All posts by Jim Garven

My name is Jim Garven. I currently hold appointments at Baylor University as the Frank S. Groner Memorial Chair of Finance and Professor of Finance & Insurance. I also currently serve as an associate editor for Geneva Risk and Insurance Review. At Baylor, I teach courses in managerial economics, risk management, and financial engineering, and my research interests are in corporate risk management, insurance economics, and option pricing theory and applications. Please email your comments about this weblog to James_Garven@baylor.edu.

Prediction Markets Update (September 29, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 62.1, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 38 (compared with 58.2 and 41.6 respectively as reported on yesterday’s update).

The state-by-state contracts now imply that Mr. Obama holds a 286-185 “lead” over Mr. McCain (based upon my cutoff price point of 55 for allocating Electoral College votes). Since yesterday, Mr. Obama has “picked up” New Hampshire (4 Electoral College votes) and Virginia (13 Electoral College votes), whereas Mr. McCain has “re-lost” North Carolina (15 Electoral College votes); North Carolina has slid back into “swing” state status. The other remaining states which have “swing” state status today include Florida (27 Electoral College votes), Nevada (5 Electoral College votes), and Ohio (20 Electoral College votes).

FiveThirtyEight.com currently gives Mr. Obama a 325.5 to 212.5 advantage over Mr. McCain.

Addendum: September 29, 2008 Electoral College Vote allocation

Barack Obama (286): 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 Hampshire (4)New Jersey (15), New Mexico (5), New York (31), Oregon (7), Pennsylvania (21), Rhode Island (4), Vermont (3), Virginia (13), Washington (11), and Wisconsin (10)

John McCain (185): Alabama (9), Alaska (3), Arizona (10), Arkansas (6), Georgia (15), Idaho (4), Indiana (11), Kansas (6), Kentucky (8), Louisiana (9), Mississippi (6), Missouri (11), Montana (3), Nebraska (5), North Dakota (3), Oklahoma (7), South Carolina (8), South Dakota (3), Tennessee (11), Texas (34), Utah (5), West Virginia (5), and Wyoming (3)

Some milestones in U.S. financial market history were set today!

Last Wednesday (September 24, 2008), I posted a blog entry entitled “Financial market risk and the “Peltzman” effect” which showed a time series graph since 2006 for the CBOE volatility index (aka “VIX”). Today is noteworthy in financial market history not only because the Dow Jones industrial average suffered its largest one day point drop in history — 778 points — but also because the VIX registered its highest closing level since its inception (in January 1990). The VIX closed today at 46.72, which is impressive considering that the average closing price for the VIX is 19.17 (this is based upon a total of 4,723 daily closing prices dating back to January 2, 1990). Today’s VIX reading also represents the 6th largest one day change in volatility for the entire time series. This is all the more impressive since volatility has been well above average long-run levels ever since the middle of September, which is the day that Lehman Brothers filed for Chapter 11 bankruptcy reorganization.

As I noted in my 9/24/2008 blog entry, VIX 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. The last time the VIX was this high was on October 8, 1998, in the middle of the so-called Long-Term Capital Management financial crisis.

Here’s the daily time series graph for VIX from January 2, 1990 through the close of business today; the spike at the far right of the graph is from today:

Prediction Markets Update (September 28, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 58.2, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 41.6 (compared with 57.8 and 41.8 respectively as reported on yesterday’s update).

The state-by-state contracts now imply that Mr. Obama holds a 269-200 “lead” over Mr. McCain (based upon my cutoff price point of 55 for allocating Electoral College votes). The only change from yesterday is that North Carolina (15 Electoral College votes) has (barely) moved back into Mr. McCain’s column. This leaves Florida (27 Electoral College votes), Nevada (5 Electoral College votes), New Hampshire (4 Electoral College votes), Ohio (20 Electoral College votes), and Virginia (13 Electoral College votes) as the “swing” states du jour.

FiveThirtyEight.com currently gives Mr. Obama a 325.5 to 212.5 advantage over Mr. McCain.

Addendum: September 28, 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 (200): Alabama (9), Alaska (3), Arizona (10), Arkansas (6), 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)

Prediction Markets Update (September 27, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 57.8, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 41.8 (compared with 56.9 and 42.2 respectively as reported on yesterday’s update).

