WEBVTT 00:01.430 --> 00:05.140 Prof: What I'd like to do this morning is spend eight 00:05.141 --> 00:09.101 or ten minutes with a few slides that are framing and background 00:09.103 --> 00:10.113 to the case. 00:10.110 --> 00:17.330 And then I'm going to ask Nancy Hite to impersonate Sharon 00:17.330 --> 00:20.710 Oster, with the flying chalk on the 00:20.710 --> 00:23.040 board, and I'm going to come around 00:23.042 --> 00:25.402 and talk to all of you about the case. 00:25.400 --> 00:29.070 And we'll work it through B school style. 00:29.070 --> 00:35.630 When you look at the institutions involved in the 00:35.625 --> 00:41.515 mortgage system, don't assume that they were 00:41.524 --> 00:47.364 designed brilliantly, or that they were thought out 00:47.357 --> 00:49.747 from beginning to end. 00:49.750 --> 00:52.130 The concept of "kluge," 00:52.131 --> 00:54.291 is that in your vocabulary? 00:54.290 --> 00:56.310 Tim, is that, "kluge," 00:56.310 --> 00:58.920 is that a-- hands up if "kluge" 00:58.917 --> 00:59.957 is familiar. 00:59.960 --> 01:03.900 I'm not going to get anywhere with that idea. 01:03.899 --> 01:07.309 "Kluge" means things that are complex 01:07.311 --> 01:08.871 and badly designed. 01:08.870 --> 01:15.060 And there's a wonderful book by Gary Marcus called Kluge, 01:15.061 --> 01:19.161 which is about badly designed stuff, 01:19.156 --> 01:24.586 from economic institutions; to human memory; 01:24.590 --> 01:32.010 to the human spine, which is a highly error-prone 01:32.010 --> 01:37.670 structure, and is as it is not 01:37.670 --> 01:43.390 because evolution said, "What's the very best 01:43.393 --> 01:48.163 support column I can make for a bipedal creature?" 01:48.160 --> 01:52.240 but, "What's the best I can do by evolving from a 01:52.242 --> 01:55.712 four-legged to a two-legged creature?" 01:55.709 --> 02:00.979 And the spine shows all kinds of design imperfections that are 02:00.978 --> 02:06.248 attributable to the fact that it evolved in a horizontal plain 02:06.248 --> 02:10.308 and then was readapted in a vertical plain. 02:10.310 --> 02:16.420 And the institutions at play in, what Posner calls the 02:16.419 --> 02:21.999 Depression of '08, and what most of us call the 02:22.002 --> 02:25.502 Recession of 08/'09, though it is, 02:25.504 --> 02:28.634 perhaps, the mother of all recessions, 02:28.628 --> 02:34.578 it has not actually obtained the depth of unemployment and 02:34.579 --> 02:40.739 under-utilization of plant and equipment that would match up 02:40.738 --> 02:43.868 with the one in the 1930s. 02:43.870 --> 02:45.310 Of course, we could still get there. 02:45.310 --> 02:55.490 It is possible that it is now 1931 and another dip is out 02:55.485 --> 02:56.935 there. 02:56.940 --> 03:00.450 I don't think that but there are those, including Will 03:00.449 --> 03:04.689 Goetzmann, who we saw a few days ago, who speculate that it might 03:04.687 --> 03:05.347 be so. 03:05.348 --> 03:15.638 This is a cast of characters for subprime lending; 03:15.639 --> 03:18.709 left to right: the homebuyer, 03:18.712 --> 03:20.812 the broker, the appraiser, 03:20.810 --> 03:23.710 the mortgage lender, the investment banker and the 03:23.712 --> 03:27.622 investors in the bonds created by the investment banks. 03:27.620 --> 03:35.850 And in the row I'm touching are the principal incentives that 03:35.854 --> 03:39.564 make the whole system go. 03:39.560 --> 03:47.520 And the critical thing is that three, 03:47.520 --> 03:50.570 and arguably four, of the main steps in the 03:50.565 --> 03:56.715 process are fee-driven, so that the alignment between 03:56.717 --> 04:02.307 the decision maker and the investor, 04:02.310 --> 04:08.020 or between the decision maker and the potential home buyer, 04:08.020 --> 04:14.320 may be muted by the decision maker thinking "fees." 04:14.318 --> 04:20.428 If I'm thinking--let's suppose I were a college admissions 04:20.428 --> 04:26.748 officer and I was paid by the live students delivered to the 04:26.752 --> 04:31.622 school, I might become very generous in 04:31.620 --> 04:34.850 my view; I might find creativity in 04:34.848 --> 04:38.478 unexpected places; I might imagine analytic 04:38.476 --> 04:41.006 firepower where none existed. 