WEBVTT 00:01.610 --> 00:04.570 Prof: So I'm going to talk about what led up to the 00:04.571 --> 00:07.841 crisis and how the crisis makes us realize that the things about 00:07.844 --> 00:10.864 the theory that we've been learning all semester that ought 00:10.857 --> 00:14.057 to be slightly different, and I've been working on a new 00:14.058 --> 00:16.468 version of the theory for the last ten years, 00:16.470 --> 00:20.040 what I call the Leverage Cycle, which I have to say didn't get 00:20.036 --> 00:22.196 very much attention ten years ago, 00:22.200 --> 00:27.130 but which now seems to be, I don't know, 00:27.130 --> 00:29.050 it seems to be getting more attention. 00:29.050 --> 00:32.830 It's almost like life imitated art, really. 00:32.830 --> 00:37.160 It couldn't have turned out more like the theory than I 00:37.164 --> 00:38.934 would have expected. 00:38.930 --> 00:42.730 So I'm going to tell you the facts and then try to fit a 00:42.733 --> 00:45.563 theory to it, and probably will spill over 00:45.563 --> 00:48.363 until Thursday, and I think Thursday I won't 00:48.364 --> 00:50.374 spend that much time finishing. 00:50.370 --> 00:53.630 I'll have a review class if anyone's interested for the 00:53.632 --> 00:54.662 whole material. 00:54.660 --> 00:56.980 And I think when you see the critique of the theory it might 00:56.978 --> 00:59.138 help put the theory in a little bit more perspective. 00:59.140 --> 01:01.710 But anyway, nothing of what I say these last two days you 01:01.713 --> 01:03.603 should feel is going to be on the exam. 01:03.600 --> 01:06.600 It's just more information that you might find interesting. 01:06.599 --> 01:09.599 So we talked last time, remember, at one of those 01:09.601 --> 01:13.041 special classes about the sub-prime mortgage market, 01:13.040 --> 01:17.490 and the idea was that you would pool together a bunch of loans. 01:17.489 --> 01:20.619 These are the--I can do this, I guess. 01:20.620 --> 01:23.590 You'd pool together a bunch of individual mortgages like this, 01:23.590 --> 01:25.960 and then you'd put them in a giant pool, 01:25.959 --> 01:28.439 and then cut the pool up into a triple-A bond, 01:28.438 --> 01:30.128 a double-A bond, a single-A bond, 01:30.134 --> 01:32.134 a triple-B bond, and this is the over 01:32.129 --> 01:33.909 collateralization and the residual. 01:33.910 --> 01:35.600 And I'm not going to go through the whole structure, 01:35.599 --> 01:38.449 but suffice it to say that the idea of this is you take 01:38.447 --> 01:40.607 individual loans which are very risky, 01:40.610 --> 01:43.470 after all these are sub-prime borrowers so everyone knew that 01:43.465 --> 01:46.525 they were risky, and you create what's supposed 01:46.533 --> 01:48.773 to be an incredibly safe bond. 01:48.769 --> 01:52.929 The definition of triple-A bond is that it has a 1 in 100 chance 01:52.931 --> 01:56.831 of going bankrupt in 10 years, of losing any principal in 10 01:56.828 --> 01:57.488 years. 01:57.489 --> 01:59.489 That was the definition they claimed. 01:59.489 --> 02:02.799 I heard a talk about power failures last night, 02:02.799 --> 02:07.289 by the way, the power grid which went out all across from 02:07.292 --> 02:11.512 Cleveland to Manhattan in 2003, and they said that was an event 02:11.508 --> 02:13.428 that should happen once every 10 years. 02:13.430 --> 02:15.310 And then when you hear what happened in the event, 02:15.310 --> 02:19.860 someone didn't trim a tree, and the line sagged into the 02:19.858 --> 02:21.838 tree, and so then it shut itself off, 02:21.842 --> 02:24.272 and then the city next door they had the same problem with 02:24.274 --> 02:26.834 someone not trimming a tree, and that line shut off, 02:26.830 --> 02:29.680 and once you have two or three lines shut off the system 02:29.681 --> 02:31.081 automatically goes down. 02:31.080 --> 02:33.720 It seems like it could happen much more often than once every 02:33.716 --> 02:34.196 10 years. 02:34.199 --> 02:36.279 But anyway, it's the same thing here. 02:36.280 --> 02:39.100 This is supposed to be once every 10 years, 02:39.101 --> 02:42.461 1 in 100 chance, and it happened in a giant way. 02:42.460 --> 02:46.210 So the idea of the triple-A, so they're supposed to very 02:46.210 --> 02:49.210 safe because if the first house defaults, 02:49.210 --> 02:52.120 the first homeowner defaults, instead of paying back the 100 02:52.116 --> 02:54.526 he owes, let's say he just stops paying, 02:54.527 --> 02:57.297 and then you throw the guy out of the house, 02:57.300 --> 02:58.780 but then you get to sell the house. 02:58.780 --> 03:01.660 The house is there as collateral for the loan. 03:01.658 --> 03:03.528 Now, the loan should have been 100. 03:03.530 --> 03:05.790 The house should have been worth much more than the 100. 03:05.788 --> 03:07.378 That's why it should have been collateral. 03:07.378 --> 03:11.178 So you should have had 120 dollars of the house to sell so 03:11.181 --> 03:15.121 even if the house went down by 33 percent to 80 that's still 03:15.117 --> 03:18.617 only a 20 dollar loss, or let's say 20 cent loss on 03:18.623 --> 03:21.603 the dollar loan, and that 20 cents comes out of 03:21.604 --> 03:22.864 the triple-B piece. 03:22.860 --> 03:26.940 So you notice how many losses do you have to have if you're 03:26.938 --> 03:28.978 losing 20 cents on a house? 03:28.979 --> 03:32.279 To have 5 dollars worth of losses you've got to have 25 of 03:32.276 --> 03:36.006 the 100 houses go down, and another 25 of the houses 03:36.006 --> 03:38.786 have to go down to lose this one, 03:38.788 --> 03:41.108 and then another whole bunch of them, 03:41.110 --> 03:43.150 35 more to go down. 03:43.150 --> 03:45.960 So you've got to have like 85 houses going down before you 03:45.956 --> 03:48.366 touch the triple-A, because the losses always come 03:48.371 --> 03:50.441 from the bottom and work their way up. 03:50.440 --> 03:53.300 So when they made these deals they thought it was 03:53.299 --> 03:56.459 inconceivable that you'd have 85 percent of the houses 03:56.455 --> 03:58.845 defaulting, or that you'd lose so much more 03:58.848 --> 04:01.538 than 20 percent on each house because things like that just 04:01.542 --> 04:02.752 hadn't happened before. 04:02.750 --> 04:04.950 And so it seemed like they were incredibly safe. 04:04.949 --> 04:08.329 So that was the structure. 04:08.330 --> 04:10.740 And the idea, again, was to take risky 04:10.736 --> 04:14.506 securities and by securitizing them create a whole bunch of 04:14.510 --> 04:17.180 apparently perfectly safe securities. 04:17.180 --> 04:20.150 Because, as we said, the goal of most investors is 04:20.149 --> 04:23.119 to invest in something that's completely safe, 04:23.120 --> 04:25.520 they don't have to worry about getting more in one state or 04:25.524 --> 04:26.524 more in another state. 04:26.519 --> 04:30.019 And this seemed like an ingenious way of turning 1 04:30.019 --> 04:33.949 trillion dollars of very risky sub-prime loans into, 04:33.949 --> 04:37.709 this is 81 percent, into 800 billion of very safe 04:37.714 --> 04:41.484 bonds and maybe riskier bonds down below that. 04:41.480 --> 04:44.670 So you could never find 1 trillion dollars worth of people 04:44.668 --> 04:47.018 willing to lend to sub-prime borrowers, 04:47.019 --> 04:49.599 but you didn't have to after the securitization, 04:49.600 --> 04:52.720 because 800 billion of the loans to them were by people who 04:52.723 --> 04:54.613 thought they were perfectly safe. 04:54.610 --> 04:57.120 You only had the guys buying these bonds down here who 04:57.119 --> 04:59.439 thought that they were running a very big risk. 04:59.440 --> 05:01.390 So the whole idea of securitization, 05:01.389 --> 05:08.109 the whole idea of the American financial system was to-- 05:08.110 --> 05:10.320 well, let's see what the whole idea was, 05:10.319 --> 05:13.509 was to create as many safe loans as possible. 05:13.509 --> 05:15.749 So you could put it a little bit more generally. 05:15.750 --> 05:17.820 I should have had this picture before. 05:17.819 --> 05:26.639 You could say if the states of the world-- 05:26.639 --> 05:29.259 if you're here today and you might have many of these 05:29.255 --> 05:31.365 different states of the world tomorrow, 05:31.370 --> 05:34.530 some people know that they're going to be rich in some states 05:34.528 --> 05:35.948 and poor in other states. 05:35.949 --> 05:39.449 What they'd like to do is get the same amount in every state. 05:39.449 --> 05:43.029 They can do that by directly buying safe bonds. 05:43.029 --> 05:44.359 That's what everybody's trying to do. 05:44.360 --> 05:46.580 They're trying to hedge themselves to get completely 05:46.583 --> 05:47.153 safe bonds. 05:47.149 --> 05:50.479 Most people don't know how to hedge so the financial system 05:50.478 --> 05:52.198 creates safe bonds for them. 05:52.199 --> 05:54.709 Other people, they do know how to hedge, 05:54.709 --> 05:57.649 but their cash flows are different in the different 05:57.651 --> 05:59.181 states because, for example, 05:59.177 --> 06:01.397 they run a business and if interest rates go up that might 06:01.399 --> 06:02.529 be bad for their business. 06:02.528 --> 06:04.568 If interest rates go down it might be good for their 06:04.565 --> 06:06.675 business, so they've got different amounts of money in 06:06.680 --> 06:07.680 the different states. 06:07.680 --> 06:10.800 And then to create hedging instruments for these people 06:10.802 --> 06:14.332 you'd like to create securities that pay a lot in states where 06:14.329 --> 06:17.279 they want the money so that way they can buy hedging 06:17.278 --> 06:18.318 instruments. 06:18.319 --> 06:23.299 So the purpose of the financial system is to create cash flows 06:23.295 --> 06:26.065 in states that people want them. 06:26.069 --> 06:28.739 For the majority of people that's the same thing in every 06:28.738 --> 06:29.118 state. 06:29.120 --> 06:32.120 For other people it's something like the Arrow securities. 06:32.120 --> 06:35.730 So they can buy money in the states when they're running 06:35.733 --> 06:36.263 short. 06:36.259 --> 06:39.059 And why is this connected to mortgages, 06:39.060 --> 06:41.340 because how do you know that anyone's going to keep their 06:41.339 --> 06:43.539 promise to deliver money in those different states, 06:43.540 --> 06:47.080 or money in every state, how do you know the people 06:47.076 --> 06:50.256 making the promise will keep their promise? 06:50.259 --> 06:51.259 Well, you don't. 06:51.259 --> 06:54.709 That's why you need collateral, and the best collateral in the 06:54.711 --> 06:56.071 country is the houses. 06:56.069 --> 06:58.759 So the purpose of the financial system, 06:58.759 --> 07:01.499 as we said all through the course, is to create securities 07:01.504 --> 07:03.724 that pay off in different states of nature, 07:03.720 --> 07:07.850 of the type people want, and that are guaranteed, 07:07.850 --> 07:09.330 so that people keep their promises, 07:09.329 --> 07:11.169 guaranteed by collateral. 07:11.170 --> 07:14.610 Houses as the best collateral made it inevitable that the most 07:14.605 --> 07:17.865 sophisticated part of the market was going to turn into the 07:17.872 --> 07:19.002 mortgage market. 07:19.000 --> 07:22.160 So at first glance you would think the most complicated part 07:22.161 --> 07:24.521 of the market is the stock market, but no. 07:24.519 --> 07:26.629 It turns out that collateral is the key, 07:26.629 --> 07:30.139 because without guaranteeing a promise the promise isn't really 07:30.142 --> 07:33.102 very good, and so houses are the best 07:33.103 --> 07:34.133 collateral. 07:34.129 --> 07:36.989 So we'll see now that the change in the theory that I want 07:36.992 --> 07:40.112 to describe is what happens when you suppose people might break 07:40.105 --> 07:43.315 their promises and you have to take into account collateral. 07:43.319 --> 07:45.369 All right, but let's get back to the facts. 07:45.370 --> 07:48.730 So there were 1 trillion dollars of these sub-prime 07:48.732 --> 07:50.012 mortgages around. 07:50.009 --> 07:51.039 So then what happened? 07:51.040 --> 07:54.640 I want to skip through this pretty quickly. 07:54.639 --> 07:57.619 People thought that it might be dangerous and they wrote 07:57.617 --> 07:59.727 insurance on the sub-prime mortgages. 07:59.730 --> 08:02.390 So an insurance on a sub-prime mortgage, 08:02.389 --> 08:06.899 CDS, Credit Default Swap, would say if 1 dollar of the 08:06.904 --> 08:10.744 principal of the triple-B bond disappears, 08:10.740 --> 08:13.640 and we saw how that could happen, you take one homeowner 08:13.639 --> 08:15.859 who loses 20 cents, I mean, that will come out of 08:15.863 --> 08:17.473 this first, but after all this stuff is 08:17.468 --> 08:19.838 wiped out, 20 cents of the losses because 08:19.843 --> 08:23.783 the homeowner instead of paying his dollar doesn't pay it all. 08:23.779 --> 08:24.479 The house is sold. 08:24.480 --> 08:28.350 You only get 80 cents back, that 20 cents comes out of the 08:28.346 --> 08:31.176 triple-B, so the insurance would then 08:31.175 --> 08:35.205 say--the buyer of insurance would get to collect the 20 08:35.206 --> 08:35.876 cents. 08:35.879 --> 08:39.489 So this seemed like another way for people even in the BBB range 08:39.490 --> 08:41.210 to guarantee their payments. 08:41.210 --> 08:46.320 Well, it turned out that the writers of insurance didn't just 08:46.317 --> 08:50.657 write 20 cents in case there was a 20 cent loss, 08:50.658 --> 08:55.178 they might write 10 dollars of insurance on the 20 cent loss. 08:55.178 --> 08:59.808 So these Credit Default Swaps are getting very close to Arrow 08:59.807 --> 09:00.807 securities. 09:00.808 --> 09:04.828 So the theoretically inclined economists who didn't think very 09:04.832 --> 09:07.672 far ahead in the Clinton Administration, 09:07.668 --> 09:10.258 namely Larry Summers and people like that, 09:10.259 --> 09:13.919 Bob Rubin, they were ecstatic about these Credit Default Swaps 09:13.924 --> 09:17.234 because to them it reminded them of Arrow securities. 09:17.230 --> 09:19.750 And they thought, my gosh, the market is coming 09:19.745 --> 09:22.585 close to creating Arrow securities and isn't it great 09:22.590 --> 09:25.650 that people will now be able to hedge much better because 09:25.653 --> 09:28.993 they've got these Arrow securities that they can trade. 09:28.990 --> 09:32.090 Now, problem was that who's writing the insurance? 09:32.090 --> 09:34.770 The people writing the insurance are big banks and 09:34.765 --> 09:35.745 people like AIG. 09:35.750 --> 09:39.400 So they're saying if you lose 20 cents we'll pay the 09:39.399 --> 09:40.259 insurance. 09:40.259 --> 09:43.039 Now, of course, that's a promise just like the 09:43.038 --> 09:46.928 promise to repay is and that should have been collateralized. 