The world of banking, it’s becoming clear, operates according to different norms from those of the rest of the business world. Take the offsite corporate weekend. Normal behavior on these occasions consists of punishing the minibar and nursing consequent hangovers, hitting on long-fancied colleagues, and putting embarrassing items, ideally pornographic videos, on one another’s hotel bills. For form’s sake, a few new ideas are cooked up, and then gradually allowed to die a natural death when everyone is back at work and liver-function levels have stabilized. In June, 1994, when a team from J. P. Morgan went on an off-site weekend to Boca Raton, they conformed to normative behavior in certain respects. Binge drinking occurred; a senior colleague’s nose was broken; somebody charged a trashed Jet Ski and many cheeseburgers to somebody else’s account. Where the J. P. Morgan team broke with tradition was in coming up with a real idea—an idea that changed the entire nature of modern banking, with consequences that are currently rocking the planet.

Complex risk engineering ignored emotions like avarice and envy. Illustration by Seymour Chwast

The new idea was based on an old one, that of the swap. Say you’re in the grocery business, and feel gloomy about your prospects. Your immediate neighbor is in the stationery business, and he feels gloomy about his prospects, less so about yours. You get to talking, and one of you hits on a brilliant idea: why not just swap revenues? You take his earnings for the year, and he takes yours. The actual business doesn’t change hands, making the swap, in banking terminology, “synthetic.” The first currency swap took place in 1981, and allowed I.B.M. to trade surplus Swiss francs and Deutsche marks for dollars held by the World Bank. The two institutions exchanged their obligations to bondholders and their bond earnings without actually exchanging the bonds. The deal, brokered by Salomon Brothers, was worth two hundred and ten million dollars over ten years and ushered in a whole new field of finance. As Gillian Tett tells it in her book “Fool’s Gold” (Free Press; $26), by the time of the Boca Raton off-site, swaps had become a roaringly successful feature of the banking world: the volume of such interest-rate and currency derivatives was worth twelve trillion dollars, more than the entire U.S. economy.

But competition was making those swap deals less profitable. The quest was for a new, and therefore newly lucrative, product to sell. What got the J. P. Morgan team rolling was this thought: instead of swapping bonds or currency or interest rates, why not swap the risk of default? In effect, it could sell the risk that a borrower won’t be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a crucial part of the business. A product that made it possible to reduce that risk—by selling it to somebody else—had the potential to create a gigantic new market.

The broad outline of the financial crash is becoming well known. The value of Gillian Tett’s book is in the level of detail with which she tells the story, concentrating on the specific sequence of inventions and innovations that made it possible. Tett, a Financial Times reporter who covered the credit markets, was one of the few people to have seen the implosion coming. A critical factor was that she has a Ph.D. in social anthropology—a “hippie” background, as one banker told her, intending no compliment. It helped her focus on what she calls “social silences” in the world of banking. It’s not always what people say that contains the most important information; often, it’s what they take for granted. To Tett, it was obvious that the banking sector was running irresponsibly large risks in the overexpansion of credit and the overingenuity of its financial engineering. So she was perfectly placed to follow the story as it happened, and to pull together the story of how we got here. There are a number of different ways of peeling this particular onion; Tett does so through the J. P. Morgan team that helped create the new credit derivatives. These lie at the heart of the current crisis, and Tett’s account of their invention and dispersal makes “Fool’s Gold” a gripping and indispensable book.

The Boca Raton meeting first bore fruit when Exxon needed to open a line of credit to cover potential damages of five billion dollars resulting from the 1989 Exxon Valdez oil spill. J. P. Morgan was reluctant to turn down Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-called Basel rules, named for the town in Switzerland where they were formulated, required that the banks hold eight per cent of their capital in reserve against the risk of outstanding loans. That limited the amount of lending bankers could do, the amount of risk they could take on, and therefore the amount of profit they could make. But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out. No need to suck up useful capital.

In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the E.B.R.D. would be on the hook for it—and, in return for taking on the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P. Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn’t even have a name: eventually, the one settled on was “credit-default swap.”

So far, so good for J. P. Morgan. But the deal had been laborious and time-consuming, and the bank wouldn’t be able to make real money out of credit-default swaps until the process became streamlined and industrialized. The invention that allowed all this to happen was securitization. Traditionally, banking involves a case-by-case assessment of the risk of every loan, and it’s hard to industrialize that process. What securitization did was bundle together a package of these loans, and then rely on safety in numbers and the law of averages: even if some loans did default, the others wouldn’t, and would keep the stream of revenue going, thereby diffusing and minimizing the risk of default. So there would be two sources of revenue: one from the sale of the loans, and another from the steady flow of repayments. Then someone had the idea of dividing up the securities into different levels of risk—a technique called tranching—and selling them off accordingly, so that riskier tranches of debt would pay a higher rate of interest than safer ones. Bill Demchak, a “structured finance” star at J. P. Morgan, took the lead in creating bundles of credit-default swaps—insurance against default—and selling them to investors. The investors would get the streams of revenue, according to the risk-and-reward level they chose; the bank would get insurance against its loans, and fees for setting up the deal.

There was one final component to the J. P. Morgan team’s invention. The team set up a kind of offshore shell company, called a Special Purpose Vehicle, to fulfill the role supplied by the European Bank for Reconstruction and Development in the first credit-default swap. The shell company would assume $9.7 billion of J. P. Morgan’s risk (in this case, outstanding loans that the bank had made to some three hundred companies) and sell off that risk to investors, in the form of securities paying differing rates of interest. According to J. P. Morgan’s calculations, the underlying loans were so safe that it needed to collect only seven hundred million dollars in order to cover the $9.7-billion debt. In 1997, the credit agency Moodys agreed, and a whole new era in banking dawned. J. P. Morgan had found a way to shift risk off its books while simultaneously generating income from that risk, and freeing up capital to lend elsewhere. It was magic. The only thing wrong with it was the name, BISTRO, for Broad Index Secured Trust Offering, which made the new rocket-science financial instrument sound like a place you went to for steak frites. The market came to prefer a different term: “synthetic collateralized debt obligations.”