04:41.009 --> 04:45.499 And so, in all these steps, the bias toward 04:45.495 --> 04:50.185 "yes," the bias toward completing a 04:50.194 --> 04:56.634 transaction, is a very powerful piece of the 04:56.634 --> 04:57.684 story. 04:57.680 --> 05:00.270 The risks are chartered here. 05:00.269 --> 05:03.009 What we're going to do, when we do the case, 05:03.009 --> 05:06.259 among other things, is to fill in the bottom row. 05:06.259 --> 05:11.099 What are the ways in which we would expect people in each of 05:11.096 --> 05:14.946 these roles to be tempted to get out of line? 05:14.949 --> 05:19.879 Out of line ethically; and quite possibly out of line 05:19.877 --> 05:20.607 legally. 05:20.610 --> 05:23.690 As in the case, there is a broker, 05:23.690 --> 05:29.200 right, who gets way beyond both ethical and legal bounds. 05:29.199 --> 05:35.559 Home ownership in the United States, 1900 to 2000, 05:35.555 --> 05:37.885 looks like this. 05:37.889 --> 05:40.749 And notice it's a truncated scale, the bottom of the scale 05:40.747 --> 05:41.697 is forty percent. 05:41.699 --> 05:47.899 The big story is a huge normative emphasis on home 05:47.901 --> 05:49.421 ownership. 05:49.420 --> 05:56.320 The belief, going back to Jefferson really, 05:56.319 --> 06:01.459 that when people own property they become "bought-in 06:01.464 --> 06:05.944 citizens", citizens who identify with the 06:05.935 --> 06:10.345 Commonwealth and who can be counted on to act in 06:10.346 --> 06:12.596 public-spirited ways. 06:12.600 --> 06:20.230 And there's a great run-up in home ownership between World War 06:20.228 --> 06:25.258 II and the 1980s, and it is fuelled by very 06:25.257 --> 06:30.207 profitable mass development of suburban housing; 06:30.209 --> 06:41.189 it is financed by FHA and related government entities; 06:41.190 --> 06:46.730 and it is rewarded by the Internal Revenue Service tax 06:46.733 --> 06:52.803 code, which gives a strong incentive for people to take out 06:52.800 --> 06:56.880 mortgages on a principal residence. 06:56.879 --> 07:04.059 Now, home ownership, I assume--do any of you own a 07:04.055 --> 07:05.075 home? 07:05.079 --> 07:12.029 Oh, I should say that Jaan Elias, who wrote the case, 07:12.031 --> 07:13.771 is with us. 07:13.769 --> 07:15.979 Welcome Jaan. 07:15.980 --> 07:17.590 Jaan Elias: Hello. 07:17.589 --> 07:18.459 Prof: Do you own a house? 07:18.459 --> 07:20.559 Jan Elias: No. 07:20.560 --> 07:22.480 Prof: Sometimes I envy that. 07:22.480 --> 07:27.190 Home ownership has all kinds of hazards. 07:27.189 --> 07:32.219 I just learned that my slate roof, a hundred year old slate 07:32.221 --> 07:35.521 roof, is at the end of its lifetime. 07:35.519 --> 07:41.939 And that's comparable to buying a--it's about the same price as 07:41.935 --> 07:46.795 the highest-end BMW, to replace a slate roof; 07:46.800 --> 07:48.510 that's a hazard. 07:48.509 --> 07:56.439 Suppose that you get laid-off; your mortgage payments continue. 07:56.440 --> 07:59.990 Suppose that there is a catastrophic illness; 07:59.990 --> 08:04.520 the mortgage payments continue, the local property taxes 08:04.521 --> 08:09.301 continue, the unanticipated maintenance issues continue. 08:09.300 --> 08:15.010 And there is quite a lot to be said for relative caution about 08:15.009 --> 08:20.159 undertaking a debt amounting to several years' income in 08:20.156 --> 08:22.306 purchasing a house. 