By mid-2007, as the housing slump took hold, the subprime mortgage market was weakening and many mortgage bonds were sinking in value. Ratings agencies began downgrading many mortgage securities, a departure from the historical pattern, Mr. Gorton later explained to investors. Concern began mounting about AIG's credit-default swaps, even though AIG didn't have large exposures to subprime-mortgage bonds issued in the worst years of 2006 and 2007.

AIG's trading partners were worried. Goldman Sachs held swaps from AIG that insured about $20 billion of securities. In August 2007, Goldman demanded $1.5 billion in collateral, arguing that the assets backing the securities were falling in value. AIG argued that the demand was excessive, and the two firms eventually agreed that AIG would post $450 million to Goldman, this person says.

Late last October, Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and it ultimately posted $1.5 billion. Goldman hedged its exposure by making a bearish bet on AIG, buying credit-default swaps on AIG's own debt, according to one person knowledgeable about this move.

When AIG's outside auditor, PricewaterhouseCoopers LLP, learned about Goldman's demands, it reviewed the value of the swaps, according to a Pricewaterhouse official cited in minutes of a meeting of the audit committee of AIG's board. Last November, when AIG reported third-quarter results, it took its first major write-down on the swaps, lowering their value by $352 million.

That same month, collateral calls came in from Merrill and Société Générale SA, says the person familiar with AIG's finances. It's not clear how much those two banks asked for, or how much they got.

AIG decided to talk to investors last Dec. 5 about the financial-product unit's exposure to the mortgage market. A Pricewaterhouse official said his firm told AIG's then-CEO, Mr. Sullivan, and a deputy six days before the event that AIG might have a "material weakness" in its risk management, according to minutes of a Jan. 15 meeting of AIG's audit committee. Pricewaterhouse declined to comment.

In his presentation to investors, held at New York's Metropolitan Club, Mr. Sullivan praised the unit's models as "very reliable" in analyzing many mortgages, saying they had helped give AIG "a very high level of comfort."

Mr. Gorton was introduced. "The models are all extremely simple," he said. "They're highly data intensive." He said he didn't rely on the default-risk predictions of credit-rating services, and instead came up with his own estimates of what was safe enough for AIG to insure.

Mr. Cassano, the unit's head, told investors: "We believe this is a money-good portfolio....As Gary said, the models we use are simple, they're specific and they're highly conservative."

But the collateral calls kept coming. By the end of 2007, at least four other banks that had purchased swaps from AIG -- UBS AG, Barclays PLC, Credit Agricole SA's Calyon investment-banking unit and Royal Bank of Scotland Group PLC -- had asked for money, according to people familiar with collateral calls. Deutsche Bank and Canadian banks CIBC and Bank of Montreal also have demanded collateral at various points, a person familiar with AIG's finances says.

In February, AIG disclosed that Pricewaterhouse had found a "material weakness" in its accounting controls. Late that month, AIG announced a $5.3 billion fourth-quarter loss, its largest ever, driven largely by write-downs on the swaps. It also said it was "possible" that actual losses on the swaps could be material.

Mr. Sullivan told investors that Mr. Cassano, the unit's head, was retiring. He remained a consultant, receiving, until recently, $1 million a month, according to a document later released by Congress.

In May, AIG announced another record quarterly loss, of $7.8 billion, largely driven by write-downs of the value of the swaps. That same month, Yale's School of Management announced it had hired Mr. Gorton away from Wharton.

Mr. Sullivan was ousted in June. As of July 31, AIG had handed over $16.5 billion in collateral on its swaps, according to a regulatory filing.

By August, AIG had increased its estimates for what it might ultimately lose on the swaps in the case of defaults to as high as $8.5 billion. (The estimates are distinct from potential losses on write-downs and collateral calls.) That same month, Mr. Gorton attended the Federal Reserve Bank of Kansas City's annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, "The Panic of 2007," which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. "It is difficult to convey," he wrote, "the ferocity of the fights over collateral."

Credit markets worsened in late August and September, and AIG's trading partners demanded additional collateral. When Lehman Brothers Holdings Inc. filed for bankruptcy protection on Sept. 15, bond markets essentially froze. That same day, rating agencies slashed AIG's credit ratings. Company executives figured the downgrade would require AIG to post more than $18 billion in additional collateral to its trading partners, according to a person familiar with the matter. Worried that a bankruptcy filing could roil markets world-wide, the government stepped in with a bailout.

The rescue didn't stop the collateral calls, which have eaten up much of the government's initial $85 billion loan commitment, which on Oct. 8 it boosted to $123 billion.

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: "There doesn't seem to be a fundamental reason why."