WEBVTT

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Prof: Hi,
this is John Geanakoplos again.

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Here to give a lecture,
that I gave one evening,

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that we couldn't record.

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So I'm going to try and
reproduce the lecture as

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faithfully as I can.

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And I think it's a historical
lecture.

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I hope you find it interesting.

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It's about the history of the
mortgage market.

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And I call it a personal
history because by some

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accident, I participated at many
of the key points in the recent

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history of the mortgage market.

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So I started off in 1989.

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I was professor here at Yale.

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I was a mathematical economist.

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I thought of myself as using
mathematics to study economics

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and staying really pretty much
as far from the real world as I

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could.

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But for some reason,
I decided that I wanted to see

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what was going on on Wall
Street.

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The most interesting
mathematical modeling of that

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day was being done on Wall
Street.

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And mathematical modeling and
finance, that is in economics.

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And so I decided.

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why not go see it?

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And so I visited a bunch of
investment banks.

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A number of my friends,
including one from Yale,

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had worked at Goldman Sachs.

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So that was the natural thing
to do.

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But, I had a little cousin who
had just been hired recently,

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a little bit before that,
at Kidder Peabody,

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which was sort of the number
seventh investment bank at the

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time,
in terms of size.

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And he introduced me to the
fellow, Ed Cerullo,

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who ran fixed income at the
time.

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And they persuaded me that it
would be much more interesting

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to go to Kidder,
Peabody and to talk to people

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like Ed Cerullo,
than go to Goldman Sachs and be

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one of a hundred visiting
professors.

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So I decided that the firm was
a little bit smaller,

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but I would see more of it.

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And why not do something a
little bit different?

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So they never had an academic
visitor, I think,

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like me spend a year there
before.

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So I went in 1989 to 1990.

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And while I was there I talked
a lot to Ed Cerullo and to the

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traders and to a bunch of other
people.

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And at the end of the my
sabbatical,

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Ed Cerullo came to me and he
said, you know I've come to

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realize that our fixed income
research department isn't very

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mathematical.

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Why don't you hire a research
department for me?

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And I'll help you along.

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But, you find the people,
you know the subject,

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you can judge,
your business is judging people

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doing research,
why don't you hire me a

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research department?

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So I hired him a research
department, which ultimately

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grew to 75 people.

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And I returned to Yale.

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And after I got back to Yale,
he called me up and he said,

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now that you've hired the
research department,

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you have heads of all these
different groups,

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why don't you run the research
department?

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You can do it from Yale,
as a consultant.

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And so I became the head of
fixed income research at Kidder

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Peabody from Yale.

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And it was quite an experience.

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I hadn't realized,
when I accepted the job,

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just how many complications
would arise.

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How many people would get job
offers from other places and

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want to leave.

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And how many models wouldn't
work.

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And then there'd have to be a
wild scramble to fix it.

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But anyway, that placed me at
an investment bank,

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that would become one of the
key players in the mortgage

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market.

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Now in the mortgage market,
well who are the players?

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They are the homeowners you all
know about.

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They are the banks who are
giving mortgage loans.

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But then there are a number of
other players that are invisible

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to much of the public,
which really dominate the

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market.

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There's the government
agencies, Fannie Mae and Freddie

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Mac, which you'll hear a lot
about.

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There are the investment banks,
like Kidder Peabody and Goldman

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Sachs and a bunch of others.

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There are the hedge funds and
there are other investors.

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And this group of people
creates a gigantic hierarchy,

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an invisible market,
that's on the same size,

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the same scale,
as the stock market.

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So I think in that time,
1989,1990, if you'd asked

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anyone in America practically,
what's an important financial

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market?

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They would have said,
the stock market.

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What's another important
financial market?

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Corporate bond market.

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What's another one?

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Well, foreign exchange market.

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What's another one?

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Options market.

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I don't think anyone would have
said the mortgage market.

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Or at least they wouldn't have
said it very early on in their

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list of important financial
markets.

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But in fact,
as I'm going to try and tell

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you during this class,
the mortgage market is not only

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on the same scale as the stock
market,

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but actually quite a bit more
complicated than the stock

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market.

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More mathematical than the
stock market.

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And in some ways,
more interesting than the stock

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market.

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And as we'll see at the end of
the course, it was the mortgage

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market that led to the greatest
crisis we've had since the

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depression.

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And in fact,
caused several similar crises

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before that.

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So mortgages appear at the
bottom.

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You have homeowners living in
their houses who need to borrow

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the money to buy the house.

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Before they can live in the
house they have to get the money

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to buy the house.

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So they borrow the money by
taking out a mortgage.

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And it's a bank or a thrift or
somebody like that who lends the

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money.

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That's the first step.

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So a mortgage is just a promise
to pay the loan back over a long

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period of time using your house
as collateral.

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An important part of mortgages
is that you have an option to

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pre pay the mortgage.

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I mean, what if you move?

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The mortgage is,
say, a 30-year promise.

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And after three years,
you might want to move.

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So, if you're gone from the
house, the house can no longer

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serve as collateral because you
don't live in it anymore.

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So there has to be some way of
getting out of the mortgage.

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And so there's an option to pre
pay it.

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Now, in the United States,
that option can be used even if

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you stay in the house.

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And it turns out to be one of
the more problematic aspects of

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valuing mortgages.

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And one of the most interesting
aspects of valuing mortgages.

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We'll come to that later.

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So this idea of a mortgage,
those three ideas,

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were already known to the
Babylonians more than 3,000

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years ago.

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So the mortgage is not a recent
invention.

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It wasn't invented after the
industrial revolution.

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It was invented more than 3,000
years ago near the Middle East.

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So, it's stayed pretty much the
same for most of those 3,000

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years until the 1930s when the
amortizing mortgage was

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invented.

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So what happened in the 1930s,
that was the time of the Great

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Depression and farmers had lots
of mortgages and they would owe,

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$7.00 a year,
say, as their interest payment.

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And at the end of 10 or 15
years, they'd have to pay $107,

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that is they make their
interest payment.

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And they pay back the balance.

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What's called now a balloon
payment.

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That's how a typical bond works.

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Well, of course when things got
really bad, a lot of them

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defaulted.

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And naturally,
they chose to default just

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before the $107 payment.

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So seeing that,
mortgage lenders decided that

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it would be much safer to make a
flat mortgage loan where the

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payment was say,
$8.00 a year for all of thirty

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years.

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Now, you pay a little bit more
each year for 29 years,

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but then you continue to pay
the $8.00 the 30th year.

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But you see,
if you add up all the extra

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payments and you realize that
there's discounting,

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the $107 way off in the end
isn't really that much money

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when looked at from the
beginning.

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And so by paying $8.00 every
year, you can get the same

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present discounted value of
paying $7.00 29 years and $107

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the 30th year.

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So that's called the amortizing
mortgage.

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It makes the lender much safer
because after a bunch of years

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have gone by,
the house presumably has gone

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up in value.

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Or even if it hasn't gone up in
value, the remaining payments

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are much less because so many
have been made that the balance

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has been amortized.

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And so actually to get out of
your mortgage,

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you need to pay less than $100
back.

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So this amortizing mortgage is
something we're going to study

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mathematically in the next
lecture.

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But now, I just mentioned that
was one of the big innovations,

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which made the mortgage market
much safer than before.

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Well so things continued pretty
much the same from the 1930s all

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the way to the 1970s when we had
securitization.

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Like many of the great
financial innovations in

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history, this one was created by
the government.

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So Fannie Mae and Freddie Mac
were government Agencies They

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were created by the government.

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They then became eventually
separate from the government.

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But they were given the task,
they were created for the

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purpose, of making mortgage
pass-throughs.

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So we're in the 1970s.

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So mortgage pass-throughs are
the second tier of this

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hierarchy.

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So the banks who had lent the
mortgage, remember when you take

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out a mortgage as a homeowner,
you're selling your promise.

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You're getting the money by
selling your promise to pay back

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later.

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So those promises are collected
by the banks.

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And instead of just sitting on
the promises,

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the banks now,
with Fannie Mae and Freddie Mac

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could sell their promises to
Fannie Mae and Freddie Mac.

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And Fannie Mae and Freddie Mac
would put them together in

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gigantic pools called pass
through pools.

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Why were they called
pass-throughs?

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Because the mortgage payments
the homeowners made would go to

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the banks and the banks would
just pass them on to the pools.

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And then the pools would
collect the money and pass that

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money on to the shareholders.

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So the ultimate lenders to the
homeowners are the people who

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buy shares in the Fannie and
Freddie pools.

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So the banks appear to the
homeowner to be lending the

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money.

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But actually,
they're not lending it all.

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They are the middleman.

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And so they collect the money
from the homeowner and they send

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it on to the actual lender,
who's the shareholder of the

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pool.

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And the banks are also the
servicer, really.

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They're getting paid a fee for
collecting the money and writing

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threatening letters if the
homeowner stops paying.

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And as we'll see later,
throwing the homeowner out of

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his house if the homeowner
doesn't pay.

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So Fannie and Freddie played an
extraordinarily important role

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in the mortgage market.

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First of all,
not any mortgage could be sold

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into these pools.

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They had to meet strict
criteria.

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You had to have a good credit
rating.

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You had to have a job.

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You had to have all sorts of--
sorry about this,

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I'm going to have to shut off
my cell phone.

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So the loan to value of the
mortgage had to be,

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that is if the house is worth
$100, the loan could only be 80%

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of it.

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You had to have a record of the
job you had and so on.

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So this was very standardized
and very high performing loans.

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You could contrast with,
say, to the world that you

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might have seen in the movie
It's a Wonderful Life.

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So in the movie It's a
Wonderful Life,

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you remember Jimmy Stewart runs
a thrift and he makes mortgage

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loans.

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And people come to him and they
say we want a loan.

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And you know one guy comes and
says he wants a loan.

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Jimmy Stewart says,
well do you have any

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collateral?

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No, I haven't built the house
yet, you know I'm trying to

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build the house.

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Do you have a record of
employment?

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No, I just moved here,
I don't have a job yet.

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Do you have someone who can
vouch for you?

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No.

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Do you have a credit rating?

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No.

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There's no such thing as credit
rating.

11:29.840 --> 11:32.970
So then Jimmy Stewart looks
into his eyes and realizes this

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is a good honest person and
gives him a loan.

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Well, that doesn't happen in
the Fannie Mae and Freddie Mac

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pools.

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They're very standardized
criterion.

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And that guy,
Martini who got the loan from

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Jimmy Stewart would never have
gotten a conforming Fannie or

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Freddie loan in the 1980s or
1990s.

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Might have gotten one in the
2000s though,

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but we'll come back to that.

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So that kind of market is very
much like the kind of market in

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the Jimmy Stewart movie,
It's a Wonderful Life,

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that gets created in his
fantasy.

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Where you know,
the town gets taken over by the

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evil banker and that evil
banker,

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whose name I've forgotten at
the moment,

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but that evil banker basically
is creating the kind of loans,

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almost, that we're talking
about now.

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Everything's mechanized and
standardized.

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Of course with standardization
you get tremendous advantages.

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For one thing,
these loans being pooled

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together and being of the same
general good quality,

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they allow the lenders,
instead of lending to a bunch

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of homeowners in Peoria like the
bank would do,

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now all those Peoria loans are
stuck with a bunch of other

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loans from all over the country
in the same big Fannie pool.

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And so the lenders,
who are the shareholders,

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have diversified their risk.

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If the big businesses in
Peoria, Illinois go under,

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it might be that all the
homeowners in Peoria will

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default on their mortgages.

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But not in the Fannie and
Freddie pools,

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because those are loans from
all over the country.

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So it would have to be that
businesses all over the country

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went bad for those loans all to
go bad.

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So secondly,
if you're getting a whole pool

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and there's an automatic
criterion for getting into the

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pool,
you don't have to worry that

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you're getting the worst loans
or the cheatiest loans or

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something.

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You know the quality,
the general quality,

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of all the loans.

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And once you have shares in a
pool, you can resell the shares.

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So a bank who has to study the
homeowner and you know have

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meetings with them.

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And you know,
Jimmy Stewart had to look into

13:32.985 --> 13:33.425
his eyes.

13:33.428 --> 13:35.958
So Jimmy Stewart may have
convinced himself the guy is a

13:35.958 --> 13:38.668
good risk, but how could Jimmy
Stewart ever sell the loan to

13:38.672 --> 13:39.502
somebody else.

13:39.500 --> 13:41.170
The other buyer,
who hasn't looked into

13:41.174 --> 13:43.034
Martini's eyes,
he's never going to believe

13:43.027 --> 13:44.877
Jimmy Stewart that that's a good
loan.

13:44.879 --> 13:47.559
So Jimmy Stewart is going to be
stuck with that loan for 30

13:47.559 --> 13:47.929
years.

13:47.928 --> 13:50.948
In the Fannie and Freddie
pools, the shareholder who buys

13:50.947 --> 13:54.017
the loans and knows they're
standardized knows exactly the

13:54.018 --> 13:57.518
same thing as the next guy who
might buy his shares from him.

13:57.519 --> 14:00.359
So if the shareholder will be
willing to pay more for the

14:00.363 --> 14:02.273
loan,
because he knows that if he

14:02.274 --> 14:04.264
needs cash,
he doesn't have to wait 30

14:04.256 --> 14:06.816
years, he can just sell his
shares to somebody else.

14:06.820 --> 14:08.680
So because of the
diversification,

14:08.678 --> 14:10.968
because of the reduction in
adverse selection,

14:10.970 --> 14:13.390
and because of this ability to
resell the shares,

14:13.389 --> 14:16.819
lenders, that is shareholders,
are willing to pay more for the

14:16.816 --> 14:17.486
mortgages.

14:17.490 --> 14:19.410
And so the mortgage rate went
down.

14:19.408 --> 14:23.418
So, I've estimated that this
operation together with the next

14:23.421 --> 14:27.231
one I'm going to talk about,
has reduced mortgage rates by

14:27.231 --> 14:28.771
at least a percent.

14:28.769 --> 14:31.629
So if you think the average
loan is $200,000,

14:31.634 --> 14:35.614
you're talking about $2,000 a
year that the average homeowners

14:35.605 --> 14:38.075
save by this financial
innovation.

14:38.080 --> 14:42.050
So securitization seems to have
been a great boon.

14:42.048 --> 14:43.978
Now in 2002,
when I made these slides,

14:43.976 --> 14:47.306
I'll just give you an idea of
the size of the mortgage market.

14:47.308 --> 14:49.808
And you have to double all
these numbers today,

14:49.808 --> 14:50.568
pretty much.

14:50.570 --> 14:54.060
So you see that you know the
stock market was around $15

14:54.056 --> 14:57.856
trillion and the mortgages
around $7 trillion at the time.

14:57.860 --> 15:02.000
And you know that compares to
$2 trillion for corporate bonds

15:02.000 --> 15:04.210
or $3 trillion for treasuries.

15:04.210 --> 15:06.210
You see how big the mortgage
market was then,

15:06.207 --> 15:07.477
and now it's twice as big.

15:07.480 --> 15:10.940
It's the same size basically as
the stock market,

15:10.943 --> 15:13.763
which hasn't really grown since
then.

15:13.759 --> 15:18.729
So, I don't have time to talk
about this.

15:18.730 --> 15:20.950
But, of course,
of the mortgage market,

15:20.952 --> 15:24.112
some of it is commercial,
some of it is residential.

15:24.110 --> 15:25.590
The vast majority is
residential.

15:25.590 --> 15:27.700
But there's a very big
commercial mortgage market.

15:27.700 --> 15:31.790
I'm going to be talking mostly
about the residential mortgage

15:31.794 --> 15:32.414
market.

15:32.408 --> 15:35.968
Some of these mortgages are in
fact held by the banks without

15:35.970 --> 15:38.640
selling them to Fannie Mae and
Freddie Mac.

