The Hampton Inn in Phoenix, an unprepossessing stucco structure set amid the haphazard low-density sprawl of South 48th Street, is unusually quiet. So much so that the owners of the midrange business hotel, which operates under the Hilton Hotels umbrella, have come in to discuss how to handle the steep drop-off in guests. General manager Gary Bowers, a burly guy with a gravelly Southwestern twang and a salt-and-pepper goatee, tells me business was great in 2007, as it was throughout the industry.

But over the summer, as the economy threatened to implode, executives and tourists alike began tightening travel budgets, and hotel occupancy in the U.S. was down by around 3 percent. In Phoenix, that number was more than 9 percent. In Bowers’ hotel, it was closer to 12 percent. “It just seemed like it came real fast, just—boom,” he says.

The struggling Hampton Inn is only one small corner in the sprawling empire of the world’s largest hotelier—none other than Stephen Schwarzman, co-founder and now chairman and C.E.O. of the Blackstone Group, the private equity giant. With its single biggest equity investment, its $26 billion acquisition in October 2007 of Hilton, which includes brands from Hampton Inn to the Waldorf-Astoria Collection, Blackstone controls nearly 4,000 hotels with more than 620,000 rooms. Now, in light of the hotel industry’s traditional vulnerability to recession, those holdings look increasingly dicey. (Editor's note: Since this story went to press, the Hilton deal hit further snags. Read our update here.)

The biggest hotel buy of all time, the Blackstone-Hilton deal stands as the apogee of the early-millennial megabuyout frenzy, where cheap and readily available credit, coupled with a relentless one-upmanship, spurred private equity firms to buy out companies at often absurd overvaluations, saddle them with massive debt, and then pay themselves hefty fees for the trouble.

For better or worse, private equity during the boom came to be almost synonymous with Schwarzman, a man known equally for his vaunted financial wizardry and his unabashed displays of wealth, most notably his notorious 60th birthday party, which cost $3 million and featured Rod Stewart and a gospel choir. A prodigy, Schwarzman had risen to managing director at Lehman Brothers by the age of 31 and co-founded Blackstone in 1985 to catch the coming wave of alternative assets like hedge funds and private equity. After a string of increasingly stunning deals, Blackstone pulled off the biggest real estate buy in history in 2007, acquiring Sam Zell’s Equity Office Properties Trust for $39 billion—a price so high that Blackstone unloaded $27 billion worth of E.O.P. assets to pay off the $16 billion debt.

Schwarzman’s high profile and profligate lifestyle—his numerous mansions and his much-derided fondness for $400 crabs for lunch—drew a backlash from the media and Congress, resulting in an ongoing legislative push to double taxes on private equity firms (an effort unofficially dubbed “the Blackstone Bill”). As the scrutiny intensified, Schwarzman began to remake his image from hyperaggressive dealmaker to world-class philanthropist, an effort that culminated in his giving in March $100 million to the New York Public Library, which, by way of thanks, will name its main building after him.

Blackstone-Hilton was the last big deal of this noisy bonanza, the collision point of leveraged-buyout fever and the hyperinflated real estate market. Blackstone’s payment for Hilton—a 40 percent premium over its share price—floated on a raft of $20 billion of the sort of cheap and flexible debt that helped spur the global liquidity crisis. At the time, Hilton was the world’s fourth-largest hotel company, and it brought to Blackstone about 3,000 hotels, spread throughout 80 countries.

When the deal happened, it was hailed as a harbinger. There was talk of other big hotels possibly selling to private equity at valuations that now look ridiculous. The share prices of Hilton’s then-flourishing rivals, Marriott, InterContinental, and Starwood, all shot up at the possibility. But none sold, and those stocks have since gone through the floor along with Blackstone’s. And as several disturbing trends collide—the burst real estate bubble, the frozen credit markets, tanking stocks—something as simple as empty rooms in places like Phoenix could determine Schwarzman’s legacy, whether he will be immortalized for his financial acumen or instead come to personify the excesses of a bloated, bygone era.

