Financial market risk and the "Peltzman" effect

In a March 2007 interview, Nobel Laureate Myron Scholes presciently notes, “My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking (italics added for emphasis).” In a December 2006 WSJ article entitled “The Risk Business”, it is noted that risk premiums seemed at the time to have been “drained” out of whole classes of financial assets. The article goes on to suggest that the reason for this was because advances in financial innovation (in all its various forms, including the buying, selling, swapping, trading and securitization of risk) had actually made the financial markets safer for investors; consequently risk premiums up to that point in time had fallen substantially.

One way to measure the overall degree of “safety” in financial markets is to look at the CBOE volatility index (aka “VIX”). Here’s what the time series looks like for this index starting December 1, 2006 (around the time that the WSJ article “The Risk Business” was published) up to yesterday.  The best way to think about it is that it measures “consensus” forecasts of future (U.S.) stock market volatility as reflected in the market prices of call and put options written on the S&P 500 index. The higher the value for VIX, the more risk averse investors are in the aggregate. What’s interesting about this time series is that at the time that Scholes’ interview was published (March 2007), forecasted stock market volatility (specifically, expected annualized volatility) had rather dramatically increased nearly twofold in a matter of a few days, going from around 10% to 20% (putting this into perspective, the long run average value for VIX, going back to January 1990, has been around 19%, so this really reflects more of a mean reversion effect). However, since July 2007 (and within the last week in particular), this data series has undergone a substantial increase in terms of its level as well as the “volatility of volatility”, as you can see in the graph below:


These data provide an important context for Scholes’ quote. The “dark side” of innovations in risk management is that they often encourage offsetting risky behaviors (e.g., as in the development over time of the subprime mortgage market); as Scholes noted, these offsetting behaviors came in the forms of more leverage and more risk taking. This is an important example of “moral hazard” in the real world, and it is commonly referred to as the “Peltzman” effect (named after economics Prof. Sam Peltzman at the University of Chicago).

Prediction Markets Update (September 24, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 54.6 , whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 44.9 (compared with 51.6 and 47.9 respectively as reported on yesterday’s update).

The state-by-state contracts imply that Mr. Obama currently holds a 269-227 “lead” over Mr. McCain (based upon my cutoff price point of 55 for allocating Electoral College votes). Since yesterday, the prices of the NEWHAMPSHIRE.DEM and NEWHAMPSHIRE.REP contracts have changed enough so that at 55 and 49 respectively, I would now put New Hampshire 4 Electoral College votes) back into the “swing” state category along with Nevada (5 Electoral College votes), Ohio (20 Electoral College votes), and Virginia (13 Electoral College votes).

FiveThirtyEight.com is unchanged from yesterday, as it continues to give Mr. Obama a 309 to 229 advantage over Mr. McCain.

Addendum: September 24, 2008 Electoral College Vote allocation

Barack Obama (269): California (55), Colorado (9), 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 Jersey (15), New Mexico (5), New York (31), Oregon (7), Pennsylvania (21), Rhode Island (4), Vermont (3), Washington (11), and Wisconsin (10)

John McCain (227): 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), West Virginia (5), and Wyoming (3)

Bloomberg News Investigates: How Ratings Brought Down Wall Street (Part 1)

SOURCE: BLOOMBERG NEWS

An exclusive two-part BLOOMBERG NEWS report investigates how flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system’s biggest crisis since the Great Depression. The BLOOMBERG NEWS report shows how — driven by competition for fees and market share — rating companies Moody’s and Standard & Poor’s issued top ratings on debt pools that included $3.2 trillion of loans to homebuyers with inferior credit between 2002 and 2007. Without those AAA ratings, the report shows, insurance companies and pension funds wouldn’t have bought the products. Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or disappearance of Bear Stearns., Lehman Brothers and Merrill Lynch, and compelled the Bush administration to propose a $700 billion Wall Street bailout.

EXCERPTS FROM PART 1 OF THE BLOOMBERG NEWS REPORT:

On knowing that it was wrong:

“I refused to go along with some of this stuff, and how they got around it, I don’t know,” says Frank Raiter, 61, a former S&P managing director whose business unit rated 85 percent of mortgage deals at the time. “They thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt.”

On turning a blind eye to the risks:

“We knew the delinquencies were bad,” Raiter says. “The fact was, if we could have hired a supreme being to tell us exactly what the loss was on a loan, they wouldn’t have hired him because the Street wasn’t going to pay us extra money to know that.”

“The part that became the most aggravating –personally irritating — is that CDO guys everywhere didn’t want to know fundamental credit analysis; they didn’t want to know from being in touch with the underlying asset,” says Mark Adelson, 48, who quit Moody’s in January 2001 after being reassigned out of the residential mortgage-backed securities business. “There is no substitute for fundamental credit analysis.”

“There was the self-delusion, which hit not just rating agencies but everybody, in the fact that the mortgage market had never, ever, had any problems, and nobody thought it ever would,” says Richard Gugliada, 46, S&P’s global ratings chief for CDOs until 2005.

Find the full story on http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s&refer=home

Intrade contract on TARP (Troubled Asset Relief Program)

Intrade has opened a new market on whether the proposed bill (AKA “TARP”, an acronym for Troubled Asset Relief Program) to bailout financial firms will pass Congress by the end of the month. The contract trades as BAILOUT.APPROVE.SEP08. Open for less than 24 hours, the market has already gained significant trading volumes, and an early verdict: the bill is far from a sure thing.

The likelihood the bill would pass by September 30th initially traded between 55% and 65% for much of yesterday. It hit an overnight high of 95% before settling at 74.8% as of 5AM CST this morning.