Umbrellas, Casinos, and The End of The World as We Know It (Patrick M. Byrne, PhD.)

I will begin this preamble to the subject systemic risk with two quotes from Warren Buffett (by quoting him I do not mean to imply his support in these efforts of mine):

• Of excess leverage in the system, Mr. Buffett has said, “No one knows who’s been swimming naked until the tide goes out.”
• Mr. Buffett calls derivatives, “financial weapons of mass destruction.”

I would like to explore the meaning of this in the context of unsettled trades in our nation’s settlement system.

Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

Consider this scenario:

• I loan you an umbrella.
• You use that umbrella as collateral to borrow 5 more from someone else.
• You take the 6 umbrellas and loan them out to your 6 brothers.
•  Each of your six brothers now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more. Each brother now has 6 umbrellas, and loans them out to 6 of his friends.
• Each of those (6 brothers) X (6 friends each) = 36 friends now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more.
• There are now 6 X 6 X 6 = 216 umbrellas in all.

It starts to rain.

• I go to you and say, “I need back that umbrella I loaned you.”
• You say, “But that was collateral for the 5 I borrowed! If I have to return your umbrella, I’ll also have to return the other 5 I borrowed using your umbrella as collateral.”
• So you go to your six brothers and say, “I need those six umbrellas back!”
• Each brother says, “But I used that umbrella as collateral for 5 more!” So they go out to get each of their six umbrellas back by going to their 36 friends and saying, “We need our umbrellas back!”

 And so on and so forth. It is easy to see how this situation, where balancing upon one umbrella were 216 borrowed and reborrowed umbrellas, could unravel in a chain reaction of “unborrowing” and returning of umbrellas.

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