15:38.639 --> 15:41.589
But a lot of them are
securitized just in the way we

15:41.591 --> 15:42.461
talked about.

15:42.460 --> 15:44.920
And they're going to be private
securitizations later that we'll

15:44.921 --> 15:45.431
talk about.

15:45.428 --> 15:52.028
And so now that securitized
part is $10 trillion.

15:52.029 --> 15:56.469
I'll give the numbers,
recent numbers,

15:56.470 --> 15:57.430
later.

15:57.428 --> 15:59.568
So actually that may be a
little bit big.

15:59.570 --> 16:02.780
The $7 trillion,
the securitized part of the

16:02.783 --> 16:04.133
mortgage market.

16:04.129 --> 16:11.679
So in 2002, the agencies
dominated the security market.

16:11.678 --> 16:15.118
The securitized loans were
almost all Fannie Mae and

16:15.124 --> 16:16.074
Freddie Mac.

16:16.070 --> 16:19.050
There's also another agency
called Ginnie Mae,

16:19.046 --> 16:22.946
but there was another part of
it, which were jumbo loans.

16:22.950 --> 16:24.150
So there was a size limit.

16:24.149 --> 16:26.519
The loans couldn't be too small
and couldn't be too big for

16:26.519 --> 16:27.869
these Fannie and Freddie pools.

16:27.870 --> 16:32.090
The government was trying to
appeal to the middle class.

16:32.090 --> 16:35.570
Establish homeownership in the
reliable middle class.

16:35.570 --> 16:39.150
And so the wealthy who were
buying million dollar homes

16:39.148 --> 16:43.118
weren't able to get their loans
sold into a Fannie or Freddie

16:43.123 --> 16:43.723
pool.

16:43.720 --> 16:47.290
And so those loans were
securitized the same way,

16:47.289 --> 16:51.829
but by private agencies and not
by banks, by investment banks,

16:51.827 --> 16:54.057
and not by the government.

16:54.058 --> 16:56.258
And that at the time,
in 2002, was half a trillion.

16:56.259 --> 16:59.669
We'll come to all these numbers
later.

16:59.669 --> 17:01.289
When we say today's numbers.

17:01.288 --> 17:04.708
So the next innovation after
the 1970s, came in the 80s and

17:04.712 --> 17:07.962
that's the collateralized
mortgage obligation market.

17:07.960 --> 17:09.660
CMOs, they are called.

17:09.660 --> 17:13.440
So the investment banks like
Kidder Peabody and Lehman

17:13.444 --> 17:16.944
Brothers, for example,
would buy some of these big

17:16.944 --> 17:17.664
pools.

17:17.660 --> 17:20.600
And then they would cut the
pools, which were just

17:20.598 --> 17:21.558
pass-throughs.

17:21.558 --> 17:24.308
So the pools just passed
through the money that the

17:24.308 --> 17:25.958
homeowners were giving them.

17:25.960 --> 17:29.110
So maybe they were passing
through $1,000 a month as the

17:29.106 --> 17:29.676
promise.

17:29.680 --> 17:34.290
Well, say Kidder Peabody,
might buy a pool promising

17:34.292 --> 17:37.642
$1,000 a month to the
shareholders.

17:37.640 --> 17:40.060
And then cut the promise into
two pieces.

17:40.058 --> 17:42.878
Maybe a floater,
which would pay $500 plus the

17:42.877 --> 17:43.877
interest rate.

17:43.880 --> 17:47.080
And so when the interest rate
went up, the payments would go

17:47.076 --> 17:49.186
up, that's why it's called a
floater.

17:49.190 --> 17:51.710
And maybe a second piece called
an inverse floater,

17:51.705 --> 17:53.715
which is $500 minus the
interest rate.

17:53.720 --> 17:56.090
So as the interest rate went
up, the payments would get

17:56.089 --> 17:56.529
smaller.

17:56.529 --> 17:58.619
But as the interest rate went
down, the payments would get

17:58.618 --> 17:58.948
bigger.

17:58.950 --> 18:00.280
That's called an inverse
floater.

18:00.278 --> 18:02.518
So that way the two add up to
$1,000.

18:02.519 --> 18:05.989
But now, you can appeal to two
different buyers.

18:05.990 --> 18:09.040
A buyer who needs the money
when interest rates go up would

18:09.041 --> 18:09.991
buy the floater.

18:09.990 --> 18:12.410
A buyer who needs the money
when interest rates go down,

18:12.411 --> 18:13.821
would buy the inverse floater.

18:13.818 --> 18:17.208
So by creating out of plain
vanilla promise,

18:17.210 --> 18:21.630
two more tailored promises,
you can target more sharply a

18:21.625 --> 18:22.725
clientele.

18:22.730 --> 18:26.010
And therefore get probably more
than half the money for each of

18:26.009 --> 18:26.909
the two pieces.

18:26.910 --> 18:29.620
And that way,
of course competition in the

18:29.615 --> 18:33.375
CMO market raises the amount
people are willing to pay for

18:33.376 --> 18:34.826
the pass-throughs.

18:34.828 --> 18:37.558
Because they can then buy them
and split them up.

18:37.559 --> 18:40.189
And sell them for more.

18:40.190 --> 18:42.100
So that raises the price of the
pass-throughs,

18:42.098 --> 18:44.918
which in turn raises the price
that the homeowners can sell

18:44.923 --> 18:46.873
their mortgage,
which in turn lowers the

18:46.867 --> 18:48.957
interest rate that the
homeowners have to pay.

18:48.960 --> 18:53.930
So again, it's another reason
why this whole operation of

18:53.931 --> 18:59.081
securitization improved the
welfare of almost everybody.

18:59.078 --> 19:04.058
So, the pieces gradually got
more complicated So if there was

19:04.057 --> 19:07.557
default or somebody prepaid,
as we talked about,

19:07.557 --> 19:10.457
used their option to pay early,
instead of getting the money

19:10.464 --> 19:13.434
you expected,
you get extra or less money

19:13.431 --> 19:15.031
than you expected.

19:15.029 --> 19:16.009
That created risk.

19:16.009 --> 19:18.509
And some of these buyers didn't
want to bear the risk.

19:18.509 --> 19:21.839
So maybe you'd make the pieces
$400 plus the interest rate and

19:21.837 --> 19:23.527
$400 minus the interest rate.

19:23.528 --> 19:27.238
And leave $200 to what might be
called a residual piece or a

19:27.242 --> 19:28.882
derivative or something.

19:28.880 --> 19:31.440
And that $200 would bear the
risk.

19:31.440 --> 19:34.190
So if someone defaulted,
you take it out of the $200

19:34.191 --> 19:36.351
piece and not of the first two
pieces.

19:36.348 --> 19:39.658
So that split up,
again, made the floater and

19:39.663 --> 19:43.883
inverse floater safer and
encouraged people to buy it.

19:43.880 --> 19:45.950
But of course,
somebody had to buy the

19:45.945 --> 19:48.455
residual piece,
which was more complicated.

19:48.460 --> 19:52.420
So, as I said,
this whole operation was a way

19:52.420 --> 19:55.120
of accomplishing two things.

19:55.118 --> 19:58.248
It made homeowners able to sell
their promises for more.

19:58.250 --> 20:00.420
So they effectively were paying
a lower interest rate.

20:00.420 --> 20:03.130
So it made it easier to move
into houses.

20:03.130 --> 20:05.790
And that's precisely what the
government intended by creating

20:05.787 --> 20:06.537
these agencies.

20:06.538 --> 20:10.068
It also allowed buyers and
investors to get money in the

20:10.074 --> 20:13.484
cases they needed it,
in the states they needed it.

20:13.480 --> 20:15.900
Because the pieces were tailor
made for them.

20:15.900 --> 20:19.360
So I realized,
while I was there at Kidder

20:19.361 --> 20:21.451
Peabody,
that this whole multi

20:21.452 --> 20:24.222
trillion-dollar operation behind
the scenes was,

20:24.220 --> 20:27.240
as I said, invisible to
everybody and was worth writing

20:27.241 --> 20:27.691
about.

20:27.690 --> 20:33.150
It was bringing great welfare
gain to the country and nobody

20:33.152 --> 20:35.192
quite knew about it.

20:35.190 --> 20:38.910
So for me, it crystalized what
the essence of finance is.

20:38.910 --> 20:41.650
The essence of finance is
you're trying to create

20:41.654 --> 20:43.764
promises,
the financial system is

20:43.761 --> 20:47.051
creating promises,
that deliver money to people in

20:47.046 --> 20:49.616
circumstances or states as I
call it,

20:49.619 --> 20:51.679
that they really need the money.

20:51.680 --> 20:53.700
But of course,
you have to guarantee that the

20:53.698 --> 20:55.348
money is going to be paid to
them.

20:55.348 --> 20:57.838
So in order to do that,
you have to have collateral.

20:57.838 --> 21:02.208
So this entire system is a way
of creating promises and backing

21:02.209 --> 21:03.829
them with collateral.

21:03.828 --> 21:05.938
So if you remember,
here are the potential

21:05.943 --> 21:08.783
promises, and maybe some people
want money down here.

21:08.778 --> 21:10.698
That's when the interest rates
go up, they're buying the

21:10.695 --> 21:11.075
floaters.

21:11.078 --> 21:12.888
Way over there,
the money's going down,

21:12.888 --> 21:15.698
the interest rates are going
down, that's the people who buy

21:15.699 --> 21:16.889
the inverse floaters.

21:16.890 --> 21:20.190
That's when they're getting
most of their money.

21:20.190 --> 21:23.120
But these promises,
you have a reason to expect to

21:23.115 --> 21:26.275
get paid, because they're backed
by the collateral.

21:26.278 --> 21:28.688
OK, so this is not a very good
picture.

21:28.690 --> 21:31.860
The houses backed the promises
of the homeowner like in

21:31.863 --> 21:32.983
Babylonian times.

21:32.980 --> 21:35.590
If the homeowner doesn't pay,
he loses his house.

21:35.588 --> 21:39.228
Then those mortgages
themselves, those mortgage

21:39.226 --> 21:44.206
promises, are backing the pools,
which are selling shares to the

21:44.205 --> 21:45.545
shareholders.

21:45.548 --> 21:49.428
But those shares are backing
the CMOs, which are making more

21:49.434 --> 21:50.954
complicated promises.

21:50.950 --> 21:53.930
So the collateral you see is
used once by the homes,

21:53.930 --> 21:56.210
once by the pools,
once for the CMOs.

21:56.210 --> 21:59.120
And then it will turn out,
as we'll see in a few minutes,

21:59.118 --> 22:02.438
that the investors who buy are
borrowing money,

22:02.440 --> 22:05.370
buying on margin,
using the CMO pieces they buy,

22:05.368 --> 22:06.998
as collateral for their
purchases.

22:07.000 --> 22:09.330
So the collateral is being used
and reused.

22:09.328 --> 22:12.038
And so in fact,
the entire system is stretching

22:12.035 --> 22:14.795
the available collateral as much
as possible.

22:14.798 --> 22:17.098
So collateral is a very scarce
resource.

22:17.098 --> 22:19.518
It's very important to running
a financial system.

22:19.519 --> 22:22.449
Many developing countries don't
have any collateral.

22:22.450 --> 22:25.460
And therefore they have a
primitive financial system.

22:25.460 --> 22:27.560
Here, there's a tremendous
incentive to stretch the

22:27.561 --> 22:28.951
collateral as much as possible.

22:28.950 --> 22:31.900
You can stretch it by using it
over and over again or by

22:31.900 --> 22:34.530
letting the same collateral back
many promises.

22:34.529 --> 22:36.389
We saw both of those,
the tranching,

22:36.390 --> 22:38.730
the different CMO pieces,
and the pyramiding,

22:38.729 --> 22:41.599
the using the same collateral
over and over again.

22:41.598 --> 22:46.518
So I wrote my first paper,
published it,

22:46.518 --> 22:47.778
in 1997.

22:47.779 --> 22:51.369
I had written it while I was at
Kidder Peabody.

22:51.368 --> 22:53.728
And one of the questions I
asked was,

22:53.730 --> 22:56.290
when you take out a loan,
not only what interest rate do

22:56.286 --> 22:58.766
you have to pay,
but how much collateral do you

22:58.767 --> 22:59.617
have to put up?

22:59.618 --> 23:02.598
And that was a question that
nobody seemed to have asked

23:02.598 --> 23:05.198
really before,
in a general equilibrium model.

23:05.200 --> 23:07.850
So that was my first paper on
the subject.

23:07.848 --> 23:10.058
I want to get back to Kidder
Peabody.

23:10.058 --> 23:13.038
Kidder Peabody,
as I said when I started,

23:13.035 --> 23:16.825
was a sleepy number seven
ranked investment bank.

23:16.829 --> 23:18.939
Didn't dominate any market.

23:18.940 --> 23:23.370
But it came to completely
dominate the CMO market.

23:23.368 --> 23:26.438
So this, as I said,
was a multi trillion-dollar

23:26.439 --> 23:27.039
market.

23:27.038 --> 23:30.448
And if you look at all the
pieces that are being promised

23:30.452 --> 23:32.992
here,
what Kidder decided to do was,

23:32.987 --> 23:35.647
things got more and more
complicated,

23:35.650 --> 23:37.640
there weren't just two pieces,
there weren't just three

23:37.641 --> 23:39.691
pieces,
there were 90 pieces typically

23:39.693 --> 23:40.483
at that time.

23:40.480 --> 23:46.300
And so a typical investment
bank that wanted to buy a pool

23:46.299 --> 23:49.159
and sell these CMO pieces.

23:49.160 --> 23:51.580
Like let's say,
Salomon or First Boston,

23:51.577 --> 23:54.427
they were the ones who first
did these CMOs.

23:54.430 --> 23:57.480
They would try to line up 90
buyers and figure out what each

23:57.477 --> 23:59.127
of the 90 were willing to pay.

23:59.130 --> 24:02.080
And then when they added up the
prices each of the 90 willing to

24:02.082 --> 24:03.852
pay,
they'd go and if they thought

24:03.846 --> 24:06.666
the sum of those was bigger than
the price in the pool,

24:06.670 --> 24:08.830
they'd go to the pool and buy
the pool.

24:08.828 --> 24:11.508
And then immediately make a
profit by selling off the 90

24:11.510 --> 24:11.950
pieces.

24:11.950 --> 24:16.620
Well, at Kidder,
the head of mortgages,

24:16.618 --> 24:20.708
who by this time by the way,
was my young little cousin,

24:20.710 --> 24:27.740
who through hard work had
worked his way up to running the

24:27.743 --> 24:30.463
small CMO operation.

24:30.460 --> 24:33.020
He got the idea that what
Kidder could do,

24:33.023 --> 24:35.843
was to find a buyer for the
riskiest piece.

24:35.838 --> 24:37.518
The one that I've put in
yellow, remember,

24:37.516 --> 24:38.126
the residual.

24:38.130 --> 24:41.140
Which was maybe called an
inverse IO, it had different

24:41.136 --> 24:43.006
names, but the riskiest pieces.

24:43.009 --> 24:46.239
Once he found the buyer,
a place to put the riskiest

24:46.240 --> 24:49.010
piece,
he would borrow the money to

24:49.006 --> 24:52.536
buy the pass through,
and hold an inventory of all

24:52.544 --> 24:53.664
the other pieces.

24:53.660 --> 24:56.570
So he knew, that eventually,
we would be able to sell off

24:56.566 --> 24:57.756
all the other pieces.

24:57.759 --> 25:00.679
And so we had a tremendous
advantage.

25:00.680 --> 25:03.450
While everyone else was looking
for buyers for 90 pieces,

25:03.453 --> 25:06.083
we had to find a buyer for one
piece or two pieces.

