Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 13 - The Mortgage Meltdown in Cleveland

Chapter 1. Introduction: The Mortgage Meltdown in Cleveland [00:00:00]

Professor Douglas W. Rae: What I'd like to do this morning is spend eight or ten minutes with a few slides that are framing and background to the case. And then I'm going to ask Nancy Hite to impersonate Sharon Oster, with the flying chalk on the board, and I'm going to come around and talk to all of you about the case. And we'll work it through B school style. When you look at the institutions involved in the mortgage system, don't assume that they were designed brilliantly, or that they were thought out from beginning to end. The concept of "kluge," is that in your vocabulary? Tim, is that, "kluge," is that a — hands up if "kluge" is familiar. I'm not going to get anywhere with that idea. "Kluge" means things that are complex and badly designed. And there's a wonderful book by Gary Marcus called Kluge, which is about badly designed stuff, from economic institutions; to human memory; to the human spine, which is a highly error-prone structure, and is as it is not because evolution said, "What's the very best support column I can make for a bipedal creature?" but, "What's the best I can do by evolving from a four-legged to a two-legged creature?" And the spine shows all kinds of design imperfections that are attributable to the fact that it evolved in a horizontal plain and then was readapted in a vertical plain.

And the institutions at play in, what Posner calls the Depression of '08, and what most of us call the Recession of 08/'09, though it is, perhaps, the mother of all recessions, it has not actually obtained the depth of unemployment and under-utilization of plant and equipment that would match up with the one in the 1930s. Of course, we could still get there. It is possible that it is now 1931 and another dip is out there. I don't think that but there are those, including Will Goetzmann, who we saw a few days ago, who speculate that it might be so.

This is a cast of characters for subprime lending; left to right: the homebuyer, the broker, the appraiser, the mortgage lender, the investment banker and the investors in the bonds created by the investment banks. And in the row I'm touching are the principal incentives that make the whole system go. And the critical thing is that three, and arguably four, of the main steps in the process are fee-driven, so that the alignment between the decision maker and the investor, or between the decision maker and the potential home buyer, may be muted by the decision maker thinking "fees." If I'm thinking — let's suppose I were a college admissions officer and I was paid by the live students delivered to the school, I might become very generous in my view; I might find creativity in unexpected places; I might imagine analytic firepower where none existed. And so, in all these steps, the bias toward "yes," the bias toward completing a transaction, is a very powerful piece of the story. The risks are chartered here. What we're going to do, when we do the case, among other things, is to fill in the bottom row. What are the ways in which we would expect people in each of these roles to be tempted to get out of line? Out of line ethically; and quite possibly out of line legally. As in the case, there is a broker, right, who gets way beyond both ethical and legal bounds.

Chapter 2. Home Ownership in the United States: 1900 - 2000 [00:05:30]

Home ownership in the United States, 1900 to 2000, looks like this. And notice it's a truncated scale, the bottom of the scale is forty percent. The big story is a huge normative emphasis on home ownership. The belief, going back to Jefferson really, that when people own property they become "bought-in citizens", citizens who identify with the Commonwealth and who can be counted on to act in public-spirited ways. And there's a great run-up in home ownership between World War II and the 1980s, and it is fuelled by very profitable mass development of suburban housing; it is financed by FHA and related government entities; and it is rewarded by the Internal Revenue Service tax code, which gives a strong incentive for people to take out mortgages on a principal residence. Now, home ownership, I assume — do any of you own a home? Oh, I should say that Jaan Elias, who wrote the case, is with us. Welcome Jaan.

Jaan Elias: Hello.

Professor Douglas W. Rae: Do you own a house?

Jaan Elias: No.

Professor Douglas W. Rae: Sometimes I envy that. Home ownership has all kinds of hazards. I just learned that my slate roof, a hundred year old slate roof, is at the end of its lifetime. And that's comparable to buying a — it's about the same price as the highest-end BMW, to replace a slate roof; that's a hazard. Suppose that you get laid-off; your mortgage payments continue. Suppose that there is a catastrophic illness; the mortgage payments continue, the local property taxes continue, the unanticipated maintenance issues continue. And there is quite a lot to be said for relative caution about undertaking a debt amounting to several years' income in purchasing a house.