09:46.928 --> 09:50.868 The trouble is that when AIG as a triple-A rated company wrote 09:50.869 --> 09:54.739 its promises many of the people who bought the insurance just 09:54.743 --> 09:58.493 figured that's such a great company it's obviously going to 09:58.489 --> 10:01.119 have the money, probably isn't going to happen 10:01.116 --> 10:03.656 anyway, so I'm not going to worry about 10:03.655 --> 10:06.245 the collateral, and they managed to make all of 10:06.253 --> 10:09.013 these promises without putting up collateral to guarantee that 10:09.014 --> 10:10.874 they are going to keep their promises. 10:10.870 --> 10:13.290 This mistake that people make, "Well, 10:13.288 --> 10:14.978 it's probably not going to happen anyway that we're going 10:14.981 --> 10:16.041 to even collect the insurance," 10:16.038 --> 10:17.788 you shouldn't have bought the insurance if you didn't think 10:17.792 --> 10:18.852 you were going to collect it. 10:18.850 --> 10:20.480 So obviously, even though it's a low 10:20.482 --> 10:22.582 probability event, you have to think what will 10:22.582 --> 10:25.152 happen when it comes time to collect the insurance. 10:25.149 --> 10:26.949 Are they going to have the money? 10:26.950 --> 10:31.040 Now, many banks in Europe bought these things and they are 10:31.037 --> 10:35.337 accused of having realized that they wouldn't be paid off. 10:35.340 --> 10:38.520 They only bought it so they could convince their regulators 10:38.524 --> 10:41.824 that they actually had a very sound bank and therefore didn't 10:41.817 --> 10:45.047 have to set aside capital, and they knew very well that 10:45.046 --> 10:47.006 they probably wouldn't be paid off. 10:47.009 --> 10:50.039 They just didn't think that it mattered because things wouldn't 10:50.043 --> 10:50.733 go that bad. 10:50.730 --> 10:52.500 So in any case, to circle back, 10:52.498 --> 10:55.858 we've got these sub-prime mortgages where you've written a 10:55.856 --> 10:57.916 bunch of apparently safe bonds. 10:57.918 --> 10:59.868 A lot of people, but not many, 10:59.866 --> 11:02.416 20 percent holding dangerous bonds, 11:02.418 --> 11:04.348 realizing that they're dangerous, and you've got a 11:04.350 --> 11:06.440 bunch of insurance written on the dangerous bonds, 11:06.440 --> 11:10.270 but of a much bigger, five times as big as the amount 11:10.272 --> 11:11.822 of dangerous bonds. 11:11.820 --> 11:15.510 If something goes wrong with that pool these bonds are going 11:15.509 --> 11:19.449 to lose and then the writers of insurance are also going to lose 11:19.451 --> 11:21.141 a huge amount of money. 11:21.139 --> 11:25.029 So what happened? 11:25.028 --> 11:30.498 Well, on top of that there was a CDO market where you took the 11:30.504 --> 11:35.714 triple-B pieces and broke those up like you did before into 11:35.711 --> 11:38.571 bonds, more triple-A's and so on. 11:38.570 --> 11:42.160 So if something happened to this original pool and a lot of 11:42.164 --> 11:45.334 homes started defaulting that would wipe out all the 11:45.326 --> 11:48.856 triple-B's forcing all these people to pay insurance. 11:48.860 --> 11:52.620 And on top of that the CDO market which is just the same 11:52.620 --> 11:55.410 thing done again, but using the triple-B's as 11:55.407 --> 11:57.627 collateral, all these things would get 11:57.629 --> 12:00.059 wiped out including the triple-A's here. 12:00.059 --> 12:01.379 And then that wasn't enough. 12:01.379 --> 12:05.239 Wall Street then wrote CDO-squareds on the triple-B and 12:05.244 --> 12:06.894 A pieces of the CDOs. 12:06.889 --> 12:08.639 All right, so we talked all about this last time. 12:08.639 --> 12:12.249 So now I want to get into what happened. 12:12.250 --> 12:12.930 Any questions? 12:12.929 --> 12:13.659 Yes? 12:13.658 --> 12:17.008 Student: So when these were being securitized like the 12:17.009 --> 12:20.299 triple-A is there any way to distinguish on paper the normal 12:20.304 --> 12:23.884 triple-A's and the triple-A's derived from like triple-B's, 12:23.879 --> 12:25.769 for example, or are all triple-A's just the 12:25.767 --> 12:27.877 same and there is no way to distinguish them? 12:27.879 --> 12:29.909 Prof: No, a buyer knows very well where 12:29.908 --> 12:31.258 his triple-A is coming from. 12:31.259 --> 12:33.579 A buyer has access to all--so if you were a buyer-- 12:33.580 --> 12:36.390 the hedge fund I work with, Ellington, 12:36.389 --> 12:38.719 was a big buyer of these kinds of things, 12:38.720 --> 12:42.230 and also you'll see what our strategy was, 12:42.230 --> 12:49.000 but we knew very well that--so let's go back to this. 12:49.000 --> 12:52.480 We were a big buyer of things here, like these triple-B's we 12:52.477 --> 12:53.537 bought a lot of. 12:53.538 --> 12:56.938 So we could get for every single home in this pool we knew 12:56.936 --> 12:59.566 the history, we know the loan to value, 12:59.568 --> 13:03.078 the income of the borrower, what zip code the borrower 13:03.076 --> 13:03.676 lives in. 13:03.678 --> 13:06.408 We know a tremendous amount of information about each one of 13:06.405 --> 13:08.625 these individual houses, how they've paid before, 13:08.625 --> 13:10.515 what kind of credit rating they have. 13:10.519 --> 13:13.619 All that information we have, and so we build the model of 13:13.615 --> 13:16.705 how reliable we think these borrowers are and what they're 13:16.711 --> 13:17.581 going to do. 13:17.580 --> 13:20.410 And so on the basis of that information we can predict what 13:20.408 --> 13:22.748 we think the value of the BBB is going to be, 13:22.750 --> 13:26.180 and whether it makes sense to buy insurance on it or not. 13:26.178 --> 13:28.748 So what was our strategy, by the way, in our hedge fund? 13:28.750 --> 13:32.280 Our strategy was, take a pool where we think that 13:32.284 --> 13:36.504 the pool is really a good pool, buy the riskiest piece which is 13:36.504 --> 13:38.734 down here, the residual that I described 13:38.732 --> 13:41.152 last time, for which there is no insurance. 13:41.149 --> 13:45.519 Now, it may be that the whole world goes to hell and we lose 13:45.522 --> 13:49.452 money on our residual, but so how do we hedge that? 13:49.450 --> 13:53.910 What we do is then we take what we think is a bad pool of loans, 13:53.908 --> 13:56.848 they're from a county that we think people aren't as reliable, 13:56.850 --> 14:00.280 say, and we don't buy the residual. 14:00.279 --> 14:01.429 In fact, we do the opposite. 14:01.428 --> 14:03.728 We buy the insurance on the triple-B. 14:03.730 --> 14:05.570 There is no insurance on the residual. 14:05.570 --> 14:07.790 So for the bad pool we've bought the insurance. 14:07.788 --> 14:10.458 For the good pool we've bought the residual, 14:10.460 --> 14:12.980 and so if we're right the residual is going to pay a lot 14:12.981 --> 14:15.551 of money because these people aren't going to default. 14:15.548 --> 14:17.678 And if the bad pool is as bad as we think they're going to 14:17.682 --> 14:19.592 default and we're going to collect the insurance. 14:19.590 --> 14:22.910 So we're going to win on both, and if the whole market 14:22.905 --> 14:25.645 collapses, well, our residual will go to 14:25.653 --> 14:27.843 zero, but so will the BBB in the bad 14:27.842 --> 14:31.292 pool and we'll collect insurance and so we'll be protected. 14:31.289 --> 14:32.379 So that was our strategy. 14:32.379 --> 14:35.449 So, yes, the answer is you have a lot of information about what 14:35.447 --> 14:36.237 you're buying. 14:36.240 --> 14:38.310 Student: It's not actually a triple-A, 14:38.306 --> 14:39.806 it's a triple-A of a bad pool. 14:39.808 --> 14:42.148 Prof: Yeah, this appears the triple-A of a 14:42.149 --> 14:45.219 bad pool, but the people buying the triple-A know exactly what's 14:45.220 --> 14:46.000 in the pool. 14:46.000 --> 14:49.290 Now, they may be dumb and not bother to think about it and 14:49.288 --> 14:52.748 just trust the triple-A rating without thinking about it, 14:52.750 --> 14:55.500 but probably a lot of them did think about it. 14:55.500 --> 14:59.980 And if we take this pool, the CDO, these triple-A's were 14:59.979 --> 15:03.749 held mostly by big banks, and you would have thought they 15:03.749 --> 15:06.629 were the most sophisticated of all the buyers because they're 15:06.629 --> 15:08.119 the ones creating the pools. 15:08.120 --> 15:09.750 So they certainly know what's in the pools. 15:09.750 --> 15:13.750 They're the ones who created this original pool here. 15:13.750 --> 15:16.930 They're the ones who underwrote those loans and so they're the 15:16.932 --> 15:19.202 ones, they know everything about it, 15:19.201 --> 15:22.351 and they're the ones holding all these triple-A's. 15:22.350 --> 15:24.410 So we're not talking about people who have no idea what 15:24.408 --> 15:25.018 they're doing. 15:25.019 --> 15:27.469 We're talking about people who supposedly do know what they're 15:27.467 --> 15:27.787 doing. 15:27.788 --> 15:31.058 All right, so that was the basis of the market. 15:31.059 --> 15:34.319 Now, what happened? 15:34.320 --> 15:37.240 So I can describe our hedging strategy and our models, 15:37.235 --> 15:38.935 but I'm not going to do that. 15:38.940 --> 15:40.460 So this was our strategy. 15:40.460 --> 15:43.130 You go long the residuals short the bad pool. 15:43.129 --> 15:46.339 Now, what happened? 15:46.340 --> 15:47.160 Here's what happened. 15:47.158 --> 15:50.878 There was an index that was created in the beginning of 15:50.878 --> 15:51.358 2006. 15:51.360 --> 15:54.610 You just put together a huge number of triple-B bonds and 15:54.614 --> 15:58.164 triple-A bonds of different pools and average their prices. 15:58.158 --> 16:02.338 That's the index, and so they're all 100, 16:02.344 --> 16:03.394 you see? 16:03.389 --> 16:08.009 And then in January of 2007 all of a sudden the market starts to 16:08.005 --> 16:11.665 go crazy, and by March and April it's collapsed. 16:11.668 --> 16:13.458 These bonds, a lot of them, 16:13.464 --> 16:16.154 the triple-B's, have collapsed from 100, 16:16.153 --> 16:19.193 where everything was, all the way down to 60, 16:19.191 --> 16:20.641 just like that. 16:20.639 --> 16:23.759 In a few months it went from 100 to 60,100 here, 16:23.755 --> 16:26.205 three or four months later it's 60. 16:26.210 --> 16:30.140 This is March of 2007. 16:30.139 --> 16:32.989 Now, what was the stock market doing then? 16:32.990 --> 16:37.100 You might remember the stock market, S&P, 16:37.096 --> 16:42.136 so here's the stock market, too far in historical time, 16:42.135 --> 16:45.865 but anyway, here's the stock market. 16:45.870 --> 16:52.200 It had this NASDAQ collapse, but this point right here is 16:52.197 --> 16:54.567 October 31st, 2007. 16:54.570 --> 16:58.880 So ten months or nine months later the stock market reaches 16:58.881 --> 16:59.701 its peak. 16:59.700 --> 17:02.810 So all this time from here up the stock market is climbing and 17:02.807 --> 17:04.027 climbing and climbing. 17:04.028 --> 17:06.378 So the sub-prime mortgage market has collapsed, 17:06.376 --> 17:09.226 but clearly the rest of the population doesn't think that 17:09.234 --> 17:10.464 things are that bad. 17:10.460 --> 17:18.010 So just to put everything in perspective, where else are we? 17:18.009 --> 17:23.319 What other big--housing, let's look at housing prices 17:23.324 --> 17:24.044 here. 17:24.038 --> 17:26.238 We're going to come back to this graph if you can see it. 17:26.240 --> 17:28.090 So this is 2000 here. 17:28.089 --> 17:29.269 This is 2009 here. 17:29.269 --> 17:30.839 Green is the housing. 17:30.839 --> 17:33.159 This is Shiller's housing index. 17:33.160 --> 17:38.600 So if you set it at 100 in 2000, up here at the very top, 17:38.604 --> 17:43.464 that's the middle of 2006, it hit its peak and then 17:43.464 --> 17:45.414 started to come. 17:45.410 --> 17:48.920 So housing hit its peak in the middle of 2006, 17:48.924 --> 17:53.144 the third quarter of 2006, and then sort of didn't come 17:53.144 --> 17:56.664 down very fast, but started to come down. 17:56.660 --> 18:01.720 Sub-prime mortgages collapsed in January of 2007 and the stock 18:01.718 --> 18:06.688 market started its very quick collapse in October-November of 18:06.692 --> 18:07.442 2007. 18:07.440 --> 18:09.130 So it was first housing prices turned, 18:09.130 --> 18:11.220 then sub-prime mortgages collapsed, 18:11.220 --> 18:14.850 then the stock market ten months later collapsed, 18:14.848 --> 18:19.118 so we have to explain all of these things and what was going 18:19.117 --> 18:19.477 on. 18:19.480 --> 18:27.540 So in the--sorry, where was I? 18:27.538 --> 18:29.388 So this is the sub-prime market collapsing. 18:29.390 --> 18:30.980 Why did this market collapse? 18:30.980 --> 18:32.620 What happened to make them collapse? 18:32.618 --> 18:37.978 This is actually an example of the wonderful nature of the 18:37.978 --> 18:40.608 American financial system. 18:40.608 --> 18:44.398 The fact the market collapsed is a great thing because why did 18:44.397 --> 18:46.817 it collapse, what was the information that 18:46.817 --> 18:49.537 made people think that things were going to go down? 18:49.538 --> 19:00.018 Well, it was this information, cumulative loss by reporting 19:00.022 --> 19:01.472 month. 19:01.470 --> 19:04.980 Let's look at some. 19:04.980 --> 19:07.220 These are Countrywide, they're one of the bad guys, 19:07.220 --> 19:10.330 that is they're one of the ones whose loans went bad and the 19:10.325 --> 19:13.855 company went out of business, basically, and got bought by 19:13.856 --> 19:14.976 Bank of America. 19:14.980 --> 19:17.530 So look at delinquencies historically. 19:17.528 --> 19:21.008 So for 2003, these are Countrywide loans 19:21.010 --> 19:22.440 given in 2003. 19:22.440 --> 19:23.810 It's the brown thing. 19:23.808 --> 19:25.608 So here are their delinquencies, 19:25.605 --> 19:26.065 right? 19:26.068 --> 19:28.538 They start at 0, naturally and then they go up 19:28.536 --> 19:31.876 to 2 percent and they stay there as a function of the pool. 19:31.880 --> 19:35.120 Some of those guys are defaulting and being thrown out 19:35.115 --> 19:35.965 of the pool. 19:35.970 --> 19:37.540 That's how delinquencies can go down. 19:37.538 --> 19:39.778 Also people can start paying after being delinquent. 19:39.779 --> 19:41.789 Delinquent just means you're missing some payments. 19:41.789 --> 19:43.299 Look at 2004. 19:43.298 --> 19:46.708 They're still hardly doing anything. 19:46.710 --> 19:48.970 And then look at 2005. 19:48.970 --> 19:51.160 Well, all of a sudden delinquencies start going up. 19:51.160 --> 19:54.640 In 2005--they're 5 percent by the end of 2007, 19:54.644 --> 19:58.134 but delinquencies, 5 percent delinquencies. 19:58.130 --> 20:01.040 We're just talking about people who missed a few payments, 20:01.040 --> 20:02.370 5 percent delinquencies. 20:02.368 --> 20:04.318 They haven't actually been thrown out of their house. 