25:06.078 --> 25:10.828
So we then had an inventory of
88 pieces, say,

25:10.833 --> 25:11.893
to sell.

25:11.890 --> 25:14.150
And as we did deal after deal,
that inventory would get bigger

25:14.147 --> 25:14.627
and bigger.

25:14.630 --> 25:18.130
So our sales force would have a
much easier time selling a

25:18.127 --> 25:18.617
piece.

25:18.618 --> 25:20.608
We wouldn't have to call
someone up and say,

25:20.611 --> 25:23.391
do you want piece number four,
that's the one we're trying to

25:23.390 --> 25:24.270
get you to buy.

25:24.269 --> 25:27.859
We'd call up and say we've got
a huge stock of different kinds

25:27.858 --> 25:30.858
of pieces, of all kinds,
from all kinds of deals.

25:30.858 --> 25:32.678
Maybe you're interested in one
of them.

25:32.680 --> 25:35.170
So it's much easier for a sales
force to sell with that

25:35.172 --> 25:38.082
situation than it was for the
other investment banks to sell.

25:38.078 --> 25:40.878
So of course,
we lured away some of the best

25:40.882 --> 25:41.862
sales people.

25:41.858 --> 25:45.318
So of course,
the down side to all of that is

25:45.324 --> 25:49.184
we had to be very careful that
the pieces we held,

25:49.181 --> 25:51.151
we knew how to hedge.

25:51.150 --> 25:53.640
We had to be very careful that
when we held all these pieces,

25:53.635 --> 25:55.745
between the time we held them
and finally sold them,

25:55.750 --> 25:57.160
we didn't lose a lot of money.

25:57.160 --> 26:00.460
And sometimes we were the ones
who held the most dangerous

26:00.464 --> 26:01.224
piece, too.

26:01.220 --> 26:04.560
So we had to figure out what
were going to be the cash flows

26:04.563 --> 26:06.833
of these pieces and how to model
them.

26:06.828 --> 26:08.858
And that's what we're going to
mathematically talk about the

26:08.858 --> 26:09.408
next few days.

26:09.410 --> 26:12.590
But I'm going to give you a
hint of this now.

26:12.588 --> 26:14.958
So we had to predict,
among other things,

26:14.958 --> 26:17.088
what the prepayments would be,
OK.

26:17.088 --> 26:19.718
And so, if you talked to a
macro economist,

26:19.722 --> 26:22.042
especially in those days,
and you say,

26:22.042 --> 26:25.432
what do you think is going to
happen in the world?

26:25.430 --> 26:28.710
They'll usually say,
well I think in the next two

26:28.710 --> 26:31.530
quarters,
unemployment is going to go up

26:31.534 --> 26:34.034
half a percent,
and then maybe things are going

26:34.029 --> 26:38.079
to get better for the next year,
and beyond that it's too hard

26:38.084 --> 26:38.884
to tell.

26:38.880 --> 26:41.340
So these mortgages are 30-year
mortgages.

26:41.338 --> 26:43.868
You can't have a prediction
that lasts a year and a half,

26:43.865 --> 26:45.665
you have to have a 30-year
prediction.

26:45.670 --> 26:47.790
And the macro economists,
by the way, are typically

26:47.789 --> 26:48.129
wrong.

26:48.130 --> 26:50.070
Even in their two-month
prediction or six month

26:50.068 --> 26:50.658
predictions.

26:50.660 --> 26:54.650
So how can we risk billions of
dollars holding an instrument

26:54.646 --> 26:57.516
that's 30 years long,
which depends on what people

26:57.517 --> 26:59.297
are going to do over the next 30
years?

26:59.298 --> 27:02.248
Well the answer is you can't
make a prediction and expect it

27:02.250 --> 27:02.950
to be right.

27:02.950 --> 27:05.140
But you can make a conditional
prediction.

27:05.140 --> 27:07.220
You can say,
if interest rates do such and

27:07.218 --> 27:10.988
such for the next four years,
and housing prices do such and

27:10.989 --> 27:14.729
such for the next four years,
then in that fifth year,

27:14.727 --> 27:16.747
pre payments will be so and so.

27:16.750 --> 27:18.850
That's a conditional prediction.

27:18.848 --> 27:21.898
It's much easier to make a
conditional prediction than an

27:21.898 --> 27:23.368
unconditional prediction.

27:23.368 --> 27:27.688
It's shocking that so many
economists are lured into making

27:27.685 --> 27:29.765
unconditional predictions.

27:29.769 --> 27:31.529
It's not a business we should
be in.

27:31.528 --> 27:33.528
We should always be making
conditional predictions.

27:33.529 --> 27:36.979
Well, I learned that lesson at
Kidder.

27:36.980 --> 27:38.910
So, you know,
the idea of possible worlds is

27:38.907 --> 27:41.687
going to play a central role in
our course from here on out.

27:41.690 --> 27:45.920
And the possible worlds are the
paths of interest rates or home

27:45.915 --> 27:46.525
prices.

27:46.529 --> 27:50.179
And so here's a very short,
this is maybe a one year into

27:50.176 --> 27:53.886
the future, and we'd have to go
30 years in the future.

27:53.890 --> 27:56.770
As you can imagine,
and this is just actually a

27:56.768 --> 27:59.898
much smaller group of
possibilities than we used to

27:59.895 --> 28:00.705
consider.

28:00.710 --> 28:03.160
But, you see all the
possibilities that could unfold

28:03.160 --> 28:04.410
over the next 12 months.

28:04.410 --> 28:08.360
And you see the blue line is
one of those possible paths.

28:08.358 --> 28:10.788
So we have to predict,
if we knew which path interest

28:10.790 --> 28:12.990
rates and housing prices were
going to take,

28:12.990 --> 28:16.220
like that blue line,
could we then predict,

28:16.220 --> 28:19.210
at the end of the blue line,
what pre payments would be.

28:19.210 --> 28:21.670
Of course, if you followed
another path down to here,

28:21.666 --> 28:24.216
we'd make a different
prediction about pre payments.

28:24.220 --> 28:27.990
So, the cash flows are the pre
payments and defaults.

28:27.990 --> 28:30.240
That's what we have to predict.

28:30.240 --> 28:34.250
And so, you might say,
what good is it to predict a

28:34.250 --> 28:37.620
different number on each of
these trees.

28:37.618 --> 28:39.978
Then basically what you're
saying is you don't know what's

28:39.982 --> 28:40.732
going to happen.

28:40.730 --> 28:42.390
But that's far from the truth.

28:42.390 --> 28:46.630
If you know what the payments
are on each of the paths and

28:46.633 --> 28:49.093
then you can hedge those paths.

28:49.088 --> 28:51.218
So for example,
suppose the payments are very

28:51.222 --> 28:52.972
low here and very high at the
top.

28:52.970 --> 28:55.750
Well, if you can buy another
instrument that pays you

28:55.753 --> 28:58.613
something at the bottom,
and you pay at the top,

28:58.611 --> 29:02.361
you can offset the variation in
cash flows and the mortgage by

29:02.355 --> 29:05.845
that other instrument and
guarantee yourself the same safe

29:05.854 --> 29:07.884
payment all the way through.

29:07.880 --> 29:10.160
That's the sort of thing that
we did it at Kidder Peabody,

29:10.164 --> 29:11.974
which we're going to study in
great detail.

29:11.970 --> 29:15.080
We held these complicated
pieces whose payments would vary

29:15.080 --> 29:15.900
tremendously.

29:15.900 --> 29:18.260
So we ran a huge risk of losing
all our money.

29:18.259 --> 29:20.439
But then we would hedge them
with some other instruments.

29:20.440 --> 29:23.150
So in the end,
we've got a pretty safe return.

29:23.150 --> 29:26.000
And because we knew the return
was safe, we felt we could pay

29:26.003 --> 29:27.673
up a good amount of money for
it.

29:27.670 --> 29:29.720
Whereas other buyers who
couldn't hedge it,

29:29.719 --> 29:31.329
wouldn't want to buy it at all.

29:31.328 --> 29:35.758
So, now let's just see how good
the predictions were.

29:35.759 --> 29:39.009
Here's a typical history of pre
payments.

29:39.009 --> 29:47.759
So you can see it ranges to 99
from 88, something like that.

29:47.759 --> 29:50.529
So it's 10 years,
11 years, of pre payments.

29:50.529 --> 29:54.079
So that's the percentage of
people who prepay every year.

29:54.078 --> 29:56.078
So it's the annualized
percentage.

29:56.078 --> 29:58.248
So every month,
you check how many people paid

29:58.249 --> 30:01.279
off their mortgage early,
and you assume that rate stayed

30:01.276 --> 30:03.166
the same for the whole 12
months,

30:03.170 --> 30:05.210
what would the pre payment
percentage be?

30:05.210 --> 30:07.070
That's what the number measures
all the time.

30:07.068 --> 30:09.338
You see in some months it's
practically zero.

30:09.338 --> 30:13.028
These are pre payments for a
mortgage issued in 1986 that had

30:13.028 --> 30:13.948
an 8% coupon.

30:13.950 --> 30:17.730
So all basically,
1986 mortgages with an 8%

30:17.733 --> 30:23.323
coupon issued by Fannie Mae or
some big pool of them anyway.

30:23.318 --> 30:25.668
So you see sometimes the pre
payments are very low,

30:25.667 --> 30:27.357
sometimes they're incredibly
high.

30:27.358 --> 30:29.868
How standing at the bottom at
the back there,

30:29.871 --> 30:33.351
in '88 say, could you possibly
have predicted that pre payment

30:33.352 --> 30:34.382
going forward?

30:34.380 --> 30:36.480
You know with the ups and downs
and stuff like that.

30:36.480 --> 30:38.500
Well you couldn't,
if you made it unconditional.

30:38.500 --> 30:40.860
But if you made it conditional,
it's not so hard.

30:40.858 --> 30:43.548
Because what do you think
happened in '93 that made pre

30:43.546 --> 30:44.786
payments go up so high?

30:44.789 --> 30:47.349
It was interest rates went down.

30:47.348 --> 30:49.888
Homeowners had an opportunity
to refinance at a lower interest

30:49.893 --> 30:51.273
rate with a different mortgage.

30:51.269 --> 30:52.379
So of course they did that.

30:52.380 --> 30:55.100
And in those other months,
when pre payments are very low,

30:55.103 --> 30:56.683
the interest rates were higher.

30:56.680 --> 31:00.820
So clearly, there's a
connection between the mortgage

31:00.817 --> 31:05.587
rate you got and your original
mortgage and the new rate that

31:05.590 --> 31:07.740
you can refinance into.

31:07.740 --> 31:10.100
And that is part of your
conditional prediction.

31:10.098 --> 31:13.438
But another thing that's
interesting is burn out.

31:13.440 --> 31:18.800
So if you look at two pools,
one issued in '95 and one

31:18.799 --> 31:22.739
issued in '92,
and with exactly the same

31:22.739 --> 31:27.889
coupons, you'll see that the
older one is always pre paying

31:27.890 --> 31:30.110
less than the new one.

31:30.108 --> 31:33.138
At least starting from '95
onward.

31:33.140 --> 31:37.410
So it's as if the old one burns
out.

31:37.410 --> 31:40.660
Once it has an opportunity to
pre pay, you see a lot of pre

31:40.664 --> 31:42.634
payments and then they slow
down.

31:42.630 --> 31:45.140
So that's another thing people
had observed.

31:45.140 --> 31:49.120
So you might have thought the
standard way of modeling things

31:49.117 --> 31:51.967
at that time was to just do a
regression.

31:51.970 --> 31:55.890
You say, well we figured out
that pre payments depend on the

31:55.890 --> 31:59.810
new interest rate and how much
more in the money you are.

31:59.808 --> 32:02.158
And it depends on how long
you've been in the money because

32:02.160 --> 32:02.890
of the burn out.

32:02.890 --> 32:06.180
You try to estimate a curve,
like an S curve or something,

32:06.180 --> 32:09.350
that depends on parameters,
that's on the interest rate,

32:09.354 --> 32:10.744
and on the burn out.

32:10.740 --> 32:12.250
How long you've been in the
money.

32:12.250 --> 32:14.940
And according to some
parameters that described the S

32:14.943 --> 32:17.123
and you tried estimate those
parameters.

32:17.118 --> 32:19.098
So that would be an old
fashioned way of measuring

32:19.096 --> 32:19.456
things.

32:19.460 --> 32:22.230
But as we're going to see in
this course, we look at

32:22.229 --> 32:24.509
everything from an agent based
approach.

32:24.509 --> 32:27.319
So what are the individual
agents doing?

32:27.318 --> 32:31.988
So, I got the idea of trying to
model all you care about is

32:31.990 --> 32:36.420
aggregate pre payments,
what is the whole pool doing?

32:36.420 --> 32:38.370
But I decided,
let's try and predict every

32:38.366 --> 32:39.266
single homeowner.

32:39.269 --> 32:42.189
So let's try to put ourselves
in the mind of every homeowner

32:42.188 --> 32:43.028
in the country.

32:43.029 --> 32:45.429
Why are they pre paying or not
pre paying?

32:45.430 --> 32:48.510
Well, they're pre paying if
they get an opportunity to save

32:48.509 --> 32:49.199
some money.

32:49.200 --> 32:55.040
But, we know from that graph
that lots of people don't

32:55.038 --> 32:56.028
prepay.

32:56.029 --> 32:59.749
Even when there's a tremendous
opportunity, only 60% percent of

32:59.750 --> 33:02.390
the people are pre paying in a
whole year.

33:02.390 --> 33:05.340
So that means the whole year
goes by, and only 60% percent of

33:05.336 --> 33:06.316
them have prepaid.

33:06.318 --> 33:09.358
So every month,
8% or 10% are pre paying.

33:09.358 --> 33:12.198
So the other 90% haven't seen
their opportunity.

33:12.200 --> 33:14.100
They've missed it or they've
waited.

33:14.098 --> 33:17.198
So clearly, not everybody jumps
at the opportunity.

33:17.200 --> 33:19.360
So it must be that people are
different somehow.

33:19.358 --> 33:23.278
Even though they're in exactly
the same circumstance in terms

33:23.278 --> 33:24.388
of refinancing.

33:24.390 --> 33:27.370
So, you have to account for the
difference.

33:27.368 --> 33:30.658
So, I imagined that different
people have a different cost of

33:30.661 --> 33:31.321
prepaying.

33:31.319 --> 33:33.309
It's a hassle to prepay.

33:33.308 --> 33:36.138
Maybe you literally have to pay
some money to prepay.

33:36.140 --> 33:38.550
Maybe you have to take a day
off from your job.

33:38.548 --> 33:40.788
Some people have other things
to do.

33:40.788 --> 33:42.718
They're not that alert because
they're paying attention to

33:42.722 --> 33:44.592
their kids or they're paying
attention to their work.

33:44.588 --> 33:46.678
So not everybody has the same
alertness.

33:46.680 --> 33:49.110
And not everyone follows
financial matters as closely as

33:49.108 --> 33:49.858
everybody does.

33:49.858 --> 33:52.378
So, also over time,
people are getting more

33:52.383 --> 33:55.633
rational and beginning to
understand the market and pre

33:55.626 --> 33:57.126
paying more and more.

33:57.130 --> 33:59.520
And of course,
people hear from their friends.

33:59.519 --> 34:01.669
If their friends are all
prepaying, it's more likely that

34:01.666 --> 34:03.466
they'll think about it and
prepay themselves.

34:03.470 --> 34:07.950
So I built a model,
together with the researchers

34:07.951 --> 34:09.821
at Kidder Peabody.

34:09.820 --> 34:13.440
And then later we built the
model of pre payments based on

34:13.436 --> 34:16.416
every individual making a
different decision.

