Moral hazard, meet adverse selection

by John Quiggin on September 19, 2008

At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.

By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

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Now for the really big one

by John Quiggin on September 19, 2008

While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:

“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.[1]

It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.

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