Good post over on Brad deLong's blog that gives a parallel perspective to the one I gave here.

According to the people deLong quotes, we have to see the subprime crisis in the context of new modes of banking, rather than in the more traditional terms of banking that have held up until now.

The conventional story about hedge funds is that, through their profit-making behaviour, they iron out the inefficiencies of the securities markets. They make money from information inefficiencies but since their investors tend to be the very firms who created the inefficiencies hedge funds act as a feedback mechanism, retrieving some of the money lost by the banks etc in the normal course of their work. In Sebastian Mallaby's words, linked to above, hedge funds "do not so much create risk as absorb it."

Hedge funds are the dung beetles of the financial world, in other words. While the great elephants of the plain lazily half-digest everything they eat, beetles, in looking after themselves, spread the fertiliser far and wide thus put all the pooey goodness back into the system.

But the problem is that the greatest profits are to be had at the margins and, in a segment of the financial market that is totally unregulated, nobody knows where those margins ought sensibly to end.

The fallacy of the subprime bet was that risk was regarded as another market inefficiency that could be addressed as a simple matter of price.

What nobody realised was that, with risk seemingly spread so thin, people at every level had an incentive to exploit the system. This was fine and dandy while new money kept getting thrown into the pot. It became a problem when the run towards the lucrative margin turned into a flight from the edge.

So, with the help of deLong's post, here's an alternative story about hedge funds, at least where they seek to bite the giddy fruit on the outer branches of the banking tree: they sought out risks that regulated and self-regulated banks dared not take on on their own and took a punt on them. The bet backfired because everyone thought they were passing the inevitable costs on to someone else before the music stopped.

But the risks were not spread so thin as they seemed. Or rather, the known knowns of subprime got large enough for people to become seriously worried about the unknown unknowns. And that's when the current panic really started to bite. After all there's nothing quite like playing Russian roulette when you think the gun is fully loaded.