Prediction Markets Update (September 15, 2008)

By comparison with real-world financial markets, prediction markets have lately grown quite boring. As was the case yesterday, the changes in the 2008.PRES.McCAIN Intrade contract (down .9 at 51.6) and 2008.PRES.OBAMA (up .4 at 47.2) Intrade contract are very marginal. There is also very little movement in the state-by-state contracts, so based upon my (somewhat arbitrary) cutoff price point of 55 for allocating Electoral College votes, it still appears that Mr. Obama and Mr. McCain are virtually tied (with 264 and 265 Electoral College votes respectively), with only Colorado (and its 9 Electoral College votes) “undecided”.

Similarly, Nate Silver’s PECOTA model (see FiveThirtyEight) shows little change from yesterday, allocating 280 (instead of 281) Electoral College votes to Mr. McCain and 259 (instead of 258) electoral College votes to Mr. Obama.

Observations concerning some of today’s events in the worlds of finance, insurance, and risk management

1. Lehman Brothers and AIG: As John Markman cleverly notes, “…the Federal Reserve stood up to the big Wall Street financial houses on Sunday and essentially told them, ‘thanks but no thanks’ on their request for a bridge loan to nowhere”. Consequently, Lehman Brothers (the 4th largest investment bank in the world) has filed for bankruptcy protection, and its shares are trading today for 23 cents per share. Bill Gross made an interesting comment concerning Lehman and American International Group (AIG) this morning on CNBC; he noted that while AIG is technically solvent, it is highly illiquid, whereas Lehman is technically insolvent but otherwise quite liquid. Just one year ago, AIG had a market capitalization of nearly $200 billion, making it one of America’s most valuable publicly traded corporations. Today, AIG’s market capitalization stands at $18 billion. The problem AIG faces is that if this company can’t resolve its liquidity problems really soon (like sometime within the next couple of days), then it risks being downgraded by the credit rating agencies. If AIG’s credit rating becomes impaired, it stands to lose a substantial share of its client base. AIG is particularly heavily exposed to commercial insurance lines of business, and their clients have no interest in doing business with credit-impaired insurers. If this scenario plays out, expect to see AIG follow up with its own bankruptcy filing.
 
2. Hurricane Ike: The three major catastrophe risk modeling firms (Applied Insurance Research (AIR), EQECAT, and Risk Management Solutions (RMS)) project insured losses of between $6 – $18 billion, primarily in the Texas counties of Brazoria, Harris, Galveston, Chambers and Jefferson. Since the Texas Windstorm Insurance Association (TWIA) is heavily exposed to insured properties in these counties, I suspect that claims may very likely exceed TWIA’s capital base of $1.87 billion, which consists $370 million in a Catastrophe Reserve Trust Fund and $1.5 billion in reinsurance. Depending upon the magnitude of TWIA’s Ike-related losses, private insurers in Texas could face assessments which would have the potential for setting in motion a financially vicious cycle in which future earnings and capitalization are impaired, which in turn adversely affect insurer credit ratings. Matters can only get worse if the Texas gulf coast gets hit with any more hurricanes any time soon.
 
3. Oil Speculation: Apparently so-called “oil speculators” were not behind the large run-up in oil prices during the first half of 2008, any more than they were behind the subsequent retreat in oil prices during the past couple of months. Last week, the Commodity Futures Trading Commission (CFTC) issued a report which provides compelling empirical evidence to the effect that financial trading hasn’t been driving price moves in oil markets after all. For a synopsis of this study, see the article from today’s Wall Street Journal entitled “See You Later, Speculator”. As I noted in my July 10, 2008 blog entry entitled “Rebuttal of ‘An open letter to all airline customers‘”, this finding comes as no surprise. Thankfully American Airlines has finally gotten around to removing the link from its home page urging consumers to “stop oil speculators by sending Congress an S.O.S.”…