democratic National Convention, Obama awoke to McCain's startling, unexpected choice. The ratings honeymoon that typically follows a lauded convention speech was cut abruptly short. Ten days later, Joe Biden, dumbfounded, merely asked, "Who is Sarah Palin?"

By the tenth, Palin had become a phenomenon. Obama had poured fuel on the fire of Palin mania the day before, remarking in a speech, "You can put lipstick on a pig, but it's still a pig." The McCain camp had pounced on the comment, casting Obama's words as a crude and deliberate attack on Palin. The country's punditry had then seized on this read. Words such as "anxious" and "concerned" had started to crop up in the liberal chatter. Could McCain really win this thing?

But the Palin groundswell, and the broader battle for the White House, would soon be overtaken by events even larger than the quadrennial election.

The banner headline across the top of that morning's New York Times read: "Wall Street's Fears on Lehman Bros. Batter Markets." The article quoted Malcolm Polley, chief investment officer at Stewart Capital Advisors, saying, "I think the market's telling you that if Lehman is going to go away, Merrill is probably the next victim."

Reading the story, Obama couldn't help but realize that all those conversations with his Wall Street contributors would now give him a material advantage over most other politicians. Even if he couldn't describe the particulars of a CDO, or the ABX index, he could talk the talk about the markets. And, indeed, the market-driven disaster had arrived.

A year before, when Obama asked his economic team how he should react to the bursting of the bubble in year two of his administration, it had only been a thought experiment. Despite Robert Wolf's prescient early warnings, the collapse had never really seemed all that imminent.

Thinking about Wolf's warning from the flying deck of Le Reve on his forty-sixth birthday, Obama, in an Oval Office interview, reflected on how he had "had the benefit of a couple of friends who, for some time had been warning about the potential of a severe financial crisis because of what was happening in the mortgage markets.

"It was one of those situations where you knew an earthquake might happen but you couldn't necessarily time the week. When Bear Stearns happened, I think that was a signal that some of the predictions I had heard a year or two years previously, might come to pa.s.s.

"At that point, I don't think we still had a sense of how bad it might get. By the time you get to Lehman's, obviously, people do have that sense.

"I can't claim that I had a crystal ball and understood what all the ramifications would be. I don't think anybody at that point understood how deep this went. The situation just of AIG, to take one example-the magnitude of the bets that had been placed-they were beyond, I think, my comprehension."