The bunching of freak events

Yesterday, I said that the trouble in the banking system was due in part to the inability to price credit derivatives accurately. This shows what I mean:

German police were investigating two cases of suspected infanticide yesterday that had resulted in the deaths of eight young children.
In the village of Darry, in the north of the country, five boys aged three to nine were found dead after their mother confessed to killing them earlier this week. Meanwhile, in the east of the country, the corpses of three other infants were found wrapped in plastic.

This shows that rare events - infanticide - can bunch together.
Similarly, defaults on debt are rare but also bunch together. The key question in pricing bundles of such debts, and their derivatives, is: to what extent do these events bunch?  How great is default correlation? Worse still, to what extent does this correlation change over time (in good times, it's low, in bad times high)? It's this question that underpins the fancy maths about pricing copulas. And the problem is that because rare events are, by definition, unusual, there's not much hard data to help. Hence the impossibility of accurate pricing.

Comments

[FSK]

The problem is that statistically, defaults should be uncorrelated.

Defaults *ARE* correlated because there's a structural defect in the monetary system. With debt-based money, a certain number of defaults are guaranteed in each bust phase of the economic cycle.

[jameshigham]

This shows that rare events - infanticide - can bunch together. Similarly, defaults on debt are rare but also bunch together.

There's some sort of correlation between these two examples too but it escapes me. Why would you say debt default is rare?