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Buffett Mixes With Mafia Don, Zombies in Loopy Book on Meltdown Review by James Pressley

Jan. 20 (Bloomberg) -- Imagine Warren Buffett mingling with a Mafia don, zombies and “fluffy bunny wabbits.” This sounds like an improbable cast of characters for a financial crisis book. Until you read the author’s name.

John Lanchester is the Briton who wrote the blackly comic novel, “The Debt to Pleasure.” He brings his mischievous wit to bear on the Great Credit Crackup in his boisterous primer, “I.O.U.: Why Everyone Owes Everyone and No One Can Pay.”

Lanchester began tracking the crisis as research for a novel. He soon concluded that he had “stumbled across the most interesting story I’ve ever found.”

His newfound mission: to explain the world of finance to the general public. His method: to boil complex instruments and linkages down to anecdotes, outlandish images and acerbic asides that strip away those layers of bank jargon. The result is the perfect read for anyone still wondering what went wrong and why. Unless you’d rather they didn’t know.

The story gets rolling with Rakel Stefansdottir, a young Icelandic woman working on a master’s degree at the University of Sussex in the U.K. One day in October 2008, she stuck her card into an ATM to get some cash, only to have the machine say that the funds weren’t available.

She shrugged it off as a glitch -- something was amiss with “the trans-Atlantic telephone line.” In fact, her card blanked because Iceland had run out of dough, Lanchester writes.

In Iceland, as elsewhere, “borrowers were urged to gorge on cheap credit, like geese being stuffed to create foie gras,” he says. These days, the geese from Reykjavik to Reno are squawking mad about “the banksters.” They won’t get much sympathy from Lanchester, who learned the power of capitalism as a child growing up with a banker father in Hong Kong.

“We want someone else to blame,” he writes. “Well boohoo. Bankers are to blame, but we’re to blame too.”

The credit crisis, in Lanchester’s view, flows from a problem, a mistake, a failure and a climate. The problem was subprime mortgages. The mistake was banks relying on flawed risk models. The failure lay with watchdogs and central bankers who ignored the flashing red lights of “too-good-to-be-true data, economic overheating and funny smells,” he writes.

All the while, he says, some Western economies “were yelling ‘Woo-hoo!’ and tearing their regulatory clothes off.” Which brings us to the climate -- the one that emerged after the Berlin Wall came tumbling down.

Before the capitalist West triumphed over the communist East, the two sides engaged in “an ideological beauty contest.” Each strove to show that it provided its citizens with “the better, fairer way of life,” he says.

In Western liberal democracies, “the jet engine of capitalism was harnessed to the oxcart of social justice,” he writes. Then the good guys won, and the jet engine was “allowed to roar off at its own speed.” The result wasn’t pretty.

Lanchester demystifies everything from leverage and zombie banks to the structure of a collateralized debt obligation, which he compares to a series of buckets: Mortgage payments flow into the top pail, the AAA tranche, then spill over into lower tranches. The bottom buckets dry up first.

As for derivatives, he sensibly reminds us that they were originally designed to hedge risks, as when a farmer agrees in advance to a price for his next harvest.

“In an ideal world, one populated by vegetarians, Esperanto speakers and fluffy bunny wabbits, derivatives would be used for one thing only: to reduce risk,” he writes.

Where Are They?

In the real world, of course, derivatives wound up magnifying risk. Buffett “was doubly right to compare the new financial products to ‘weapons of mass destruction’ -- first, because they are lethal, and, second” -- drumroll, please -- “because no one knows how to track them down.”

Every good story needs a villain, and Lanchester fingers the credit-default swap as “the chief baddy, the gang leader, the Mafia don, the most destructive of the WMDs.” No one was assigned to policing CDS, let alone to figuring out whether the counterparties could afford to pay up.

“It’s a severe case of caveat emptor,” he says, “except actually the buyer didn’t need to beware, because the taxpayer was going to bail him out.” The real policy was “buyer, dude, don’t bother bewaring, we’ve got this covered.”

When I set this book aside, the immortal words of Pogo leaped to mind: “We have met the enemy and he is us.”