34:16.420 --> 34:18.680
So an individual is
characterized by his cost and

34:18.677 --> 34:19.427
his alertness.

34:19.429 --> 34:22.199
So different individuals have
different costs and different

34:22.197 --> 34:22.767
alertness.

34:22.768 --> 34:25.818
And by watching how they
behave, we can come to guess

34:25.818 --> 34:29.158
what the cost and alertness is
of each of these people.

34:29.159 --> 34:33.559
So you see this model captures
all the effects that we talked

34:33.556 --> 34:34.726
about already.

34:34.730 --> 34:39.220
If you have a pool of people,
you can see the vertical is how

34:39.215 --> 34:41.305
many people of each types.

34:41.309 --> 34:43.879
So there are different costs
and different alertnesses.

34:43.880 --> 34:46.480
And so at the beginning,
when you have a new pool,

34:46.478 --> 34:48.968
like on the right,
there are a lot of people.

34:48.969 --> 34:51.999
And as, they get opportunities
to refinance,

34:52.000 --> 34:55.410
it's not random people who
prepay, it's the people with the

34:55.405 --> 34:58.395
highest alertness and the lowest
cost who prepay.

34:58.400 --> 35:00.460
So over time,
as a pool gets older,

35:00.456 --> 35:03.296
the distribution of people is
going to shift.

35:03.300 --> 35:07.010
It's going to be have less
hyper alert and low cost people

35:07.007 --> 35:09.737
and more high cost and low alert
people.

35:09.739 --> 35:11.749
That's why the pool is going to
slow down.

35:11.750 --> 35:14.590
So burn out is naturally
explained by an agent based

35:14.586 --> 35:15.196
approach.

35:15.199 --> 35:18.059
So anyway, as we go through the
course, we're going to emphasize

35:18.059 --> 35:19.329
this agent based approach.

35:19.329 --> 35:22.549
So building a model like that,
starting in the 1980s,

35:22.554 --> 35:25.844
and making a conditional
prediction, you can get a fit

35:25.840 --> 35:27.390
that looks like this.

35:27.389 --> 35:30.099
So notice, you make some
gruesome errors,

35:30.099 --> 35:32.609
like over here,
that was an expensive,

35:32.608 --> 35:35.588
'97, '98, that was an important
mistake.

35:35.590 --> 35:39.990
But you can fit this kind of
pre payment surprisingly well.

35:39.989 --> 35:43.869
OK, so that was my Kidder
Peabody days.

35:43.869 --> 35:46.339
And I thought,
my gosh, we're doing incredibly

35:46.335 --> 35:46.715
well.

35:46.719 --> 35:48.779
We're helping the country.

35:48.780 --> 35:52.500
We're doing things in a
colossal scale that nobody had

35:52.503 --> 35:53.843
ever done before.

35:53.840 --> 35:56.820
I think I may have not
emphasized enough that Kidder

35:56.815 --> 35:59.085
Peabody came to dominate this
market.

35:59.090 --> 36:02.730
We controlled over 20% of all
the issuance.

36:02.730 --> 36:05.130
Remember, there were trillions
of dollars of things being

36:05.125 --> 36:05.505
issued.

36:05.510 --> 36:09.410
So this little group of 20 year
old kids basically,

36:09.407 --> 36:12.057
plus me the old guy in
research.

36:12.059 --> 36:14.489
So them, the traders,
they were issuing something on

36:14.492 --> 36:17.262
the scale of half a trillion to
a trillion dollars of these

36:17.260 --> 36:17.690
CMOs.

36:17.690 --> 36:22.100
These kids in their mid 20s or
late twenties.

36:22.099 --> 36:24.679
And the world seemed to be a
better place for it.

36:24.679 --> 36:26.829
And I thought,
my gosh this is an untold story

36:26.833 --> 36:27.843
that needs telling.

36:27.840 --> 36:30.110
And it's an incredible success
story.

36:30.110 --> 36:37.290
Well, things suddenly changed
and in 1994 there was a crash.

36:37.289 --> 36:39.919
So this is the first of three
crashes I've lived through.

36:39.920 --> 36:42.300
There was a scandal at Kidder
Peabody,

36:42.300 --> 36:45.280
the Joe Jet scandal,
who was a trader,

36:45.280 --> 36:49.380
a government bond trader,
who was accused of doctoring

36:49.375 --> 36:52.385
the books and faking his big
profits.

36:52.389 --> 36:55.089
He had been Kidder Peabody man
of the year in 1993.

36:55.090 --> 36:58.130
And then in 1994,
they decided that all his

36:58.126 --> 37:02.246
profits were fictitious and that
he doctored the books.

37:02.250 --> 37:03.470
And so he was fired.

37:03.469 --> 37:05.889
But he sued Kidder for
discrimination.

37:05.889 --> 37:08.299
And it was a tremendous
controversy that was in the

37:08.300 --> 37:10.520
front pages of the papers for
months on end.

37:10.518 --> 37:12.658
And finally,
General Electric,

37:12.657 --> 37:15.897
who owned Kidder Peabody,
closed the firm.

37:15.900 --> 37:19.360
After hundred 135 five years,
or I guess 129 years,

37:19.358 --> 37:20.948
they closed the firm.

37:20.949 --> 37:24.899
So I had to go back one day,
from Yale,

37:24.900 --> 37:27.170
to Kidder Peabody,
and I invited those 75 people

37:27.168 --> 37:29.338
in the research department into
my office,

37:29.340 --> 37:31.760
and I said you're fired.

37:31.760 --> 37:34.910
And then I got up and I went to
the office next door and

37:34.907 --> 37:36.967
somebody said to me,
you're fired.

37:36.969 --> 37:41.089
And so we all fired each other
and the entire 130-year-old

37:41.090 --> 37:42.970
company came to a close.

37:42.969 --> 37:49.939
So, the head trader of
mortgages and bunch of his top

37:49.943 --> 37:55.313
lieutenants decided from a hedge
fund.

37:55.309 --> 37:58.039
So Kidder Peabody got closed,
actually sold,

37:58.041 --> 38:01.091
it wasn't closed,
it was sold to Paine Webber.

38:01.090 --> 38:04.350
And Paine Webber dropped the
name Kidder Peabody and hired

38:04.347 --> 38:06.687
many of the people from Kidder
Peabody.

38:06.690 --> 38:08.790
And in fact,
the second tier,

38:08.786 --> 38:12.756
or the more junior group of
mortgage traders at Kidder

38:12.755 --> 38:14.885
Peabody,
which was the leading mortgage

38:14.889 --> 38:17.159
company at the time,
they took over the desk at

38:17.157 --> 38:17.917
Paine Webber.

38:17.920 --> 38:20.190
And then Paine Webber was
bought by UBS.

38:20.190 --> 38:22.780
And those same guys took over
the desk at UBS.

38:22.780 --> 38:26.530
So the junior crew at Kidder
Peabody, some of whom were

38:26.532 --> 38:29.732
Yalies by the way,
ended up running the UBS.

38:29.730 --> 38:31.730
Or a big part of the UBS
mortgage desk.

38:31.730 --> 38:34.510
But in any case,
our mortgage traders,

38:34.507 --> 38:37.957
the head guys,
decided to from a hedge fund.

38:37.960 --> 38:42.340
Instead of selling,
the CMOs, they would buy the

38:42.336 --> 38:42.986
CMOs.

38:42.989 --> 38:45.259
And we called it Ellington
Capital Management.

38:45.260 --> 38:47.260
So I was one of six partners.

38:47.260 --> 38:48.770
I was a small partner,
because again,

38:48.771 --> 38:49.571
I stayed at Yale.

38:49.570 --> 38:53.910
So this introduces the last
player, the hedge funds.

38:53.909 --> 38:56.349
So what is a hedge fund?

38:56.349 --> 38:58.329
You heard the name,
I'm sure a thousand times.

38:58.329 --> 38:59.639
It has a bad name now.

38:59.639 --> 39:03.069
But a hedge fund basically
means four things.

39:03.070 --> 39:05.670
It means it's someone who
hedges.

39:05.670 --> 39:09.160
You don't just buy and hold the
thing and hope that the cash

39:09.159 --> 39:11.639
flows are good,
you try to protect yourself

39:11.641 --> 39:13.891
against as many risks as
possible.

39:13.889 --> 39:16.959
Just like I explained,
we were doing at Kidder when we

39:16.960 --> 39:20.030
tried to get the same cash flows
in every scenario.

39:20.030 --> 39:21.800
And we're going to
mathematically study that in

39:21.800 --> 39:22.610
remaining lectures.

39:22.610 --> 39:24.760
But you try to hedge,
that's where the name comes

39:24.755 --> 39:25.065
from.

39:25.070 --> 39:27.750
So you try to offset as many
risks as you can.

39:27.750 --> 39:29.180
Of course, you still run some
risks.

39:29.179 --> 39:31.729
But you're offsetting setting
as many as you can.

39:31.730 --> 39:34.210
The second most important
thing, is most of it's done,

39:34.206 --> 39:36.776
or a lot of a buying is done,
not most, but a lot of the

39:36.777 --> 39:38.597
buying is done with borrowed
money.

39:38.599 --> 39:39.889
That's called leverage.

39:39.889 --> 39:42.419
You don't just take your
investor capital and buy

39:42.418 --> 39:44.578
something, you take your
investor capital,

39:44.577 --> 39:47.787
you borrow some extra money,
and then you buy some stuff.

39:47.789 --> 39:50.829
And the stuff you buy you use
as collateral to guarantee that

39:50.827 --> 39:53.507
the lenders are going to get
their money paid back.

39:53.510 --> 39:54.950
So a hedge fund is generally
leveraged.

39:54.949 --> 39:58.959
The third definition of a hedge
fund, third characteristic,

39:58.956 --> 40:01.786
is that they're very lightly
regulated.

40:01.789 --> 40:02.729
So what does that mean?

40:02.730 --> 40:08.870
That means that a broker who
sells something has to make sure

40:08.867 --> 40:13.877
that the client on behalf of
whom he's buying,

40:13.880 --> 40:17.310
the broker, the stockbroker,
has to make sure that the

40:17.313 --> 40:20.363
purchased item is appropriate
for his client.

40:20.360 --> 40:22.170
We have no such obligations.

40:22.170 --> 40:27.670
We can buy and sell with anyone
we choose on behalf of our

40:27.673 --> 40:28.643
clients.

40:28.639 --> 40:31.389
But our clients have to be
sophisticated investors.

40:31.389 --> 40:33.189
We have to vouch that they're
sophisticated.

40:33.190 --> 40:35.850
If they have enough money,
like say $5 million to invest

40:35.851 --> 40:37.791
in the hedge fund,
they are by definition

40:37.788 --> 40:38.658
sophisticated.

40:38.659 --> 40:43.529
And then they don't need to be
protected by having a broker

40:43.532 --> 40:48.572
who's necessarily watching out
to see whether investments are

40:48.574 --> 40:49.924
appropriate.

40:49.920 --> 40:52.170
We tell them what we're
investing in and,

40:52.166 --> 40:55.026
of course, we're obliged to
explain our strategy.

40:55.030 --> 40:57.420
But once they understand our
strategy,

40:57.420 --> 41:03.810
we don't have to meet the same
test that a simple broker meets

41:03.813 --> 41:08.643
on behalf of,
let's say a poor retired

41:08.643 --> 41:10.223
individual.

41:10.219 --> 41:14.039
So there's less regulation and
the fourth characteristic is

41:14.043 --> 41:16.883
hedge funds typically charge
higher fees.

41:16.880 --> 41:18.360
So that's what a hedge fund is.

41:18.360 --> 41:21.040
Now, the first hedge fund was
started in the 1940s,

41:21.039 --> 41:22.969
I believe, by someone named
Jones.

41:22.969 --> 41:24.949
And he was a stock picker.

41:24.949 --> 41:27.089
And what he did,
is instead of picking let's say

41:27.088 --> 41:29.548
the best car company,
which he might have thought was

41:29.552 --> 41:32.842
Ford and leaving it at that,
he would try to hedge his risk.

41:32.840 --> 41:35.850
So he'd buy Ford,
and he'd short all the other

41:35.849 --> 41:36.919
car companies.

41:36.920 --> 41:40.310
So effectively,
he wasn't just betting on Ford

41:40.309 --> 41:41.289
doing well.

41:41.289 --> 41:44.159
Because he could lose if the
whole economy went badly,

41:44.155 --> 41:46.855
Ford and every other car
company could go badly.

41:46.860 --> 41:49.660
Instead he was betting that
Ford would do better than the

41:49.659 --> 41:50.759
other car companies.

41:50.760 --> 41:54.210
So he was concentrating his bet
on something he understood more.

41:54.210 --> 41:55.780
You can't be an expert about
everything.

41:55.780 --> 41:57.930
Presumably he was an expert
about cars.

41:57.929 --> 42:00.019
And he knew Ford was better
than General Motors.

42:00.018 --> 42:01.908
So that was a bet he wanted to
take.

42:01.909 --> 42:04.649
But he didn't want to take a
bet on the whole economy doing

42:04.652 --> 42:05.412
well or badly.

42:05.409 --> 42:11.919
So that was the beginning of
the idea of the hedged fund.

42:11.920 --> 42:16.340
Now there's so many risks that
a car company or any company

42:16.335 --> 42:16.865
runs.

42:16.869 --> 42:19.289
Does their president know what
he's doing?

42:19.289 --> 42:21.039
Is Detroit going to be a good
city?

42:21.039 --> 42:22.769
Is there going to change in
government regulation?

42:22.768 --> 42:25.118
Is some foreign competitor
going to appear on the scene?

42:25.119 --> 42:27.359
Is the price of oil suddenly
going to change?

42:27.360 --> 42:30.700
There's so many things they can
go wrong in a company,

42:30.704 --> 42:32.854
it really is very hard to
hedge.

42:32.849 --> 42:37.029
So hedging really makes much
more sense when you can make the

42:37.027 --> 42:38.627
problem mathematical.

42:38.630 --> 42:42.110
Well see, with mortgages it
really is a mathematical problem

42:42.108 --> 42:43.698
to a much greater extent.

42:43.699 --> 42:45.669
So it makes much more sense to
hedge.

42:45.670 --> 42:47.970
And I think it makes much more
sense to be a hedge fund if

42:47.972 --> 42:49.592
you're trading in the mortgage
market.

42:49.590 --> 42:53.260
Anyway, that's what I found out
when I visited Wall Street in

42:53.255 --> 42:54.045
those days.

42:54.050 --> 42:55.580
So what did the hedge fund do?

42:55.579 --> 42:59.569
Instead of creating these CMOs,
the hedge fund would buy them.

42:59.570 --> 43:01.630
And of course,
buy the most complicated one.

43:01.630 --> 43:04.420
So in effect,
the hedge funds would buy the

43:04.423 --> 43:07.153
most complicated,
the residual piece we're

43:07.152 --> 43:09.882
talking about,
and try to hedge that.

43:09.880 --> 43:11.240
So effectively,
the hedge fund,

43:11.244 --> 43:13.774
by hedging it,
was really carving out the cash

43:13.768 --> 43:16.978
flows of that last piece into
complicated ways and selling

43:16.983 --> 43:19.073
them off to stabilize its
profits.

43:19.070 --> 43:22.690
So really, the hedge fund
actually was continuing the work

43:22.690 --> 43:26.120
of the investment bank of
creating more and more pieces

43:26.121 --> 43:28.411
and trying to allocate the risk.

43:28.409 --> 43:31.539
And so the hedge fund is part
of the entire operation,

43:31.539 --> 43:36.359
which was making this mortgage
market behind the scenes make

43:36.356 --> 43:41.006
home ownership so much easier
and reduce people's risk.

43:41.010 --> 43:51.540
Or so it seemed.

43:51.539 --> 43:53.869
We had a hard time raising
money to begin with.

