The Bubble

Connelly's colleagues were fleeing even faster than they'd come on board in the boom years. At staff meetings, the gallows humor -- only half funny -- was, "We're having a sales contest, and the winner gets to keep his job," Connelly said.

By last summer, the atmosphere was motionless in his office. Each morning, Connelly visited a Web site called "the Mortgage Lender Implode-O-Meter," which chronicled lenders that were going under. His day "went from talking to 10 people and doing eight transactions to talking to 10 people and doing one transaction," he recalled.

By summer's end, he said, "I was working alone in that office."

Chapter VIII Secret War Room

July 19, 2007 . Fed Chairman Bernanke tells Congress: "Rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better."

Bernanke and others at the Fed still did not see how severely the troubles would cascade through the economy.

The chairman did warn Congress of "significant financial losses" in the subprime industry, saying there were "implications of this for financial markets." He was right. Within days, Countrywide Financial, the nation's largest mortgage lender, announced that its profit had fallen by a third as more homeowners defaulted. The Bear Stearns hedge funds that had invested heavily in the subprime market went under. The largest bank in France, BNP Paribas, suspended three funds that held mortgage-backed securities.

Then the credit raters -- Moody's, Standard & Poor's and Fitch, which over time had become high priestesses of the global capital markets -- astonished investors by abruptly downgrading many subprime-backed securities that they had previously blessed. The rating companies, which assign letter grades to all kinds of debt issued by companies, municipalities and countries, came under criticism from investors who questioned whether they had issued rosy assessments because they had been paid by the banks whose securities they rated. The credit raters responded that they have procedures in place to prevent conflicts of interest.

Banks and investors also questioned whether there were hidden weaknesses in the broader market for mortgage-backed securities and other complex investments, such as collateralized debt obligations, or CDOs, which combined various kinds of debt.

As a result, banks, anticipating their own losses, began to hoard cash and refused to lend. The fallout: A major part of the machinery of U.S. capitalism -- the $28 trillion credit market that ensures big companies can pay their employees and buy equipment by taking out loans -- nearly shut down. In August, the credit crunch sent the stock market into its most volatile period since the Enron days.

The Fed pumped money directly into the markets, loaning to banks and accepting as collateral the mortgage-backed securities that few investors wanted anymore.

At the Treasury Department, Robert Steel, undersecretary for domestic finance, called Wall Street executives, housing agencies and the Fed for counsel but particularly sought out two men who had shown keen insight before the collapse.

One was Edward Gramlich, who had been warning for years that subprime borrowers were vulnerable to overextending themselves. He had since retired from the Fed and had just published a book, "Subprime Mortgages: America's Latest Boom and Bust." Gramlich told Steel that borrowers went beyond their means and that lenders encouraged it -- and now homeowners needed counselors to avert foreclosures.