The state-by-state contracts now imply that Mr. Obama holds a 269-185 “lead” over Mr. McCain (based upon my cutoff price point of 55 for allocating Electoral College votes). Although Mr. Obama has not increased his Electoral College total since yesterday, both Florida (27 Electoral College votes) and North Carolina (15 Electoral College votes) have now moved out of Mr. McCain’s column and assumed “swing state” status, along with Nevada (5 Electoral College votes), New Hampshire (4 Electoral College votes), Ohio (20 Electoral College votes), and Virginia (13 Electoral College votes). As I noted yesterday, it was apparent that Florida was on the verge of becoming a “swing” state, so this change does not come as a surprise.

FiveThirtyEight.com currently gives Mr. Obama a 310 to 228 advantage over Mr. McCain.

Addendum: September 27, 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 (185): Alabama (9), Alaska (3), Arizona (10), Arkansas (6), Georgia (15), Idaho (4), Indiana (11), Kansas (6), Kentucky (8), Louisiana (9), Mississippi (6), Missouri (11), Montana (3), Nebraska (5), North Dakota (3), Oklahoma (7), South Carolina (8), South Dakota (3), Tennessee (11), Texas (34), Utah (5), West Virginia (5), and Wyoming (3)

A previously unpublished essay finally gets to see the light of day!

Keith Murphy writes, “Déjà vu, which is French for “already seen,” is the feeling that you have already witnessed a scene or a situation even though you are seeing it for the first time.” The Financial Crisis of 2008 is having this very effect upon me. The last time that the U.S. suffered through a financial catastrophe related to the real estate sector of the economy was during the so-called savings and loan (S&L) crisis of the 1980s. The Troubled Asset Relief Program (aka “TARP”) which has been proposed by Treasury Secretary Hank Paulson is essentially the 2008 version of the Resolution Trust Corporation (RTC), a governmental entity created by the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989 for the purpose of liquidating assets of failed thrift institutions.

The S&L crisis stimulated considerable public policy and academic interest in the roles played by federal financial guarantee programs. At the time of the S&L crisis, I was an assistant professor of finance at University of Texas-Austin, and I was motivated to write an essay which explored various moral hazard and adverse selection aspects of mispriced financial guarantees. While I never published this essay before, I have used it on occasion in my teaching. Although this essay is now nearly 20 years old, I think that it nevertheless raises a number of important issues which lie at the heart of the current financial crisis.

_________________________________________________________

Federal Financial Guarantees: Problems and Solutions

by

James R. Garven

Besides insuring bank and thrift deposits, the federal government guarantees a number of other financial transactions, including farm credits, home mortgages, student loans, small business loans, pensions, and export credits (to name a few). Recently, the financial difficulties of the banking industry have focused considerable attention on the structure and viability of the deposit insurance system. However, the structural problems of deposit insurance are shared by many of these other programs.

In order to better understand the problems faced by federal financial guarantee programs, consider the conditions which give rise to a well functioning private insurance market. In private markets, insurers segregate policyholders with similar exposures to risk into separate risk classifications, or pools. As long as the risks of the policyholders are not significantly correlated (that is, all policyholders do not suffer a loss at the same time), pooling reduces the risk of the average loss through the operation of a statistical principle known as the “law of large numbers”. Consequently, an insurer can cover its costs by charging a premium that is roughly proportional to the average loss. Such a premium is said to be actuarially fair.

By limiting membership in a risk pool to policyholders with similar risk exposures, the tendency of higher risk individuals to seek membership in the pool (commonly referred to as adverse selection) is controlled. This makes participation in a risk pool financially attractive to its members. Although an individual with a high chance of loss must consequently pay a higher premium than someone with a low chance of loss, both will insure if they are averse to risk and premiums are actuarially fair. By charging risk-sensitive premiums and limiting coverage through policy provisions such as deductibles, the tendency of individuals to seek greater exposure to risk once they have become insured (commonly referred to as moral hazard) is also controlled.