20:04.319 --> 20:05.309 It takes 18 months. 20:05.309 --> 20:06.799 Nobody's lost anything. 20:06.798 --> 20:08.818 They've just been delinquent for a little while. 20:08.818 --> 20:15.198 So what was the catastrophe that made the market collapse? 20:15.200 --> 20:17.070 Well, this is it. 20:17.068 --> 20:21.258 So WALA means Weighted Average Age. 20:21.259 --> 20:22.639 So look at the months. 20:22.640 --> 20:27.300 So you take things that were issued in--this is the 20:27.304 --> 20:28.894 securitization. 20:28.890 --> 20:33.370 They're bundled together in the beginning of 2006. 20:33.368 --> 20:36.398 This is the second half of 2006, but the loans actually 20:36.404 --> 20:39.834 started in 2005 they just didn't get--the homeowners got their 20:39.833 --> 20:41.073 mortgages in 2005. 20:41.069 --> 20:43.659 They got securitized in 2006. 20:43.660 --> 20:46.820 So you look at the delinquencies and you see that 20:46.816 --> 20:50.296 nothing happens the first 12 months, these are losses, 20:50.300 --> 20:53.260 and then eventually it goes it 1 percent. 20:53.259 --> 20:55.329 The losses go to 1 percent. 20:55.328 --> 20:57.278 We're not talking about giant numbers. 20:57.279 --> 20:58.959 Well, everybody saw that. 20:58.960 --> 21:03.930 Then they looked at the losses for things issued second half of 21:03.928 --> 21:05.798 2006, and the losses, 21:05.804 --> 21:09.974 that's this blue line, they are going to, 21:09.974 --> 21:14.614 we're talking about 20 months later, 21:14.608 --> 21:17.798 they're going to 1 percent or 1.2 percent. 21:17.798 --> 21:20.858 You look at the things issued in 2007, which means that the 21:20.855 --> 21:24.015 loans you're really measuring from somewhere in the middle of 21:24.015 --> 21:24.485 2006. 21:24.490 --> 21:29.480 At 1 year you're at half a percent. 21:29.480 --> 21:34.790 And in the second half of 2007 you're at .2 percent losses, 21:34.787 --> 21:36.797 so no losses at all. 21:36.798 --> 21:39.538 So nothing horrible has happened except for the fact 21:39.540 --> 21:41.370 there's an obvious pattern here. 21:41.368 --> 21:44.678 It seems like every newer vintage is getting worse, 21:44.684 --> 21:46.944 and worse, and worse, and worse. 21:46.940 --> 21:50.090 And so it was on that basis, just seeing things getting 21:50.089 --> 21:52.249 worse before there were any losses. 21:52.250 --> 21:54.340 Remember, these are very sophisticated people betting 21:54.342 --> 21:55.712 hundreds of millions of dollars. 21:55.710 --> 21:57.610 They're thinking hard about this. 21:57.608 --> 22:00.678 Even though nothing had happened yet the market 22:00.679 --> 22:01.479 collapsed. 22:01.480 --> 22:05.350 So this collapse that happens here is before anybody has lost 22:05.346 --> 22:06.116 any money. 22:06.118 --> 22:07.748 Hardly anyone's been thrown out of their house. 22:07.750 --> 22:09.440 Nothing's happened in the economy, 22:09.440 --> 22:12.850 but the traders have already figured out things are on a bad 22:12.851 --> 22:15.081 course, things are going to look really 22:15.076 --> 22:16.666 bad and the market collapsed. 22:16.670 --> 22:18.320 So we had warning. 22:18.319 --> 22:20.229 This is the beginning of 2007. 22:20.230 --> 22:22.710 We're almost at the end of 2009, so it was almost three 22:22.709 --> 22:23.259 years ago. 22:23.259 --> 22:26.179 Nearly three years ago everybody should have known that 22:26.178 --> 22:29.098 the market had figured out that there was going to be a 22:29.096 --> 22:31.256 catastrophe in the sub-prime world, 22:31.259 --> 22:34.709 a real catastrophe because the losses were going to be 40 22:34.712 --> 22:35.332 percent. 22:35.329 --> 22:36.669 That's what they were expecting. 22:36.670 --> 22:39.780 You can't have losses like that unless you throw out, 22:39.779 --> 22:43.319 you know, it's a huge number of people that have to get thrown 22:43.316 --> 22:46.016 out of their houses, and you have to lose a huge 22:46.021 --> 22:48.921 amount of money on each house in order to get losses of 40 22:48.920 --> 22:49.480 percent. 22:49.480 --> 22:51.680 Like I said, if you lose 50 percent on every 22:51.675 --> 22:54.375 loan you have to throw 80 percent of the people out of 22:54.384 --> 22:56.534 their houses to get 40 percent losses. 22:56.529 --> 23:00.539 So this meant that people were expecting gigantic catastrophe. 23:00.538 --> 23:02.828 By the way, that was an exaggeration because this is the 23:02.830 --> 23:03.540 triple-B piece. 23:03.538 --> 23:06.528 I meant the triple-B piece was going to lose 40 percent. 23:06.528 --> 23:10.828 So the triple-B piece is only protected by 6 or 8 percent so 23:10.828 --> 23:14.398 it means the total losses would be 10 percent, 23:14.400 --> 23:16.440 10 or 15 percent, which means if you're losing 50 23:16.439 --> 23:18.899 percent on a house 30 percent of the people are going to be 23:18.903 --> 23:20.223 thrown out of their houses. 23:20.220 --> 23:23.000 So it's like 30 percent losses and 30 percent of the people 23:23.000 --> 23:24.390 thrown out of their houses. 23:24.390 --> 23:27.280 That was the expectation then, but that's still terrible. 23:27.278 --> 23:29.538 There were five million sub-prime people, 23:29.538 --> 23:32.428 so the market at this point is expecting 30 percent of them to 23:32.433 --> 23:35.093 be thrown out of their houses with 30 percent losses even 23:35.092 --> 23:37.182 though the losses are 1 percent or less. 23:37.180 --> 23:41.380 So you can see how far sighted the market is. 23:41.380 --> 23:43.460 So our government, everybody should have been 23:43.457 --> 23:46.477 warned right at this point that something was going to happen. 23:46.480 --> 23:48.940 Now, did the stock market realize this was such a 23:48.940 --> 23:51.870 catastrophe, absolutely not because the 23:51.871 --> 23:55.531 stock market waited until the end of 2007, 23:55.529 --> 23:58.589 which we're talking about here, and now look at where the 23:58.589 --> 24:00.339 losses are in sub-prime bonds. 24:00.338 --> 24:02.788 Here the stock market started to go down. 24:02.788 --> 24:06.088 So it had all this warning that something horrible was happening 24:06.085 --> 24:08.695 in the mortgage market, but the stock market owners 24:08.700 --> 24:10.060 thought nothing of it. 24:10.058 --> 24:11.588 They thought, "Well, how could this 24:11.589 --> 24:12.649 possibly affect us?" 24:12.650 --> 24:15.890 And only here do they start to catch on. 24:15.890 --> 24:20.890 So to give you an example of the losses, this is only up to 24:20.894 --> 24:24.954 December 2007, people kept announcing losses. 24:24.950 --> 24:26.420 Merrill announced 9 billion. 24:26.420 --> 24:28.930 Citi Corp announced 10 billion and then the next week another 24:28.925 --> 24:29.465 10 billion. 24:29.470 --> 24:32.230 UBS announced 3.7 billion and then another 10 billion. 24:32.230 --> 24:34.930 Goldman announced 5 billion, Morgan Stanley 4 billion. 24:34.930 --> 24:37.630 Every other day someone was coming out saying that they had 24:37.628 --> 24:38.838 lost all these billions. 24:38.838 --> 24:40.958 And that was only in December 2007. 24:40.960 --> 24:43.550 The losses accelerated like crazy through 2008, 24:43.551 --> 24:46.541 so there were hundreds of billions of dollars lost. 24:46.538 --> 24:48.948 Now, the whole sub-prime market is only 1 trillion, 24:48.952 --> 24:51.752 but remember there was all that insurance written on it. 24:51.750 --> 24:53.570 And who was writing the insurance? 24:53.568 --> 24:56.828 These very same people were the ones writing the insurance. 24:56.828 --> 24:59.398 So you not only lost the hundreds of billions in the 24:59.401 --> 25:02.361 sub-prime market, but also multiply that by 5, 25:02.361 --> 25:06.331 the hundreds of billions all these guys wrote in insurance 25:06.332 --> 25:09.122 and in CDO triple-A's that they held. 25:09.118 --> 25:16.788 So, all right, now let's say one other fact 25:16.788 --> 25:21.718 that's quite interesting. 25:21.720 --> 25:24.530 These are prepayments. 25:24.528 --> 25:28.958 So I told you that in sub-prime loans for the first two years, 25:28.961 --> 25:32.741 the sub-prime loan, you'd be locked into the loan. 25:32.740 --> 25:36.410 A huge penalty if you prepaid, but between year two and year 25:36.411 --> 25:38.821 three you could prepay, get a new loan, 25:38.817 --> 25:41.857 refinance it and then in year three the interest rate would 25:41.859 --> 25:42.279 jump. 25:42.279 --> 25:43.889 So what would people do? 25:43.890 --> 25:46.980 Well, people who made all their payments the first two years 25:46.978 --> 25:49.958 would be regarded as reliable payers and so of course they 25:49.961 --> 25:51.011 would refinance. 25:51.009 --> 25:52.849 They'd no longer be such sub-prime people. 25:52.848 --> 25:57.328 They'd refinance into loans with lower interest because 25:57.328 --> 26:00.978 they'd be regarded as better credit risks. 26:00.980 --> 26:05.270 So if you go back to 2003 you see that after the second year 26:05.268 --> 26:07.738 prepayments go up to 70 percent. 26:07.740 --> 26:11.000 So 70 percent of the people would refinance their loan 26:11.003 --> 26:12.793 between year two and three. 26:12.788 --> 26:16.518 In 2004, that's the pink one, the same thing happened, 26:16.521 --> 26:20.821 60 or 70 percent of all those people over the course of a year 26:20.817 --> 26:22.717 refinanced their loans. 26:22.720 --> 26:25.600 So that means that the original lenders got 70 percent of the 26:25.596 --> 26:26.216 money back. 26:26.220 --> 26:28.180 It's like a prepayment like we have in mortgages. 26:28.180 --> 26:30.580 Well, in sub-prime these guys had a huge incentive to do it 26:30.583 --> 26:32.493 once they proved that they were good people. 26:32.490 --> 26:34.750 And as I told you, most of the sub-prime borrowers 26:34.751 --> 26:37.611 are young people who had screwed up with their credit cards and 26:37.614 --> 26:39.974 things like that, and after they paid for a while 26:39.971 --> 26:42.741 people would realize that they'd settled down and give them a new 26:42.740 --> 26:44.750 loan, but look what's happened to 26:44.750 --> 26:48.470 these numbers, so if you jump to 2007 all 26:48.471 --> 26:52.891 these things just collapsed, no more prepayments, 26:52.888 --> 26:56.088 and once there are no more prepayments that means the 26:56.086 --> 26:58.726 lenders don't get their 70 percent back. 26:58.730 --> 27:00.460 So if you're a hedge fund figuring, 27:00.460 --> 27:03.060 "How much can I lose if I buy one of these sub-prime 27:03.057 --> 27:05.047 things," you know that between year two 27:05.050 --> 27:07.740 and year three you're going to get 70 percent of your money 27:07.740 --> 27:10.060 back so you can't lose more than 30 percent. 27:10.058 --> 27:13.268 All of a sudden you're getting 10 percent of your money back 27:13.271 --> 27:15.451 which means you could lose 90 percent. 27:15.450 --> 27:18.690 So, why would that have happened? 27:18.690 --> 27:21.150 Well, we're going to come to that. 27:21.150 --> 27:25.190 So those are the basic facts. 27:25.190 --> 27:28.690 I don't have time to say more than that, so any questions 27:28.685 --> 27:30.305 about those basic facts? 27:30.308 --> 27:32.918 Now we need something to explain how they happened. 27:32.920 --> 27:33.540 Yes? 27:33.538 --> 27:36.348 Student: So ultimately the slope of the line is getting 27:36.349 --> 27:38.979 steeper, is that what you're saying, so the projected loss 27:38.976 --> 27:39.986 percentage, right? 27:39.990 --> 27:40.950 Prof: Exactly. 27:40.950 --> 27:44.460 So people were realizing--yeah, that was all that it was. 27:44.460 --> 27:48.350 People just said to themselves every-- 27:48.348 --> 27:50.978 that's exactly what I'm saying that people said, 27:50.980 --> 27:54.730 "Look, we know that losses are going to increase, 27:54.730 --> 27:56.910 but they're probably not going to get very far. 27:56.910 --> 27:59.310 Historically they get to 3 percent or 4 percent or 27:59.310 --> 28:00.390 something like that. 28:00.390 --> 28:00.820 That's it. 28:00.818 --> 28:01.958 That's all we have to worry about. 28:01.960 --> 28:04.660 And it's early on, so it's not like we've seen any 28:04.657 --> 28:08.017 losses, but they just seem to be happening so much faster than 28:08.018 --> 28:09.118 they did before. 28:09.118 --> 28:11.158 Let's extrapolate that curve." 28:11.160 --> 28:12.850 Now, how do you extrapolate a curve like that? 28:12.848 --> 28:14.968 There are so many ways you could extrapolate it. 28:14.970 --> 28:17.320 So the market extrapolated and thought, "Gosh, 28:17.317 --> 28:19.897 things are getting just much worse," and the market 28:19.902 --> 28:21.032 started to collapse. 28:21.028 --> 28:24.048 So you see, in real trading markets people respond very 28:24.049 --> 28:26.119 quickly to very little information. 28:26.118 --> 28:28.718 I mean, their whole livelihood depends on it. 28:28.720 --> 28:31.910 It's all they're thinking about and so they're coming up with 28:31.913 --> 28:34.523 quick conclusions, which in this case like in many 28:34.522 --> 28:36.282 others, they're not so crazy. 28:36.279 --> 28:39.369 They're realizing something bad is happening and they're acting 28:39.372 --> 28:41.952 very quickly, and so huge--billions of 28:41.954 --> 28:46.204 dollars are being lost just on the basis of this amount of 28:46.196 --> 28:47.086 evidence. 28:47.088 --> 28:51.358 I think this brings home how fast the market acts and how 28:51.356 --> 28:55.316 expectations about the future are driving prices, 28:55.318 --> 28:56.958 and therefore how much information-- 28:56.960 --> 28:58.830 you remember, we said that if you just pay 28:58.826 --> 29:00.916 attention to the market you can learn a lot. 29:00.920 --> 29:03.280 Well, we didn't learn that much, the whole stock market. 29:03.278 --> 29:05.068 They weren't paying attention to what was happen. 29:05.068 --> 29:07.098 The mortgage market was collapsing. 29:07.098 --> 29:09.088 That should have meant something, but they weren't 29:09.086 --> 29:10.096 paying attention to it. 29:10.098 --> 29:13.058 Nothing in the world seemed to change because there were no 29:13.059 --> 29:14.489 people on the streets yet. 29:14.490 --> 29:16.580 Now there are people unemployed, there are people on 29:16.576 --> 29:19.116 the streets, there are going to be millions 29:19.124 --> 29:21.514 of guys on the streets pretty soon, 29:21.509 --> 29:23.079 homeowners on the streets. 29:23.078 --> 29:26.248 And of course so now the stock market has caught on that things 29:26.250 --> 29:27.120 are really bad. 29:27.118 --> 29:32.138 All right, so any more questions about this? 29:32.140 --> 29:35.370 So now I want to talk about a way of understanding what 29:35.367 --> 29:37.637 happened, and then I'm going to end. 29:37.640 --> 29:40.430 So I'm going to go from more general to more specific. 