08:22.310 --> 08:25.900 Now, there's also a political dimension to this, 08:25.899 --> 08:34.039 which is that the old fashioned local banking method of writing 08:34.035 --> 08:39.805 mortgages was extremely cautious and was, 08:39.808 --> 08:43.258 first explicitly and then, later, implicitly racist and 08:43.264 --> 08:44.804 "genderist." 08:44.798 --> 08:50.128 It was all about well-employed white men. 08:50.129 --> 08:57.529 And there is an ideological strand, 08:57.529 --> 09:00.279 that is not Jeffersonian but is more recent, 09:00.278 --> 09:03.398 and has to do with equality of opportunity to own houses, 09:03.399 --> 09:09.649 which has pushed policy towards are more permissive attitude. 09:09.649 --> 09:14.519 Finally, there is, of course, the pro-market view, 09:14.519 --> 09:17.889 which became dominant in this country in the Ronald Reagan 09:17.894 --> 09:20.944 era, which says "Let people cut 09:20.937 --> 09:23.307 the deals they want to cut. 09:23.308 --> 09:25.958 Get the government out of the transaction. 09:25.960 --> 09:27.560 Deregulate." 09:27.558 --> 09:31.468 And in many cases deregulation was a spectacular success, 09:31.470 --> 09:34.750 for example, the airline industry, 09:34.751 --> 09:40.341 the trucking industry, but deregulation of finance is 09:40.336 --> 09:43.016 a slipperier undertaking. 09:43.019 --> 09:48.129 A history of home values here. 09:48.129 --> 09:54.019 It's an index chart that has 1890 indexed to 100 and the gist 09:54.024 --> 09:59.334 of the argument in this chart--did I take this from the 09:59.328 --> 10:00.998 case, or not? 10:01.000 --> 10:03.980 Jan Elias: No. Prof: The gist of the 10:03.980 --> 10:07.840 argument in this chart is that: by the time we are done with 10:07.836 --> 10:10.566 the current meltdown, home values, 10:10.568 --> 10:14.998 adjusted for inflation, will be back about where they 10:15.004 --> 10:16.044 were in 1890. 10:16.039 --> 10:25.709 10:25.710 --> 10:30.480 This is a map of Philadelphia, and it's a historically 10:30.480 --> 10:32.100 interesting map. 10:32.100 --> 10:34.680 I couldn't find a comparable one for Cleveland, 10:34.682 --> 10:36.312 though I'm sure one exists. 10:36.308 --> 10:44.248 In 1937 mortgages were collapsing all over the country. 10:44.250 --> 10:47.770 And the Roosevelt Administration pushed through 10:47.774 --> 10:52.224 Congress a piece of legislation called The Home Owners Loan 10:52.216 --> 10:55.356 Corporation, HOLC, Home Owners Loan 10:55.355 --> 10:56.435 Corporation. 10:56.440 --> 10:59.810 And the Home Owners Loan Corporation was charged with 10:59.808 --> 11:03.238 finding out how to know in advance if a mortgage would 11:03.243 --> 11:04.283 likely fail. 11:04.278 --> 11:10.628 And the technique was not to look at credit scores but to 11:10.633 --> 11:17.303 look at housing locations; and to look at the condition of 11:17.299 --> 11:22.669 housing in a neighborhood; and at the demographics of who 11:22.669 --> 11:23.679 lived there. 11:23.678 --> 11:29.718 And it was crudely racist and biased in many, 11:29.721 --> 11:31.371 many ways. 11:31.370 --> 11:35.990 It was explicitly racist about blacks; 11:35.990 --> 11:39.860 it was explicitly racist about Jews; 11:39.860 --> 11:44.400 it was explicitly racist about Italians, most of all Southern 11:44.398 --> 11:45.228 Italians. 11:45.230 --> 11:52.080 And it was a four-point scale, the worst category - level D - 11:52.075 --> 11:54.045 was red, and the term 11:54.052 --> 11:56.462 "redlining" comes from this, 11:56.460 --> 12:00.350 and the idea was to tell the banking world not to lend money 12:00.349 --> 12:01.469 in those zones. 12:01.470 --> 12:07.460 Yellow was a little better, then blue, 12:07.460 --> 12:14.580 then green and the idea was to put mortgage money into the 12:14.580 --> 12:18.210 safest, wealthiest neighborhoods with 12:18.205 --> 12:20.985 the most homogeneous populations. 