Today's comment is by Eric Roseman, Investment Director and Editor of Commodity Trend Alert.

Dear A-Letter Reader,

Since last March, I've been warning about the Derivatives Time-Bomb.

There's a real threat out there and it continues to grow by the day. The threat is so great that a former Federal Reserve regional governor and a dozen Wall Street banks have been working to reduce the number of unmatched trades in derivatives since 2005. That number continues to shrink, which is good news. But there's still trillions of dollars outstanding in these contracts.

Now we've got a new type of derivative on the Street, widely popular and largely unregulated: Credit Default Swaps.

The notional value of Credit Default Swaps now sits at roughly $20.4 trillion dollars as of June 30, 2006, according to the Bank of International Settlements (BIS). To give you an idea of how enormous that number really is, consider that all the stocks traded on the New York Stock Exchange (NYSE) are worth about $14.8 trillion dollars. That's huge.

Worse, derivatives are unregulated. And they have either plagued or destroyed numerous financial institutions and even municipalities over the last 35 years, including a near-term collapse of the financial system in August 1998.

The latest batch of derivatives manufactured by Wall Street, Credit Default Swaps, provides a way for investors to trade credit risk. If you're worried about a bond defaulting or declining in value, you can hedge your exposure with these securities. But with the majority of traders out there harboring very little market experience and running hundreds of billions of dollars in hedge funds and other collective investment vehicles, mostly unregulated, the threat of a systemic event leading to a crash is obviously possible. It's possible because the majority of these institutions all use similar risk-management models, which could exacerbate a crash.

The good news is that U.S. interest rates are heading lower, at least for the next 12-18 months. The Fed will probably cut rates in 2007 to alleviate real estate stress and the slowdown in manufacturing. If employment growth stalls, then the Fed will cut rates even sooner. The point is this: lower interest rates should reduce the odds of a systemic derivatives-based crash. That's because it creates liquidity, which should ultimately reduce the risk of a leveraged disaster -- at least for the time being.

For now, things look benign for derivatives. But if interest rates start to rise again later in 2007 or 2008, the odds of a global systemic shock will grow much louder.

ERIC ROSEMAN, Investment Director

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