I have excerpted an analogy (flood insurance) from Doug Noland's Credit Bubble Bulletin (which can be read in its entirety at Prudent Bear.com, Dec 8th issue). This relates to the "counterparty risk" argument that I believe large hedgers are exposed to. I submit that the "flood" these counterparties will be subjected to will be in the form of higher gold prices (certainly not an impossible event is it?).
A second lesson of the analogy relates to capital and investment distortions out of the old economy (disinvestment)into the so called new (overinvestment). I think we are seeing that fallout today with high energy prices and shortages. And we are seeing signs of it in the metals markets (PGE's).
"All derivatives do is shift risk from one party to another. And, importantly, they generally transfer risk to thinly capitalized financial players and speculators lacking the wherewithal to shoulder this burden in the event of a severe market dislocation. Derivatives, furthermore, foster credit excess and speculation, which destroy wealth, not “enhance” it.
If you will bear with me for a few minutes, I have my favorite analogy of the present derivatives bubble – “A Derivate Story” telling a tale of a spectacular boom in flood insurance.
“Imagine a quaint and tranquil town near a pristine river. Throughout history, this river has been prone to the occasional dangerous flood that would completely wipe out the few unfortunate homeowners within the flood zone. Demonstrating the prudence that comes from a keen appreciation of history, few individuals were willing to take the big risk of gambling with Mother Nature. But after many floodless years an enterprising local insurance company began offering limited flood protection. Cautiously, this initial coverage was only for homes constructed outside of the 100-year flood plane, the policies had large deductibles, and were offered only at premium rates. A few daring residents jump at the opportunity of living along the river, although they chose the plots on the highest ground. Building commenced on several structures, as word of flood insurance profits traveled quickly.
Soon, other firms offered flood insurance and, seeing extraordinary profit potential, most soon provided insurance within the 100-year flood plane. Insurance rates drop precipitously, and insurers became increasingly accommodative. Not surprisingly, the new insurance was quite popular and construction soon commenced on homes up and down the banks of the river. An economic boom took hold throughout the community, for the homebuilders, the carpet weavers, cabinet-makers and, certainly, the real estate agents. The local banks were absolutely ecstatic with surging loan growth and lending profits. The insurance companies, of course, also prospered mightily with flood insurance revenues soaring as new homes popped up all along the water. And the greater the economic boom, the more residents that desired to live on the river. Soon, writing flood insurance became the most profitable business in town.
Before long, insurance companies were moving in from out of town to set up shops to write flood policies. The local banks began peddling flood insurance as well. An active market developed in reinsurance, as a few of the writers of flood protection sought to shift some of their growing exposure. Importantly, the low cost and ease of availability of flood insurance incited an unprecedented building boom along the river. Throughout, all agreed that flood insurance and the ability to mitigate risk was the greatest thing that had ever happened to the community – it ushered in a “New Era.” With euphoria overflowing, everyone extrapolated recent wealth increases far into the future, while the local economy prospered like never before. After all, each year the new homes became larger and more extravagant, property values rose, and the profits from writing and trading flood insurance grew exponentially.
Over time, the local economy comes to revolve around the activities of writing flood insurance, lending and financial services, home building, foreign car dealerships, retail and luxury goods and, importantly, the active trading of reinsurance contracts. And as these “New Economy” enterprises flourish during the boom, the community loses interest in “Old Economy” businesses. With bankers and financiers allocating funding to homebuilding, financial services, and “New Economy” startups, many previous stalwart “Old Economy” businesses wither and die. Previous successful machinists and craftsmen close down their shops, some taking sales jobs at the new malls and restaurants. Others set up digs in one of several flashy new office buildings. There they become employees of the many rapidly expanding enterprises seeking in some manner to profit from escalating home prices, “New Age” startups, and rising asset prices generally. Virtually everyone endeavors to profit from the insurance boom. Many citizens quit their jobs to trade contracts in the booming flood reinsurance market, as speculative trading flourishes throughout the thriving community.
And after years of drought, the aggressive insurance companies have come to dominate almost all financial and economic aspects of the community. They solely determine which industries and companies have access to capital. The conservative banks that in the past guarded carefully against excess were either taken over or went out of business. Some of the surviving “old community” banks, having struggled to profit in an increasingly competitive lending market, are now the largest providers of flood insurance and active traders in reinsurance contracts. Hubris runs very high, and the financial sector becomes increasingly expansive. All the major financial firms now employ the most brilliant weatherpersons. Virtually all, curiously, believe that there has been a permanent change in weather patterns. The faith in the “New Era” takes firm hold, with nothing but blue skies ahead. After all, why worry when the most successful insurance companies now employ the best and brightest young mathematicians and weather forecasters. Besides, these “rocket scientists” have developed sophisticated “dynamic hedging” models and strategies that call for active buying in the re-insurance marketplace in the unlikely event of any significant change in atmospheric pressure. I will end my foray into fiction writing with torrential rains inundating the community and the levies beginning to give way.”
One of the points I am trying to make with my flood insurance analogy is that the ease of availability of insurance changes behavior and fosters credit and speculative excess, as well as endemic over spending. Without the proliferation of insurance, there would not have been a building boom along the river and an unsound boom throughout the community. Furthermore, let’s recognize that the boom has profound effects on the structure of both the economy and the stability of the financial system. Sure, the boom has all the appearances of healthy prosperity on the surface, but it is unsustainable, with the foundation of this prosperity very frail and in wait of the inevitable accident. Importantly, the boom in insurance contracts creates processes that greatly increase systemic risk to the next flood. And with an entire community having sprouted along the river, there is no doubt that the next flood will be a complete wipeout. When the heavy rains come and the river begins to overflow, the speculators will move to dump the insurance contracts they have written or they may attempt to reinsure. But there will be no liquidity in this market– no one to take the other side of these speculative trades. After all, with everyone having accumulated so much risk during the boom, who has the capacity to step up to the plate in the face of potential catastrophe? And when the catastrophic flood damages are sustained, there will be no one with the wherewithal to settle the massive claims and the insurance market will collapse. |