Blackstone didn’t fly blindly into the Hilton deal. It was already heavily into hotels, having spent $17 billion in the three previous years, and it controlled 100,000 rooms, spread amid such holdings as La Quinta Inns and Blackstone’s own luxury LXR line, a portfolio of once-rundown, exotically located hotels that it bought and restored. But even for a firm that maintains a formidable in-house real estate unit and nine separate real estate funds, and has a proven track record in smaller hotel transactions, Hilton was an unusually big meal.

After the Hilton acquisition, many observers expected Blackstone to do what it usually did: start spinning off assets to pay down the debt. Whether the company planned from the outset to keep all the hotels—it says it did—it has little choice now. Shortly after Blackstone and Hilton agreed to terms, the subprime debacle led to the credit markets freezing up, bringing the mega-L.B.O. era to a halt. The market is so sluggish that much of the $20 billion in debt associated with the Hilton deal, which in better days would have been moved with relative ease, remains unsold. J.P. Morgan inherited the debt from Bear Stearns, which helped finance the deal. One Morgan insider believes that the federal government—and thus taxpayers—may have assumed the debt during Morgan’s takeover of Bear.

With the decline in buyout deals, Blackstone and other private equity firms that rely on associated fees started slipping as well. Blackstone went partly public in June 2007, in a mind-bendingly complicated arrangement in which the firm’s principals got to maintain control, reap a mint from the initial public offering, and keep the performance of its individual assets private. Since then, things have dropped off steadily. Blackstone reported losses in two of its first three quarters, and its stock, which debuted at about $35, recently languished near $16. Schwarzman has seen his own stake fall by about $4 billion.

The hotel industry, which achieved record revenues in 2007, has also soured, from Phoenix to Phuket. Kristin Knox, a former Hilton employee now at Hotel Asset Value Enhancement, in California, sums up the “consensus” on the purchase: “Overvalued, and it happened at the wrong time for them.”

After Blackstone bought Hilton, it went whole hog, poaching a team of blue-chip hotel executives and mounting an expansion jag just as the industry—which historically mirrors the economy—was about to descend into what may be the worst slump in recent memory. Hilton has about 1,000 new hotels in various stages of development, including about 860 slated to be built in the U.S., mostly in suburbs and office parks. While relatively few projects are in the works in foreign markets, where Hilton’s competitors have pulled way ahead, more are on the way. Hilton is aiming to build 75 hotels in India, 20 in China, 150 in the Caribbean and Latin America, 10 in Nigeria, 30 Hampton Inns in Britain, and 25 midrange Hilton Garden Inns in Turkey.

Hilton’s growth will rely heavily on franchisees and real estate investment trusts. They put together the financing to buy or build the hotels and either pay Hilton license fees of between 8 and 10 percent of room, food, and drink revenues—in order to take advantage of Hilton’s name, branding operations, and reservations system—or pay more to have Hilton itself manage the properties. This approach ensures that Hilton doesn’t bear the cost of building the hotels, but it does leave the independent owners and franchisees at the mercy of the deepening commercial-lending freeze. Lodging Econometrics, which tracks industry growth trends, estimates that 360 U.S. hotel projects were called off in the third quarter of 2008, a seven-year high, and says some of Hilton’s have been affected.

Even assuming Hilton’s hotels are built as planned, they will probably have to cope with significant vacancies, at least for a time, as worldwide business travel contracts. “We’re in for a long global recession,” says an executive at another major private equity firm, “and Hilton needs to expand in a way that hotels have never expanded before just to get back to zero, to get back to what Blackstone paid. This is definitely a bull-market play, and we’re not in a bull market.”