43:53.869 --> 43:56.969
Because after all,
Kidder Peabody had just gone

43:56.967 --> 43:58.177
out of business.

43:58.179 --> 44:02.199
And not only had we gone out of
business, but there was a

44:02.204 --> 44:04.294
general crisis at the time.

44:04.289 --> 44:06.749
It was not only the trading
scandal of Joe Jett,

44:06.748 --> 44:09.158
but at the same time,
there was a crisis in the

44:09.155 --> 44:10.355
derivatives market.

44:10.360 --> 44:13.800
Because all these complicated
pieces that were being created

44:13.802 --> 44:16.432
where pieces went up and pieces
went down,

44:16.429 --> 44:18.649
of course if you didn't know
how to hedge your risk,

44:18.650 --> 44:20.700
you could end up losing a lot
of money.

44:20.699 --> 44:25.489
So Orange County went bankrupt
in 1994.

44:25.489 --> 44:27.049
And what did Orange County do?

44:27.050 --> 44:29.270
They bought a bunch of inverse
floaters.

44:29.268 --> 44:32.278
So when the interest rates were
going down in the early '90s,

44:32.275 --> 44:34.375
they were making a huge amount
of money.

44:34.380 --> 44:40.170
And the fellow who ran Orange
County's municipal investments,

44:40.170 --> 44:44.320
was twice municipal investor of
the year.

44:44.320 --> 44:46.060
But in 1994,
when everything turned around

44:46.061 --> 44:48.061
and interest rates skyrocketed
for the year,

44:48.059 --> 44:50.349
his inverse floaters became
almost worthless,

44:50.349 --> 44:52.649
and he bankrupted Orange County.

44:52.650 --> 44:56.570
So, it was some of our inverse
floaters that were being bought,

44:56.568 --> 44:58.968
which helped bankrupt Orange
County.

44:58.969 --> 45:02.479
Plus Kidder Peabody had just
gone out of business because of

45:02.483 --> 45:03.143
Joe Jett.

45:03.139 --> 45:08.049
So it was very difficult for
our hedge fund to raise money.

45:08.050 --> 45:14.510
Our motto was we created the
mess, let us clean it up.

45:14.510 --> 45:16.530
Nonetheless,
we did raise some money.

45:16.530 --> 45:19.480
We had an important starting
investment from the Ziff

45:19.480 --> 45:22.090
Brothers and we had an
incredible boom time.

45:22.090 --> 45:24.530
We made fantastic returns our
first few years.

45:24.530 --> 45:26.010
50% returns.

45:26.010 --> 45:31.420
And we grew into the biggest
mortgage hedge fund in the

45:31.418 --> 45:32.418
country.

45:32.420 --> 45:34.670
And things were booming along.

45:34.670 --> 45:37.400
And then suddenly,
there was another crash in

45:37.404 --> 45:37.844
1998.

45:37.840 --> 45:40.620
So this was the second crash
that I was exposed to.

45:40.619 --> 45:43.709
So, what happened in this crash?

45:43.710 --> 45:47.370
Well, as I told you,
we were buying mortgages as the

45:47.367 --> 45:51.457
hedge fund, buying that residual
piece, and buying it with

45:51.456 --> 45:52.816
borrowed money.

45:52.820 --> 45:55.630
So we would buy the piece,
let's say for $100,

45:55.626 --> 45:57.306
by borrowing $80 dollars.

45:57.309 --> 45:59.529
So we'd use $20 dollars of
investor capital,

45:59.530 --> 46:03.190
we'd borrow the other $80,
we'd buy the piece for $100,

46:03.190 --> 46:06.710
and then we'd leave the piece
with the lender as collateral.

46:06.710 --> 46:09.150
So if we didn't pay them back
the $80, the guy could keep our

46:09.153 --> 46:09.483
piece.

46:09.480 --> 46:12.330
So his $100 piece was
protecting his $80 dollar loan.

46:12.329 --> 46:16.209
So things were swimming along.

46:16.210 --> 46:18.360
We're going to talk a lot about
leverage later.

46:18.360 --> 46:21.990
Well, in 1998,
one of the big competitors,

46:21.989 --> 46:24.019
Long Term Capital,
which was founded,

46:24.018 --> 46:25.768
as I think I mentioned earlier
in the course,

46:25.768 --> 46:29.678
by Meriwether,
who was the most important,

46:29.679 --> 46:33.629
famous, fixed income trader on
Wall Street from Salomon.

46:33.630 --> 46:37.820
And two Nobel Prize winners,
who I've mentioned many times,

46:37.820 --> 46:39.200
and you're going to hear about
again,

46:39.199 --> 46:43.199
Merton and Scholes,
creators, especially Scholes,

46:43.199 --> 46:46.779
of the Black-Scholes model,
the most important tool on Wall

46:46.780 --> 46:49.660
Street for managing risk,
as we'll discover in a few

46:49.657 --> 46:50.097
lectures.

46:50.099 --> 46:51.969
So these guys,
the three of them,

46:51.965 --> 46:55.165
and nine other partners,
12 of them, created this wildly

46:55.172 --> 46:56.692
successful hedge fund.

46:56.690 --> 46:58.580
And in 1998,
it suddenly went out of

46:58.583 --> 46:59.183
business.

46:59.179 --> 47:01.369
And in fact,
the government had to step in

47:01.371 --> 47:03.351
with all the big investment
banks,

47:03.349 --> 47:05.039
coordinating the big investment
banks,

47:05.039 --> 47:08.489
to take it over so the whole
market wouldn't crash down

47:08.492 --> 47:09.262
around it.

47:09.260 --> 47:12.570
We celebrated the crash of Long
Term Capital,

47:12.574 --> 47:17.024
figuring that was one of our
big competitors out of business

47:17.019 --> 47:20.109
and now we would have an easier
time.

47:20.110 --> 47:24.310
But, I remember thinking at the
time that was a mistake.

47:24.309 --> 47:26.889
But anyway, a few months later,
we got a margin call.

47:26.889 --> 47:30.239
So suddenly,
on a Friday morning in October

47:30.240 --> 47:33.590
of '98,
one of our lenders called us up

47:33.585 --> 47:36.085
and said,
we think the prices have gone

47:36.085 --> 47:37.995
down,
it's not $100 anymore,

47:37.998 --> 47:39.458
it's less than that.

47:39.460 --> 47:44.520
We need X million dollars of
extra margin to put for us to

47:44.516 --> 47:45.666
contribute.

47:45.670 --> 47:48.190
Because the $100 piece
protecting the $80 loan,

47:48.193 --> 47:50.883
it was no longer $100 piece,
it was a lower piece,

47:50.882 --> 47:52.532
so there was less cushion.

47:52.530 --> 47:55.010
We need extra cash to have a
bigger cushion.

47:55.010 --> 47:58.180
So we said, oh this is crazy,
the prices haven't gone down

47:58.175 --> 47:59.725
that far, that's not fair.

47:59.730 --> 48:02.520
And they said,
you have until 4 o'clock Friday

48:02.516 --> 48:04.186
afternoon to pay us back.

48:04.190 --> 48:06.490
And if you don't pay us back,
then on next business day,

48:06.489 --> 48:08.069
which happened to be Tuesday
morning,

48:08.070 --> 48:10.090
because it was Columbus Day
holiday on Monday,

48:10.090 --> 48:13.040
we'll just sell off all your
pieces and pay ourselves back

48:13.041 --> 48:16.411
out of the proceeds the $80 and
give you whatever is left over.

48:16.409 --> 48:19.099
Well, we figured what was left
over wasn't going to be very

48:19.103 --> 48:19.433
much.

48:19.429 --> 48:20.889
Because they only needed their
$80.

48:20.889 --> 48:22.769
So they didn't have an
incentive to sell for the best

48:22.773 --> 48:24.013
possible price,
although of course,

48:24.005 --> 48:26.285
they would tell us they'd sell
for the best possible price.

48:26.289 --> 48:29.199
They wouldn't and it would be a
fire sale.

48:29.199 --> 48:32.499
So we didn't know what to do.

48:32.500 --> 48:35.820
And we couldn't raise the money
by 4 o'clock on Friday.

48:35.820 --> 48:37.080
So we called up Warren Buffett.

48:37.079 --> 48:39.459
We said, well this is so
unfair, they're forcing us to

48:39.460 --> 48:41.840
sell, there's no reason why we
should have to sell.

48:41.840 --> 48:43.690
This margin call is not proper.

48:43.690 --> 48:45.130
It's not right.

48:45.130 --> 48:46.830
There's no reason we have to
sell.

48:46.829 --> 48:49.209
What's going to happen is on
Tuesday we're going to be forced

48:49.206 --> 48:50.946
to sell all of our bonds at the
same time.

48:50.949 --> 48:52.849
And they're going to all sell
for like $80 or something.

48:52.849 --> 48:55.169
It's going to be a terrible
blood bath, a fire sale.

48:55.170 --> 48:56.990
Prices will go for nothing.

48:56.989 --> 48:58.959
We'll be totally wiped out so
unfairly.

48:58.960 --> 49:00.930
Why don't you buy our firm.

49:00.929 --> 49:04.069
We'll give you half our firm,
some big percentage of our

49:04.070 --> 49:04.470
firm.

49:04.469 --> 49:06.169
You just make the margin call
for us.

49:06.170 --> 49:10.680
And then you could have this
firm with these great bonds.

49:10.679 --> 49:12.059
It's just a travesty.

49:12.059 --> 49:13.789
And it's going to be such a
good investment for you.

49:13.789 --> 49:17.129
And you can save us and save
the bonds and stop this

49:17.128 --> 49:17.848
travesty.

49:17.849 --> 49:19.739
And he said excuse me?

49:19.739 --> 49:20.989
And we said,
well it's unfair,

49:20.987 --> 49:23.007
they're going to force us to
sell on Tuesday.

49:23.010 --> 49:25.750
And the bonds will go for
nothing when they are perfectly

49:25.748 --> 49:26.578
valuable bonds.

49:26.579 --> 49:27.589
And they are going to wipe us
out.

49:27.590 --> 49:29.780
You can prevent that from
happening and own our great

49:29.784 --> 49:30.084
firm.

49:30.079 --> 49:31.719
And he said,
hell I think,

49:31.715 --> 49:34.915
I'll wait for Tuesday and buy
the bonds myself.

49:34.920 --> 49:38.590
And so Warren Buffett didn't
rescue us.

49:38.590 --> 49:41.610
And so that Tuesday it looked
like we would go out of

49:41.610 --> 49:42.250
business.

49:42.250 --> 49:46.640
But over the weekend,
we managed to hold an auction

49:46.637 --> 49:49.357
and sell the bonds ourselves.

49:49.360 --> 49:52.370
So in other classes in
economics, you find out how to

49:52.369 --> 49:53.469
conduct auctions.

49:53.469 --> 49:55.509
I don't have time to describe
this in great detail.

49:55.510 --> 49:58.930
But let me just say,
that in a typical auction you

49:58.934 --> 50:01.734
have to worry about the winners
curse.

50:01.730 --> 50:04.670
Everybody's thinking,
I'd better not be the highest

50:04.673 --> 50:07.563
bidder, because that means I
probably overpaid.

50:07.559 --> 50:10.149
Because those smart guys are
bidding against me.

50:10.150 --> 50:14.100
So what we did over the weekend
was, we called everybody up and

50:14.099 --> 50:17.669
we said, we've been forced by a
margin call to sell these

50:17.668 --> 50:18.368
things.

50:18.369 --> 50:19.909
There's going to be a great
deal for you.

50:19.909 --> 50:21.969
So why don't you come back from
your vacation,

50:21.974 --> 50:24.454
one guy came back from
Budapest, one big trader on Wall

50:24.454 --> 50:24.964
Street.

50:24.960 --> 50:27.910
We got a huge collection of
traders there over the weekend.

50:27.909 --> 50:29.819
We showed them our bonds so
they could think about it.

50:29.820 --> 50:32.310
And on Monday we held our
auction.

50:32.309 --> 50:34.429
We didn't sell everything at
the same time.

50:34.429 --> 50:36.709
At 12 o'clock,
we sold the first third of our

50:36.713 --> 50:37.133
bonds.

50:37.130 --> 50:39.080
At 2 o'clock, the second third.

50:39.079 --> 50:42.409
And at 4 o'clock,
the third third.

50:42.409 --> 50:44.239
Actually, we got a little
behind schedule,

50:44.239 --> 50:45.309
but that was our plan.

50:45.309 --> 50:47.579
And so what happened was that
at 12 o'clock,

50:47.583 --> 50:49.173
everybody basically bid $80.

50:49.170 --> 50:53.700
So we said, we're one of the
bidders ourselves,

50:53.697 --> 50:54.877
of course.

50:54.880 --> 50:57.240
We told everybody,
they all did it by email,

50:57.242 --> 50:59.882
we emailed everybody back,
you've been outbid.

50:59.880 --> 51:01.610
Either by someone else or by us.

51:01.610 --> 51:02.450
You've been outbid.

51:02.449 --> 51:03.939
And all these guys,
one from Budapest,

51:03.940 --> 51:06.820
from all over the world back
there,

51:06.820 --> 51:08.170
thinking we're going out of
business,

51:08.170 --> 51:10.290
bidding $80,
they don't get to buy anything.

51:10.289 --> 51:11.439
So what would they do?

51:11.440 --> 51:13.720
What would they be thinking?

51:13.719 --> 51:16.839
So between 12:00 and 2:00,
we're on the edge of our seats.

51:16.840 --> 51:17.950
Are they going to bid $80 again?

51:17.949 --> 51:19.379
Which means,
of course, we get nothing.

51:19.380 --> 51:21.770
Because we just pay back the
loan for $80 and we go out of

51:21.773 --> 51:23.793
business and our investors go
out of business.

51:23.789 --> 51:26.439
Or are they going to realize
that they have to bid more in

51:26.440 --> 51:27.790
order to beat other people.

51:27.789 --> 51:29.589
So we had no idea what was
going to happen.

51:29.590 --> 51:34.270
But the price was basically $95
a 2 o'clock and $99 at 4

51:34.268 --> 51:35.118
o'clock.

51:35.119 --> 51:38.559
So we celebrated saving our
firm.

51:38.559 --> 51:42.559
And it turned out there was
another complication after that,

51:42.556 --> 51:44.246
which I won't get into.

51:44.250 --> 51:47.790
Which is that the thing had
happened over the holidays.

51:47.789 --> 51:54.879
And so the next morning,
the buyers didn't get their

51:54.878 --> 51:55.988
bonds.

51:55.989 --> 51:58.149
Remember, we don't have the
bonds to sell them.

51:58.150 --> 52:00.300
They're sitting with the person
who lent us the money.

52:00.300 --> 52:02.820
So it was over a holiday,
and the bonds didn't get

52:02.820 --> 52:04.260
transferred to the buyers.

52:04.260 --> 52:07.930
And so the prime broker who was
supposed to vouch for all this,

52:07.932 --> 52:09.772
it was a holiday for him too.

52:09.768 --> 52:11.448
And so the whole thing was a
mess.

52:11.449 --> 52:13.639
And it's actually quite an
amazing story,

52:13.643 --> 52:15.513
which I don't have time to
tell.

52:15.510 --> 52:18.130
But anyway, when the buyers
didn't get their bonds,

52:18.132 --> 52:21.232
the next morning on Tuesday,
they all got alarmed that maybe

52:21.226 --> 52:23.006
we didn't even have the bonds.

52:23.010 --> 52:25.560
And so everybody made a margin
call against us.

52:25.559 --> 52:28.299
And we went from celebrating to
suddenly thinking we're out of

52:28.304 --> 52:29.074
business again.

52:29.070 --> 52:31.800
But sometimes,
when you're so badly off,

52:31.795 --> 52:34.585
people realize that they have
to stop.

