The Bubble

The Fed wanted to get cash to Bear Stearns to keep it afloat. By 7 a.m. the next day, the central bank had helped arrange a loan to Bear Stearns, the first time since the Great Depression that the Fed had intervened with public money on behalf of an institution other than an ordinary commercial bank with regular deposits.

Over the weekend, Treasury Secretary Henry M. Paulson Jr. helped manage negotiations over whether J.P. Morgan should buy Bear Stearns. Some suitors were contemplating bidding only for pieces of the company, but Paulson wanted all of Bear Stearns to be sold. That Sunday night, J.P. Morgan agreed to buy Bear Stearns but only if the Fed agreed to take $30 billion of mortgage-backed securities on Bear Stearns's books, putting the risk of default on taxpayers. The Fed, believing it had no better option, accepted the deal.

J.P. Morgan announced it would pay $236 million for Bear Stearns -- or $2 per share -- 99 percent below its value a year earlier. Paulson wanted to keep the sale price low so it wouldn't seem as though the government were bailing out Bear Stearns. Within a few days, Bear Stearns had negotiated the price up to $10. Critics still argued that the Fed took unprecedented action to bail out a private financial firm, raising the likelihood that other investment firms would be emboldened to take similar risks.

Chapter XI 'Return to Basics'

Four business days after shutting down the Florida investment pool, the state reopened it, and by late March, in the aftermath of the run on the pool, localities had pulled about $17 billion from their accounts, some two-thirds of the pool's total. The localities have limited access to their money; they pay a penalty if they take out more than a set amount. Not all of the money in the fund is available for withdrawal because the fund's managers have set aside the investments that have lost the most value in the hope that they will bounce back.

Milligan, the interim head of the state-run funds, maintains that the pool's problems were exaggerated. "There's c ertainly nothing wrong with investing in mortgage-backed investments," he said. But he added that the fund is no longer investing in them.

That's not good enough for Pons, the Leon County superintendent. "Everybody was chasing the interest rates," he said. Pons has been pulling out funds from the pool, and he plans to get out the rest -- about $20 million -- as restrictions permit. His new strategy: He's parked the school district's money over at Capital City Bank, where his good friends gave him the emergency loan. "So I can get to it," he said.

Kevin Connelly, a Vienna mortgage broker who had seen borrowers and lenders push the envelope, sought security, too. He had to find another job when Pinnacle Financial was sold to a California mortgage company, Impac, that tried to resuscitate the business but failed. He was worried about the effect on his family -- his wife; his daughter, a 20-year-old student at Northern Virginia Community College; and his son, 17. "It's been difficult," he said. "My family has been accustomed to a lifestyle that my current income doesn't sustain." He's had to sell investment properties and dip into his savings to keep things afloat.

Connelly decided to become a loan officer at an Arlington branch of a large regional bank. No more subprime loans. No more mortgages without income documentation. Extensive training programs for loan officers. "I was looking for someplace where I could reinvent myself," he said. In many ways, the mortgage business has reverted to the way it was when Connelly started nearly 30 years ago. Loans come with employment verification and a sizeable down payment.

"It's a return to the basics," he said.

Chapter XII History Rewritten

By April, it was widely feared that the United States was falling into recession. Bernanke, appearing before Congress, would only allow that a "recession is possible."

Some of the nation's biggest banks have lost billions of dollars and have booted out their top executives. Some forecasters predict that 3 million more homes could go into foreclosure in coming years. The housing problems are often concentrated in low-income, high-immigration neighborhoods in places such as Prince William County, where there were 3,344 foreclosures last year, up from 282 in 2006 and 52 in 2005, county records show.

At the Fed, Bernanke has been working to expand the agency's role in monitoring how Wall Street bundles mortgages. The central bank is closely studying a wider range of financial institutions than ever before. Meanwhile, the Fed has so far this year provided $435 billion in short-term loans to squeezed banks.

The Fed chairman remains convinced that the central bank's role in rescuing Bear Stearns helped avert a global financial disaster.

Some economists have said that the Fed played a role in creating the problem. "The U.S. was too ambitious in trying to prop up growth in the early 2000s through low interest rates, through aggressive fiscal policy, in ways that weren't sustainable," said Kenneth Rogoff of Harvard University, a former chief economist for the International Monetary Fund. "It exacerbated these risks down the road."

Alan Greenspan, who was famously opaque while presiding over the Fed during the bubble, bluntly defends his tenure. "The prevailing notion is that the bubble is indigenous to the United States, is caused by Federal Reserve policy and if the people at the Federal Reserve, especially the chairman, were sensible, this thing would not have happened," Greenspan said in an interview. "History is being rewritten, and I will tell you this is not the history that I remember."

His view is that long-term global interest rates, not the short-term rates that the Fed controls, drove housing bubbles around the world in the past decade. "The tie between Federal Reserve policy and housing prices is just not there," Greenspan said.

On Capitol Hill, the credit raters have come under heavy criticism as well. House Financial Services Committee Chairman Barney Frank (D-Mass.) and other critics question whether the raters need to be replaced by a more effective gatekeeper to the global financial markets. The rating companies recently agreed to changes in how they charge for some ratings.

Lawmakers also have pursued housing bills to help troubled borrowers trade problematic mortgages for more affordable government-backed loans. But President Bush and his allies in Congress threatened to block the proposals, saying they would cost taxpayers too much.

Chapter XIII 'Everybody's Culpable'

David E. Zimmer began putting out job feelers after being laid off as an executive at People's Choice, a subprime lender, interviewing with hedge funds and others to see whether there was any interest in his expertise in the arcane world of structured finance. There wasn't. He blamed it on the falling-knife syndrome: The market for subprimes made firms wary of investing in the field and hiring someone like him who specialized in it.

"Who wants to catch the knife?" he said.

Zimmer, though, figured there was a need for his kind of specialized knowledge. He started a consulting business, Princeton Structured Finance Analytics Group, assessing the value of institutional investors' holdings in mortgages and the underlining loans in securities. Already, he said, there's a lot of interest from accounting firms, auditors and others.

Looking back on the past few years, he said: "Everybody's culpable in this -- everybody -- Wall Street, investors, originators, brokers. At every point in the process, something broke down."

He added, "Do you want to get philosophical? Are people self interested? Absolutely. It's what makes capital markets efficient. As we've learned, it's also what makes them dangerous."

Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.