Hilton’s new chief executive, Chris Nassetta, insists that financing has been secured for all the hotels under construction, mostly from local and regional banks before commercial lending soured. He says that the credit crunch is going to have “some impact” on near-term plans—chiefly on the next round of new hotels, as developers strain to find financing—but not enough to derail the long-term strategy. He predicts that the hotel-industry slump and the chaos roiling the financial markets will be reversed quickly enough. “What’s going on with globalization and the emerging markets and the growth of the middle classes,” he says, “is a very powerful megatrend that bodes extraordinarily well for our business.”

Jon Gray, the 38-year-old co-head of Blackstone’s real estate division, also defends the Hilton acquisition. Gray, who led the high-wire E.O.P. deal, reports to Schwarzman and Blackstone president and chief operating officer Tony James. He pushed for the Hilton deal and handled the negotiations. (According to Blackstone insiders, Schwarzman approved the acquisition and kept abreast of discussions but didn’t personally work on it.) “We’ve bought nine public lodging companies in the past 10 years, and in each transaction, people have told us we overpaid,” Gray said at a June conference held at the now-Blackstone-owned Waldorf-Astoria in Manhattan. “So far, we’ve done okay.”

Discussing Hilton’s growth potential, Gray threw out the word amazing like confetti from a rooftop, a sharp counterpoint to the gloom peddled by everyone else at the conference. “The greatest opportunities,” he said, “are when you’re prepared to step in when other people are running away.”

By acquiring Hilton, Blackstone bought a company with a history of stepping in when others were running away. In 1919, Conrad Hilton bought a Texas flophouse called the Mobley for $40,000. After failing as a banker, a legislator, and a music promoter, Hilton spruced up the Mobley and, in short order, turned it around. Soon, he began buying up other fixer-upper hotels in Texas and beyond. In 1940, as fears of a Japanese attack on California depressed real estate values, Hilton started buying high-end hotels there cheaply. (The move would be echoed six decades later when Blackstone acquired La Quinta and Extended Stay Hotels after the September 11 attacks had badly shaken the hotel industry.) In 1949, Hilton bought the Waldorf-Astoria, and in 1954, he bought out his main competitor, the 10-hotel chain Statler, for $111 million, in what was the single largest real estate transaction since the Louisiana Purchase.

When Conrad Hilton died in 1979, he left 185 hotels. His son Barron took over as C.E.O. and continued to grow the company until 1996, when Stephen Bollenbach, a hard-knuckled dealmaker who had worked for Disney, was named C.E.O. and co-chairman of the board, alongside Barron. Under Bollenbach, Hilton Hotels experienced the most fevered growth spurt in its history. In 1999, Hilton bought the struggling Promus Hotels, whose brands included Doubletree, Hampton Inn, Homewood Suites, and Embassy Suites, for $4 billion. And in 2006, Hilton spent $5.7 billion to buy back the 400-hotel-strong Hilton International chain, which it had spun off in 1964. That bifurcation had hobbled Hilton overseas because it meant that only core Hilton hotels, not other lines like Doubletree or Embassy Suites, could be built abroad. With the domestic and international operations reunited, Hilton suddenly had huge international growth potential. This, along with the handful of valuable real estate assets Hilton owned outright, like the Waldorf-Astoria and the Chicago O’Hare Hilton, made the company attractive to Blackstone.

Anticipating an economic downturn,  Bollenbach engineered the sale. When Blackstone was courting the hotel firm, Hilton’s board and Bollenbach already had misgivings that maintaining the company’s pace of expansion “may not be achievable,” according to Securities and Exchange Commission filings.

Bollenbach walked away with about $125 million and later boasted that it was the best deal he’d ever made. It worked out well for Barron Hilton too, who raked in about $1 billion. He plans to leave the vast majority of his fortune to the family’s charitable foundation—and not to his wayward granddaughter Paris. He declined to comment for this article, though an assistant says he’s enjoying his retirement, adding pleasantly, “He has no idea what Blackstone is doing, and he could care less.”