Now, there's also a political dimension to this, which is that the old fashioned local banking method of writing mortgages was extremely cautious and was, first explicitly and then, later, implicitly racist and "genderist." It was all about well-employed white men. And there is an ideological strand, that is not Jeffersonian but is more recent, and has to do with equality of opportunity to own houses, which has pushed policy towards are more permissive attitude. Finally, there is, of course, the pro-market view, which became dominant in this country in the Ronald Reagan era, which says "Let people cut the deals they want to cut. Get the government out of the transaction. Deregulate." And in many cases deregulation was a spectacular success, for example, the airline industry, the trucking industry, but deregulation of finance is a slipperier undertaking. A history of home values here. It's an index chart that has 1890 indexed to 100 and the gist of the argument in this chart — did I take this from the case, or not?

Jaan Elias: No.

Professor Douglas W. Rae: The gist of the argument in this chart is that: by the time we are done with the current meltdown, home values, adjusted for inflation, will be back about where they were in 1890.

Chapter 3. The Home Owners Loan Corporation [00:10:26]

This is a map of Philadelphia, and it's a historically interesting map. I couldn't find a comparable one for Cleveland, though I'm sure one exists. In 1937 mortgages were collapsing all over the country. And the Roosevelt Administration pushed through Congress a piece of legislation called The Home Owners Loan Corporation, HOLC, Home Owners Loan Corporation. And the Home Owners Loan Corporation was charged with finding out how to know in advance if a mortgage would likely fail. And the technique was not to look at credit scores but to look at housing locations; and to look at the condition of housing in a neighborhood; and at the demographics of who lived there. And it was crudely racist and biased in many, many ways. It was explicitly racist about blacks; it was explicitly racist about Jews; it was explicitly racist about Italians, most of all Southern Italians.

And it was a four-point scale, the worst category - level D - was red, and the term "redlining" comes from this, and the idea was to tell the banking world not to lend money in those zones. Yellow was a little better, then blue, then green and the idea was to put mortgage money into the safest, wealthiest neighborhoods with the most homogeneous populations. And from the point of view of managing the mortgage crisis, it was not a terrible policy. From the point of view of managing cities and communities, it was catastrophic because what it did was to accelerate the creation of slums in areas where mortgage money was unavailable for the sale or purchase of housing, or, for that matter, for the large-scale repair of housing. They did it to two hundred — they did the process to two hundred American cities in a single year, including New Haven. Across Chapel Street is class D.

Chapter 4. Case-Schiller Home Price Index and the Mortgage Meltdown in Cleveland [00:13:09]

This is the Case-Schiller home prices story and let's lay it out here from the year 2000 to 2007. And this is, when Goetzmann talked about Case-Schiller being a reassuring data series, if you look at it between here and here, if you look at a five-year period or even a six-year period, it looks like a process of continued appreciation in home prices. And there was nothing in the data, that would have, given conventional econometric models, would have triggered the suspicion that the end was nigh. The chart is also interesting because Cleveland is this line. So that, Cleveland is a less extreme story in price appreciation than the cases everybody talks about, which were Miami and Las Vegas and Los Angeles. This is the same story shown in year-on-year percentage change and it actually doesn't add much to our knowledge, I'm going to skip it.

This is Cleveland price appreciation from 2000 into 2007, compared with the country at large, and the gist is that Cleveland was not a hot — not a hot city. And it was — it is in that respect, I hope I've got — I've missed a chart here. There's a huge story about Northeastern industrial cities, by which I mean virtually all the cities from St. Louis on the left side to Boston on the right side. They all had their take-off in the middle of the nineteenth century. They were all going almost vertical in the years 1850 to 1900, 1910. By 1920 their growth rates slowed down almost to zero, and were — fluctuated wildly during the Depression years, recovered briefly in World War II, and then went sharply south from 1950 on. New Haven's case, the strength of the inner city economy forms an almost perfect arch, with the starting point in 1840, the peak in 1950, and the bottom in about 1990. And there's actually been a little bit of recovery since.

But Cleveland is a classic industrial city. It is the place where Standard Oil set up its first large refining plants. It was an advantage-point in transportation because it was an intersection between very high quality east-west freight rail and Great Lakes shipping. And when rail became subordinated to trucking and when suburban development became dominant over the reuse of industrial urban neighborhoods, Cleveland suffered mightily. This income map of Cleveland, where medium incomes, under $22,700, are shown in the darkest rust tone, is where the case takes place; the green dot is approximately the location of Slavic Village. I wouldn't swear to it or argue with Jaan if he said move it three or four degrees of the compass north or east or south or west, but it's right about there. And it is on the edge of a large post-industrial working class neighborhood, or mega-neighborhood, in a declining industrial city.

