"Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient." -- Alan Greenspan, then Federal Reserve chairman, 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives "because we don't really understand how they work." Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential "hydrogen bombs."

And Warren Buffett presciently observed five years ago that derivatives were "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives -- exotic contracts that promised to protect investors from losses, thereby fueling riskier practices that led to the financial meltdown. For more than a decade, Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street.

"What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so," Greenspan told the Senate Banking Committee in 2003. "We think it would be a mistake," to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest, Greenspan's faith in derivatives remains unshaken.

The problem is not that the contracts failed, he said. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as "the pharmacist who fills the prescription ordered by our physician."

But others hold a starkly different view of how global markets unwound, and the role that Greenspan played in setting up this unrest.

"Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives," said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

The derivatives market is a whopping $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

If Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

Derivatives were created to soften or "hedge" investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value "derives" from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes.

On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid -- for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, appearances on Capitol Hill and heavily attended speeches, Greenspan banked on the goodwill of Wall Streeters to self-regulate as he fended off restrictions.

Ever since housing began to collapse, Greenspan's record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nation's real estate market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out price increases with higher rates. Others have criticized Greenspan for not disciplining institutions that lent indiscriminately.

But whatever history ends up saying about those decisions, Greenspan's legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading.

Faith in the system

As the nascent derivatives market took hold in the early 1990s, and in subsequent years, critics decried an absence of rules forcing institutions to disclose their positions and set aside funds as a reserve against bad bets. Time and again, Greenspan proclaimed that risks could be handled by the markets themselves.

"Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury," recalled Alan Blinder, a former Federal Reserve board member. "I think of him as consistently cheerleading on derivatives."

In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options and futures trading, began exploring derivatives regulation. The commission, then led by Brooksley Born, invited comments about how best to oversee certain derivatives.

Born was concerned that unfettered, opaque trading could "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it," she said in congressional testimony. Born's views incited fierce opposition from Greenspan and Robert Rubin, then the Treasury secretary. Greenspan warned that too many rules would damage Wall Street, prompting traders to take their business overseas.

Born pushed ahead. On June 5, 1998, Greenspan, Rubin and Arthur Levitt, then chairman of the Securities and Exchange Commission, called on Congress to prevent Born from acting until more senior regulators developed their own recommendations. Levitt says he now regrets that decision. Greenspan and Rubin were "joined at the hip on this," he said. "They were certainly very fiercely opposed to this and persuaded me that this would cause chaos."

Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term Capital Management nearly collapsed, dragged down by disastrous bets on, among other things, derivatives. Despite that event, Congress froze the Commodity Futures Trading Commission's regulatory authority for six months. The following year, Born departed.

Attempt at oversight

In November 1999, senior regulators -- including Greenspan and Rubin -- recommended that Congress permanently strip the Commodity Futures Trading Commission (CFTC) of regulatory authority over derivatives.

Greenspan, according to lawmakers, then used his prestige to make sure Congress followed through. "Alan was held in very high regard," said Jim Leach, R-Iowa, who led the House Banking and Financial Services Committee at the time. "You've got an area of judgment in which members of Congress have nonexistent expertise."

As the stock market roared forward on the heels of a historic bull market, the dominant view was the good times were due in large part to Greenspan's steady hand at the Fed.

"He had a way of speaking that made you think he knew exactly what he was talking about at all times," said Sen. Tom Harkin, D-Iowa. In 2000, Harkin asked what might happen if Congress weakened the CFTC's authority.

"If you have this exclusion and something unforeseen happens, who does something about it?" he asked Greenspan.

Greenspan said Wall Street could be trusted. "You can have huge amounts of regulation, and I will guarantee nothing will go wrong, but nothing will go right either," he said.

The House overwhelmingly passed the bill that kept derivatives clear of CFTC oversight. The Senate passed it. President Bill Clinton signed it into law.

And even as Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms. But that shared risk has since morphed from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives magnified the downturn.

The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers and imperiled the insurance giant American International Group has been fueled by the fact that they and their customers were linked to one another by derivatives.