A bad bet? Freddie and Newt make markets cautious

Polls and prediction markets have Newt Gingrich moving up in the Republican field, but they conflict.

The polls have Gingrich moving towards first place with 17.6 in Real Clear Politics' latest aggregated trend, while Herman Cain is falling fast and Mitt Romney is staying steady.

The prediction markets, such as Betfair and Intrade, have Gingrich solidifying his second place standing at 15.3 percent likelihood to win the Republican nomination, but well below Romney at 68.5 percent likelihood.

Polls describe the world as it is today and prediction markets describe the world on Election Day. The chart below shows how they vary over the last 10 days and the news over Gingrich's involvement with Freddie Mac is a perfect illustration of why they differ.

Gingrich and many Republicans allies blame the Great Recession on Fannie and Freddie and tie leading Democrats to their actions. Throughout the 2008 campaign and into the 2012 campaign, Gingrich argued that Fannie and Freddie, a unique quasi-government entity, recklessly bet on subprime loans that eventually sunk the economy into recession. Further, he says, the two organizations took those actions against his advice.

During the Oct. 11 debate, he solidified his position by stating, "If you want to put people in jail… You ought to start with Barney Frank and Chris Dodd. And let's look at the politicians who created the environment, the politicians who profited from the environment, and the politicians who put this country in trouble."

Blaming Fannie and Freddie completely for the recession is not defensible with data. The damage that really sunk the economy was the securities that multiplied initial bets, made by organizations such as Fannie and Freddie, many times over. In an efficient market those securities would reflect the underlying risk of the initial bets, but with the help of very complex design and less than diligent reviews by the credit agencies that risk was not realized by most people in the financial sector until it was too late.

Yet, Fannie and Freddie had all of the same problems as other major financial institutions, and it was compounded by the moral hazard of implicit government backing. This allowed the organizations to be more reckless than a comparable organization that did not have the ability to infer the solvency of their debt in the case of a major collapse. This moral hazard was created with the complicity of the leadership of both parties, including Gingrich when he was Speaker of the House.

Regardless of Fannie and Freddie's culpability in the financial crisis, it became secondary in the story of Gingrich's 2012 campaign when the facade that Gingrich was fighting against them tirelessly came crashing down in the last few days. First, he received questions in the CNBC debate about the $300,000 the public then knew he received from them; he denied lobbying for them and stated that he "offered them advice on precisely what they didn't do." An AP article from 2008 refutes this claim, noting that he "talked and wrote about what he saw as the benefits of the Freddie Mac business model". Second, Bloomberg has now found sources claiming he actually made at least $1.6 million with Freddie Mac.

Gingrich claimed in the CNBC debate that he was giving advice as a historian; it seems unlikely Freddie Mac would pay an ordinary historian, even the best in the world, a $25,000 to $30,000 per month retainer or at least $1.6 million. More plausibly, Freddie Mac justified Gingrich's outsized salary based on his access to the Bush administration and the Republican leadership. In the next few weeks I expect we will learn more about what Gingrich lobbied for in his 12 years in the private sector.

While the prediction markets may not have foreseen the particular case that Gingrich was much more involved with Freddie Mac than he previously admitted, they expected that some negative revelations would come to light. Romney has been running for president for more than four years now, being the front runner in many respects for nearly three years. Major revelations about Romney are unlikely. Gingrich has been selling books and raising money for his non-profit for the last few years, hardly worth the scrutiny of the media.

Will his campaign for the Republican nomination handle this new scrutiny and the new revelations that will follow? Prediction markets are skeptical; they provide a low, but statistically significant, likelihood that it can happen. Follow the numbers live along with us!

David Rothschild is an economist at Yahoo! Research. He has a Ph.D. in applied economics from the Wharton School of Business at the University of Pennsylvania. His dissertation is in creating aggregated forecasts from individual-level information. Follow him on Twitter @DavMicRot and email him at thesignal@yahoo-inc.com.

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