So, there's the great arch. And the concentration of subprime lending in Cleveland, shown in the darkest tones here, includes the neighborhood we're talking about.

Chapter 5. Posner and "The Depression of '08" [00:18:26]

And then there's Posner. On page 284, I hope all of you have memorized page 284, where he's apportioning blame: "But although the financiers bear the primary responsibility for the depression," that's his name for the recession, "I do not think they can be blamed for it, implying moral censure, any more than one can blame a lion for eating a zebra. Capitalism is Darwinism." Pretty dark interpretation.

Professor Douglas W. Rae: Is it Jennifer?

Student: Yes.

Prof. Douglas W. Rae: That's the trouble with letting me learn your name; you get cold called. There's a story in this where a local broker ends up being sentenced to prison. Do you remember that part of it or not?

Student: Mark.

Professor Douglas W. Rae: Okay, Mark. Can you give us a little recap on Mark?

Student: Mark Kellogg submitted fraudulent data for about seventy homes, and — or somehow ended up, I'm not sure of the process of flipping a house exactly, but he did it to seventy homes and they all ended up defaulting on the loans, the people that he sold it to.

Professor Douglas W. Rae: Okay, so Mark's sin would be what? Let's try somebody else. What's Mark — if Mark were a relative of yours and you had to have Thanksgiving dinner with him while he was on furlough from Ohio State Penitentiary, what topic would you want it to reflect on; ethical topic? You want to take a shot at this?

Student: Perhaps, as you just mentioned with the topic of preying on zebras, perhaps something like that, and that — using a position to benefit from people at a much [inaudible] than you, and to their detriment and to your gain.

Professor Douglas W. Rae: Okay. So the buyers, on your telling, are zebras. Okay, that's a plausible position. If the buyers are zebras, are the zebras in any way blamable in this story? What do you think?

Student: It's possible that they're blamable, if they were given good information, but in this situation they were given completely wrongful information and led to believe that it was true.

Professor Douglas W. Rae: Okay.

Student: Like, a plausible person would believe that.

Professor Douglas W. Rae: Can we tell a story where it's plausible to blame the buyers?

Student: Yes. Where they should have known that they don't have the income to pay the loan and they were going to default, and so therefore they should have not bought the home.

Professor Douglas W. Rae: Thank you. And are their instances where people are encouraged to lie about their incomes?

Student: I think there's a big problem with a lot of these "Jumbo Subprime Mortgages" they called them, where people were buying really big houses, or second houses, with subprime mortgages and in that case it is their fault, because they were just being greedy, right. And trying to take — trying to either falsify documents or go for the type of loans that would allow them to get these second properties without really having enough to back it up.

Professor Douglas W. Rae: Okay. So, that's the sin of pride or gluttony, not really gluttony, but it's bricks and mortar gluttony. Yes?

Student: Well there were also NINJA loans, which I think is a very appropriate acronym because of the sneakiness, but it was an acronym for no income, no job and no assets.

Professor Douglas W. Rae: Okay, NINJA: No Income, No Job, No Assets. And why would anyone encourage another human being to seek a NINJA loan? Is it obvious?

Student: Well, if you're one of the three steps that profits off of the fee of making — of having that loan go through, then you don't even — it doesn't really matter to you if it — or it doesn't matter to you if it defaults as much as it matters to the buyer or to the bank.

Professor Douglas W. Rae: Okay. So as long as you can successfully pass it along to the next step, you collect the fee and you're home-dry no matter what happens.

Student: Right, and your reputation [inaudible].

Professor Douglas W. Rae: Okay now, let's stop and see what we got for a diagram here, Sharon.

Student: [inaudible].

Professor Douglas W. Rae: Unpack your diagram.

Student: Okay, so I guess this is...

Professor Douglas W. Rae: I knew you'd be good at diagrams.

Student: Our game of Pictionary. So, I'm trying to map out what exactly went wrong, and I would start with a home in the Slavic community and then I would end, maybe, here with Bank of Scotland. And between "Joe six pack" purchasing a home with a $22,000 yearly income, which was the average I saw, that was misrepresented as being worth about $80,000 from the broker who works with a — I figured we could have everyone fill in the parts for me. Like, how do we get from the home to the international crisis?

Professor Douglas W. Rae: Okay, so who's [technical chat]. What's the next step in the chain to the right of broker?

Student: Probably someone will give a rating for this mortgage so that the broker will be able to package it with other mortgages and sell it to an investment banker.

Professor Douglas W. Rae: Okay, so there's a credit rating story, but there's also another story that's closer to ground level. It concerns the house itself.