Some of the more existential challenges facing Hilton Hotels are epitomized by one of its flagship properties, the Waldorf-Astoria in Manhattan. The Waldorf is arguably the most recognized hotel in the world, just as Hilton is the most recognized hotel brand. Both before and after Blackstone took over Hilton, Schwarzman used the Waldorf frequently for events. Recent highlights include a $1,000-a-plate benefit for the Appeal of Conscience Foundation and two September round tables, one about the credit crisis and another on the suddenly cowed private equity industry. Reported the Wall Street Journal: “Schwarzman’s insights were in much demand during the two-hour round table, so much so that at one point, he laughingly objected, ‘Why do I always get called on first?’ ”

Recently, I stayed in a room on the 16th floor of the Waldorf. The rug was ratty, the TV was old, the wall sconces in the bathroom were flecked with black paint, the tub was chipped and stained, and the bathroom mirror had come loose, leaving an inch-wide gap that receded into darkness. Far from becoming suffused with a sense of old-time Manhattan sophistication, I was overcome with the feeling that I had stumbled into a rich, aging aunt’s seldom-used guest bedroom. Worse, when I had tried to check in, I was told the computers were down. They remained that way for several hours. When I inquired about the business center, I was shown to a shabby facility where no one could figure out how to hook a Mac up to a printer. All the directions were for PCs. My visit suggested that the Waldorf has been coasting on its name and fallen more than a little behind the times—a problem when Blackstone is hoping to open Waldorfs all over the world to capitalize on the cachet of the original. I resolved to take this up with Hilton’s new C.E.O.

Nassetta had worked with Blackstone’s Gray when Nassetta was C.E.O. of Host Hotels & Resorts, a REIT based in Bethesda, Maryland, and one of the country’s largest owners of hotel properties. During his tenure, Nassetta more than doubled the holdings of Host, which routinely generated strong returns. In 1998, Blackstone took a 19 percent stake in Host, in exchange for a portfolio of domestic luxury hotels. Several deals between the two companies followed, and Gray and Nassetta became friends. After Blackstone and Hilton agreed to terms in July 2007, Gray called him up. Nassetta, 46 years old and the father of six girls, pulled up stakes and set out for Beverly Hills, where Hilton is headquartered. “The vision of [Hilton] is really simple,” he says. “It’s to be the preeminent global lodging company. My guess is, we will be the biggest. But for me it means being the best.”

When I speak to Nassetta, he is staying in the $10,000-a-night Presidential Suite at the Waldorf, which features a simple wooden rocking chair once owned by President Kennedy and an imposing desk that belonged to General Douglas MacArthur. Nassetta is animated about both the room and the job. When he gets excited, his voice rises almost to a squeak. “I’ve got a lot of energy,” he says, “and I’m having an amazing amount of fun. It’s just so stimulating. You have this opportunity, and to do all this—you can imagine!” He tells me he’s been sequestered in the room for five days straight, talking to owners and various industry types but is looking forward to flying down to Memphis the next day to surprise his mother on her birthday. (Later, when I knock on the front door of the suite to grab something I’d left, he tells me to come in, calling out, “I’m actually just sitting in John F. Kennedy’s chair doing some email. It’s actually pretty comfortable. Maybe some of it will rub off on me.”)

I lodge my complaints about the state of my room, particularly about the TV. “You don’t have one of these?”

Nassetta says with a laugh, pointing to a giant flat-screen model on the wall of his suite. “Every room within a couple of years will have one of those.” He launches into his plans for the Waldorf, which he acknowledges has been “underinvested in” over the years. He plans an overhaul of the systems, technology, air-conditioning, food and beverage service, and street-level retail space, which is currently vacant. He’s looking to upgrade the rooms, the facilities—the whole thing. “In the next couple of years, you’re going to see a very different Waldorf-Astoria,” he says.

