A Crack in The System

The structure was an early form of collateralized debt obligations. CDOs were a hit almost from the start. It would take several years and a housing bubble for CDOs backed by mortgages to catch on. At Financial Products, the credit-default swap was only one of many innovations in play, but Cassano was passionate about how it could help the firm.

"It was a watershed event in 1998 when J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate," Cassano told an investment banking conference in 2007. "These trades were the precursors to what's become the CDO market today."

Even as Cassano spoke, the housing market was collapsing, the lack of diversity of the CDO debt was being exposed, and the risk for Financial Products was rising.

3: 'It's the Hardest Thing'

By summer 1998, after four years as president, Savage found himself thinking even harder about risk, particularly credit risk. It was often difficult to quantify the likelihood that someone would pay back a loan.

Savage kept his distance from developing trades, with the idea that he could better maintain his objectivity about potential pitfalls. He sometimes wondered whether Cassano's enthusiasm for the credit deals colored his ability to assess them. Cassano's lawyer, F. Joseph Warin, said in a recent interview that Cassano took care to follow procedures that minimized risk.

Greenberg, too, kept at Savage about the risk, even while keeping on the pressure for greater profits. On Wall Street, investment banks and other financial institutions were mad for private contracts called derivatives, Wall Street's jargon for a contract based on something trading now, but settling in the future. (A credit-default swap is a kind of derivative in which one company takes on the future credit risk of another.)

Derivative contracts accounted for more of the world's financial activity by the day. Some in Washington had taken notice, and thought investors and regulators needed to know more about these privately arranged deals that were cloaked from outside scrutiny and clouded by complexity.

Brooksley Born, the 57-year-old head of the Commodity Futures Trading Commission, argued forcefully for a public debate about whether derivatives posed an unknown and growing risk to the world's financial system. She testified at least 17 times before Congress on the subject.

Her campaign gained no traction. More powerful regulators, including Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt, opposed Born. They and others said her agency had no authority over derivatives and that her call for action was casting a "shadow of regulatory uncertainty over an otherwise thriving market."

Greenspan, in particular, argued a free-market view. He saw derivatives as a mechanism that unlocked efficiency, allowing dormant capital to flow into the system, greasing the gears of the world's economy. The Clinton administration and many congressional Democrats endorsed the notion that too much regulation stymied growth.

Greenspan pushed the idea that the marketplace was self-correcting, a view that he often espoused in speeches at economic conferences around the world. He invited Greenberg to attend one such meeting in Basel, Switzerland. Greenberg couldn't go, so he arranged for Savage to go. Chief executives of banks, investment firms and insurance companies, as well as U.S. and German regulatory officials, filled the room.

Greenspan, already celebrated as an economic guru, commanded attention every time he spoke. The question he posed that day resonated with Savage for a long time.