Wednesday, 11/20, Market WrapUp (threat of terrorism on oil pipelines)

Financial Sense Online ^ | 11/20/2002 | James J. Puplava

[Soren]

I'm usually skeptical when I hear claims of "this time it's different", but one area where it really is different this go around is the level of derivatives. I found Ferguson's comments very interesting. While derivatives increase the dispersion of risk, it seems to me that they may lead to an increase in the aggregate level of risk. The parallel I draw is with the health insurance market. When a reinsurer writes aggregate stoploss coverage to a carrier, they require the carrier to maintain a meaningful share of the risk. The purpose is to ensure prudent underwriting by the carrier. In the mortgage market, it seems to me that if lenders are insulated from interest rate risk and credit risk that the credit quality of borrowers is likely to decline as lenders loosen their standards to pump up the bottom line. I suspect credit derivatives are priced using historical default rates, which reflect tighter standards. This leads me to suspect that once interest rates start to rise, we will see an increase in defaults that is greater than previous downturns and widespread disenchantment by writers of credit derivatives.

[rohry]

"I suspect credit derivatives are priced using historical default rates, which reflect tighter standards."

This is what Puplava claims is the problem with all the derivatives, i.e. the computer models are based on the predicted likelyhood of an event occurring. He claims that there will be an event ("The Perfect Storm") that will occur at some point that the computer models said would "never" occur. At that point the models fall apart and the "balanced" derivatives diverge and become unbalanced risks that have to be covered (gold shorts, long term-interest rates vs. short term rates, junk bonds, currency imbalamces, etc).