In contrast, federal financial guarantees often exaggerate the problems of adverse selection and moral hazard. Premiums are typically based upon the average loss of a risk pool whose members’ risk exposures may vary greatly. This makes participation financially unattractive for low risk members who end up subsidizing high risk members if they remain in the pool. In order to prevent low risk members from leaving, the government’s typical response has been to make participation mandatory. However, various avenues exist by which low risk members can leave “mandatory” risk pools. For example, prior to the reorganization of the Federal Savings and Loan Insurance Corporation (FSLIC) as part of the Federal Deposit Insurance Corporation (FDIC), a number of low risk thrifts became commercial banks. This change in corporate structure enabled these firms to switch insurance coverage to the FDIC, which at the time charged substantially lower premiums than did the FSLIC. Similarly, terminations of overfunded defined benefit pension plans enable firms to redeploy excess pension assets as well as drop out of the pension insurance pool operated by the Pension Benefit Guarantee Corporation (PBGC).

Although financial restructuring makes it possible to leave mandatory insurance pools, the costs of leaving may be sufficiently high for some low risk firms that they will remain. Unfortunately, the only way risk-insensitive insurance can possibly become a “good deal” for remaining members is by increasing exposure to risk; for example, by increasing the riskiness of investments or financial leverage. Furthermore, this problem is even more severe for high risk members of the pool, especially if they are financially distressed. The owners of these firms are entitled to all of the benefits of risky activities, while the insurance mechanism (in conjunction with limited liability if the firm is incorporated) minimizes the extent to which they must bear costs. Consequently, it is tempting to “go for broke” by making very risky investments which have substantial downside risk as well as potential for upside gain. The costs of this largely insurance-induced moral hazard problem can be staggering, both for the firm and the economy as a whole.

In light of this analysis, it is interesting to consider the current policy debate over the financial difficulties of the banking industry and the FDIC. Recently, capital requirements as well as deposit insurance premiums have been raised in response to the crisis. Ironically, as Professor George Kaufman of Loyola University has noted, the banking industry is undercapitalized largely because federal deposit insurance has permitted banks to substitute government capital for private capital. Although increased capital requirements will (at least in the short run) mitigate the moral hazard of increased risk exposure, in the long run the cycle of increased risk exposure and higher premium costs is likely to continue so long as the structure of the present system is not reformed.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms which engender lower adverse selection and moral hazard costs. Policymakers would do well to consider how private insurers, who cannot rely upon taxpayer-financed bailouts, resolve these problems. The most common private market solution typically involves some combination of risk-sensitive premiums and economically meaningful limits on coverage. Federal financial guarantee programs should be similarly designed so that excessively risky behavior is penalized rather than rewarded.

Prediction Markets Update (September 26, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 56.9, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 42.2 (compared with 56.7 and 43.5 respectively as reported on yesterday’s update).

The state-by-state contracts continue to 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). Based upon this criterion, Nevada (5 Electoral College votes), New Hampshire (4 Electoral College votes), Ohio (20 Electoral College votes), and Virginia (13 Electoral College votes) would be considered “swing” states. However, Virginia (current price: 55), New Hampshire (current price: 54), and Ohio (current price: 53.4) are definitely leaning Mr. Obama’s way. Nevada is pretty much split down the middle between the two candidates (NEVADA.DEM’s price is 48, compared with NEVADA.REP’s price of 49.8). Also, I could help but notice that Florida is on the cusp of becoming a “swing” state; currently FLORIDA.DEM’s price is 44, compared with FLORIDA.REP’s price of 55.1).

FiveThirtyEight.com currently gives Mr. Obama a 310 to 228 advantage over Mr. McCain.

Addendum: September 26, 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)

Prediction Markets Update (September 25, 2008)

The 2008.PRES.OBAMA Intrade contract now trades at 56.7, whereas the 2008.PRES.McCAIN Intrade contract is currently trading at 43.5 (compared with 54.6 and 44.9 respectively as reported on yesterday’s update).

The state-by-state contracts continue to 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). As was the case yesterday, I continue to put Nevada (5 Electoral College votes), New Hampshire (4 Electoral College votes), Ohio (20 Electoral College votes), and Virginia (13 Electoral College votes) into the “swing” state category based upon this criterion.

FiveThirtyEight.com currently gives Mr. Obama a 307.8 to 230.2 advantage over Mr. McCain.

Addendum: September 25, 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)