Student: Need an evaluation of the house, like, what the house value is.

Professor Douglas W. Rae: Okay. And there's a saying in real estate "appraise as instructed." And it's not altogether false that whoever hires — think about the incentives. You're an appraiser, and Paul here hires you to do an appraisal and you're going to get a fee of 1,100 bucks for doing it. And Paul lets it be known that he thinks this house really ought to be worth something north of $200,000. And you go out in the field, do the comparables and the number comes up at $140,000. Tim, what thought might cross your mind if you were — I understand in your case it, of course, wouldn't, but in, say, my case?

Student: It might cross your mind to trust all and just go with the $200,000 prediction.

Professor Douglas W. Rae: Okay. And the second step in the reasoning is?

Student: No-one will ever know.

Professor Douglas W. Rae: No-one will ever know and next time Paul goes to the Yellow Pages for an appraisal?

Student: He'll come to you.

Professor Douglas W. Rae: He'll come to you or he's more likely to. He's a damn sight less likely to if you undercut his deal. I'll tell you a Yale story about appraisals: when I was in city government we leased High Street and Wall Street to Yale for ninety-nine years; we were broke, we needed money. And the Mayor sat down with Benno Schmidt, and Benno said, "Well, the University will handle the appraisal for you," and they did. The two streets together leased for one million dollars for ninety-nine years. It should have been a lot more than that and there were those, in city government, who thought I was the guy who got the number that low. I was actually pulling hard on making the number at least one zero or a zero-and-a-half higher. I'd allow the Law School to build that gorgeous underground library, because the ground rights went with the streets. And so "appraise as instructed" is an important component in this story. We had the appraiser there. So, who else is involved and what are their incentives? Paul?

Student: Well, you've got the local bank that's actually doing the lending.

Professor Douglas W. Rae: Okay.

Student: And they probably will get a fee for the loan that they take and then if they can package and sell it off to someone else, they don't end up with the loan on their books so they couldn't, probably, care less how it performs over the long run.

Professor Douglas W. Rae: Okay. So — terrific, so, the lender is also fee-driven and is inclined to think that she or he can escape accountability when the property defaults, if it defaults. And why would that be? What are the — what do we turn these loans into at the next stage?

Student: Usually it's sold off to a big investment bank or basically a financial powerhouse where they pull the mortgages into these giant, collateralized debt obligations or [over speaking].

Professor Douglas W. Rae: Okay, CDOs, famous acronym. Do you want to add anything to this?

Jaan Elias: Not really.

Professor Douglas W. Rae: Okay. So you've got the banks creating these huge bundles, and the bundles — what story could you tell to say that bundling these mortgages from all across the country might be a good thing from the economy's point of view. Is there anything you could say?

Student: It diversifies the risk for those who are taking them out.

Professor Douglas W. Rae: Okay. It diversifies the risk, say a little more.

Student: Well, presumably, the people who are packaging them can take out a bunch of — do a lot of financial analysis and determine that the risk of the number of defaults would be lower than the benefit of the people actually paying their loans back. So, the people who take out the package would have a favorable risk return.

Professor Douglas W. Rae: Okay. And part — were you about to say something?

Student: I think it also increase the market of potential buyers, because now, rather than owning a mortgage and having to deal with an investor one-on-one, you have a pooling and servicing agreement that has a company as a servicer who handles all the collection of payments and distribution of money into different investments.

Professor Douglas W. Rae: Okay. So, you've got an institutional mechanism that makes this work relatively smoothly, and you're interested, when you create these bundles, in having the risks have relatively low correlation with one another. What would be a bad bundle is one where we can know that some of the mortgages are defaulting and infer from that, that lots of others are likely to default. And a bundle that was geographically concentrated, on Slavic Village for example, would have that second characteristic and that would be a bad thing. So, there is a story about risk management that makes that work. Now, are the agencies, like Moody's, these outfits that judge credit-worthiness of companies and other financial intermediaries, are they in this story anywhere? I don't know if they — Jaan, does Moody's get into your case? I don't think I found it.

Jaan Elias: Just as a kind of footnote. There are bating the CDOs.

Professor Douglas W. Rae: Okay. So, everybody know what Moody's and its rivals do? Anybody want to help us with that?

Student: Moody's and its rivals are — essentially collect a fee from anyone who wants to spin-off an asset or a debt obligation to actually rate the soundness of the security for whatever it's supposed to be. They sign a rating like Triple A or Single A.