52:34.590 --> 52:38.140
And so there was a big
conference call on Wednesday in

52:38.141 --> 52:40.821
which all of lenders,
the sort of number two people

52:40.824 --> 52:43.094
at all the big investment banks
got together in the conference

52:43.085 --> 52:44.535
call,
and they agreed that if they

52:44.543 --> 52:46.673
all tried to get their money
back at the same time,

52:46.670 --> 52:47.690
none of them would get it.

52:47.690 --> 52:51.030
And so they waited for us to
gradually work ourselves out of

52:51.030 --> 52:52.050
the predicament.

52:52.050 --> 52:56.930
So we survived the crash of
1998.

52:56.929 --> 52:59.419
And then after that,
we had another boom year.

52:59.420 --> 53:01.840
An incredible year in 1999.

53:01.840 --> 53:10.610
And things kept booming again
for eight years or nine years

53:10.605 --> 53:12.565
until 2007.

53:12.570 --> 53:15.350
Before, I get to that,
that experience was so seared

53:15.347 --> 53:17.257
in my mind,
the second crisis,

53:17.262 --> 53:20.022
the 1998 crisis was so seared
in my mind,

53:20.018 --> 53:22.808
that I wrote a paper called The
Leverage Cycle.

53:22.809 --> 53:25.189
In which I said,
what basically happens is

53:25.190 --> 53:28.560
people borrow a lot of money and
they're very leveraged.

53:28.559 --> 53:30.699
Then something bad happens in
the economy.

53:30.699 --> 53:34.069
And the lenders suddenly reduce
the leverage.

53:34.070 --> 53:36.920
And so the big leveraged
buyers, they go out of business.

53:36.920 --> 53:40.040
The leverage goes way down.

53:40.039 --> 53:41.829
Lenders will ask for more
collateral.

53:41.829 --> 53:43.719
And there's also the bad news.

53:43.719 --> 53:46.239
And those three things together
completely crush the market.

53:46.239 --> 53:48.819
And so lots of people are out
of business and the whole

53:48.818 --> 53:49.628
thing's a mess.

53:49.630 --> 53:53.470
But then after things settle
down, there's another boom.

53:53.469 --> 53:56.479
And then it's going to repeat
itself over and over again.

53:56.480 --> 53:59.950
So that's The Leverage Cycle
story I told in 2003.

53:59.949 --> 54:02.819
I wrote it right after the
crisis of '98 and I said that

54:02.824 --> 54:05.084
this crisis,
which in '98 seems to be so

54:05.079 --> 54:08.399
small, could be repeated on a
much grander scale for the whole

54:08.400 --> 54:09.000
economy.

54:09.000 --> 54:13.870
So we had these boom years,
right after the crisis of '98.

54:13.869 --> 54:16.549
And then in 2007,2008,
there was another crash.

54:16.550 --> 54:18.240
This time on a grand scale.

54:18.239 --> 54:19.709
But it was exactly the same
kind.

54:19.710 --> 54:21.990
And the last two lectures of
this course are going to be

54:21.985 --> 54:23.265
about the most recent crisis.

54:23.268 --> 54:28.598
And so we're going to
mathematically reexamine this

54:28.599 --> 54:30.199
entire story.

54:30.199 --> 54:33.079
And again, after the 2008
crash, when we almost went out

54:33.081 --> 54:34.971
of business again,
our hedge fund.

54:34.969 --> 54:37.699
In 2009, we had the best year
we've ever had.

54:37.699 --> 54:40.949
Better than all those other
years, even in '95.

54:40.949 --> 54:46.139
So three times in a row.

54:46.139 --> 54:47.979
There's a crash,
a boom, a crash,

54:47.976 --> 54:49.466
a boom, a crash,
a boom.

54:49.469 --> 54:54.209
We made back more money in 2009
than we lost in the crisis of

54:54.210 --> 54:55.160
2007,2008.

54:55.159 --> 54:59.179
So the course has to end with
an explanation of why these

54:59.181 --> 55:01.911
cycles happened over and over
again.

55:01.909 --> 55:02.749
It can't be an accident.

55:02.750 --> 55:05.670
It can't be all my fault that
I've been in three of them.

55:05.670 --> 55:08.020
There's got to be something
systematic going on.

55:08.018 --> 55:10.808
And that what I've been writing
about it.

55:10.809 --> 55:12.239
And how I'll end course.

55:12.239 --> 55:13.529
And by the way,
as you'll see,

55:13.525 --> 55:16.005
I spent a lot of time talking
to the federal reserve,

55:16.010 --> 55:18.080
and Bernanke,
and Summers,

55:18.079 --> 55:22.649
and also with the ECB,
the European Central Bank about

55:22.648 --> 55:24.258
the leverage cycle.

55:24.260 --> 55:28.710
Which I think is generally
becoming recognized as a central

55:28.711 --> 55:29.481
problem.

55:29.480 --> 55:34.510
But I want to end this lecture
in the next 15 or so minutes,

55:34.505 --> 55:39.185
20 minutes, by pointing out one
change in the market.

55:39.190 --> 55:40.780
The next big change in the
market.

55:40.780 --> 55:44.390
The next wave of securitization.

55:44.389 --> 55:47.489
So, this is the sub prime
market, which we haven't

55:47.494 --> 55:48.514
mentioned yet.

55:48.510 --> 55:54.630
And which I will now describe.

55:54.630 --> 56:02.610
OK, so what is the sub prime
mortgage market.

56:02.610 --> 56:06.520
So I already pointed out that
securitization was a great idea.

56:06.518 --> 56:11.398
Now it was applied,
remember, to prime mortgages.

56:11.400 --> 56:14.280
You had to be a very reliable
homeowner to get one of those

56:14.278 --> 56:15.568
Fannie or Freddie loans.

56:15.570 --> 56:18.560
And because those people were
so reliable,

56:18.559 --> 56:20.419
although they didn't behave
perfectly rationally,

56:20.420 --> 56:23.410
you had cost and alertness
issues, they still were very

56:23.413 --> 56:24.193
predictable.

56:24.190 --> 56:31.550
Well, a combination of things
happened in the late '90s.

56:31.550 --> 56:34.650
Investors began to get the
idea, this has worked out so

56:34.648 --> 56:38.198
well, and there's so many people
who don't own homes in America

56:38.204 --> 56:39.644
because they're poor.

56:39.639 --> 56:43.419
Maybe we can extend home
ownership to still more people.

56:43.420 --> 56:45.820
Of course, they're going to be
riskier, because they're poorer,

56:45.815 --> 56:46.855
they have less resources.

56:46.860 --> 56:50.190
But we'll charge them a higher
interest rate and that will

56:50.193 --> 56:52.243
compensate us for the extra
risk.

56:52.239 --> 56:56.409
The government also saw this as
a great opportunity to help the

56:56.409 --> 56:56.879
poor.

56:56.880 --> 56:59.560
So this combination of
investors getting the idea and

56:59.559 --> 57:01.619
the government wanting to
sponsor it,

57:01.619 --> 57:03.449
led to the creation of a new
market,

57:03.449 --> 57:06.029
the sub prime market,
which is what I'm going to

57:06.034 --> 57:06.864
describe now.

57:06.860 --> 57:09.020
And I'm going to talk about
what went wrong,

57:09.018 --> 57:11.778
or begin to talk about what
went wrong, but I'm going to

57:11.780 --> 57:14.090
leave most of it for the last
two classes.

57:14.090 --> 57:16.720
So as I said,
securitization is so important

57:16.717 --> 57:18.387
because,
let me remind you,

57:18.387 --> 57:20.437
typically when a bank makes a
loan,

57:20.440 --> 57:25.480
the bank finds out a lot about
who it is lending to.

57:25.480 --> 57:30.270
But the bank is a bunch of
managers and stuff.

57:30.268 --> 57:34.338
The shareholders of the bank
are the people whose money is at

57:34.335 --> 57:34.805
risk.

57:34.809 --> 57:37.459
They aren't the ones looking at
the loans.

57:37.460 --> 57:40.030
So if you're a shareholder,
you own stock in a bank,

57:40.032 --> 57:42.552
two years later the bank is
going to make a loan to

57:42.554 --> 57:44.224
somebody, risking your money.

57:44.219 --> 57:47.149
And you've got no idea who the
guy is that the bank is lending

57:47.148 --> 57:47.388
to.

57:47.389 --> 57:50.459
Or what the characteristics are
of the person who is getting a

57:50.456 --> 57:50.806
loan.

57:50.809 --> 57:54.109
Think of the securitization
when you're buying a pool.

57:54.110 --> 57:57.000
When you get this pool,
you could be told what are the

57:56.996 --> 57:59.826
characteristics of all the
homeowners in the pool.

57:59.829 --> 58:01.379
It's something very concrete.

58:01.380 --> 58:03.760
A bank lends to homeowners,
it lends to businesses.

58:03.760 --> 58:05.330
It's doing 6,000 things.

58:05.329 --> 58:08.549
Of course, it's risky to have
bank capital.

58:08.550 --> 58:10.660
You know, equity,
own shares of the bank.

58:10.659 --> 58:11.689
Because you don't know what
they're doing.

58:11.690 --> 58:13.020
And they are doing so many
different things.

58:13.018 --> 58:16.918
You should feel a lot more
comfortable if where your money

58:16.916 --> 58:19.306
is going is very well
delineated.

58:19.309 --> 58:21.239
That's the idea of a
securitization.

58:21.239 --> 58:27.729
It's very well defined where
the money is going.

58:27.730 --> 58:30.090
So it makes people more willing
to lend.

58:30.090 --> 58:33.050
Corporate debt,
that's another way of lending

58:33.050 --> 58:33.590
money.

58:33.590 --> 58:37.560
But if you own bonds in a firm,
you're not the first person to

58:37.557 --> 58:38.597
get paid back.

58:38.599 --> 58:41.109
The people lending with
collateral get their money

58:41.110 --> 58:41.520
first.

58:41.518 --> 58:44.218
And if the firm goes bankrupt,
there is a big court case and

58:44.217 --> 58:46.317
it takes a long time to get your
money back.

58:46.320 --> 58:47.810
Not in a securitization.

58:47.809 --> 58:52.369
So there are many ways that a
securitization is more

58:52.367 --> 58:56.567
attractive than lending money
through a bank.

58:56.570 --> 58:58.490
And that's the reason for the
securitizations.

58:58.489 --> 59:01.749
Now here are the current
numbers, the 2007 numbers.

59:01.750 --> 59:04.750
And there haven't been much
securitizations since then.

59:04.750 --> 59:08.840
So the agencies are now up to
$4 trillion, Fannie and Freddie.

59:08.840 --> 59:12.510
Now those jumbo loans I told
you about, the big loans that

59:12.507 --> 59:15.657
the rich people take out,
remember, which was $0.5

59:15.661 --> 59:18.431
trillion in 2003,
is now $0.8 trillion.

59:18.429 --> 59:20.769
But there are two more markets
that have been created.

59:20.769 --> 59:22.829
There's the Alt-A.

59:22.829 --> 59:25.449
Those are people who don't have
credit ratings good enough to

59:25.447 --> 59:26.797
get the Fannie Freddie loans.

59:26.800 --> 59:28.260
That's $0.8 trillion.

59:28.260 --> 59:30.350
But they are pretty good credit
ratings.

59:30.349 --> 59:33.409
And then the sub prime
population, of which there were

59:33.409 --> 59:35.429
$1 trillion loans issued by
2007.

59:35.429 --> 59:40.619
That's $1.8 trillion of lesser
credit loans that didn't exist

59:40.619 --> 59:42.089
at all in 2002.

59:42.090 --> 59:45.100
So you add these numbers up,
4.8,0.8, and 1,

59:45.099 --> 59:49.439
that's $6.6 and $4 trillion of
unsecuritized the banks are just

59:49.440 --> 59:50.700
holding loans.

59:50.699 --> 59:53.689
So over $10 trillion of loans
as I said.

59:53.690 --> 59:55.950
OK, and then you add the
commercials on top of that and

59:55.947 --> 59:58.497
you're getting very close to the
value of the stock market.

59:58.500 --> 1:00:03.660
So all right so we've talked
about this.

1:00:03.659 --> 1:00:15.439
The advantages of securitized
loans.

1:00:15.440 --> 1:00:18.580
All right, so how did the sub
prime market began?

1:00:18.579 --> 1:00:20.789
Well, you had to have a few
legal hurdles.

1:00:20.789 --> 1:00:22.969
The first one,
which some countries haven't

1:00:22.974 --> 1:00:25.734
managed to achieve and some
people now are doubting we

1:00:25.730 --> 1:00:28.570
should've ever done,
is it legal to charge a high

1:00:28.568 --> 1:00:31.588
interest rate to someone just
because they're riskier.

1:00:31.590 --> 1:00:33.010
Is that usury?

1:00:33.010 --> 1:00:36.350
Or is that a reasonable return,
because you're making a bigger

1:00:36.347 --> 1:00:36.727
risk?

1:00:36.730 --> 1:00:41.000
So, there are anti usury laws
on the books.

1:00:41.000 --> 1:00:44.790
And so in order to make these
loans, they had to become

1:00:44.788 --> 1:00:45.628
legalized.

1:00:45.630 --> 1:00:48.720
You had to get congress to pass
a law to say that higher

1:00:48.717 --> 1:00:51.747
interest rate loans for riskier
people is not usury.

1:00:51.750 --> 1:00:55.360
So then, you also had to figure
out the tax treatment,

1:00:55.364 --> 1:00:57.074
which happened in 1986.

1:00:57.070 --> 1:01:00.820
And so the first pools were
created in the late '80s,

1:01:00.820 --> 1:01:02.750
the early '90s,
and Kidder Peabody,

1:01:02.750 --> 1:01:06.560
by the way, the firm I worked
for at exactly that time,

1:01:06.559 --> 1:01:11.079
was one of the first creators
of these sub prime like loans.

1:01:11.079 --> 1:01:13.079
So it was very small in the
early days.

1:01:13.079 --> 1:01:14.879
And it worked pretty well in
the early days.

1:01:14.880 --> 1:01:18.070
And, as I said,
by 2007 it had grown to $1

1:01:18.074 --> 1:01:22.754
trillion, 5 million people at an
average loan of $200,000.

1:01:22.750 --> 1:01:28.040
Now, these are people who,
as I said, have bad credit

1:01:28.041 --> 1:01:29.061
ratings.

1:01:29.059 --> 1:01:31.499
And so they pay a higher
interest rate.

1:01:31.500 --> 1:01:34.270
Instead of say 6% at the time,
or 5% at the time,

1:01:34.268 --> 1:01:37.728
they might pay 5% or 6% of the
mortgage rate at that time.

1:01:37.730 --> 1:01:40.770
They might pay 8% for the first
two years.

1:01:40.768 --> 1:01:43.298
And then at the end of the
first two years,

1:01:43.300 --> 1:01:45.350
the rate jumps up by another
3%.

1:01:45.349 --> 1:01:46.949
Maybe to LIBOR plus 6%.

1:01:46.949 --> 1:01:49.379
LIBOR, remember,
is the inter bank interest

1:01:49.375 --> 1:01:49.775
rate.

1:01:49.780 --> 1:01:52.670
So, it's already high,
and then it jumps up after a

1:01:52.668 --> 1:01:53.708
couple of years.

1:01:53.710 --> 1:01:57.490
Now, many people have said this
is the kind of predatory

1:01:57.492 --> 1:01:58.182
lending.

1:01:58.179 --> 1:02:01.179
That the homeowner is being
lured into taking out a loan,

1:02:01.177 --> 1:02:04.387
not realizing that in a couple
of years, the rate is going to

1:02:04.389 --> 1:02:05.139
go way up.

