I want my RTC!

I want my, I want my, I want my RTC! (apologies to Dire Straits!). Yesterday, Nicholas Brady, Eugene Ludwig and Paul Volcker published an article in the Wall Street Journal entitled “Resurrect the Resolution Trust Corp.” This article makes the case for the establishment of a new, “temporary” credit crisis resolution mechanism. As Brady, Ludwig, and Volcker note, “There are precedents — such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management.”

Well, it appears that Messrs. Brady, Ludwig and Volcker may have gotten their wish today. According to a Wall Street Journal article entitled “U.S. Plans to Clean Up Finance System As Part of Widening Effort to Stem Crisis”, the federal government, “…is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s. At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies, according to people familiar with the matter, a device that echoes similar moves taken in past financial crises. It’s size could reach hundreds of billions of dollars.”
The stock market reacted very positively this afternoon to this news (with gains in the major indices ranging from 3.9-4.8%), and as I write this, stock futures contracts are also pointing toward a substantial continuation of this rally tomorrow. The main effect of this plan seems to be that it has assured investors that there is a plan in place for an orderly resolution of credit crisis. Markets hate uncertainty, and the rather ad hoc nature to date of the various US federal government interventions (e.g., involving Bear Stearns, Fannie, Freddie, and AIG) would now appear to be a thing of the past. Having said this, the amount of skin that the US taxpayer now has in the game has increased substantially. Before this news came out, the feds had already put around $800 billion of taxpayer capital at risk since March 2008 (putting this into perspective, this amounts to per capita contingent capital of nearly $2,700 for every man, woman and child living in the United States). It now appears that the level of contingent U.S. taxpayer capital committed to resolving the credit crisis has increased substantially!

Prediction Markets Update (September 18, 2008)

Although Nate Silver’s PECOTA model (see FiveThirtyEight) continues to show a 288 to 250 Electoral College advantage for John McCain over Barack Obama, the “trend” begun yesterday continues today; i.e., 2008.PRES.OBAMA is rallying while 2008.PRES.McCAIN is selling off. Specifically, the 2008.PRES.OBAMA Intrade contract now trades at 51.7, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 47.7 (compared with 50.7 and 48.6 respectively as reported on yesterday’s update). The pundits claim that that the slippage is due to McCain’s comments earlier this week to the effect that he believed that the “…fundamentals of the economy are strong”; with financial markets volatility particularly high this week, Mr. Obama apparently turned these comments into a marginal political advantage.

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 264-240 lead over Mr. McCain. Since yesterday, Ohio (20 Electoral College votes) has moved into the “swing” state category, whereas Virginia (13 Electoral College votes) has moved back into McCain’s column. This leaves Nevada (5 Electoral College votes), Colorado (9 Electoral College votes), and Ohio (20 Electoral College votes) as the “swing” states du jour.

Addendum: September 18, 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 (240): 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), Oklahoma (7), South Carolina (8), South Dakota (3), Tennessee (11), Texas (34), Utah (5), Virginia (13), West Virginia (5), and Wyoming (3)

Wharton Faculty Discuss Financial Crisis

I would like to call attention to four videos which I showed in my risk management course this morning at Baylor University (in the order in which they were presented):

1. Jeremy Siegel: On the Resilience of American Finance

2. Joseph Gyourko: Fannie, Freddie, and the Housing Bust

3. Franklin Allen: Lessons from the Subprime Crisis

4. Richard Herring: What’s Next for Investment Banks

All four of these lectures were delivered at Wharton on Tuesday afternoon, September 16 at a Wharton “Teach-In” (see http://www.wharton.upenn.edu/teach_in_09_16_08.cfm). I also recommend viewing a panel discussion from that same day featuring Wharton professors Franklin Allen, Richard Herring, and Susan Wachter entitled “Wall Street’s Day of Reckoning: Turmoil in the Global Market”.

After viewing these videos, I now feel like I have a rough idea of how this (the so-called credit crisis) all came about. It’s really all about (perverse) incentives. I hope we can figure out a way to sunset (that’s a politically correct way of saying “get rid of”) Fannie Mae and Freddie Mac. We also need to think seriously about reforming public policy toward real estate; e.g., by abolishing the tax deductibility of mortgage interest. During the bubble we were encouraging consumers to make highly levered bets on a risky asset class (i.e., residential real estate), and it was funded by the likes of investment banks like Bear Stearns who had only had $1 of their own money and $32 of other people’s (creditors’) money at risk.

Also, according to the Wharton professor Joseph Gyourko, it now appears (after the fact) that the rating agencies probably relied too much upon historical US real estate market price data which showed that prior to the crisis, the national average price for residential real estate had never declined during the course of the postwar (WWII) period. The rating agencies incorrectly inferred from these data that real estate isn’t all that risky, and this helped to feed unrealistic expectations concerning real estate as an asset class (specifically that unlike all other asset classes, real estate “always” goes “up”!).