29:40.430 --> 29:43.620 So I'm going to talk about a way of understanding what 29:43.615 --> 29:47.275 happened and then we're going to talk concretely about how you 29:47.281 --> 29:51.071 would change the mathematics we've been doing all semester. 29:51.068 --> 29:55.658 So my view of all this is that it's the leverage cycle, 29:55.660 --> 29:59.150 which is--the leverage cycle, as I'll define it in a second, 29:59.150 --> 30:01.590 has to do with putting up collateral to make sure you're 30:01.589 --> 30:03.729 going to pay, and so far in the course we've 30:03.727 --> 30:07.317 paid no attention to that, and in all of economic theory 30:07.316 --> 30:10.036 they never paid attention to that. 30:10.038 --> 30:13.298 You can read anyone of those textbooks that were on the 30:13.304 --> 30:16.694 reading list by all of the great Nobel Prize winners, 30:16.690 --> 30:18.530 and all the great financial economists, 30:18.528 --> 30:23.018 and you'll never see the word, hardly ever see the word 30:23.023 --> 30:25.313 collateral, and you'll never see, 30:25.308 --> 30:27.708 what's the equilibrium amount of collateral? 30:27.710 --> 30:32.170 And so that's been entirely missing. 30:32.170 --> 30:33.850 So, in fact, if you think about 30:33.845 --> 30:37.245 macroeconomics and the Fed they always tell you that if things 30:37.250 --> 30:40.100 go bad in the economy reduce the interest rate. 30:40.098 --> 30:42.168 That's the way we can stimulate investment. 30:42.170 --> 30:45.140 We can raise the price of assets by lowering the interest 30:45.137 --> 30:45.507 rate. 30:45.509 --> 30:48.409 If we raise the interest rate we'll lower the price of assets. 30:48.410 --> 30:52.490 We can always get the economy to boom or slow down by 30:52.487 --> 30:54.837 adjusting the interest rate. 30:54.838 --> 30:58.348 The most important thing ever done in macroeconomics in theory 30:58.348 --> 31:01.968 and practice is to establish the Federal Reserve and give it the 31:01.972 --> 31:04.622 responsibility of managing interest rates. 31:04.618 --> 31:07.568 Now, in my view it should be managing collateral rates and 31:07.571 --> 31:08.661 not interest rates. 31:08.660 --> 31:10.460 And in fact it has the power to manage, 31:10.460 --> 31:12.970 it's been given the authority to manage collateral rates when 31:12.974 --> 31:15.294 it was created, but it just never exercises 31:15.292 --> 31:16.222 that authority. 31:16.220 --> 31:19.330 Now, as I said in class, Shakespeare already had this 31:19.330 --> 31:19.750 idea. 31:19.750 --> 31:21.640 In The Merchant of Venice, 31:21.640 --> 31:24.810 as we said, they were haggling over the interest rate and not 31:24.809 --> 31:27.509 just over collateral and Shakespeare anticipated the 31:27.506 --> 31:29.986 impatience theory of interest and Shylock, 31:29.990 --> 31:31.910 who you know, the modern reading of The 31:31.911 --> 31:34.611 Merchant of Venice is that it's about anti-Semitism and 31:34.609 --> 31:36.439 Shylock is supposed to be a bad guy. 31:36.440 --> 31:39.170 I don't think Shakespeare intended that at all. 31:39.170 --> 31:41.620 In fact, Shylock is much more sophisticated, 31:41.618 --> 31:44.238 by far, and much better understanding of what's going on 31:44.237 --> 31:45.947 in the world than either Antonio-- 31:45.950 --> 31:49.130 well, certainly than Antonio who is the merchant of Venice 31:49.132 --> 31:52.192 and Bassanio's actually, I think, quite clever, 31:52.192 --> 31:56.282 although Harold Bloom makes Bassanio out to be an idiot and 31:56.282 --> 31:58.532 a dupe, and can't imagine how Portia 31:58.528 --> 32:00.258 could possibly marry such a guy. 32:00.259 --> 32:04.619 But anyway, I think that Bassanio is a very attractive 32:04.615 --> 32:09.295 guy and I think that Shylock, he's the only one who really 32:09.299 --> 32:11.929 understands what's going on. 32:11.930 --> 32:16.190 So he explains the entire modern theory of impatience to 32:16.194 --> 32:20.624 Bassanio and Antonio and says that's why the interest rate 32:20.615 --> 32:22.085 should be high. 32:22.088 --> 32:24.238 And then they haggle over the collateral. 32:24.240 --> 32:26.050 And of course, Shakespeare, 32:26.053 --> 32:28.153 in my view, thought the collateral was much 32:28.150 --> 32:30.430 more important than the interest because nobody can remember the 32:30.428 --> 32:32.938 rate of interest they agreed on, but everybody remembers the 32:32.943 --> 32:34.163 pound of flesh collateral. 32:34.160 --> 32:39.850 And remember that the play ends with the ships all sinking, 32:39.848 --> 32:44.618 apparently, and so should Shylock take his collateral or 32:44.622 --> 32:46.542 not, and the court rules not that 32:46.542 --> 32:49.222 you should reduce the collateral or you shouldn't take the 32:49.215 --> 32:51.885 collateral but you should have a different collateral. 32:51.890 --> 32:54.900 It should have been a pound of flesh, but not a drop of blood. 32:54.900 --> 32:57.790 So it's the responsibility of the judicial system and the 32:57.792 --> 33:00.482 regulatory body to monitor not the interest rate, 33:00.480 --> 33:03.140 not the amount of the borrowing, but the collateral 33:03.136 --> 33:04.356 that's put up for it. 33:04.358 --> 33:06.568 And that's exactly what my message is going to be. 33:06.568 --> 33:08.728 We have to manage the collateral. 33:08.730 --> 33:12.000 And so I wrote about this starting in 1997, 33:12.000 --> 33:16.580 and 2003, and then again in 2008, and I've written with a 33:16.577 --> 33:19.397 bunch of people, and I have students who wrote 33:19.402 --> 33:19.712 on it. 33:19.710 --> 33:23.380 And Araujo and Pascoa were two Brazilians who wrote about it. 33:23.380 --> 33:25.840 I gave a talk there in 1997. 33:25.839 --> 33:27.449 I got them going on it. 33:27.450 --> 33:31.580 And then Bernanke himself wrote about collateral in the '90s at 33:31.577 --> 33:34.967 the same time, even earlier than I was, 33:34.971 --> 33:40.721 but he didn't have the idea of leverage and collateral rate. 33:40.720 --> 33:42.530 He knew that you needed collateral. 33:42.529 --> 33:45.509 He talked about collateral, but he didn't talk about the 33:45.510 --> 33:46.650 ratio and the rate. 33:46.650 --> 33:47.840 So what do I mean by that? 33:47.838 --> 33:50.278 If you have a house that's worth 100 dollars, 33:50.284 --> 33:53.564 say, it's collateral for a loan because if you don't pay the 33:53.560 --> 33:55.450 loan they can take your house. 33:55.450 --> 33:58.110 So that's called no recourse collateral if they take your 33:58.113 --> 34:00.733 house, but they can't go after you for anything more. 34:00.730 --> 34:03.570 Now that, in fact, is not by law what happens, 34:03.571 --> 34:05.531 but in practice what happens. 34:05.528 --> 34:08.158 If you default on your mortgage they'll take your house, 34:08.155 --> 34:10.925 but they aren't going to come after you to try and get your 34:10.925 --> 34:12.545 income or something like that. 34:12.550 --> 34:14.810 So it's as if all they can do is take your house. 34:14.809 --> 34:18.119 In some states explicitly by law they can only take your 34:18.117 --> 34:18.597 house. 34:18.599 --> 34:21.339 In other states you still owe the money, but they always just 34:21.342 --> 34:22.672 say, "Forget about it. 34:22.670 --> 34:24.330 We're just taking your house." 34:24.329 --> 34:28.099 So I'm going to assume that they take your house and no 34:28.101 --> 34:28.591 more. 34:28.590 --> 34:33.570 If the house is worth 100 dollars and you borrow 80 then 34:33.574 --> 34:37.024 the collateral rate is 125 percent, 34:37.018 --> 34:41.768 because a 100 dollar house is protecting an 80 dollar loan, 34:41.769 --> 34:43.849 so it's 125 percent. 34:43.849 --> 34:46.559 The loan to value, it's an 80 dollar loan on a 100 34:46.559 --> 34:48.219 dollar house, is 80 percent. 34:48.219 --> 34:51.919 The margin is the margin of safety, 34:51.920 --> 34:54.690 it's a 100 dollar house so the lender thinks that he's 34:54.686 --> 34:57.816 protected because he's holding a 100 dollar house and he only 34:57.817 --> 34:59.067 gave you 20 dollars. 34:59.070 --> 35:03.500 So it's 20 percent and the leverage is 5 because with 20 35:03.498 --> 35:08.408 dollars of cash you've managed to buy a house worth 5 times as 35:08.411 --> 35:09.541 much, 100. 35:09.539 --> 35:11.399 So these numbers are all the same thing. 35:11.400 --> 35:13.550 It's just different ways of saying the same thing. 35:13.550 --> 35:17.020 So I prefer leverage, but collateral rate, 35:17.023 --> 35:19.483 they're all the same thing. 35:19.480 --> 35:21.360 Student: Could you explain what the 5 is? 35:21.360 --> 35:24.360 Prof: 5 is a 100 dollar house and you only paid 20 35:24.362 --> 35:24.902 dollars. 35:24.900 --> 35:26.560 You borrowed the other 80. 35:26.559 --> 35:30.489 So with 20 dollars of cash you can manage to own a 100 dollar 35:30.485 --> 35:32.445 asset, so the leverage is 5. 35:32.449 --> 35:35.959 So people who borrow a lot can own huge quantities of things 35:35.960 --> 35:38.340 even though they had hardly any money. 35:38.340 --> 35:40.340 So, as I say, when you're negotiating the 35:40.335 --> 35:42.525 loan you have to negotiate the interest rate, 35:42.532 --> 35:44.932 but you also have to negotiate the leverage. 35:44.929 --> 35:48.189 How much cash do you have to put down in order to get the 35:48.193 --> 35:48.663 house? 35:48.659 --> 35:51.459 How much can you borrow using the house as collateral? 35:51.460 --> 35:54.240 Now, in the standard theory that Fisher taught that we've 35:54.235 --> 35:56.805 described in this class, you've got supply and demand 35:56.813 --> 35:58.503 determining the interest rate. 35:58.500 --> 36:00.140 Leverage never appeared. 36:00.139 --> 36:03.759 We just always assumed everyone was going to repay their loan. 36:03.760 --> 36:07.660 So in my theory supply and demand are going to determine 36:07.655 --> 36:10.625 both the interest rate and the leverage. 36:10.630 --> 36:13.670 Now that seems a little shocking because how can one 36:13.672 --> 36:15.762 equation determine two variables? 36:15.760 --> 36:17.780 So I think it's for this reason that economists, 36:17.780 --> 36:20.720 basically all these years, ignored leverage because they 36:20.722 --> 36:23.992 just didn't see any way to fit two variables with one equation 36:23.987 --> 36:25.697 and solve for two variables. 36:25.699 --> 36:27.759 So they just said, "Well, for simplicity 36:27.760 --> 36:29.820 we'll assume everyone always repays." 36:29.820 --> 36:34.080 Now, what is it that's going to determine leverage? 36:34.079 --> 36:37.769 Well, this is common sense as Fisher and Shakespeare before 36:37.766 --> 36:41.576 him said that interest rates are determined by impatience. 36:41.579 --> 36:44.529 In my view leverage, there are many determinants, 36:44.530 --> 36:47.480 but the most important determinant is volatility, 36:47.483 --> 36:49.823 the volatility of the asset price. 36:49.820 --> 36:50.740 Why is that? 36:50.739 --> 36:54.789 Because you've got a house of 100 protecting the 80 dollar 36:54.791 --> 36:56.941 loan, if you think the housing price 36:56.938 --> 36:59.988 is going up and down and it might fall below 80 then you're 36:59.989 --> 37:01.619 not going to feel very safe. 37:01.619 --> 37:04.689 If you think the housing price is rock solid at 100 you're 37:04.688 --> 37:07.918 going to feel very safe and you'll even loan more than 80. 37:07.920 --> 37:10.450 So the volatility of the housing price, 37:10.449 --> 37:14.479 obviously, is what controls how safe the lender feels, 37:14.480 --> 37:17.550 and so volatility has got to be the most important determinant 37:17.545 --> 37:19.815 of leverage, but it's hard to see how to fit 37:19.818 --> 37:21.778 that into a supply and demand equation. 37:21.780 --> 37:25.210 So the theory, my theory, is going to be that 37:25.210 --> 37:28.620 the higher the leverage is, which supply and demand is 37:28.617 --> 37:30.937 going to determine, the higher the asset prices 37:30.940 --> 37:34.350 are, and the lower leverage is the lower the asset prices are. 37:34.349 --> 37:37.089 Now, why should this be the case? 37:37.090 --> 37:45.070 Well, in my view there are many different potential buyers, 37:45.070 --> 37:47.990 let's say a continuum of potential buyers and each of 37:47.992 --> 37:51.142 them has a different view of what the asset is worth, 37:51.139 --> 37:55.109 and so you have this continuum. 37:55.110 --> 37:59.130 Now, let's, for simplicity even, suppose that everyone has 37:59.130 --> 38:02.800 a number in his head about what the asset's worth. 38:02.800 --> 38:04.240 That's what we did on the very first day. 38:04.239 --> 38:06.699 Everyone had a reservation price of the asset. 38:06.699 --> 38:08.739 And let's say, though, that they're willing to 38:08.737 --> 38:10.367 buy more than one football ticket. 38:10.369 --> 38:13.229 They're willing to buy as many football tickets as they can get 38:13.231 --> 38:15.911 as long as the price is less than the reservation price. 38:15.909 --> 38:18.869 So what happens, the people who have the highest 38:18.873 --> 38:22.093 valuation naturally are going to buy the assets, 38:22.090 --> 38:24.160 and the people with low valuations are going to sell 38:24.164 --> 38:25.994 them, and somewhere there will be a 38:25.987 --> 38:26.707 marginal guy. 38:26.710 --> 38:28.550 So people above here are going to be the buyers, 38:28.552 --> 38:30.592 and people below here are going to be the sellers. 38:30.590 --> 38:32.170 And what's the price going to be? 38:32.170 --> 38:35.270 It's going to be the valuation of this marginal guy. 38:35.268 --> 38:38.948 He's marginal precisely because he's indifferent between being a 38:38.949 --> 38:42.689 buyer or a seller which means the price for him is just right. 38:42.690 --> 38:45.350 These guys up here think the price is too low. 38:45.349 --> 38:46.239 That's why they're buyers. 38:46.239 --> 38:48.159 These guys down here think the price is too high. 38:48.159 --> 38:49.309 That's why they're sellers. 38:49.309 --> 38:52.239 So this is all consistent with what we saw in the football 38:52.237 --> 38:53.107 ticket example. 