12:20.990 --> 12:27.080 And from the point of view of managing the mortgage crisis, 12:27.076 --> 12:30.326 it was not a terrible policy. 12:30.330 --> 12:35.540 From the point of view of managing cities and communities, 12:35.538 --> 12:40.378 it was catastrophic because what it did was to accelerate 12:40.376 --> 12:45.036 the creation of slums in areas where mortgage money was 12:45.041 --> 12:49.621 unavailable for the sale or purchase of housing, 12:49.620 --> 12:52.930 or, for that matter, for the large-scale repair of 12:52.932 --> 12:53.612 housing. 12:53.610 --> 12:57.690 They did it to two hundred--they did the process to 12:57.690 --> 13:02.420 two hundred American cities in a single year, including New 13:02.423 --> 13:03.243 Haven. 13:03.240 --> 13:06.450 Across Chapel Street is class D. 13:06.450 --> 13:16.140 This is the Case-Schiller home prices story and let's lay it 13:16.144 --> 13:22.394 out here from the year 2000 to 2007. 13:22.389 --> 13:27.079 And this is, when Goetzmann talked about 13:27.082 --> 13:32.862 Case-Schiller being a reassuring data series, 13:32.860 --> 13:37.330 if you look at it between here and here, 13:37.330 --> 13:40.690 if you look at a five-year period or even a six-year 13:40.690 --> 13:44.100 period, it looks like a process of 13:44.101 --> 13:48.231 continued appreciation in home prices. 13:48.230 --> 13:53.160 And there was nothing in the data, that would have, 13:53.162 --> 13:59.282 given conventional econometric models, would have triggered the 13:59.278 --> 14:02.828 suspicion that the end was nigh. 14:02.830 --> 14:10.360 The chart is also interesting because Cleveland is this line. 14:10.360 --> 14:17.010 So that, Cleveland is a less extreme story in price 14:17.013 --> 14:23.533 appreciation than the cases everybody talks about, 14:23.533 --> 14:30.323 which were Miami and Las Vegas and Los Angeles. 14:30.320 --> 14:37.690 This is the same story shown in year-on-year percentage change 14:37.693 --> 14:43.623 and it actually doesn't add much to our knowledge, 14:43.616 --> 14:46.636 I'm going to skip it. 14:46.639 --> 14:57.369 This is Cleveland price appreciation from 2000 into 14:57.371 --> 15:01.301 2007, compared with the country at 15:01.298 --> 15:06.938 large, and the gist is that Cleveland 15:06.937 --> 15:11.387 was not a hot-- not a hot city. 15:11.389 --> 15:16.689 And it was--it is in that respect, I hope I've got--I've 15:16.690 --> 15:18.810 missed a chart here. 15:18.808 --> 15:24.248 There's a huge story about Northeastern industrial cities, 15:24.249 --> 15:28.829 by which I mean virtually all the cities from St. 15:28.830 --> 15:34.080 Louis on the left side to Boston on the right side. 15:34.080 --> 15:41.570 They all had their take-off in the middle of the nineteenth 15:41.567 --> 15:42.857 century. 15:42.860 --> 15:51.190 They were all going almost vertical in the years 1850 to 15:51.192 --> 15:53.012 1900,1910. 15:53.009 --> 16:01.579 By 1920 their growth rates slowed down almost to zero, 16:01.580 --> 16:08.110 and were-- fluctuated wildly during the Depression years, 16:08.110 --> 16:13.070 recovered briefly in World War II, and then went sharply south 16:13.070 --> 16:14.290 from 1950 on. 16:14.288 --> 16:19.348 New Haven's case, the strength of the inner city 16:19.351 --> 16:23.661 economy forms an almost perfect arch, 16:23.658 --> 16:28.548 with the starting point in 1840, the peak in 1950, 16:28.549 --> 16:31.999 and the bottom in about 1990. 16:32.000 --> 16:35.080 And there's actually been a little bit of recovery since. 16:35.080 --> 16:39.230 But Cleveland is a classic industrial city. 16:39.230 --> 16:43.510 It is the place where Standard Oil set up its first large 16:43.513 --> 16:44.893 refining plants. 