Prediction Markets Update (September 17, 2008)

Although Nate Silver’s PECOTA model (see FiveThirtyEight) continues to indicate a 288 to 250 Electoral College advantage for John McCain over Barack Obama, today there has been a shift in the prediction markets data which now appear to convey a marginal advantage to Mr. Obama. Specifically, the 2008.PRES.OBAMA Intrade contract has rallied 1.8 points and is now trading at 50.7, wheras the 2008.PRES.McCAIN Intrade contract has sold off 1.9 points and is currently trading at 48.6.

Looking at the state-by-state contracts, it appears (based upon my cutoff price point of 55 for allocating Electoral College votes) that Mr. Obama currently holds a 264-247 lead over Mr. McCain, with Nevada (5 Electoral College votes), Virginia (13 Electoral College votes), and Colorado (9 Electoral College votes) representing “swing” states. Based upon yesterday’s prices, Nevada and Virginia were being counted as McCain states, but both NEVADA.REP and VIRGINIA.REP have sold off enough that they now count as swing states.

The big change today is in the price of the NEVADA.DEM contract; it is currently trading for 58.3, compared with only 45 yesterday. Considering how poorly the U.S. stock market performed today, in retrospect I would have been smart to have shorted the US stock market and gone long in 2008.PRES.OBAMA yesterday, but of course hindsight is always superior to foresight! However, since NEVADA.REP is trading for 50, it is still premature (based upon the arbitrary algorithm that I have selected) to “award” Mr. Obama with Nevada’s 5 Electoral College votes (note: since the prices reported by Intrade are not necessarily synchronous, it is possible for the sum of the .DEM and .REP state contract prices to exceed (or be less than) 100 at any given point in time).

Addendum: September 17, 2008 Electoral College Vote allocation

Barack Obama (264): California (55), Connecticut (7), Delaware (3), District of Columbia (3), Hawaii (4), Illinois (21), Iowa (7), Maine (4), Maryland (10), Massachusetts (12), Michigan (17), Minnesota (10), New Hampshire (4), New Jersey (15), New Mexico (5), New York (31), Oregon (7), Pennsylvania (21), Rhode Island (4), Vermont (3), Washington (11), and Wisconsin (10)

John McCain (247): Alabama (9), Alaska (3), Arizona (10), Arkansas (6), Florida (27), Georgia (15), Idaho (4), Indiana (11), Kansas (6), Kentucky (8), Louisiana (9), Mississippi (6), Missouri (11), Montana (3), Nebraska (5), North Carolina (15), North Dakota (3), Ohio (20), Oklahoma (7), South Carolina (8), South Dakota (3), Tennessee (11), Texas (34), Utah (5), West Virginia (5), and Wyoming (3)

Some thoughts about AIG being "too big to fail"

Today, I learned an interesting fact about the AIG CDS situation. Apparently AIG has in excess of $400 billion in exposure to credit derivatives, much of which were sold to foreign as well as U.S. banks. The reason why banks like to purchase CDS’s is that this enables them to satisfy risk-based capital requirements associated with holding risky bonds (e.g., instruments like mortgage backed securities (MBS’s) and collateralized debt obligations (CDO’s)) in their asset portfolios. Therefore, AIG may in fact be big to fail because if it does, then this would likely unleash a financial contagion throughout the banking system which would substantially limit the availability of credit throughout the US economy.

Here’s a simple explanation of how financial contagion could occur if AIG were to fail. If AIG failed, then banks who relied up AIG’s contingent capital (in the form of CDS’s) would be required to raise cash in order to comply with risk-based regulatory capital requirements. Probably quite a few banks would not be successful in doing this on a timely basis, and would be forced to file for bankruptcy. In this scenario, surviving banks who managed to comply with regulatory capital requirements would naturally become quite reticent about lending. The net result would be a substantial credit shock for the overall real economy.

One final point; apparently the U.S. penchant for bailing out “too big to fail” financial institutions is going global. For example, lately the Bank of England is beginning to act much more “Fed-like” in terms of establishing contingent credit facilities for troubled financial institutions in the UK. Anyway, the real world is providing us with lots of risk management data and it will be interesting to see how this all plays out.