Inevitably, J. P. Morgan’s innovation was taken up by more aggressive and less cautious banks. Mortgage-based versions of collateralized debt obligations were especially profitable. These C.D.O.s involved the techniques that the J. P. Morgan team had developed, but their underlying assets were pools of mortgages—many of them based on the most lucrative mortgages, the now notorious subprime loans, which paid higher than usual rates of interest. (These new instruments could be pretty exotic: some consisted of C.D.O.s of C.D.O.s, pools of pools of debt.) J. P. Morgan was wary of them, as it happens, because it didn’t see how the risks were being engineered down to a safe level. But institutions like Citigroup, U.B.S., and Merrill Lynch plunged in.

The new financial instruments, as clever as they were, had an unfortunate side effect: they broke banking. At its heart, banking is a simple business. Customers deposit money at a bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. This isn’t glamorous or interesting, but banking is not supposed to resemble skydiving or hip-hop; what recommends it is that it’s a good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of the loans is critical, because those loans are the bank’s earning assets.

This isn’t some incidental issue; it’s the very core of what banking is. But the model of packaging plus securitization spurned the principle that a bank had to individually assess and monitor every loan. The mathematics of valuation models—horrendously complex equations to assess probabilities and correlations, cooked up in mad-scientist style by the firms’ “quants”—took on the burden of assessing statistical risk. The idea that a banker looks a borrower in the eye and takes a view on whether he can trust him came to seem laughably nineteenth-century. As for the risks? Well, as Lawrence Summers said when he was Deputy Secretary of the Treasury, “The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.”

Alas, Richard A. Posner, a judge on the U.S. Court of Appeals for the Seventh Circuit, observes with pointed restraint, “That turned out not to be true.” The result has been, in the title phrase of Posner’s new book, “A Failure of Capitalism” (Harvard; $23.95). He argues that we are now in a bona-fide depression, which he defines as “a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation.” His book is an attempt to write “a concise, constructive, jargon- and acronym-free, non-technical, unsensational, light-on-anecdote, analytical examination of the major facets of the biggest U.S. economic disaster in my lifetime and that of most people living today.”

Accounts of the banking-and-credit crisis tend to focus their explanations, which usually also means their blame, on one or more of the following four factors: greed, stupidity, government, and the banks. The process resembles a children’s game in which you spin an arrow and it lands on a word. Tett spins twice, and lands on greed and the banks; Posner suggests that he doesn’t know what the word “greed” means, and his spin lands firmly on government. “We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails,” he writes. “The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.”

This isn’t an original conclusion, but the way Posner arrives at it is new and bracing. His first claim to fame was as one of the founders of a school of thought that takes economic ideas and techniques and applies them to the law, as well as to life more generally. He has published nearly twenty books in just the past decade, a superhuman rate of productivity, bearing in mind that Posner is also a practicing judge, a senior lecturer at the University of Chicago, and an energetic blogger (in association with the Nobel Prize-winning economist Gary Becker). He has the rare kind of mind that is a pure pleasure to watch in action, regardless of the subject and the argument being made.

“A Failure of Capitalism” argues that the risks taken by the banks were rational, for two main reasons. First, it’s only with the benefit of hindsight that we can know that a bubble in prices was taking place. Bankers had to assign a probability to the prospect that there was a bubble, and, second, to the prospect that, if there was a bubble and it burst, house prices would fall by twenty per cent or more—this being the decline that precipitated the general crisis of bank insolvency. Now, suppose that the risk of both things happening was one per cent. Whether an event with that likelihood is worth worrying about depends on what its consequences will be. From the larger point of view, the consequences included systemic meltdown; but Posner invites us to focus our attention on what they looked like for individual bankers. They had strong incentives for taking the maximum amount of risks in their lending, since risks are correlated with rewards, and the bankers were so well paid that they didn’t really have to worry about being laid off. “The greater the gains are from taking risks that enable very high short-term profits, and the better cushioned the executive is by his severance package against the cost of losing his job, the more risks he rationally will take,” Posner notes. Besides, if a bank avoids these risks, and its competitors don’t and therefore make more money during the boom, the cautious bank risks going out of business anyway, because its clients will walk away.

People taking out what now look like crazily risky mortgage loans were being rational, too, because they were acting on the widespread assumption that house prices would continue rising. If house prices fell, well, tough luck, they’d walk away from the loan and go bankrupt—but they probably had lousy credit ratings anyway. “Thus the downside of the home buyer’s speculative investment is truncated, making his ‘reckless’ behavior not only rational but also consistent with his being well informed about the risks,” Posner writes. The conclusion: “Risky behavior of the sort I have been describing was individually rational during the bubble. But it was collectively irrational.” As for the idea that the bankers were dumb to get so carried away: “I am skeptical that readily avoidable mistakes, failures of rationality, or the intellectual deficiencies of financial managers whose IQs exceed my own were major factors in the economic collapse. Had the mistakes that brought down the banking industry been readily avoidable, they would have been avoided.”

This is a familiar place for these arguments to end up: economists often find that apparently erratic behavior is, at heart, rational. It helps that the definition of rationality can be stretched to include emotion, which “is not necessarily or even typically irrational,” Posner argues. Reckless greed, incompetent assessments of probability, blindness to the inevitability of downturns, failure to hedge risks so big that they threaten a firm’s very existence: all are rational.