16:44.889 --> 16:50.989 It was an advantage-point in transportation because it was an 16:50.985 --> 16:57.075 intersection between very high quality east-west freight rail 16:57.082 --> 17:00.032 and Great Lakes shipping. 17:00.028 --> 17:04.918 And when rail became subordinated to trucking and 17:04.916 --> 17:10.816 when suburban development became dominant over the reuse of 17:10.824 --> 17:16.924 industrial urban neighborhoods, Cleveland suffered mightily. 17:16.920 --> 17:24.190 This income map of Cleveland, where medium incomes, 17:24.190 --> 17:30.440 under $22,700, are shown in the darkest rust 17:30.442 --> 17:36.262 tone, is where the case takes place; 17:36.259 --> 17:41.269 the green dot is approximately the location of Slavic Village. 17:41.269 --> 17:45.449 I wouldn't swear to it or argue with Jaan if he said move it 17:45.449 --> 17:49.559 three or four degrees of the compass north or east or south 17:49.557 --> 17:51.547 or west, but it's right about there. 17:51.548 --> 17:58.668 And it is on the edge of a large post-industrial working 17:58.673 --> 18:03.863 class neighborhood, or mega-neighborhood, 18:03.855 --> 18:08.385 in a declining industrial city. 18:08.390 --> 18:12.570 So, there's the great arch. 18:12.568 --> 18:16.828 And the concentration of subprime lending in Cleveland, 18:16.834 --> 18:21.334 shown in the darkest tones here, includes the neighborhood 18:21.334 --> 18:23.234 we're talking about. 18:23.230 --> 18:27.980 And then there's Posner. 18:27.980 --> 18:33.320 On page 284, I hope all of you have 18:33.321 --> 18:38.821 memorized page 284, where he's apportioning blame: 18:38.823 --> 18:42.163 "But although the financiers bear the primary 18:42.160 --> 18:44.820 responsibility for the depression," 18:44.815 --> 18:47.535 that's his name for the recession, 18:47.538 --> 18:53.518 "I do not think they can be blamed for it, 18:53.519 --> 18:57.049 implying moral censure, any more than one can blame a 18:57.053 --> 18:58.823 lion for eating a zebra. 18:58.819 --> 19:01.369 Capitalism is Darwinism." 19:01.369 --> 19:07.349 Pretty dark interpretation. 19:07.349 --> 19:46.819 > 19:46.819 --> 19:48.419 Prof: Is it Jennifer? 19:48.420 --> 19:49.920 Student: Yes. 19:49.920 --> 19:50.230 Prof. 19:50.233 --> 19:51.883 Douglas W. Rae: That's the trouble with 19:51.883 --> 19:54.523 letting me learn your name; you get cold called. 19:54.519 --> 19:59.939 There's a story in this where a local broker ends up being 19:59.944 --> 20:02.044 sentenced to prison. 20:02.038 --> 20:03.858 Do you remember that part of it or not? 20:03.859 --> 20:05.759 Student: Mark. 20:05.759 --> 20:07.939 Prof: Okay, Mark. 20:07.940 --> 20:09.320 Can you give us a little recap on Mark? 20:09.318 --> 20:12.528 Student: Mark Kellogg submitted 20:12.525 --> 20:16.245 fraudulent data for about seventy homes, 20:16.250 --> 20:19.940 and--or somehow ended up, I'm not sure of the process of 20:19.940 --> 20:24.090 flipping a house exactly, but he did it to seventy homes 20:24.085 --> 20:27.705 and they all ended up defaulting on the loans, 20:27.710 --> 20:29.840 the people that he sold it to. 20:29.838 --> 20:33.658 Prof: Okay, so Mark's sin would be what? 20:33.660 --> 20:36.790 Let's try somebody else. 20:36.788 --> 20:42.378 What's Mark--if Mark were a relative of yours and you had to 20:42.375 --> 20:47.765 have Thanksgiving dinner with him while he was on furlough 20:47.770 --> 20:54.310 from Ohio State Penitentiary, what topic would you want it to 20:54.313 --> 21:01.993 reflect on; ethical topic? 