38:53.110 --> 38:57.590 Now, one little twist is where does this have to be? 38:57.590 --> 39:00.980 Well, it depends on how much money these guys up here have. 39:00.980 --> 39:03.220 So Fisher actually said this. 39:03.219 --> 39:06.709 If you make people who really like to consume now richer 39:06.710 --> 39:09.820 you're going to get a different interest rate, 39:09.820 --> 39:12.230 or if you make the patient people richer you'll have a 39:12.228 --> 39:13.228 lower interest rate. 39:13.230 --> 39:14.880 Well, the same logic here. 39:14.880 --> 39:18.120 If you make the natural buyers richer you're not going to need 39:18.117 --> 39:21.197 as many of them to buy the assets and the marginal guy will 39:21.195 --> 39:23.315 go up here and the price will rise, 39:23.320 --> 39:25.510 not because the payoffs of the asset have changed, 39:25.510 --> 39:28.710 but because the marginal buyer has gone up. 39:28.710 --> 39:33.510 So to put it another way, a more important way, 39:33.510 --> 39:37.280 if it's easier to borrow because leverage is higher, 39:37.280 --> 39:41.190 so you can buy that 100 dollar house with only 10 dollars down 39:41.188 --> 39:44.238 instead of 20 dollars down, then each of these natural 39:44.239 --> 39:46.929 buyers instead of being able to afford to buy one house can buy 39:46.934 --> 39:48.764 two houses or two mortgage securities, 39:48.760 --> 39:50.770 or buy a house that's twice as big. 39:50.768 --> 39:53.688 So the natural buyers, with a lot of leverage, 39:53.690 --> 39:57.990 a few of them will be able to buy all the assets, 39:57.989 --> 40:01.669 and the marginal buyer will be very high and the price will be 40:01.666 --> 40:02.386 very high. 40:02.389 --> 40:05.119 If there's no leverage and no borrowing it's going to take a 40:05.123 --> 40:06.843 lot of them to buy all the assets, 40:06.840 --> 40:09.640 and the marginal buyer will be down here and the price will be 40:09.643 --> 40:10.153 very low. 40:10.150 --> 40:14.440 So leverage is clearly going to affect the price. 40:14.440 --> 40:17.940 And notice how shocking this is. 40:17.940 --> 40:19.500 What would Fisher say about this? 40:19.500 --> 40:21.970 So this sounds like such common sense, how could this be wrong? 40:21.969 --> 40:23.229 It sounds like it's so obvious. 40:23.230 --> 40:25.760 But now, why didn't anybody say this before? 40:25.760 --> 40:27.890 Why didn't Fisher say this? 40:27.889 --> 40:29.169 Because remember what Fisher said. 40:29.170 --> 40:34.700 He said the price of every asset is the fundamental value 40:34.702 --> 40:36.682 of the cash flows. 40:36.679 --> 40:40.179 You take the future cash flows and you discount them by the 40:40.175 --> 40:42.825 interest rate, say, and that's what the price 40:42.827 --> 40:43.247 is. 40:43.250 --> 40:46.570 I'm saying, even if the interest rate doesn't change, 40:46.570 --> 40:49.470 you just change the amount of leverage so these natural buyers 40:49.472 --> 40:51.862 at the top, fewer of them are going to be 40:51.855 --> 40:55.275 able to buy all the assets, then that's going to make the 40:55.275 --> 40:56.095 price higher. 40:56.099 --> 40:58.869 So the price is not going to be equal to the fundamental value. 40:58.869 --> 41:01.089 In fact, there isn't a fundamental value. 41:01.090 --> 41:03.420 It all depends on the different opinions of the different 41:03.423 --> 41:03.803 people. 41:03.800 --> 41:05.890 So what are the reasons they differ? 41:05.889 --> 41:09.809 Why should there be people who disagree about what the value 41:09.806 --> 41:10.136 is? 41:10.139 --> 41:13.229 I think that there are basically four reasons, 41:13.231 --> 41:14.471 or five reasons. 41:14.469 --> 41:17.499 Four of them, anyway, are one, 41:17.501 --> 41:21.371 these people, let's say, are more risk 41:21.371 --> 41:25.451 tolerant than the people down here. 41:25.449 --> 41:28.209 So the people down here are so scared to hold these assets 41:28.210 --> 41:30.050 because they might pay low numbers, 41:30.050 --> 41:33.650 low payoffs in some states and high payoffs in other states. 41:33.650 --> 41:38.030 So that assumes that they can't insure themselves against 41:38.032 --> 41:39.052 everything. 41:39.050 --> 41:42.100 So that's another crucial ingredient to my theory which 41:42.099 --> 41:44.209 I'm not going, you know, in the background 41:44.211 --> 41:46.561 here is the idea there's not insurance for everything. 41:46.559 --> 41:51.959 So the asset here is going to be regarded as risky if it pays 41:51.960 --> 41:54.930 less in some states than other. 41:54.929 --> 41:57.249 So because some people are less risk averse, they're more risk 41:57.253 --> 41:59.393 tolerant, they're going to be willing to pay more for the 41:59.387 --> 41:59.767 asset. 41:59.769 --> 42:00.809 That's one reason. 42:00.809 --> 42:03.529 Another reason is these people might just be more optimistic 42:03.527 --> 42:04.447 than these people. 42:04.449 --> 42:08.379 So far we've assumed that everybody believed in the same 42:08.376 --> 42:09.516 probabilities. 42:09.518 --> 42:12.728 What if these guys' probability of the up state is always higher 42:12.733 --> 42:15.133 than these guys' probability of the up state? 42:15.130 --> 42:17.160 Then they're going to be willing to pay more than these 42:17.164 --> 42:17.584 guys are. 42:17.579 --> 42:21.259 Another reason might be these people simply like the asset. 42:21.260 --> 42:22.570 They like living in the house. 42:22.570 --> 42:24.350 These people are the New York bankers. 42:24.349 --> 42:25.219 They're just lending money. 42:25.219 --> 42:27.119 They couldn't care less about living in the house. 42:27.119 --> 42:29.059 The house to them is just a source of income. 42:29.059 --> 42:30.939 For these people, they really want to live in the 42:30.936 --> 42:31.246 house. 42:31.250 --> 42:35.090 So another thing could be some people just have more expertise. 42:35.090 --> 42:39.700 They know how to read all these statements of loans. 42:39.699 --> 42:41.919 They can analyze the loan level data, 42:41.920 --> 42:43.580 and these people don't have the time, 42:43.579 --> 42:46.829 or it gives them a headache, or they don't know how to find 42:46.833 --> 42:48.913 the loan level data to go through, 42:48.909 --> 42:50.999 house by house, who the homeowners are and how 42:50.996 --> 42:53.156 reliable they are, so naturally they're going to 42:53.157 --> 42:55.447 be scared of buying because they're going to figure these 42:55.449 --> 42:56.719 guys know more than they do. 42:56.719 --> 42:59.769 So these are all different reasons why some people would be 42:59.766 --> 43:01.866 willing to pay more than other people. 43:01.869 --> 43:04.079 And so therefore, and as I say, 43:04.079 --> 43:08.129 in the standard theory the asset price is supposed to be 43:08.132 --> 43:10.052 the fundamental value. 43:10.050 --> 43:13.050 We don't talk very much about the heterogeneity of the people 43:13.050 --> 43:15.700 and how that makes the definition of fundamental value 43:15.699 --> 43:16.749 hard to maintain. 43:16.750 --> 43:19.840 So in my theory, in short, in equilibrium in 43:19.844 --> 43:23.734 normal times or good times there's going to be too much 43:23.731 --> 43:27.331 leverage and therefore too high asset prices, 43:27.329 --> 43:30.179 and in bad times there's going to be too little leverage and 43:30.184 --> 43:33.334 therefore too low asset prices, and this recurs over and over 43:33.327 --> 43:34.847 again, and it's what I call the 43:34.846 --> 43:36.666 Leverage Cycle, what I called the Leverage 43:36.670 --> 43:36.950 Cycle. 43:36.949 --> 43:39.889 Now, let me give you an example of what people really had to pay 43:39.891 --> 43:40.781 for these things. 43:40.780 --> 43:47.050 So for a bank buying a triple-A security there's regulation 43:47.048 --> 43:53.208 which forces them to put a certain amount of cash down. 43:53.210 --> 43:56.390 So they have their depositors' money, so they can buy things 43:56.391 --> 43:59.141 with depositors' money, but they have to put some of 43:59.143 --> 44:00.603 their own capital down. 44:00.599 --> 44:02.849 So how much do they have to put down? 44:02.849 --> 44:05.799 1.6 percent, so they could leverage 60 to 1, 44:05.798 --> 44:09.088 a 100 dollar asset, they only paid 1.6 dollars in 44:09.092 --> 44:09.712 cash. 44:09.710 --> 44:13.030 If you look at all the so called toxic mortgage securities 44:13.034 --> 44:15.664 of which there were 2 and 1 half trillion, 44:15.659 --> 44:19.319 these are the things that crushed all the banks that they 44:19.317 --> 44:21.347 held, I went through security by 44:21.351 --> 44:24.841 security and made a guess as to how much cash was put down by 44:24.844 --> 44:27.934 the buyer of each of those securities and on average I 44:27.927 --> 44:30.047 got-- so this is not absolutely 44:30.050 --> 44:32.130 accurate, there are a lot of guesses, 44:32.126 --> 44:33.936 but I got 16 to 1 as the leverage. 44:33.940 --> 44:37.600 So that meant that, if that number's right, 44:37.596 --> 44:41.506 it means 150 billion dollars of cash was paid, 44:41.512 --> 44:44.562 and 2.35 trillion was borrowed. 44:44.559 --> 44:47.009 That's 16 to 1 leverage. 44:47.010 --> 44:49.940 So that means that, you know, think about it, 44:49.940 --> 44:53.610 Bill Gates and Warren Buffett, two people by themselves, 44:53.605 --> 44:56.465 in 2006 had almost 150 billion dollars. 44:56.469 --> 44:59.379 So that means two guys in the whole economy could have bought 44:59.382 --> 45:02.252 every single toxic mortgage security because they could have 45:02.248 --> 45:04.868 borrowed the rest of the money they needed to buy. 45:04.869 --> 45:07.889 So when you think of where this line is what I'm saying is that 45:07.893 --> 45:11.653 for all the mortgage securities, all the toxic mortgage 45:11.646 --> 45:15.646 securities, sub-prime, all those supposedly dangerous 45:15.646 --> 45:19.296 securities you could have had the marginal buyer way up here. 45:19.300 --> 45:20.740 That's all that was required. 45:20.739 --> 45:22.589 Those are the only number of people, 45:22.590 --> 45:25.580 this top little echelon of people bought all those 45:25.576 --> 45:27.746 securities, could have bought all those 45:27.751 --> 45:30.301 securities because they had enough money to do it, 45:30.300 --> 45:32.590 and they hardly had to put anything down. 45:32.590 --> 45:36.020 All right, the same was true with housing. 45:36.018 --> 45:38.908 Now, let's look at this theory a little bit. 45:38.909 --> 45:41.989 So I should have--sorry, I could have put this in a 45:41.985 --> 45:42.905 better thing. 45:42.909 --> 45:47.639 So I give all these talks with Shiller for alumni during the 45:47.637 --> 45:48.357 crisis. 45:48.360 --> 45:50.660 We haven't given one in a while, but there was, 45:50.659 --> 45:51.909 you know, lots of them. 45:51.909 --> 45:54.569 Like every month or two months we'd be giving one of these 45:54.572 --> 45:57.052 talks and they'd bring in all these donors to say, 45:57.050 --> 46:01.240 "Yale needs your money now," and they'd say, 46:01.239 --> 46:03.519 "We don't have any money. 46:03.519 --> 46:05.439 So anyhow, I'm just joking. 46:05.440 --> 46:08.070 So we'd have a lot of these talks and Shiller would always 46:08.067 --> 46:09.217 put up the green graph. 46:09.219 --> 46:11.449 So on the right hand side, I showed you this before, 46:11.445 --> 46:12.575 it's his famous diagram. 46:12.579 --> 46:15.929 He did a brilliant thing. 46:15.929 --> 46:19.469 He decided to collect data on every transaction. 46:19.469 --> 46:22.459 Every time someone purchased a house he'd keep track of it, 46:22.460 --> 46:24.050 because it's all public information, 46:24.050 --> 46:27.160 and then he'd compare it to the same house that was sold before, 46:27.159 --> 46:30.179 and do a few other tricks that I don't have time to explain, 46:30.179 --> 46:34.849 to make an index of the housing prices in the whole country. 46:34.849 --> 46:38.879 And so he'd done this going back many years, 46:38.880 --> 46:41.960 but starting in 2000 the thing that he called attention to 46:41.958 --> 46:44.168 before anybody, he said, "Look at this. 46:44.168 --> 46:45.008 Look at this line. 46:45.010 --> 46:49.760 The housing price index from 2000 to 2006 it's gone up by 46:49.759 --> 46:52.049 almost 100 percent." 46:52.050 --> 46:56.450 The housing index was 100 in 2000 when it started, 46:56.452 --> 46:58.252 that's 110, sorry. 46:58.250 --> 46:59.010 This is 100. 46:59.010 --> 47:04.180 It was 100 when it started here in 2000 and it goes up to 190 in 47:04.175 --> 47:04.745 2006. 47:04.750 --> 47:10.480 That's 90 percent in 6 years. 47:10.480 --> 47:15.510 To almost double in six years that means it's gone up 12 47:15.507 --> 47:18.247 percent a year or something. 47:18.250 --> 47:21.450 So a staggering increase in the price of housing, 47:21.454 --> 47:23.664 and then it started to go down. 47:23.659 --> 47:26.519 So he called attention to this already as it was coming up. 47:26.518 --> 47:29.008 So in 2004 and 2005 he was saying, "My gosh, 47:29.012 --> 47:30.002 there's a bubble. 47:30.000 --> 47:31.800 It's going crazy," and he'd say, 47:31.800 --> 47:33.100 "Everybody is nuts. 47:33.099 --> 47:35.829 Americans, there's irrational exuberance and people are so 47:35.826 --> 47:38.596 crazy that they just think things are always going to go up 47:38.599 --> 47:41.709 and the price is going up higher and higher and higher." 47:41.710 --> 47:44.440 And then when it got so high the narrative changed. 47:44.440 --> 47:46.720 People started getting worried and they started telling 47:46.719 --> 47:49.589 everyone the world was coming to an end and the prices went down, 47:49.590 --> 47:52.150 and down, and down because we have irrational exuberance. 47:52.150 --> 47:53.850 And things are picking up a little bit, 47:53.849 --> 47:55.409 but we don't know whether people are irrationally 47:55.414 --> 47:56.484 exuberant, or pessimistic, 47:56.480 --> 48:00.020 or they're blipping, but anyway, they're irrational. 48:00.018 --> 48:03.428 So that's a story that has a certain compelling nature to it 48:03.427 --> 48:07.007 and he deserves a lot of credit for calling attention to it. 48:07.010 --> 48:10.710 But in my story I say these prices are related to leverage. 48:10.710 --> 48:15.200 So I went through every loan, loan by loan, 48:15.204 --> 48:18.634 that wasn't a government loan. 48:18.630 --> 48:19.820 So these are private loans. 48:19.820 --> 48:21.680 You can't get the data on government loans. 48:21.679 --> 48:26.089 So on private loans you know every time someone took out a 48:26.094 --> 48:30.204 mortgage they were selling the loan, so therefore they 48:30.197 --> 48:31.977 published the data. 48:31.980 --> 48:35.800 You know what the appraised value of the house was or the 48:35.797 --> 48:39.337 sale price if they were buying it for the first time, 48:39.342 --> 48:42.072 and you know what all the loans are. 48:42.070 --> 48:46.370 So I added up the value of all the loans and I divided it by 48:46.373 --> 48:49.753 the price of the house, and I subtracted it off to get 48:49.753 --> 48:52.323 what the down payment was, the cash down payment, 48:52.318 --> 48:54.838 so this is 2 percent down, 4 percent down, 48:54.840 --> 48:57.630 6 percent down, or if you take 100 percent 48:57.628 --> 49:00.418 minus this, this is the loan to value, 49:00.418 --> 49:02.048 so this is 100 percent. 49:02.050 --> 49:03.290 You've borrowed everything. 49:03.289 --> 49:07.309 Here you borrowed 98 percent of the value, 96 percent of the 49:07.309 --> 49:10.239 house, 94 percent of the house, etcetera. 49:10.239 --> 49:15.049 So in 2000 these are slightly riskier people. 