Betting on a “Depression”

A friend of mine who bets on Intrade (he made money correctly betting that Rod Blagojevich would survive into this year) alerted me to the fact that Intrade now has a market for whether the U.S. will go into “depression” in 2009 (warning: that link will resize your browser window). Their definition of “depression” is “a cumulative decline in GDP of more than 10.0% over four consecutive quarters,” but they don’t really mean that. What triggers the payout is if the sum of the quarterly annualized GDP growth rates for four consecutive quarters is less (more negative) than -10.0%. (To see the difference: GDP in Q3 2008 was 0.13% smaller than in Q2 2008, but this was reported as an annualized rate of -0.5%.) This would mean that the total economic contraction over those four quarters would be more than (about) 2.5%. This would make the current recession the worst since at least 1981-82 (which had a total peak-to-trough decline of 2.6%), but not necessarily anything that anyone would call a depression.

On to the interesting bit: the last price for this market was 56.3, meaning that the market assigns a 56% probability to the occurrence of a “depression” as defined by Intrade. The average forecast collected by the Wall Street Journal shows a “cumulative decline” of 7.8% (from Q3 2008 to Q2 2009 the forecasts are for contractions at annual rates of 0.5%, 4.3%, 2.5%, and 0.5%), or a peak-to-trough contraction of about 1.9%. Of the 54 individual forecasts collected by the Journal (you can download the data to a spreadsheet), 22, or 41%, are predicting a depression by Intrade’s definition.

So Intrade is more pessimistic than the experts. There has been a lot of talk about the accuracy of prediction markets like Intrade, but a lot depends on the liquidity of the individual market, and this one doesn’t have much (you can see all the outstanding bids and asks). We’ll just have to wait and see who wins this contest.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "Betting on a “Depression”"

  1. Dan Stephens   January 24, 2009 at 10:49 am

    I’d say the odds are very high that what most people will think is a depression is unfolding, whether or not it meets some arbitrary definition of one. Credit markets are seizing up because most banks are insolvent (search for Prof. Roubini comments) mainly due to mortgage losses, especially second mortgage losses. Consumers are seizing up because about 25% now have zero or negative equity in their homes and massively reduced retirement funds. Commercial property borrowers and their lenders are now sinking fast. All these trends due to negative wealth effects continue to get worse. I think the best, and, maybe, the only way, to stop them is a completely different approach than lender-only Wall Street bailouts, even if combined with tax cuts and government spending programs. Such a new plan, The AllStreets Bailout Plan, is described in detail at http://www.themortgagenews.info or http://www.themortgagenews.net. A summary and discussion follows.The attempts to save the economy by recapitalizing banks top-down via TARP-like programs, special lending facilities, or government-owned bad banks won’t work because the underlying collateral of loans remains impaired, and so do the borrowers. So what if you make the banks whole enough to lend again? Who will the recapitalized banks lend to? You can fix lender balance sheets by wiping out all their losses with federal money, but the economic and housing systems remain broken until borrower balance sheets are fixed. Lender-only rescues are also a very unfair use of taxpayers’ resources. The government is by and for the people, not for the lenders.As long as so many real estate borrowers remain upside down, or close to it, they will be financially incapacitated, real estate markets will freeze up along with lending, and real estate values can’t recover for a very long time. In the meantime, walk-aways, bankruptcies, and foreclosures will skyrocket, and businesses who all ultimately depend on consumer spending will suffer. The longer it takes to achieve an effective solution, the more difficult it will be to craft an economic recovery due to the accumulating irreversible damages to all economic players.The best and fairest approach is to recapitalize consumers and lenders at the same time with low-interest, long-term, direct federal government loans that convert excess mortgage debt to low-interest, long-term loans, not secured by the properties, so the consumer can resume selling, buying or refinancing their homes. Most existing bad mortgage loans will be made good, the good ones will be improved, consumer debt payments will be eased, home values will stop falling, bank loan write-offs will be stopped, lender balance sheets will be liquefied, and the values of mortgage securities will be restored and be made more liquid. As part of the program foreclosures must be suspended for a year and the toxic terms of subprime ARMs be modified globally by government fiat.To achieve fairly distributed federal government direct lending, the government gives the owner of every residential property, including investment properties and second homes, a Housing and Economic Recovery Certificate (“HERC”) equal in value to 80% of the drop in the market value of the property from December 2006 to the date of the law (on average 15% of the value of the property as of January, 2009), and one HERC to every adult citizen who does not own a residential property worth 10% of the median home price in the area they live.In the case of a HERC identified with a property, if there is a mortgage it must be submitted to the mortgagee to initiate two federal loans to pay down the mortgage principal. The lender and borrower would each get a loan worth half the value of the HERC as a 30-year fixed rate loan at 3% interest from the federal government. In this case the HERC loans are not secured by the property, so for most homeowners, the underwater equity is restored and converted to a long-term non-mortgage loan. The lender is liquefied and recapitalized at the same time. Not only is the loan now good, but the lender has new money to lend. The payment on the remaining principal of the mortgage would be recast at its original rate over its remaining term (not applicable to interest-only payment loans).To be fair to adult citizens who don’t own a residential property, they would get a HERC worth 10% of the median home price in their neighborhood. The HERC could be used to pay off credit cards, finance a business (recourse to borrower), take a personal loan or use it as second mortgage money to buy a residential property (in this case only, the loan would be secured by the property). Home values probably would not quickly return to their former inflated values, but resume a gradual upward trend more in line with general inflation, and the banking system, the mortgage system, and the economy would be restored to a condition where normal growth is again possible.

    • Guest   January 25, 2009 at 10:55 am

      Dan,Amazing! Look what I dug up in a 1640 Dutch newspaper:As long as so many [tulip] borrowers remain upside down, or close to it, they will be financially incapacitated, [tulip] markets will freeze up along with lending, and [tulip] values can’t recover for a very long time. In the meantime, walk-aways, bankruptcies, and foreclosures will skyrocket, and businesses who all ultimately depend on consumer spending will suffer. The longer it takes to achieve an effective solution, the more difficult it will be to craft an economic recovery due to the accumulating irreversible damages to all economic players.The best and fairest approach is to recapitalize consumers and lenders at the same time with low-interest, long-term, direct federal government loans that convert excess [tulip] debt to low-interest, long-term loans, not secured by the [tulips], so the consumer can resume selling, buying or refinancing their [tulips]. Most existing bad [tulip] loans will be made good, the good ones will be improved, consumer debt payments will be eased, [tulip] values will stop falling, bank loan write-offs will be stopped, lender balance sheets will be liquefied, and the values of [tulip] securities will be restored and be made more liquid. As part of the program [tulip] foreclosures must be suspended for a year and the toxic terms of [tulip] ARMs be modified globally by government fiat.The fist sentence of the second paragraph is a real gem!