Nassetta spent his first 60 days on the job “circumnavigating the globe,” often with Blackstone’s Gray at his side, touring facilities, trying to get a handle on the way Hilton works, and brainstorming ways to reform its sometimes stodgy and unwieldy organizational structure. He has also been raiding other companies to assemble what John Arabia, managing director at the real estate consulting firm Green Street Advisors, calls “a lodging dream team.” In June, for instance, Nassetta hired two leading specialists in the luxury sector, Ross Klein and Amar Lalvani, who oversaw the expansion of the game-changing W Hotels chain, to spearhead the launch of a Hilton lifestyle brand in the first quarter of 2009.

Despite the harsh economic climate, Nassetta contends that Hilton isn’t struggling. He rhapsodizes about Blackstone, about working with Gray, about Hilton itself. “Our competitors want to talk the deal down and say, ‘Oh my God, they gotta be hating life,’ but the fact is, we’re feeling great,” he says. “All we’re thinking about is, What is this business going to look like three, five, 10 years down the road? And we’re as pure as the driven snow on that objective. I sense nothing but total alignment with me, with these guys, and that’s what I love about it. All the oars are in the water going in the same direction, which is a lovely thing.”

Hotel companies are stubborn, big-footed, slow-moving fauna with huge overhead. As such, they’re uniquely vulnerable to changes in the economy. These days, they’re getting it from all sides: rising airfares and cuts in airline service; widespread financial-industry layoffs; declining leisure travel; high gas prices, labor costs, and construction costs; heightened tension in domestic and global politics; galloping xenophobia—you name it. Occupancy is falling, down 5 to 7 percent in September compared with the same month in 2007, while supply keeps rising, carried forward by the momentum of the hotel boom during 2006 and 2007. By September 2008, the number of hotels was up nearly 12.8 percent year over year in the U.S. But during the first half of 2008, according to Smith Travel Research, occupancy fell in every region on earth, save for the Middle East and Africa. Despite jacked-up room rates, revenue per available unit is also dropping.

Among Hilton’s competitors, Marriott saw its third-quarter profits slide 28 percent, and its share price has dropped about 40 percent so far in 2008. This year, shares of InterContinental, Starwood, and Wyndham have fallen 35, 50, and 40 percent, respectively, and Wyndham is planning layoffs. In late September, Steven Kent, a hotel-industry analyst at Goldman Sachs, cut his estimates for seven major hotel companies, saying he expects revenue to continue falling “well into 2009” and hotel shares to “grind lower in the coming 12 months.”

Hilton is growing so fast that some of its new hotels are starting to cut in on its old ones. A couple of blocks down South 48th Street in Phoenix from Bowers’ Hampton Inn, there’s another Hilton-brand hotel under construction: a 125-room Homewood Suites that will also target business travelers. “It’s going to take some of my business, absolutely,” Bowers tells me. Asked how he expects to cope with the rapidly deteriorating economy and added competition, he tosses his head back toward his office, where the local owners are still sitting. “That’s what we’re talking about now. We’re real concerned.” Adds Jim Flynn, a former senior vice president at Doubletree: “Right now, there’s too many instances where Hilton and Doubletree compete against each other.”

So far, Blackstone insists that Hilton is outperforming expectations. During an earnings call in August, Blackstone’s James acknowledged that suburban business hotels, which make up the bulk of Hilton’s U.S. pipeline, were weak. But thanks to strong franchise growth, he said, Hilton’s revenue before expenses was up by double digits since the beginning of the year. James’ assertion confounded some analysts: “If you beat the data, it’ll admit to anything,” one remarked. “Being up 10 percent—I’m not sure how that’s possible given where the industry is.”

There is a lot riding on the outcome of the Hilton deal, and it will be several years before anyone can say with any certainty whether it was a worthy gamble. If Blackstone can defy the odds and the naysayers, expand Hilton in the teeth of a grim economy, and emerge in a position to dominate the global hotel industry when the economy rebounds, that would constitute perhaps the capstone on Schwarzman’s remarkable career. If not, well, he can always try to unload the Waldorf-Astoria to ease the impact. He just might want to throw up a fresh coat of paint beforehand to goose the sale price.