49:15.050 --> 49:19.910 Amazingly they're putting down 14 percent, not amazingly. 49:19.909 --> 49:22.969 They're putting down 14 percent so it's 7 to 1 leverage. 49:22.969 --> 49:24.359 But then look what happened. 49:24.360 --> 49:26.970 The leverage went up, and up, and up, 49:26.965 --> 49:29.785 and up, and up, and up, and then it was, 49:29.789 --> 49:32.539 in 2006, less than 3 percent down. 49:32.539 --> 49:34.719 These people were 30 to 1 leveraged. 49:34.719 --> 49:37.439 I said the securities market was 16 to 1 leveraged, 49:37.440 --> 49:39.510 the triple-A part 60 to 1 leveraged. 49:39.510 --> 49:43.570 Here they're 30 to 1 leveraged and so the prices went up. 49:43.570 --> 49:46.030 But yes the prices went up because the leverage went up. 49:46.030 --> 49:48.530 You hardly had to put any money down. 49:48.530 --> 49:51.720 That's why people were willing to buy such expensive houses 49:51.722 --> 49:55.082 because they weren't actually putting that much money down. 49:55.079 --> 49:57.829 And then leverage collapsed like this and you had to put 49:57.829 --> 50:01.559 more and more money down, and then the whole market, 50:01.561 --> 50:03.741 you know, you can't get a loan basically 50:03.742 --> 50:05.692 anymore unless you're getting a government loan. 50:05.690 --> 50:09.120 And so leverage collapsed and the housing prices went down. 50:09.119 --> 50:12.409 Leverage was collapsing faster and in front of housing prices. 50:12.409 --> 50:15.169 So I think it's the leverage which is a crucial determinant 50:15.168 --> 50:17.238 of the price, and not irrational exuberance, 50:17.237 --> 50:19.417 although I think there is irrational exuberance, 50:19.420 --> 50:23.040 but I think leverage is what's underneath it and more basic. 50:23.039 --> 50:25.279 Now, let's do the same thing with prices. 50:25.280 --> 50:28.900 So we did the sub-prime index before. 50:28.900 --> 50:31.390 This red line is the prime index. 50:31.389 --> 50:34.609 So we're talking about not sub-prime homeowners, 50:34.614 --> 50:38.044 but prime, people with brilliant credit ratings and 50:38.043 --> 50:38.733 stuff. 50:38.730 --> 50:41.810 So even now years, three years after the crisis 50:41.806 --> 50:44.526 has started, the losses on these pools are 50:44.525 --> 50:47.515 still in the single digits, 5 percent, 6 percent, 50:47.521 --> 50:49.781 things like that and most of these, 50:49.780 --> 50:52.530 8 percent maybe, and most of these, 50:52.530 --> 50:56.090 these are the trip--the top piece of a pool of prime 50:56.090 --> 50:56.930 borrowers. 50:56.929 --> 51:02.289 So most of these loans are, they're protected by 8 percent 51:02.289 --> 51:04.359 of the bottom piece. 51:04.360 --> 51:07.070 So you have to go through 8 percent losses before you touch 51:07.065 --> 51:07.715 them at all. 51:07.719 --> 51:12.449 So it's just inconceivable that you'd see 40 percent losses, 51:12.447 --> 51:14.287 but so what happened? 51:14.289 --> 51:16.609 These bonds were at 100. 51:16.610 --> 51:18.510 This is 100 over here. 51:18.510 --> 51:20.470 The price is 100. 51:20.469 --> 51:21.599 They're at 100. 51:21.599 --> 51:23.919 Now, the interest rate is changing and the prices are 51:23.922 --> 51:26.432 going up and down because they're supposed to be floaters 51:26.425 --> 51:29.325 which always pay more or less depending on the interest rate. 51:29.329 --> 51:32.429 So they should be locked in at 100, but they're not floating 51:32.431 --> 51:35.171 exactly on the same time, you know, they don't change 51:35.166 --> 51:36.426 their float so fast. 51:36.429 --> 51:38.919 So the price is going up and down because of that, 51:38.916 --> 51:41.856 but it's clear that nobody thinks there are going to be any 51:41.860 --> 51:42.420 losses. 51:42.420 --> 51:46.950 And then all of a sudden in 2007, but later, 51:46.949 --> 51:50.069 this is much later than the sub-prime market collapse, 51:50.070 --> 51:54.070 these prices collapse, and they collapse all the way 51:54.065 --> 51:55.835 to 60, shocking. 51:55.840 --> 51:58.280 It's just inconceivable, I think, that people could have 51:58.282 --> 52:00.552 thought there are going to be 40 percent losses, 52:00.550 --> 52:03.640 or that everybody could have thought there are going to be 40 52:03.641 --> 52:06.341 percent losses, and then they've shot back up 52:06.342 --> 52:06.772 to 80. 52:06.769 --> 52:07.949 So there's been a huge gain. 52:07.949 --> 52:11.999 So if you look at a typical hedge fund like Ellington you'll 52:12.001 --> 52:15.921 see that we lost a lot of money, and now we've made a huge 52:15.916 --> 52:17.286 amount of money. 52:17.289 --> 52:20.829 So that was not such brilliant hedging, but anyway. 52:20.829 --> 52:23.749 So, but now why did these prices collapse and go back up? 52:23.750 --> 52:26.450 Is it that people just got totally irrationally pessimistic 52:26.447 --> 52:28.507 and then they said, "Oh, things can't really 52:28.507 --> 52:30.007 be that bad," and things got better? 52:30.010 --> 52:33.460 Well, let's look at the leverage, what is the down 52:33.458 --> 52:37.608 payment, the same thing as before on triple-A securities. 52:37.610 --> 52:41.060 Now amazingly the Fed has never kept these numbers, 52:41.063 --> 52:44.243 and they're still not keeping these numbers. 52:44.239 --> 52:48.459 So I testified in front of Ben Bernanke and the Board of 52:48.460 --> 52:50.610 Governors on October 2008. 52:50.610 --> 52:54.170 There were several of us, but it was for four and a half 52:54.170 --> 52:54.690 hours. 52:54.690 --> 52:58.330 And I showed them this graph. 52:58.329 --> 53:02.479 So this graph is at my hedge fund, Ellington--it's just a 53:02.483 --> 53:06.123 bunch of securities that we're used to trading. 53:06.119 --> 53:08.589 It's how much they were offering to lend us, 53:08.594 --> 53:12.054 what the down payment was they were insisting if we wanted to 53:12.050 --> 53:13.950 leverage as much as we could. 53:13.949 --> 53:16.639 So we didn't leverage anything like that, but this is what they 53:16.635 --> 53:19.405 were offering us on the kinds of securities that we're interested 53:19.405 --> 53:19.705 in. 53:19.710 --> 53:22.220 So this is not the greatest data because we're only looking 53:22.219 --> 53:24.689 at what we're interested in, and we're only looking at the 53:24.686 --> 53:25.636 offers made to us. 53:25.639 --> 53:27.319 So, but looked what happened. 53:27.320 --> 53:29.820 In '98 when there was a leverage crisis, 53:29.822 --> 53:32.972 that was the last one, I must have skipped a slide 53:32.965 --> 53:36.425 where I said the last leverage cycle ended in '98. 53:36.429 --> 53:37.749 It was 10 percent down. 53:37.750 --> 53:41.090 That means 10 to 1 leverage, and then suddenly it went to 40 53:41.090 --> 53:41.940 percent down. 53:41.940 --> 53:43.690 So leverage drastically dropped. 53:43.690 --> 53:47.010 The down payment, the margin, radically increased 53:47.007 --> 53:50.947 for a few months during the crisis then it went back to 10 53:50.949 --> 53:51.779 percent. 53:51.780 --> 53:53.480 Then we had 10 percent down for a long time. 53:53.480 --> 53:54.510 That's 10 to 1 leverage. 53:54.510 --> 53:58.830 And then for a couple of years it became 5 to 1 leverage, 53:58.829 --> 54:02.529 so 20 to 1,5 to 1, sorry, 5 percent down means 20 54:02.530 --> 54:03.920 to 1 leverage. 54:03.920 --> 54:08.330 So the leverage had drastically increased, 54:08.329 --> 54:12.509 and then leverage suddenly started collapsing and lenders 54:12.509 --> 54:15.569 asked for more and more down payments, 54:15.570 --> 54:16.810 more and more down payments. 54:16.809 --> 54:19.819 And leverage was just collapsing, and it happened 54:19.815 --> 54:22.695 ahead of the prices, and then leverage actually 54:22.697 --> 54:25.137 picked up here and went down again. 54:25.139 --> 54:28.429 Then--this graph is quite old now, May. 54:28.429 --> 54:29.989 I should have updated it. 54:29.989 --> 54:33.059 Leverage has gone way up again and the prices have gone way up. 54:33.059 --> 54:35.539 So you see, leverage goes down the prices go down. 54:35.539 --> 54:37.959 Leverage goes up the prices go up, and leverage is still 54:37.961 --> 54:39.901 heading up and the prices are much higher. 54:39.900 --> 54:41.870 So that's my view. 54:41.869 --> 54:45.249 It's leverage that's determining a lot of these 54:45.248 --> 54:45.908 things. 54:45.909 --> 54:48.199 All right, and so as I said, there's recurring leverage 54:48.197 --> 54:48.577 cycles. 54:48.579 --> 54:51.699 In 1998 there was a leverage cycle. 54:51.699 --> 54:53.779 That's when Long-Term Capital--so there was a book on 54:53.775 --> 54:55.925 the collapse of Long-Term Capital that Lowenstein wrote 54:55.931 --> 54:57.171 that's on the reading list. 54:57.170 --> 54:58.870 Before that was Orange County. 54:58.869 --> 55:03.949 You remember my firm Kidder Peabody went out of business in 55:03.945 --> 55:05.955 1994, the end of '94. 55:05.960 --> 55:09.990 The beginning of '94, Orange County got bankrupted 55:09.985 --> 55:14.665 partly thanks to buying securities from Kidder Peabody. 55:14.670 --> 55:17.160 Some of you may live in Orange County. 55:17.159 --> 55:18.959 In any case that was the derivatives crisis, 55:18.960 --> 55:21.420 and in 1987 there was a stock market crash, 55:21.420 --> 55:24.820 so anyway, it's hard to document all the historical 55:24.815 --> 55:28.885 leverage cycles because the Fed has never kept this data, 55:28.889 --> 55:31.539 and most other firms don't keep their historical data. 55:31.539 --> 55:34.879 We at Ellington realized after '98 that this was a huge 55:34.884 --> 55:37.364 problem, leverage, and so we kept all the 55:37.360 --> 55:38.600 historical data. 55:38.599 --> 55:41.329 That's when I wrote my first paper on leverage and collateral 55:41.333 --> 55:43.433 and that being a crucial ingredient of the-- 55:43.429 --> 55:45.649 so we have this data and practically nobody else has. 55:45.650 --> 55:47.680 So for me the most important thing, 55:47.679 --> 55:51.959 the first step the Fed should do is keep track of the leverage 55:51.956 --> 55:55.116 that is being allowed for, the margins that are being 55:55.123 --> 55:58.123 demanded on every security, housing and securities. 55:58.119 --> 56:00.829 And I heard this talk, I told you, 56:00.829 --> 56:05.789 last night on the collapse of the electric grid in 2003, 56:05.789 --> 56:10.009 and so I said, "What have you done?" 56:10.010 --> 56:12.050 Obviously the obvious question everyone wanted to know. 56:12.050 --> 56:13.670 So, "What have you done to make it safer?" 56:13.670 --> 56:17.010 And they said the one thing they did is now they've spent 56:17.010 --> 56:20.410 tens and tens of millions of dollars getting more data. 56:20.409 --> 56:24.289 So they now monitor every single power line in real time. 56:24.289 --> 56:27.029 They had farmed that out to other people before and they 56:27.032 --> 56:28.632 weren't very careful about it. 56:28.630 --> 56:31.120 Now they're incredibly careful about monitoring every single 56:31.123 --> 56:31.423 line. 56:31.420 --> 56:34.640 So as soon as one line goes down they switch the electricity 56:34.641 --> 56:37.701 and they move it evenly across a bunch of other lines. 56:37.699 --> 56:40.749 In the old days when a power line went down the grid 56:40.751 --> 56:43.101 automatically-- sort of, electricity went, 56:43.101 --> 56:45.871 the power went to the next closest place and that would 56:45.869 --> 56:49.199 overload the next closest one and maybe make that one go down. 56:49.199 --> 56:54.949 Now if they know it's gone down they choose how to re-divide it. 56:54.949 --> 56:57.259 But the point is, you can't do all that without 56:57.257 --> 56:59.447 information, and they're spending tens of 56:59.454 --> 57:02.604 millions of dollars monitoring everything and we still are not 57:02.599 --> 57:04.199 monitoring what leverage is. 57:04.199 --> 57:07.179 I think it's a shocking thing. 57:07.179 --> 57:10.269 We should be monitoring leverage and then we should be 57:10.268 --> 57:12.588 regulating it, and instead we haven't even 57:12.592 --> 57:15.042 begun to monitor it, much less to figure out how to 57:15.039 --> 57:15.629 regulate it. 57:15.630 --> 57:18.480 Now, why was the leverage cycle--I said, 57:18.476 --> 57:20.956 this recurs over and over again. 57:20.960 --> 57:25.560 So why was the leverage cycle so bad this time than it was 57:25.563 --> 57:26.293 before? 57:26.289 --> 57:27.999 So this is my short version. 57:28.000 --> 57:31.070 I have a long version of this. 57:31.070 --> 57:34.640 The short version is because leverage got higher than it ever 57:34.637 --> 57:36.587 did before, and there are lots of reasons 57:36.585 --> 57:38.465 why leverage got higher than it ever did before. 57:38.469 --> 57:41.779 We had this period of low volatility for a long time, 57:41.784 --> 57:43.254 so it made it higher. 57:43.250 --> 57:47.750 We then had securitization which we didn't have before. 57:47.750 --> 57:52.800 So a sub-prime borrower would have had to put down a huge down 57:52.802 --> 57:56.312 payment in the old days, because people would have 57:56.309 --> 57:58.139 regarded it as such a risky thing, 57:58.139 --> 58:01.769 but once we packaged all the sub-prime loans together in a 58:01.766 --> 58:05.836 big security and the triple-A guy got the best of the houses, 58:05.840 --> 58:08.570 not each house, not a share of every house, 58:08.570 --> 58:10.570 but only a share of the very best houses, 58:10.570 --> 58:14.270 it all of a sudden became a much safer loan and so you could 58:14.273 --> 58:16.663 borrow a lot more money against it, 58:16.659 --> 58:18.739 against that triple-A loan. 58:18.739 --> 58:21.969 So the triple-A piece, using that as collateral, 58:21.969 --> 58:25.509 you could borrow a lot of money, a big percentage of the 58:25.514 --> 58:28.614 price of the triple-A thing you could borrow, 58:28.610 --> 58:30.990 whereas if you had a single sub-prime loan people would 58:30.985 --> 58:33.575 never lend more than 50 percent of the value of the house or 58:33.583 --> 58:34.203 something. 58:34.199 --> 58:38.109 The second reason why things were so bad was because we had a 58:38.114 --> 58:39.684 double leverage cycle. 58:39.679 --> 58:42.169 We had leverage shooting through the roof not just in 58:42.172 --> 58:43.612 securities as it had before. 58:43.610 --> 58:46.980 As I showed you in '98 where it was at 10 percent down, 58:46.980 --> 58:49.270 and then there was a collapse to 40 percent down, 58:49.268 --> 58:52.488 and then back to 10 percent down, that was a big change, 58:52.489 --> 58:54.939 in the crisis stage, leverage collapse, 58:54.940 --> 58:57.800 but here we had it in housing as well where there was a 58:57.800 --> 58:59.230 feedback between the two. 58:59.230 --> 59:02.400 So why is it that all these people stopped being able to 59:02.400 --> 59:05.740 refinance their loans in 2007, which contributed so much to 59:05.744 --> 59:06.614 the losses? 