1:02:05.139 --> 1:02:07.399
But actually,
there's some rationale to this.

1:02:07.400 --> 1:02:09.790
It turns out,
that if you've made your

1:02:09.786 --> 1:02:12.556
payments for two or three
consecutive years,

1:02:12.561 --> 1:02:16.691
the market thinks you're not
such a subprime person anymore.

1:02:16.690 --> 1:02:19.590
After all, many subprime
borrower are people who are

1:02:19.594 --> 1:02:20.054
young.

1:02:20.050 --> 1:02:22.280
They didn't pay their credit
cards in college.

1:02:22.280 --> 1:02:24.060
Or they defaulted on something.

1:02:24.059 --> 1:02:26.509
And once they're married,
have a house,

1:02:26.510 --> 1:02:29.800
have kids, and they pay for
three consecutive years,

1:02:29.798 --> 1:02:32.698
the market figures,
well these people are much

1:02:32.701 --> 1:02:33.541
better.

1:02:33.539 --> 1:02:36.879
So we'll give them another
loan, they can refinance into a

1:02:36.878 --> 1:02:38.868
loan with a lower interest rate.

1:02:38.869 --> 1:02:40.789
Because they are no longer
considered subprime.

1:02:40.789 --> 1:02:43.659
Maybe they moved to Alt-A or
maybe even into prime.

1:02:43.659 --> 1:02:48.019
So you could count on 70%,
by the end of the third year,

1:02:48.023 --> 1:02:50.803
of people refinancing their
loan.

1:02:50.800 --> 1:02:54.770
During all those years from the
90s and the early 2000s.

1:02:54.768 --> 1:02:57.808
So you'd be left with 30% of
the people who didn't refinance.

1:02:57.809 --> 1:02:59.369
Why didn't they refinance?

1:02:59.369 --> 1:03:00.579
Probably because there's
something wrong with them,

1:03:00.583 --> 1:03:01.923
they were missing their loans
[correction: payments].

1:03:01.920 --> 1:03:05.220
They were much riskier than the
original pool to begin with.

1:03:05.219 --> 1:03:06.719
So naturally,
you're going to charge them a

1:03:06.719 --> 1:03:07.539
higher interest rate.

1:03:07.539 --> 1:03:10.279
So it's not such a crazy thing
that the interest rate went up

1:03:10.277 --> 1:03:11.097
after two years.

1:03:11.099 --> 1:03:13.939
It isn't necessarily a sign of
predatory lending.

1:03:13.940 --> 1:03:16.090
OK, now how do these loans get
started?

1:03:16.090 --> 1:03:17.950
There's somebody called an
originator.

1:03:17.949 --> 1:03:22.369
A broker would find a
homeowner, a subprime homeowner,

1:03:22.367 --> 1:03:26.867
and then go to originator who
would create the deal.

1:03:26.869 --> 1:03:29.559
Now what would the deal be?

1:03:29.559 --> 1:03:33.689
The pool would be a bunch of
subprime homeowners and you'd

1:03:33.693 --> 1:03:36.453
have to get some data on the
people.

1:03:36.449 --> 1:03:37.949
You'd have to figure out do
they have a job?

1:03:37.949 --> 1:03:39.069
What's their debt?

1:03:39.070 --> 1:03:40.610
What's their income?

1:03:40.610 --> 1:03:42.050
Things like that.

1:03:42.050 --> 1:03:45.140
And all that would have to be
reported to the potential

1:03:45.135 --> 1:03:45.645
buyers.

1:03:45.650 --> 1:03:49.360
So a buyer in the shares of
these subprime pools would get a

1:03:49.358 --> 1:03:49.798
list.

1:03:49.800 --> 1:03:50.850
Not by name.

1:03:50.849 --> 1:03:52.609
You can't reveal the name of
the homeowners.

1:03:52.610 --> 1:03:54.770
But what the zip code is of
every house.

1:03:54.768 --> 1:03:57.658
And what the basic
qualifications were of the

1:03:57.661 --> 1:03:58.451
homeowner.

1:03:58.449 --> 1:03:59.319
Do they have a job?

1:03:59.320 --> 1:04:00.950
What's the loan to value on the
loan?

1:04:00.949 --> 1:04:02.719
What's their debt to income
ratio?

1:04:02.719 --> 1:04:03.779
Stuff like that.

1:04:03.780 --> 1:04:09.350
Now, the servicer,
who's often the originator.

1:04:09.349 --> 1:04:13.459
Let's say the originator is an
investment bank.

1:04:13.460 --> 1:04:17.490
The servicer might be the same
investment bank or a specialty

1:04:17.489 --> 1:04:18.229
servicer.

1:04:18.230 --> 1:04:21.670
What they do is just what the
banks did in the Fannie Freddie

1:04:21.670 --> 1:04:22.130
story.

1:04:22.130 --> 1:04:23.840
They're the ones sending the
letters,

1:04:23.840 --> 1:04:26.740
telling people they have to
pay, collecting the money,

1:04:26.739 --> 1:04:29.909
and dividing it up to the
bondholders,

1:04:29.909 --> 1:04:31.819
as we'll describe in a second.

1:04:31.820 --> 1:04:37.370
And they have one extra job.

1:04:37.369 --> 1:04:40.619
Because they're subprime loans,
you can expect a bigger

1:04:40.615 --> 1:04:42.535
percentage of them to default.

1:04:42.539 --> 1:04:45.159
And when people default,
sometimes they can't make the

1:04:45.159 --> 1:04:47.779
payments, they lose their job,
something like that.

1:04:47.780 --> 1:04:51.060
The servicer is given the right
to modify the loan.

1:04:51.059 --> 1:04:53.379
The servicer can say,
OK I understand you can't pay,

1:04:53.378 --> 1:04:55.378
of course you can't pay,
you're out of a job,

1:04:55.380 --> 1:04:56.700
you don't have any money.

1:04:56.699 --> 1:04:59.469
There's no point of us throwing
you out of the house right away,

1:04:59.465 --> 1:05:00.865
maybe you'll get the job back.

1:05:00.869 --> 1:05:03.879
So we'll work out a deal where
we delay your payments,

1:05:03.880 --> 1:05:06.670
or maybe reduce the payments,
maybe even we reduce the

1:05:06.670 --> 1:05:10.150
principle that you owe,
because in the end that's going

1:05:10.148 --> 1:05:12.598
to make our bondholders more
money.

1:05:12.599 --> 1:05:15.469
So the all the bondholders have
no right to talk to the

1:05:15.471 --> 1:05:16.111
homeowner.

1:05:16.110 --> 1:05:17.680
They don't know even though the
homeowner's name.

1:05:17.679 --> 1:05:19.649
But the servicer who is sending
the homeowner letters all the

1:05:19.652 --> 1:05:21.852
time and getting the money,
of course the servicer knows

1:05:21.853 --> 1:05:23.893
the name and has the right to
modify the loan.

1:05:23.889 --> 1:05:26.949
And if the homeowner doesn't
pay and the loan is not

1:05:26.949 --> 1:05:28.539
modified,
because the servicer doesn't

1:05:28.543 --> 1:05:31.773
think it's worth it,
then the servicer can kick the

1:05:31.773 --> 1:05:34.153
homeowner out of his house.

1:05:34.150 --> 1:05:38.690
And take the house and sell it
and pay the proceeds to the

1:05:38.692 --> 1:05:39.252
fund.

1:05:39.250 --> 1:05:42.550
But there's one extremely
interesting provision that if

1:05:42.547 --> 1:05:45.977
the homeowner is not paying,
during the time the homeowner

1:05:45.983 --> 1:05:48.453
doesn't pay,
the servicer has to make the

1:05:48.449 --> 1:05:52.379
payments for the homeowner into
the trust for the bond holders.

1:05:52.380 --> 1:05:55.710
That's supposed to give the
servicer an incentive to hurry

1:05:55.710 --> 1:05:59.160
up and figure out what to do to
change the loan or throw the

1:05:59.157 --> 1:06:00.207
homeowner out.

1:06:00.210 --> 1:06:03.050
And of course,
when the house is finally sold,

1:06:03.054 --> 1:06:06.474
the servicer can recoup his
advance payments out of the

1:06:06.469 --> 1:06:08.049
proceeds of the sale.

1:06:08.050 --> 1:06:13.940
And then later,
the rest of the money goes to

1:06:13.940 --> 1:06:16.350
the bondholders.

1:06:16.349 --> 1:06:19.259
Now, the rating agencies played
an important role in determining

1:06:19.257 --> 1:06:21.147
the ratings that I'm about to
describe.

1:06:21.150 --> 1:06:23.100
So here's the thing would look.

1:06:23.099 --> 1:06:28.079
You have all the homeowners
stuck into a pool,

1:06:28.077 --> 1:06:30.067
all those loans.

1:06:30.070 --> 1:06:31.750
I'm going to go for ten more
minutes, by the way.

1:06:31.750 --> 1:06:34.770
You have all these loans stuck
in a pool.

1:06:34.768 --> 1:06:36.798
So the money would be coming
in, the homeowners,

1:06:36.797 --> 1:06:39.387
remember, are paying this high
interest rate because they are

1:06:39.387 --> 1:06:40.377
subprime borrowers.

1:06:40.380 --> 1:06:43.110
So there's $100 of loans that
went out.

1:06:43.110 --> 1:06:44.670
Let's say each loans is for
$1.00.

1:06:44.670 --> 1:06:47.890
Where does the originator get
the money to lend to the

1:06:47.889 --> 1:06:48.679
homeowners?

1:06:48.679 --> 1:06:51.799
Well, the originator is at the
same time creating the bonds.

1:06:51.800 --> 1:06:55.480
So there'd be AA bonds,
AA, A, BBB, with a bunch of

1:06:55.478 --> 1:06:58.858
minuses too, the over
collateralization and the

1:06:58.862 --> 1:06:59.822
residual.

1:06:59.820 --> 1:07:03.160
So you'd create $81 of AAA
bonds.

1:07:03.159 --> 1:07:06.469
These guys would pay that
LIBOR, the inter bank rate,

1:07:06.469 --> 1:07:08.569
which let's say was 5% percent.

1:07:08.570 --> 1:07:11.780
Plus a tiny bit,
20 basis points,

1:07:11.777 --> 1:07:12.777
so 5.2%.

1:07:12.780 --> 1:07:15.740
The AA would pay a little bit
more than that.

1:07:15.739 --> 1:07:17.659
And the single a little bit
more than.

1:07:17.659 --> 1:07:20.739
That's probably misprint,
that should be LIBOR plus 10.

1:07:20.739 --> 1:07:23.089
LIBOR plus 20,
LIBOR plus 30,

1:07:23.092 --> 1:07:26.122
and then the BBBs,
LIBOR plus 130.

1:07:26.119 --> 1:07:30.939
So you'd issue $81 worth of
triple AAAs, $7 of AAs,

1:07:30.940 --> 1:07:33.160
$5 of As, $5 of BBBs.

1:07:33.159 --> 1:07:35.489
That adds up to $88, $93, $98.

1:07:35.489 --> 1:07:40.069
You're only getting $98.

1:07:40.070 --> 1:07:43.260
So you've got $98 worth of
bonds that you used.

1:07:43.260 --> 1:07:47.140
So the originator has sold
these bonds for $98.

1:07:47.139 --> 1:07:51.039
He's got to lend $100,
so he's $2.00 short so far.

1:07:51.039 --> 1:07:53.639
But you notice that the
interest rate all these

1:07:53.637 --> 1:07:57.137
bondholders are getting is 5%
percent, or a little bit more.

1:07:57.139 --> 1:07:59.049
The homeowners are paying 8%.

1:07:59.050 --> 1:08:01.840
So there's extra money coming
in that doesn't have to go to

1:08:01.842 --> 1:08:02.712
the bondholders.

1:08:02.710 --> 1:08:06.770
So there's this residual piece
that gets the right to get the

1:08:06.769 --> 1:08:08.529
extra interest payments.

1:08:08.530 --> 1:08:11.970
So the originator either holds
residual piece or finds some

1:08:11.967 --> 1:08:15.167
hedge fund and says,
OK, you buy the residual piece.

1:08:15.170 --> 1:08:18.200
And maybe the residual piece is
worth $5.00.

1:08:18.199 --> 1:08:20.369
So $98 plus $5.00 is $103.

1:08:20.368 --> 1:08:23.248
So the originator has gotten
$103.

1:08:23.250 --> 1:08:25.890
The broker's fees,
remember the broker had to find

1:08:25.894 --> 1:08:27.464
the homeowners,
gets $2.00.

1:08:27.460 --> 1:08:29.030
So now he's only got $101.

1:08:29.029 --> 1:08:31.579
So he lends the $100 and
pockets $1.00.

1:08:31.578 --> 1:08:35.708
So the originator would get 1%
bear no risk for his work in

1:08:35.706 --> 1:08:37.126
creating the deal.

1:08:37.130 --> 1:08:41.920
Now, how can these AAA pieces
be rated AAA?

1:08:41.920 --> 1:08:44.390
Now, to be rated AAA mean
there's a one in a hundred

1:08:44.390 --> 1:08:46.960
chance, or something,
that you're going to default.

1:08:46.960 --> 1:08:56.070
So how could that possibly be,
when the loans are so risky?

1:08:56.069 --> 1:09:00.589
Well, what happens if somebody
defaults?

1:09:00.590 --> 1:09:02.230
So this is the calculation.

1:09:02.229 --> 1:09:07.099
What happens if somebody
defaults?

1:09:07.100 --> 1:09:10.760
Well, if you haven't paid for
the first 30 days,

1:09:10.764 --> 1:09:12.874
that happens quite often.

1:09:12.868 --> 1:09:14.648
But if you go,
60 days without paying,

1:09:14.646 --> 1:09:16.036
nothing bad happens to you.

1:09:16.038 --> 1:09:20.518
After 60 days,
you get a letter saying you're

1:09:20.521 --> 1:09:26.431
delinquent and a note is being
made that's going to have an

1:09:26.430 --> 1:09:29.690
impact on your credit score.

1:09:29.689 --> 1:09:32.519
So being 60 days delinquent,
seriously delinquent,

1:09:32.520 --> 1:09:34.080
is bad for the homeowner.

1:09:34.078 --> 1:09:36.838
After 90 days,
you're considered likely to

1:09:36.837 --> 1:09:37.507
default.

1:09:37.510 --> 1:09:39.990
And so you get these very
threatening letters from the

1:09:39.993 --> 1:09:40.513
servicer.

1:09:40.510 --> 1:09:42.670
And after 120 days,
the servicer can start to try

1:09:42.671 --> 1:09:44.161
and throw you out of the house.

1:09:44.158 --> 1:09:46.058
But to throw you out of the
house, maybe they have to go to

1:09:46.056 --> 1:09:47.656
court, they have to do a whole
bunch of things.

1:09:47.658 --> 1:09:49.918
And so in those days,
it took 18 months,

1:09:49.920 --> 1:09:52.120
14 more months,
after the four already,

1:09:52.122 --> 1:09:53.632
to throw somebody out.

1:09:53.630 --> 1:09:56.820
It now, has taken on average,
a couple of years,

1:09:56.823 --> 1:09:57.983
or three years.

1:09:57.979 --> 1:10:00.069
It's getting more and more
complicated to throw somebody

1:10:00.070 --> 1:10:00.300
out.

1:10:00.300 --> 1:10:01.590
Which we're going to get to in
a minute.

1:10:01.590 --> 1:10:09.510
So you could be thrown out
after say 18 months.

1:10:09.510 --> 1:10:11.990
Now what happens if you're
thrown out of the house.

1:10:11.988 --> 1:10:14.318
Let's say, the house is sold
for $0.80.

1:10:14.319 --> 1:10:20.949
When you originally had a $1.00
loan.