Professor Douglas W. Rae: Okay. And if I'm — Yale was Triple A, and I think we're now Double A, what's a Triple A — what's the advantage of a Triple A rating?

Student: If you have a higher rating then that means you can get a lower cost of capital. So, if you actually want to raise some money you can raise it for a lot less — a lower interest rate.

Professor Douglas W. Rae: So, it reduces the cost of capital, and it therefore has great value to you. Now, if you could bribe Moody's, if you were completely amoral and you could bribe Moody's to make something Triple A when it was really B, it would be worth paying a lot, right? The actual economic value of those ratings is huge. What keeps Moody's honest?

Student: Their reputation; the fact that they have, for years, made sure that the ratings that they're giving are actually safe investments.

Professor Douglas W. Rae: Okay. And in general, people on the buy side are going to want the rating agencies to tell the truth and people on the sell side will be ambivalent about that, so there are cross-pressures there. And there is patent evidence of great inflation in the ratings that these firms produce. Does that surprise you, Paul?

Student: Not really, no, because they get paid by the sell side not by the buy side.

Professor Douglas W. Rae: Absolutely. So, they are doing — they are, in a sense, appraising as instructed and that's a pretty scary part of this whole thing. Let's reach all the way back to Adam Smith for a minute, and Smith's story, not just of the invisible hand, but of the generally benign working of markets. In everything Smith says is embedded a basic norm of truth that I'm not selling you a false mirage of a loaf of bread; I'm selling you an actual loaf of bread. I'm not selling you coffee or a substance that looks like coffee; I'm selling you coffee. And the basic accountability in bilateral trade, where you're buying something from me or I'm buying something from you, we keep each other honest, right? Where it's two parties and there's no information asymmetry, right? Where there are two parties with symmetrical information.

The most foundational aspect of a market system is that buyer and seller are equipped to keep each other honest. And where there is a huge information asymmetry, we invent things like Moody's or appraisals of real estate as a substitute, a way of creating or simulating information symmetry. But if the third party agencies act like sellers to the side that pays them, the information asymmetry is actually made worse, right. And the strongest case for increased government regulation of the finance industry generally, actually, is the difficulty of policing the police; of tracking the integrity of estimates put out there by people who are in the business of correcting information asymmetries. Jaan, are there aspects of the case that you would urge us to pay greater attention to?

Jaan Elias: [laughs] Well, first of all, on the Triple A story, and this may not be in the case, per say, but it's certainly part of the thing. Not only is there a nice little boost to the true cost of capital if you get rated Triple A, but there are certain funds and certain buyers, like money market funds and other funds, that only can buy Triple A bonds. So once you've crossed that threshold, you have just absolutely increased the number of people and possible purchasers of your funds. Because if you put money in a money market fund, you want a reasonably liquid investment, you want a reasonably assured return. These are not supposed to be risky investments and therefore money market funds, all kinds of other funds, are limited to Triple A bonds. So, getting to the Triple A level was really important. To say something, you could go, "I'm not a big fan of their performance in this case," but in terms of Moody's & Fitch and everything, the collusion doesn't — there doesn't have to be explicit collusion in the sense that, if I give you this bond to rate, I will never rate a bond again unless you give me a Triple A rating.

What happened in this case is Moody's and Fitch and others put out fairly explicit guidelines on what they consider to be Triple A. So, you're the bond packager at the iBank, you're bringing together all these mortgages. And you say "I have to reach a fifteen percent threshold level, where it's fifteen percent over collateralized, or I have to buy CDS, which are the default swaps, in order to ensure this investment and get it over that Triple A bump," you do exactly what you need to do to get that Triple A rating. And what happened when the crisis hit is we had all of these people who are just over the Triple A rating and they — I mean, with them just over you don't have a spread — you don't have a usual probability distribution. All of these guys who were creating these CDOs knew exactly where the finish line was, and went just a step over that to make sure that they would get the Triple A ratings. So, the fact that they were not very well understood, that the historic data went back three years and they felt very confident in doing stuff with three years of data, I think that's an interesting way. Because, when you're looking for active collusion you expect guys in seedy bars, trading information and dollars in brown paper envelopes, and sometimes it's not that explicit. There are ways that gaming the system without having anyone do anything that even resembles something that sketchy.

Professor Douglas W. Rae: So, it may be that legitimate cheating, cheating in a good blue suit, is more dangerous than cheating in a seedier setting with seedier...