59:06.610 --> 59:13.780 It's not because the interest rates were suddenly too high for 59:13.777 --> 59:14.597 them. 59:14.599 --> 59:15.549 Those didn't change at all. 59:15.550 --> 59:18.610 It's that the lenders suddenly demanded a much bigger down 59:18.612 --> 59:19.152 payment. 59:19.150 --> 59:22.000 Instead of 3 percent down they had to put 25 percent down and 59:22.003 --> 59:24.673 they couldn't afford to do it, so they couldn't refinance 59:24.666 --> 59:25.376 their loan. 59:25.380 --> 59:28.160 They didn't have the cash, so they were stuck with the old 59:28.157 --> 59:31.127 loan, and so the original lender was in much more jeopardy. 59:31.130 --> 59:34.420 And then the last thing is the CDS market. 59:34.420 --> 59:35.530 So I have to explain this. 59:35.530 --> 59:37.870 That's why it's going to spill over into next time. 59:37.869 --> 59:40.479 So these insurance things, there are many ways of 59:40.476 --> 59:43.786 interpreting what they did and why they were so dangerous, 59:43.789 --> 59:48.119 but one of them is that they allowed people to write 59:48.115 --> 59:51.675 insurance to lose huge amounts of money. 59:51.679 --> 59:52.879 So that's an obvious thing. 59:52.880 --> 59:55.210 That's why the losses were so big, but more interesting than 59:55.213 --> 59:57.983 that, they allowed the pessimists to 59:57.981 --> 1:00:02.231 leverage themselves, because in our old story from 1:00:02.228 --> 1:00:07.318 way back here, in this old story--where was 1:00:07.315 --> 1:00:10.645 the old story with that? 1:00:10.650 --> 1:00:13.040 In this story, remember, I said that the 1:00:13.041 --> 1:00:15.621 natural buyers, you'd have fewer of them if 1:00:15.619 --> 1:00:17.459 they could leverage a lot. 1:00:17.460 --> 1:00:19.750 So what were these guys down here doing? 1:00:19.750 --> 1:00:24.180 Well, they couldn't do anything except sell the assets and maybe 1:00:24.175 --> 1:00:25.365 make the loans. 1:00:25.369 --> 1:00:27.329 As the price got higher and higher these guys down here, 1:00:27.329 --> 1:00:29.579 presumably, were getting more and more disgusted and thinking, 1:00:29.579 --> 1:00:30.629 "Well, this market's ridiculous, 1:00:30.630 --> 1:00:32.270 and the price is way too high. 1:00:32.269 --> 1:00:33.859 We don't want to buy here." 1:00:33.860 --> 1:00:36.650 And I've talked to a lot of insurance companies like 1:00:36.646 --> 1:00:39.376 Northwestern Mutual Life, the guy who runs that. 1:00:39.380 --> 1:00:43.750 He said, "We used to be a big buyer of mortgage securities 1:00:43.748 --> 1:00:46.918 and sub-prime mortgages and stuff in 2004, 1:00:46.920 --> 1:00:49.610 and the price got so high in 2006 to us it became ridiculous 1:00:49.608 --> 1:00:51.658 so we just dropped out of the market." 1:00:51.659 --> 1:00:53.869 But dropping out of the market is one thing. 1:00:53.869 --> 1:00:56.159 What if they could bet against the market? 1:00:56.159 --> 1:00:58.429 Well, they had no opportunity to do that before. 1:00:58.429 --> 1:01:00.559 They couldn't express their negative view, 1:01:00.559 --> 1:01:09.859 but starting in 2005 where this CDS market really took off, 1:01:09.860 --> 1:01:12.620 they could suddenly express their negative view. 1:01:12.619 --> 1:01:17.099 So in my view and in my opinion what happened was that at end of 1:01:17.103 --> 1:01:21.163 2005 the pessimists for the first time were able to bet on 1:01:21.159 --> 1:01:23.009 the market going down. 1:01:23.010 --> 1:01:25.960 And so that's what started to make prices go down, 1:01:25.961 --> 1:01:27.651 because of the CDS market. 1:01:27.650 --> 1:01:31.520 When prices started to go down the mortgage securities that had 1:01:31.518 --> 1:01:35.328 been sold with all that leverage for high prices started to go 1:01:35.326 --> 1:01:36.446 down in price. 1:01:36.449 --> 1:01:39.699 That meant that new securitizations weren't worth 1:01:39.701 --> 1:01:40.041 it. 1:01:40.039 --> 1:01:42.119 You couldn't make the profit that we were talking about 1:01:42.123 --> 1:01:44.403 before, putting all of these things together and selling off 1:01:44.398 --> 1:01:44.938 the bonds. 1:01:44.940 --> 1:01:46.670 The bonds are being sold for a lower price. 1:01:46.670 --> 1:01:51.160 You couldn't lend all that money to these people. 1:01:51.159 --> 1:01:53.599 You were getting the money to lend to the people by selling 1:01:53.603 --> 1:01:54.113 the bonds. 1:01:54.110 --> 1:01:56.560 If you sell the bonds at a lower price you don't have the 1:01:56.563 --> 1:01:57.883 money to lend to the people. 1:01:57.880 --> 1:02:03.900 So in order to make the bonds sell for a higher price they 1:02:03.900 --> 1:02:09.710 demanded that the homeowners put up more collateral, 1:02:09.710 --> 1:02:12.340 and then that meant the homeowners couldn't refinance, 1:02:12.340 --> 1:02:14.720 and then that started to make the world more dangerous, 1:02:14.719 --> 1:02:16.949 and that's why, then, on securities, 1:02:16.949 --> 1:02:19.819 the lenders on securities reduced the leverage and then 1:02:19.824 --> 1:02:21.744 the whole thing started to spiral. 1:02:21.739 --> 1:02:24.819 That's my story of how the things started. 1:02:24.820 --> 1:02:26.780 So let's say that. 1:02:26.780 --> 1:02:30.760 In the bottom of the leverage cycle the same bad three things 1:02:30.757 --> 1:02:31.817 always happen. 1:02:31.820 --> 1:02:35.150 Number one there's scary bad news that creates more 1:02:35.150 --> 1:02:37.550 uncertainty and more disagreement. 1:02:37.550 --> 1:02:41.320 So it wasn't just that people thought that losses were going 1:02:41.320 --> 1:02:45.220 to go from 40 percent to 20 percent on sub-prime mortgages. 1:02:45.219 --> 1:02:48.229 It's that they went from 4 percent expected, 1:02:48.230 --> 1:02:51.380 with a range of 1 to 5 percent, to 30 percent, 1:02:51.380 --> 1:02:54.670 but maybe they'd be 80 percent, the losses. 1:02:54.670 --> 1:02:56.930 There was a huge volatility--nobody really knew 1:02:56.929 --> 1:02:58.699 what the hell was going to happen. 1:02:58.699 --> 1:03:00.589 They had to extrapolate those curves. 1:03:00.590 --> 1:03:01.950 How do you know how to extrapolate? 1:03:01.949 --> 1:03:04.809 For a decade the curves had been flat. 1:03:04.809 --> 1:03:06.409 Suddenly they're starting to accelerate. 1:03:06.409 --> 1:03:08.209 How do you know how to extrapolate them? 1:03:08.210 --> 1:03:10.710 There's huge uncertainty, huge volatility, 1:03:10.708 --> 1:03:13.938 and so naturally the lenders are going to be much more 1:03:13.940 --> 1:03:17.110 nervous and lend only with much more collateral. 1:03:17.110 --> 1:03:20.450 Once the lenders lend with much more collateral those people at 1:03:20.452 --> 1:03:22.882 the top can't afford to buy things anymore. 1:03:22.880 --> 1:03:25.780 They're going to have to sell. 1:03:25.780 --> 1:03:26.980 So there's de-leveraging. 1:03:26.980 --> 1:03:29.470 Sorry, and the people at the top are going to have to sell, 1:03:29.469 --> 1:03:33.109 but the price is going to go down, and because they borrowed 1:03:33.114 --> 1:03:35.714 money and using an asset as collateral, 1:03:35.710 --> 1:03:37.070 their leverage--we talked about that-- 1:03:37.070 --> 1:03:39.190 their losses are going to be gigantic because they're 1:03:39.190 --> 1:03:40.080 betting, essentially, 1:03:40.079 --> 1:03:41.799 on things going up, and things are going down so 1:03:41.800 --> 1:03:43.120 they lost a huge amount of money. 1:03:43.119 --> 1:03:45.829 So this is always the same thing. 1:03:45.829 --> 1:03:46.979 There is scary bad news. 1:03:46.980 --> 1:03:49.340 Margins get tougher, and the most optimistic 1:03:49.338 --> 1:03:52.458 leveraged buyers are the ones who got crushed because they 1:03:52.463 --> 1:03:55.593 were betting on things going up and they go bankrupt. 1:03:55.590 --> 1:03:57.690 So now, what's so bad about this? 1:03:57.690 --> 1:04:03.130 I'm running out of time here, and I haven't gotten to how the 1:04:03.130 --> 1:04:05.490 math is going to change. 1:04:05.489 --> 1:04:06.409 So what's so bad? 1:04:06.409 --> 1:04:09.389 So I'm going to talk for four more minutes and hand back the 1:04:09.385 --> 1:04:12.205 exams, or should I just hand back the exams right now? 1:04:12.210 --> 1:04:14.820 What do you--are you? 1:04:14.820 --> 1:04:16.070 I'll talk four more minutes. 1:04:16.070 --> 1:04:18.620 Some of you aren't going to come next time, 1:04:18.621 --> 1:04:21.601 maybe most of you, so I'll do how the math changes 1:04:21.599 --> 1:04:22.449 next time. 1:04:22.449 --> 1:04:24.439 So what's so bad about the leverage cycle? 1:04:24.440 --> 1:04:27.540 So let's just think about all the bad things that happened. 1:04:27.539 --> 1:04:30.959 Number one, you can have a tiny group of people at the top 1:04:30.963 --> 1:04:34.153 controlling the price, because they can borrow so much 1:04:34.148 --> 1:04:34.748 money. 1:04:34.750 --> 1:04:36.870 Now we've always assumed that everybody was rational. 1:04:36.869 --> 1:04:38.829 What if these buyers are kind of crazy? 1:04:38.829 --> 1:04:43.049 A few guys can make the price skyrocket because they can 1:04:43.052 --> 1:04:44.822 borrow so much money. 1:04:44.820 --> 1:04:47.490 Now, once they do that and they're making the price of 1:04:47.492 --> 1:04:49.862 assets skyrocket, people are going to build more 1:04:49.860 --> 1:04:50.870 of those assets. 1:04:50.869 --> 1:04:53.899 So they're going to use real resources to build projects that 1:04:53.898 --> 1:04:57.128 are probably crazy and are going to be very costly to reverse. 1:04:57.130 --> 1:05:01.080 But let's leave aside now people being crazy. 1:05:01.079 --> 1:05:03.409 What else happens in the leverage cycle? 1:05:03.409 --> 1:05:07.189 Well, in the leverage cycle when you're leveraged a lot, 1:05:07.193 --> 1:05:11.393 as we said, that's going on the Tobin diagram to the right. 1:05:11.389 --> 1:05:14.499 It's like borrowing money to bet in the stocks. 1:05:14.500 --> 1:05:17.440 That means if the stocks go up you multiply your winnings. 1:05:17.440 --> 1:05:20.050 If the stocks go down you multiply your losses. 1:05:20.050 --> 1:05:22.980 So in the leverage cycle people who are lucky, 1:05:22.976 --> 1:05:26.356 if things keep going up, they get incredibly rich. 1:05:26.360 --> 1:05:28.040 It's a tremendous mystery in economics. 1:05:28.039 --> 1:05:32.119 Why is it that inequality increased so much? 1:05:32.119 --> 1:05:34.439 Well, one of the reasons, I think, is the leverage cycle, 1:05:34.440 --> 1:05:37.610 that people were betting and making more and more money and 1:05:37.610 --> 1:05:41.670 so that's why inequality was-- is helping to spread inequality. 1:05:41.670 --> 1:05:45.030 Now, another thing is the worst, probably the biggest 1:05:45.032 --> 1:05:49.042 problem is that once the asset prices fall everything gets hard 1:05:49.043 --> 1:05:49.693 to do. 1:05:49.690 --> 1:05:53.020 So if you want to get a new credit card, what does it mean 1:05:53.016 --> 1:05:54.356 to get a credit card? 1:05:54.360 --> 1:05:56.760 It means that you sell your promise, right, 1:05:56.764 --> 1:05:57.514 to a buyer. 1:05:57.510 --> 1:06:01.530 Now, why should a buyer buy your promise for 100, 1:06:01.530 --> 1:06:03.980 you're promising to pay back in the future, 1:06:03.980 --> 1:06:07.470 so he's paying 100 for you when the very same promise that 1:06:07.471 --> 1:06:10.901 someone made six months ago is selling for 65 because the 1:06:10.902 --> 1:06:12.742 prices have all collapsed. 1:06:12.739 --> 1:06:15.609 They're not going to buy the new promises when they can buy 1:06:15.610 --> 1:06:17.540 the old promises at such a low price. 1:06:17.539 --> 1:06:20.199 Who's going to buy a new mortgage when the old mortgages 1:06:20.202 --> 1:06:21.172 are selling at 65? 1:06:21.170 --> 1:06:24.410 Who's going to buy a new auto loan when the old auto loans are 1:06:24.414 --> 1:06:25.324 selling so low? 1:06:25.320 --> 1:06:27.050 So nobody can get a new loan. 1:06:27.050 --> 1:06:31.560 Nobody can sell a new promise, and no business can sell its 1:06:31.561 --> 1:06:32.341 promise. 1:06:32.340 --> 1:06:35.270 There are old businesses that everybody understands whose 1:06:35.266 --> 1:06:38.086 bonds are out there being traded at very low prices. 1:06:38.090 --> 1:06:41.110 The investors are going to all buy the old assets not the new 1:06:41.106 --> 1:06:41.556 assets. 1:06:41.559 --> 1:06:43.549 That's why activity collapses. 1:06:43.550 --> 1:06:46.420 Then another terrible thing is, what if the optimists are 1:06:46.418 --> 1:06:48.978 indispensable to the economy like the big banks? 1:06:48.980 --> 1:06:51.140 They go out of business and then everything topples. 1:06:51.139 --> 1:06:53.849 Well, why didn't the big banks take that into account? 1:06:53.849 --> 1:06:55.919 Shouldn't they have realized that the losses would be so big 1:06:55.918 --> 1:06:57.038 and try to protect themselves? 1:06:57.039 --> 1:06:59.949 Well, they're not taking into account that when they go under 1:06:59.945 --> 1:07:02.655 and the managers lose a lot of money that there are other 1:07:02.657 --> 1:07:05.467 people they don't care about like all their workers and the 1:07:05.465 --> 1:07:08.125 rest of the economy that's losing even more that they're 1:07:08.130 --> 1:07:09.680 not paying attention to. 1:07:09.679 --> 1:07:12.869 So they're not internalizing all the losses when they go out 1:07:12.871 --> 1:07:13.631 of business. 1:07:13.630 --> 1:07:17.640 Another incredibly bad thing is, what we're suffering from 1:07:17.641 --> 1:07:19.331 now is, debt overhang. 1:07:19.329 --> 1:07:23.659 There are a tremendous number of people, homeowners to name 1:07:23.661 --> 1:07:25.681 one, who are under water. 1:07:25.679 --> 1:07:29.189 That means they owe more money than their house is worth, 1:07:29.190 --> 1:07:33.220 or banks that have more debts than the value of the assets 1:07:33.219 --> 1:07:35.289 they hold, or firms that have more debt 1:07:35.288 --> 1:07:36.928 than the value of the assets they hold. 1:07:36.929 --> 1:07:39.049 Now, many of these people don't just go bankrupt. 1:07:39.050 --> 1:07:40.990 They keep going because maybe they'll get lucky. 1:07:40.989 --> 1:07:44.479 Maybe some miracle will happen and the stuff they own is going 1:07:44.483 --> 1:07:45.633 to go up in value. 1:07:45.630 --> 1:07:46.930 So they don't stop. 1:07:46.929 --> 1:07:49.639 They still exist, but they're what people have 1:07:49.643 --> 1:07:50.673 called zombies. 1:07:50.670 --> 1:07:53.520 They're not doing anything productive because what's the 1:07:53.523 --> 1:07:56.853 point in fixing up your house if more than likely you're going to 1:07:56.846 --> 1:07:58.296 end up losing it anyway. 