1:10:20.948 --> 1:10:25.048
Well, during the time the guy
hasn't paid for that year and a

1:10:25.051 --> 1:10:29.151
half, if it was an 8% coupon,
that means a year and a half is

1:10:29.153 --> 1:10:29.703
12%.

1:10:29.699 --> 1:10:31.539
So $0.12 the guy hasn't paid.

1:10:31.538 --> 1:10:33.918
So the servicers had to pay up
the $0.12.

1:10:33.920 --> 1:10:36.500
And then you have to hire a
broker to resell the house.

1:10:36.500 --> 1:10:38.070
That costs six more cents.

1:10:38.069 --> 1:10:40.809
And the guy probably didn't
pays taxes for the whole year

1:10:40.805 --> 1:10:41.435
and a half.

1:10:41.439 --> 1:10:43.539
So that's another three cents
or so, that you've lost,

1:10:43.542 --> 1:10:44.972
depending on what the tax rate
is.

1:10:44.970 --> 1:10:48.300
So you've lost $0.12 of
servicer advances,

1:10:48.295 --> 1:10:52.185
$0.06 to the broker,
that's $0.18 $0.03 cents for

1:10:52.188 --> 1:10:54.458
the taxes, that's $0.21.

1:10:54.460 --> 1:10:56.690
And the house only sold for
$0.80 instead of 100.

1:10:56.689 --> 1:11:00.279
That's $0.41 cents you've
already lost.

1:11:00.279 --> 1:11:02.279
That's a sort good scenario.

1:11:02.279 --> 1:11:04.349
You've already lost 40%.

1:11:04.350 --> 1:11:09.730
So the bondholders know that
with this scenario they're going

1:11:09.729 --> 1:11:12.779
to lose 40% about of their loan.

1:11:12.779 --> 1:11:16.069
Where does that 40% is $0.40
cents, because remember there's

1:11:16.073 --> 1:11:19.373
only $1.00 loan to that guy,
where does that come out of?

1:11:19.368 --> 1:11:24.118
Well, there was this over
collateralization of $2.00.

1:11:24.118 --> 1:11:27.858
This is extra money pouring
into the deal because everyone

1:11:27.863 --> 1:11:30.033
else is paying a higher coupon.

1:11:30.029 --> 1:11:35.289
So you take the money out of
this extra cash flow that's

1:11:35.291 --> 1:11:36.441
coming in.

1:11:36.439 --> 1:11:38.939
If the default,
the lost $0.40 is more than the

1:11:38.944 --> 1:11:42.214
extra cash flow coming in that
year, then you reduce the over

1:11:42.212 --> 1:11:43.412
collateralization.

1:11:43.409 --> 1:11:46.149
There was $2.00 dollars.

1:11:46.149 --> 1:11:49.839
These bondholders were only
owed $98 and there's $100 of

1:11:49.837 --> 1:11:51.177
loans outstanding.

1:11:51.180 --> 1:11:54.830
So you could lose $2.00 of
loans and still have as much

1:11:54.831 --> 1:11:57.131
loans backing these bondholders.

1:11:57.130 --> 1:12:00.820
But once you get to the next
dollar, you're going to take the

1:12:00.823 --> 1:12:02.983
$0.40 first out of the BBB
piece.

1:12:02.979 --> 1:12:06.669
So as more and more houses go
under, you go through the over

1:12:06.673 --> 1:12:09.183
collateralization,
the extra interest.

1:12:09.180 --> 1:12:11.970
Then you start taking things
out of the BBB piece.

1:12:11.970 --> 1:12:14.930
After you wipe that out,
then you go to the A piece,

1:12:14.926 --> 1:12:17.476
and then the AA and finally go
to the AAA.

1:12:17.479 --> 1:12:22.049
So how could you possibly think
those pieces at the top were

1:12:22.047 --> 1:12:22.587
AAAs?

1:12:22.590 --> 1:12:25.820
Well because let's do a simple
calculation.

1:12:25.819 --> 1:12:28.559
Actually, they look incredibly
safe when you start to think

1:12:28.560 --> 1:12:29.080
about it.

1:12:29.078 --> 1:12:33.978
All this extra interest and the
over collateralization and stuff

1:12:33.976 --> 1:12:37.006
like that it's sort of 8%
protection.

1:12:37.010 --> 1:12:44.400
And on top of that,
you've got the lower pieces

1:12:44.399 --> 1:12:49.219
bearing the original losses.

1:12:49.220 --> 1:12:54.090
OK, so even if you expected 40%
percent of the homeowners to

1:12:54.090 --> 1:12:57.640
default, which is an
astronomical figure.

1:12:57.640 --> 1:13:00.080
It was typically,
in the past,

1:13:00.076 --> 1:13:02.256
less than a few percent.

1:13:02.260 --> 1:13:04.960
Even if you thought 40$ of the
homeowners would be thrown out

1:13:04.962 --> 1:13:07.652
of their houses,
and 40% of each homeowner was

1:13:07.654 --> 1:13:11.454
going to be lost in the scenario
we just described of the 40%

1:13:11.449 --> 1:13:16.679
loss,
40% times 40% is only 16%.

1:13:16.680 --> 1:13:19.610
But the AAA pieces are
protected by 8% and then are

1:13:19.612 --> 1:13:22.722
protected by another 19%,
because they're only the top

1:13:22.720 --> 1:13:23.190
81%.

1:13:23.189 --> 1:13:27.419
So 16% doesn't come anywhere
close to the AAA guys.

1:13:27.420 --> 1:13:30.980
So that, in 2007,
was a horrible scenario to

1:13:30.980 --> 1:13:31.810
imagine.

1:13:31.810 --> 1:13:35.320
That 40% of the homeowners,
they are 5 million homeowners.

1:13:35.319 --> 1:13:38.509
That means 2 million people
tossed on to the streets,

1:13:38.514 --> 1:13:42.084
losing 40% of each of the homes
and you don't come close to

1:13:42.078 --> 1:13:43.428
touching the AAAs.

1:13:43.430 --> 1:13:48.530
That's why it seemed like they
should be AAAs and so many

1:13:48.532 --> 1:13:51.632
people were willing to buy them.

1:13:51.630 --> 1:13:54.440
I've got one more thing to add
to this background piece.

1:13:54.439 --> 1:13:56.629
The credit default swap.

1:13:56.630 --> 1:13:59.190
By the way, things are even
rosier than that,

1:13:59.189 --> 1:14:02.239
at least looked at from the
point of view of 2007 Because

1:14:02.237 --> 1:14:05.117
remember,
70% of the people were always

1:14:05.122 --> 1:14:05.972
prepaying.

1:14:05.970 --> 1:14:08.320
That means you got 70% of your
money back for sure.

1:14:08.319 --> 1:14:11.979
So you only had 30% of the
people left who could possibly

1:14:11.975 --> 1:14:12.625
default.

1:14:12.630 --> 1:14:17.980
So instead of having 40%
default, you'd probably have 40%

1:14:17.978 --> 1:14:19.218
of the 30%.

1:14:19.220 --> 1:14:22.800
So you see, you could easily
imagine that your AAAs were

1:14:22.797 --> 1:14:23.967
completely safe.

1:14:23.970 --> 1:14:27.200
And so I think the credit
rating agencies didn't do such a

1:14:27.204 --> 1:14:30.104
horrible thing rating these
things as people say.

1:14:30.100 --> 1:14:32.130
But I haven't finished the
story.

1:14:32.130 --> 1:14:33.940
So watch what happens.

1:14:33.939 --> 1:14:37.729
So a new invention that
happened in the end of 2005 was

1:14:37.733 --> 1:14:39.563
the credit default swap.

1:14:39.560 --> 1:14:42.330
CDS they are called,
which you've heard a lot.

1:14:42.328 --> 1:14:44.338
So what is a credit default
swap?

1:14:44.340 --> 1:14:47.220
It's just insurance on each of
these bonds.

1:14:47.220 --> 1:14:50.740
So a credit default swap on the
BBB would say,

1:14:50.738 --> 1:14:53.678
if there's a dollar of
principal lost,

1:14:53.680 --> 1:14:55.900
because the homeowner's
default, you take the loss out

1:14:55.899 --> 1:14:59.429
of the triple BBB,
you can get insurance on the

1:14:59.426 --> 1:15:00.556
triple BBB.

1:15:00.560 --> 1:15:04.770
A CDS just is a promise to pay
a dollar for every dollar that's

1:15:04.770 --> 1:15:06.470
lost in the triple BBB.

1:15:06.470 --> 1:15:09.290
And the CDS on the A is a
promise to pay a dollar for

1:15:09.287 --> 1:15:11.237
every dollar that's lost on the
A.

1:15:11.239 --> 1:15:15.089
So that was a huge market.

1:15:15.090 --> 1:15:17.310
It suddenly took off in 2005.

1:15:17.310 --> 1:15:20.860
And then there was an index
that was created in 2006.

1:15:20.859 --> 1:15:24.319
So these are insurance on
particular deals.

1:15:24.319 --> 1:15:26.039
But if you put all the
insurance together,

1:15:26.042 --> 1:15:28.312
you can make an index of what
the insurance is like.

1:15:28.310 --> 1:15:32.050
And so you can tell how
valuable the bonds are.

1:15:32.050 --> 1:15:34.910
Because if you see that the
insurance premium is changing

1:15:34.912 --> 1:15:37.672
you know that people realize
there's a bigger chance of

1:15:37.673 --> 1:15:38.853
default of the BBB.

1:15:38.850 --> 1:15:41.360
So the insurance market,
the index of it,

1:15:41.363 --> 1:15:45.013
is going to tell you a lot of
information about what what's

1:15:45.010 --> 1:15:47.210
going on in the subprime world.

1:15:47.210 --> 1:15:51.560
OK, now, I don't have time to
get to these legal issues.

1:15:51.560 --> 1:15:54.550
But I want to add the last fact.

1:15:54.550 --> 1:15:58.270
Things seemed to be going so
well in the subprime world from

1:15:58.270 --> 1:16:01.030
the late 80s,
early 90s, all through 2000,

1:16:01.027 --> 1:16:04.647
all through the middle 2000s
that people got more ambitious

1:16:04.648 --> 1:16:05.208
still.

1:16:05.210 --> 1:16:06.430
So what did they do?

1:16:06.430 --> 1:16:08.050
They created CDOs.

1:16:08.050 --> 1:16:11.480
So what are CDOs now?

1:16:11.479 --> 1:16:15.089
Remember, we had these loans
that got cut up into bonds.

1:16:15.090 --> 1:16:17.130
There was insurance in the
bonds.

1:16:17.130 --> 1:16:20.960
So people said,
let's take the BBB bonds.

1:16:20.960 --> 1:16:23.250
They're sort of at the bottom,
they're protected a little bit,

1:16:23.252 --> 1:16:24.082
but near the bottom.

1:16:24.078 --> 1:16:26.768
Let's cut those up into
different pieces.

1:16:26.770 --> 1:16:30.360
So we take BBB bonds from all
different deals,

1:16:30.362 --> 1:16:34.832
we put those into another pool,
and now we cut those into

1:16:34.832 --> 1:16:36.512
different pieces.

1:16:36.510 --> 1:16:40.150
And so you might have a pool
that's from California,

1:16:40.149 --> 1:16:42.789
and a pool that's from Detroit,
and a pool that's from Florida,

1:16:42.788 --> 1:16:44.468
that would just be a horrible
combination,

1:16:44.470 --> 1:16:47.280
or a pool that's from Illinois
and Ohio and stuff like that.

1:16:47.279 --> 1:16:48.569
You put them all together.

1:16:48.569 --> 1:16:53.179
And now, somehow the market
decided that we could cut these

1:16:53.184 --> 1:16:56.684
into AAAs, AAs,
and As with the same logic as

1:16:56.684 --> 1:16:57.564
before.

1:16:57.560 --> 1:17:01.020
But, this turned out to be
catastrophic.

1:17:01.020 --> 1:17:03.620
In fact, the market went one
step further,

1:17:03.619 --> 1:17:07.359
and not only took the BBBs that
we said before and made them

1:17:07.362 --> 1:17:10.092
collateral for more AAA bonds
and CDOs.

1:17:10.090 --> 1:17:14.270
But then took the As from this,
which came from the BBBs and

1:17:14.265 --> 1:17:17.375
cut those up into more AAAs,
CDO squareds.

1:17:17.380 --> 1:17:22.040
So that was the mortgage
market, the subprime mortgage

1:17:22.037 --> 1:17:22.827
market.

1:17:22.828 --> 1:17:27.228
So you see, that there's a
tremendous amount of synthetic

1:17:27.230 --> 1:17:27.860
stuff.

1:17:27.859 --> 1:17:31.029
By the way, these insurance
pieces, if you're writing

1:17:31.028 --> 1:17:34.808
insurance, you're promising to
pay basically what the BBBs pay,

1:17:34.806 --> 1:17:36.936
so it's like an artificial BBB.

1:17:36.939 --> 1:17:41.329
So they created the synthetic
BBBs and used those to cut up

1:17:41.332 --> 1:17:43.152
too in the CDO market.

1:17:43.149 --> 1:17:49.999
OK, so I'm going to stop now
with one final word.

1:17:50.000 --> 1:17:54.880
So the subprime market of $1
trillion, plus the Alt-A market,

1:17:54.877 --> 1:17:58.047
became the new frontier of
mortgages.

1:17:58.050 --> 1:18:00.650
And as I said,
everything went swimmingly in

1:18:00.652 --> 1:18:02.592
the 1990s and the early 2000s.

1:18:02.590 --> 1:18:06.240
And then in 2007,
there was a tremendous crash.

1:18:06.238 --> 1:18:10.008
So in January of 2007,
February of 2007,

1:18:10.005 --> 1:18:14.925
the BBB insurance index
plummeted from 100 to 75.

1:18:14.930 --> 1:18:16.780
At that point,
everyone declared,

1:18:16.775 --> 1:18:18.965
oh this is just the subprime
market.

1:18:18.970 --> 1:18:20.630
It's small thing,
don't worry about it.

1:18:20.630 --> 1:18:22.110
Bernanke said there's no
problem.

1:18:22.109 --> 1:18:24.309
The stock market didn't blip at
all.

1:18:24.310 --> 1:18:28.070
It continued on until October
of 2007 when it hit its high.

1:18:28.069 --> 1:18:30.799
The world took notice of the
subprime collapse,

1:18:30.800 --> 1:18:33.040
but everybody said it wouldn't
amount to anything,

1:18:33.038 --> 1:18:35.548
because everybody
underestimated the importance of

1:18:35.551 --> 1:18:36.681
the mortgage market.

1:18:36.680 --> 1:18:39.300
So we're going to see in the
last two lectures,

1:18:39.302 --> 1:18:42.272
how this unraveling of the
subprime market led to the

1:18:42.269 --> 1:18:44.379
unraveling of the entire
economy.

1:18:44.380 --> 1:18:47.080
And we're going to show that
everything that I've described,

1:18:47.078 --> 1:18:49.888
although it sounds very much
more complicated with subprimes

1:18:49.891 --> 1:18:52.181
than it did with the prime
mortgages earlier,

1:18:52.180 --> 1:18:57.590
is really when you get down to
it, the same story of leverage

1:18:57.592 --> 1:19:00.212
and crashes and then booms.

1:19:00.210 --> 1:19:03.560
And we're going to begin the
next class by talking about the

1:19:03.560 --> 1:19:06.690
mathematics of the prime
mortgage market and prepayments

1:19:06.685 --> 1:19:08.215
and how to value those.

1:19:08.220 --> 1:19:12.150
And gradually we're going to
get to the crisis and what

1:19:12.148 --> 1:19:16.438
caused it and what we should do
to prevent future crises.

1:19:16.439 --> 1:19:17.399
Thanks.

1:19:17.399 --> 1:19:21.999