Jaan Elias: Or you're using a formula that's really untested by a heck of a lot of data, may be also a bad idea. And to go on, I'm actually kind of surprised, Doug, given that we're at an elite university with lots of people with connections to Wall Street in some way or another, that everyone thought the zebra was the people buying the houses. If you look at the data, and you have Mark Kellogg's purchase list there, if you look at the data, you begin to notice not only is there a pattern in who the appraiser is, but there are patterns as to who the buyer is. We have this one buyer here, and I'm just looking at it in a four-year period, bought five houses, six houses, all with the same broker, all with the same appraiser. We go down and there are others here, seven or eight times. Just look at the names and they repeat themselves.

So, I would put the question back here, who's the lion and who's the zebra in this case? Was it the iBanks? They were relying on these folks in Cleveland to do a reasonable job in appraising, in putting out the thing, and in the end, that's what went into those formulas that I was talking about. The fact that, okay, you have houses that are appraised at this much and historically they default at, let's say, a ten percent rate. But they didn't take into account the fact that you have people who are just jiggering the system and going, in a six month period, buying a house at $25,000 and selling it at $85,000 with no evidence of any remodeling. And it just goes on, you [inaudible] go through with it. The sell sheet is actually fascinating if you want to play junior detective; if you want to see how these patterns — and the data, and you can look at the data, and go "You know, this can't be right. This really can't be right in terms of selling and how much they're selling the things for." And it's actually, when you look at the story of Cleveland, which wasn't a hot market, and you can't come up with a story like you might for Miami or Las Vegas and think "Well, a lot of old people are going to move here and that's the reason land value's coming up." You can't come up with a story like that for Cleveland and it's a wonderful town, don't get me wrong, but there isn't...

Professor Douglas W. Rae: Worst yes, they've got the Indians and the Browns.

Jaan Elias: Yes and they have the Rock 'n' Roll Hall of Fame but there's really, you know, it's hard to come up with a story. So, why are we getting this kind of occurrence and so on? So, that's the point I would make.

Professor Douglas W. Rae: Okay.

Student: So, one thing that I saw was I felt like the zebra really represents potential profits and economic profit more than an individual in itself. So, if you look from each of the actors' point of views, the zebra is really what they're — the profits that they're going after under the system that's set up. So, rationally, each player is acting in their own best interests but, in the end, the big picture ends up where it hurts the system as a whole. And so, I think that it's very easy to want to put blame on a specific party or a specific group, but it's just very difficult to do because everybody's working under the incentives that has been created for that party.

Jaan Elias: And may I offer another potential zebra to consider, which is the folks — let's say you're buying one of these houses and the house next to you has been bought for $25,000 and sold for $85,000 with no visible improvement. You bought your home for $30,000, you've put another $40,000 into it, you have a legitimately $70,000 house, how are you going to feel when that house next to you gets boarded up and goes into foreclosure because someone has been playing the appraisal game? So, there's an externality here to consider too in the overall community.

Professor Douglas W. Rae: So, who's got an idea about how to fix all this? Would it be drumming truth-telling into three year olds? Would it be — yes?

Student: I think there's a huge gap in government oversight, particularly with regard to the ratings that, I mean, when Moody's is — although they have the cross pressures that you talked about, but when Moody's is being paid by one side and not the other and even if we assumed that they're all inflated and therefore just interpret them to be suspect, without some third party that's completely disinterested, like the government coming in and telling you how to rate it, you're not going to get truthful ratings and therefore the whole system falls apart from the top.

Professor Douglas W. Rae: Yes, that sounds right. And one of my own inclinations would be to compel the initial lenders to hold a given percentage equity in each loan so that they can't utterly ignore the probability of default. On Monday I'm going to, Monday is a wildcard in the syllabus, and I had planned to use it to do the Morys business plan, but it turns out that there are people who think it would be a terrible idea if the Morys business plan got to the Yale Daily News. And while we're 110 really good friends, I think I'd be nuts to use that at this stage. We'll do that at the end of the semester when it won't be — when it will not cause bloodshed somewhere in the system. And we'll do a — I'd like to do two things with Monday. One is: I'll post a case on Vioxx, the drug which was a COX-II inhibitor and did a lot of good for people like me with knee trouble, but it killed a few of them. And there were hard feelings and a vast avalanche of lawsuits, and we'll look at that. I'm also going to post Federalist Paper number ten. Could I — hands up if you've read Federalist ten. No American, nobody who's going to do business in this country, should fail to get the idea of the fundamental design of the American political system, which is spelled out in only a few thousand words there. See you on Monday.

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