1:07:58.300 --> 1:08:00.750 So all these homeowners are not doing anything to take care of 1:08:00.746 --> 1:08:03.226 their houses, the banks aren't making loans, 1:08:03.233 --> 1:08:06.613 these firms aren't making productive investments because 1:08:06.612 --> 1:08:09.072 they know they're so far under water. 1:08:09.070 --> 1:08:12.470 So another horrible thing happens is that if you try to 1:08:12.474 --> 1:08:15.124 collect the collateral when people default, 1:08:15.123 --> 1:08:16.893 it's a costly operation. 1:08:16.890 --> 1:08:20.390 So in sub-prime loans it takes 18 months to throw somebody out 1:08:20.393 --> 1:08:21.373 of their house. 1:08:21.368 --> 1:08:24.438 So during those 18 months the guy's not paying his mortgage. 1:08:24.439 --> 1:08:28.039 He's not paying his taxes, all of which you have to make 1:08:28.039 --> 1:08:28.629 up for. 1:08:28.630 --> 1:08:31.060 He's trashing the house, or if he doesn't trash it he 1:08:31.055 --> 1:08:33.705 leaves the house and some neighbor trashes it and rips out 1:08:33.713 --> 1:08:35.023 everything in the house. 1:08:35.020 --> 1:08:38.070 The average sub-prime loan, when you force someone out of 1:08:38.074 --> 1:08:40.974 their house and sell it, you get back 1 quarter of the 1:08:40.966 --> 1:08:42.436 value of the house now. 1:08:42.439 --> 1:08:45.349 At the beginning people assumed it could never be less than 80 1:08:45.351 --> 1:08:45.831 percent. 1:08:45.829 --> 1:08:47.609 Now it's 1 quarter. 1:08:47.609 --> 1:08:52.339 Then there are other more complicated things that can go 1:08:52.337 --> 1:08:55.517 wrong which I'm going to skip over. 1:08:55.520 --> 1:09:00.010 So let's just see what happens now with housing. 1:09:00.010 --> 1:09:02.340 So what is it that's happening with housing? 1:09:02.340 --> 1:09:04.630 If you look at people underwater, why are people 1:09:04.634 --> 1:09:06.054 defaulting on their houses? 1:09:06.050 --> 1:09:07.770 It's because they're underwater. 1:09:07.770 --> 1:09:11.130 So here is for every different kind of mortgage, 1:09:11.128 --> 1:09:14.558 starting at sub-prime and going down to prime. 1:09:14.560 --> 1:09:16.520 These are except government loans. 1:09:16.520 --> 1:09:20.150 This is the fraction of people who default every month, 1:09:20.146 --> 1:09:23.436 not every year, and here's their loan to value. 1:09:23.439 --> 1:09:24.899 So how did I figure out the loan to value? 1:09:24.899 --> 1:09:26.849 I had to look at all the original loans. 1:09:26.850 --> 1:09:29.520 I did this house by house, or Ellington, 1:09:29.518 --> 1:09:32.318 my hedge fund, actually the guys there who 1:09:32.323 --> 1:09:36.153 were former students here, they actually figured all this 1:09:36.154 --> 1:09:36.844 out. 1:09:36.840 --> 1:09:38.320 They went house by house. 1:09:38.319 --> 1:09:42.449 They got what the loan sizes were on all the houses, 1:09:42.448 --> 1:09:45.198 and then using the Shiller index they know what the house 1:09:45.203 --> 1:09:47.613 was bought for, and assuming the zip code index 1:09:47.613 --> 1:09:50.463 dropped by 20 percent they figured every house in the index 1:09:50.462 --> 1:09:52.802 went down by 20 percent, so they could get the current 1:09:52.797 --> 1:09:53.457 value of the house. 1:09:53.460 --> 1:09:56.700 So this is the ratio of the loan to the current value of the 1:09:56.699 --> 1:09:57.139 house. 1:09:57.140 --> 1:10:00.150 Current combined loan to value ratio. 1:10:00.149 --> 1:10:03.569 So 140 means the loans all together, first and second loans 1:10:03.569 --> 1:10:07.049 are 140 percent of what they estimate the value of the house 1:10:07.046 --> 1:10:07.456 is. 1:10:07.460 --> 1:10:08.680 So look at what happens. 1:10:08.680 --> 1:10:12.490 If you're sub-prime and you've got that--I can't see my--this 1:10:12.492 --> 1:10:14.972 is--140's over here somewhere, right? 1:10:14.970 --> 1:10:18.050 You're defaulting more than 6 percent a month. 1:10:18.050 --> 1:10:21.440 If you're 160 you're defaulting at 8 percent. 1:10:21.439 --> 1:10:24.519 Every month 8 percent of those people are becoming serious 1:10:24.523 --> 1:10:26.853 delinquent and probably will never repay; 1:10:26.850 --> 1:10:28.110 8 percent a month. 1:10:28.109 --> 1:10:30.249 In one year they're all going to be gone. 1:10:30.250 --> 1:10:35.030 So you can see this is shockingly sensitive to loan to 1:10:35.028 --> 1:10:35.748 value. 1:10:35.750 --> 1:10:37.760 It's not that people are defaulting because they lost 1:10:37.756 --> 1:10:38.256 their jobs. 1:10:38.260 --> 1:10:41.980 They're defaulting because it's not worth it for them to pay. 1:10:41.979 --> 1:10:42.819 They're not stupid. 1:10:42.819 --> 1:10:46.119 Why should they pay 160,000 when the house is only worth 1:10:46.118 --> 1:10:46.718 100,000? 1:10:46.720 --> 1:10:49.230 It's just how can they, you know, times are tough. 1:10:49.229 --> 1:10:51.779 What are they going to do, tell their children, 1:10:51.784 --> 1:10:53.234 well, we can't feed you? 1:10:53.229 --> 1:10:55.449 You can't go to school, because daddy and mommy have to 1:10:55.453 --> 1:10:57.683 pay this thing where we don't really have to pay it? 1:10:57.680 --> 1:10:58.750 They're not going to do it. 1:10:58.750 --> 1:11:02.620 So somehow, I couldn't convince Larry Summers of this, 1:11:02.622 --> 1:11:03.722 I tried hard. 1:11:03.720 --> 1:11:08.410 I wrote an Op-Ed in The New York Times in October of 1:11:08.412 --> 1:11:08.962 2008. 1:11:08.960 --> 1:11:12.090 I wrote another one in 7, October. 1:11:12.090 --> 1:11:13.630 No, a year ago. 1:11:13.630 --> 1:11:16.870 What are we talking about, October of 2008 then March of 1:11:16.868 --> 1:11:20.398 2009, saying that the only way to save the housing market was 1:11:20.400 --> 1:11:22.050 to write down principal. 1:11:22.050 --> 1:11:24.440 Now, writing down principal means saying, 1:11:24.436 --> 1:11:27.356 if the loan is 160,000, maybe the house used to be 1:11:27.363 --> 1:11:29.933 200,000, the house is only 100,000 now. 1:11:29.930 --> 1:11:32.710 You just say, "We're writing off 80,000 1:11:32.706 --> 1:11:33.606 of the loan. 1:11:33.609 --> 1:11:36.919 It's now only 80,000 that the homeowner owes." 1:11:36.920 --> 1:11:39.340 Now, who's going to pay for the lost 80,000? 1:11:39.340 --> 1:11:40.930 I say, nobody has to pay for it. 1:11:40.930 --> 1:11:43.670 The government doesn't have to pay a penny. 1:11:43.670 --> 1:11:46.340 The bond holder, the lender would be better off 1:11:46.341 --> 1:11:50.001 writing down the loan to 80,000 than throwing the guy out of the 1:11:49.998 --> 1:11:52.378 house and getting 40,000 in the end, 1:11:52.380 --> 1:11:55.240 because once the loan is written down to 80,000 the 1:11:55.243 --> 1:11:58.113 homeowner now has 20,000 of equity in the house. 1:11:58.109 --> 1:12:02.029 He'll either work hard to fix it up and spruce it up and sell 1:12:02.033 --> 1:12:04.653 it for 100,000, or he'll actually pay the 1:12:04.649 --> 1:12:05.369 80,000. 1:12:05.368 --> 1:12:07.938 Either way the lender is going to get 80,000, 1:12:07.939 --> 1:12:08.699 not 40,000. 1:12:08.698 --> 1:12:12.558 So this is a win-win as I called it in the editorial with 1:12:12.560 --> 1:12:15.530 Susan Koniak, a coauthor, a law professor at 1:12:15.527 --> 1:12:16.007 BU. 1:12:16.010 --> 1:12:18.710 It's a win-win situation and it's not happening. 1:12:18.710 --> 1:12:22.800 And it's not happening because the loans are all in the hands 1:12:22.802 --> 1:12:24.102 of the servicers. 1:12:24.100 --> 1:12:27.630 So remember I said there was this big pool with all the loans 1:12:27.627 --> 1:12:29.977 in them and then there were the bonds. 1:12:29.979 --> 1:12:32.849 And so the bond holders, these are the people who'd like 1:12:32.854 --> 1:12:34.794 to see the principal written down, 1:12:34.788 --> 1:12:37.548 but the bond holders don't know who the homeowners are and 1:12:37.546 --> 1:12:39.526 aren't legally allowed to talk to them. 1:12:39.529 --> 1:12:42.559 There's a servicer in the middle who's a big bank who's 1:12:42.564 --> 1:12:44.594 writing the letter saying pay up, 1:12:44.590 --> 1:12:47.030 and if they pay up they distribute the money to the bond 1:12:47.034 --> 1:12:47.484 holders. 1:12:47.479 --> 1:12:49.649 If they don't pay up the servicer throws them out of the 1:12:49.653 --> 1:12:49.973 house. 1:12:49.970 --> 1:12:52.810 The servicer, the big bank doesn't own the 1:12:52.814 --> 1:12:53.374 loans. 1:12:53.368 --> 1:12:57.258 They're getting paid a percentage, like .5 percent of 1:12:57.262 --> 1:13:00.412 the principal, so they have no incentive to 1:13:00.408 --> 1:13:02.428 write down these loans. 1:13:02.430 --> 1:13:05.430 If they write down the loan in half they lose half their fee. 1:13:05.430 --> 1:13:08.250 If they write down the loan to 80,000 and then the guy sells 1:13:08.247 --> 1:13:10.587 the house they don't service the house anymore. 1:13:10.590 --> 1:13:11.940 They lose all their fees. 1:13:11.939 --> 1:13:14.929 Instead, Obama, thanks to my classmate Larry 1:13:14.927 --> 1:13:17.567 Summers and all his other advisors, 1:13:17.569 --> 1:13:20.849 they've given these servicers license not to write down any 1:13:20.850 --> 1:13:22.730 loans, but to pretend that they're 1:13:22.725 --> 1:13:24.745 writing down the interest on the loans. 1:13:24.750 --> 1:13:26.970 Now, that would be great, and that's actually what's 1:13:26.967 --> 1:13:27.487 happening. 1:13:27.488 --> 1:13:29.878 The servicers are basically not even kicking the people out of 1:13:29.881 --> 1:13:30.471 their houses. 1:13:30.470 --> 1:13:33.030 So these people are not paying anything now. 1:13:33.029 --> 1:13:36.119 There are millions of them not paying anything still living in 1:13:36.119 --> 1:13:36.879 their houses. 1:13:36.880 --> 1:13:39.530 In a year or two they're going to get thrown out, 1:13:39.528 --> 1:13:41.788 but of course they're not going to pay. 1:13:41.788 --> 1:13:44.958 This is the ideal situation for the servicer because he's still 1:13:44.956 --> 1:13:47.506 collecting his fee, the homeowners can't sell, 1:13:47.507 --> 1:13:50.257 they don't want to leave because they're not paying 1:13:50.255 --> 1:13:52.425 anything, and the bondholders are getting 1:13:52.426 --> 1:13:52.846 screwed. 1:13:52.850 --> 1:13:55.770 So it's a catastrophe. 1:13:55.770 --> 1:13:56.850 And finally, after a year, 1:13:56.854 --> 1:13:59.334 if you read the Op-Ed's in The New York Times and 1:13:59.327 --> 1:14:01.147 the The Wall Street Journal, 1:14:01.149 --> 1:14:03.499 in the last week or two they have been deluged with people 1:14:03.497 --> 1:14:05.247 saying, "Why aren't they writing 1:14:05.246 --> 1:14:06.256 down principal?" 1:14:06.260 --> 1:14:09.310 So this is something that a year or two ago I already 1:14:09.305 --> 1:14:10.005 advocated. 1:14:10.010 --> 1:14:12.070 Anyone with any common sense would have seen that was what 1:14:12.070 --> 1:14:14.280 was inevitably going to happen and we didn't do anything about 1:14:14.275 --> 1:14:14.525 it. 1:14:14.529 --> 1:14:16.889 So I've got one more minute to finish. 1:14:16.890 --> 1:14:20.540 So what should we do about the leverage cycle? 1:14:20.538 --> 1:14:24.808 Well, the thing to do about the leverage cycle is to reverse the 1:14:24.810 --> 1:14:28.270 three bad things that happen in a leverage cycle. 1:14:28.270 --> 1:14:31.820 The first one was that there was too little--the most 1:14:31.815 --> 1:14:34.335 important one is leverage collapse. 1:14:34.340 --> 1:14:38.750 So the Fed has to go and increase leverage. 1:14:38.750 --> 1:14:42.040 So it used to be 30 to 1 or 20 to 1 now it's close to 1 to 1 on 1:14:42.037 --> 1:14:44.687 many assets, although it's gone up a little bit. 1:14:44.689 --> 1:14:47.699 So the Fed has actually done something about this. 1:14:47.699 --> 1:14:48.669 What does it have to do? 1:14:48.670 --> 1:14:50.420 Not lend at lower interest. 1:14:50.420 --> 1:14:52.200 The Fed cut the interest rate to 0 and said, 1:14:52.204 --> 1:14:53.704 "Look how great we are." 1:14:53.698 --> 1:14:55.638 Well, that did nothing practically. 1:14:55.640 --> 1:14:58.610 The reason the Fed has cut the interest rate to zero is to give 1:14:58.609 --> 1:15:01.579 money to the big banks because the banks have to pay depositors 1:15:01.581 --> 1:15:02.541 like you and me. 1:15:02.538 --> 1:15:04.838 Now, on your checking account or savings account you're 1:15:04.835 --> 1:15:07.385 getting zero practically because the Fed lowered the interest 1:15:07.385 --> 1:15:07.975 rate to 0. 1:15:07.979 --> 1:15:10.899 That means the banks make money because they don't have to waste 1:15:10.902 --> 1:15:12.852 any money giving it to their depositors. 1:15:12.850 --> 1:15:15.550 That's the reason why the interest rate went down to 0, 1:15:15.552 --> 1:15:18.662 and they try to dupe the public into thinking it's because it's 1:15:18.658 --> 1:15:19.908 a Keynesian stimulus. 1:15:19.908 --> 1:15:21.998 It's not stimulating anything basically. 1:15:22.000 --> 1:15:24.860 What you have to do is lend with less collateral and the 1:15:24.863 --> 1:15:26.533 banks aren't willing to do it. 1:15:26.529 --> 1:15:29.749 The Fed has go around the banks and lend with less collateral, 1:15:29.750 --> 1:15:32.360 which I'm running out of time so I can't explain how it's 1:15:32.359 --> 1:15:35.149 actually done that and that's one of the big reasons leverage 1:15:35.154 --> 1:15:36.324 is starting to go up. 1:15:36.319 --> 1:15:39.869 Secondly, you have to replace some of the natural buyers who 1:15:39.872 --> 1:15:43.062 have gone out of business, the ones at the top who are 1:15:43.064 --> 1:15:44.574 doing all the buying. 1:15:44.569 --> 1:15:47.169 Without them the price is going to be worth much less. 1:15:47.170 --> 1:15:49.140 The government is going to have to do some buying. 1:15:49.140 --> 1:15:52.160 So through the PPIP program and other things it is doing some of 1:15:52.162 --> 1:15:52.502 that. 1:15:52.500 --> 1:15:55.840 And then finally the first thing, the most important thing, 1:15:55.844 --> 1:15:57.694 the crisis began with housing. 1:15:57.689 --> 1:16:01.589 Housing is the first thing you have to do to lessen the 1:16:01.585 --> 1:16:05.115 instability and the uncertainty in the economy. 1:16:05.118 --> 1:16:07.788 It's now started with housing and it spread to other people 1:16:07.787 --> 1:16:08.797 who are under water. 1:16:08.800 --> 1:16:10.780 That's where all the uncertainty comes from. 1:16:10.779 --> 1:16:12.589 So we have to straighten out who's going to go out of 1:16:12.587 --> 1:16:14.427 business and who's not going to go out of business. 1:16:14.430 --> 1:16:17.060 We have to write down principal of the homes. 1:16:17.060 --> 1:16:19.810 That's the way to reduce that uncertainty. 1:16:19.810 --> 1:16:22.600 And in the long run we have to prevent the next leverage cycle 1:16:22.600 --> 1:16:24.430 by never letting leverage get so high. 1:16:24.430 --> 1:16:28.120 So we have to keep the data and we have to prevent people from 1:16:28.122 --> 1:16:30.002 asking for so little margins. 1:16:30.000 --> 1:16:35.000