21:01.990 --> 21:09.280 You want to take a shot at this? 21:09.278 --> 21:13.528 Student: Perhaps, as you just mentioned 21:13.532 --> 21:17.222 with the topic of preying on zebras, 21:17.220 --> 21:21.280 perhaps something like that, and that-- 21:21.278 --> 21:27.518 using a position to benefit from people at a much 21:27.519 --> 21:31.029 > 21:31.028 --> 21:33.478 than you, and to their detriment and to your gain. 21:33.480 --> 21:33.890 Prof: Okay. 21:33.890 --> 21:35.690 So the buyers, on your telling, 21:35.690 --> 21:36.470 are zebras. 21:36.470 --> 21:43.260 Okay, that's a plausible position. 21:43.259 --> 21:48.009 If the buyers are zebras, are the zebras in any way 21:48.012 --> 21:50.392 blamable in this story? 21:50.390 --> 21:56.010 What do you think? 21:56.009 --> 21:59.229 Student: It's possible that they're 21:59.228 --> 22:02.138 blamable, if they were given good 22:02.140 --> 22:04.700 information, but in this situation they were 22:04.704 --> 22:07.134 given completely wrongful information and led to believe 22:07.127 --> 22:08.007 that it was true. 22:08.009 --> 22:10.019 Prof: Okay. 22:10.019 --> 22:11.929 Student: Like, a plausible person would 22:11.932 --> 22:12.572 believe that. 22:12.568 --> 22:16.998 Prof: Can we tell a story where it's plausible to 22:16.999 --> 22:18.529 blame the buyers? 22:18.529 --> 22:20.469 Student: Yes. 22:20.470 --> 22:25.140 Where they should have known that they don't have the income 22:25.141 --> 22:29.101 to pay the loan and they were going to default, 22:29.098 --> 22:32.418 and so therefore they should have not bought the home. 22:32.420 --> 22:33.970 Prof: Thank you. 22:33.970 --> 22:39.130 And are their instances where people are encouraged to lie 22:39.127 --> 22:41.117 about their incomes? 22:41.118 --> 22:44.438 Student: I think there's a big problem 22:44.442 --> 22:48.602 with a lot of these "Jumbo Subprime Mortgages" 22:48.597 --> 22:51.617 they called them, where people were buying really 22:51.618 --> 22:53.048 big houses, or second houses, 22:53.046 --> 22:56.116 with subprime mortgages and in that case it is their fault, 22:56.118 --> 22:57.708 because they were just being greedy, 22:57.710 --> 22:58.850 right. 22:58.848 --> 23:01.968 And trying to take--trying to either falsify documents or go 23:01.971 --> 23:05.251 for the type of loans that would allow them to get these second 23:05.250 --> 23:08.320 properties without really having enough to back it up. 23:08.319 --> 23:10.889 Prof: Okay. 23:10.890 --> 23:15.700 So, that's the sin of pride or gluttony, not really gluttony, 23:15.695 --> 23:18.735 but it's bricks and mortar gluttony. 23:18.740 --> 23:21.250 Yes? 23:21.250 --> 23:24.260 Student: Well there were also NINJA 23:24.259 --> 23:26.389 loans, which I think is a very 23:26.390 --> 23:29.460 appropriate acronym because of the sneakiness, 23:29.460 --> 23:31.800 but it was an acronym for no income, 23:31.799 --> 23:33.169 no job and no assets. 23:33.170 --> 23:34.360 Professor Douglas W. 23:34.358 --> 23:35.778 Rae: Okay, NINJA: No Income, 23:35.776 --> 23:36.686 No Job, No Assets. 23:36.690 --> 23:44.680 And why would anyone encourage another human being to seek a 23:44.679 --> 23:46.439 NINJA loan? 23:46.440 --> 23:48.920 Is it obvious? 23:48.920 --> 23:52.780 Student: Well, if you're one of the 23:52.784 --> 23:57.784 three steps that profits off of the fee of making-- 23:57.779 --> 24:00.589 of having that loan go through, then you don't even-- 24:00.588 --> 24:02.028 it doesn't really matter to you if it-- 24:02.028 --> 24:04.958 or it doesn't matter to you if it defaults as much as it 24:04.957 --> 24:06.977 matters to the buyer or to the bank. 24:06.980 --> 24:08.470 Prof: Okay. 24:08.470 --> 24:11.910 So as long as you can successfully pass it along to 24:11.912 --> 24:14.942 the next step, you collect the fee and you're 24:14.941 --> 24:17.421 home-dry no matter what happens. 24:17.420 --> 24:18.930 Student: Right, and your reputation 24:18.926 --> 24:19.916 > 24:19.920 --> 24:20.180 .. 24:20.179 --> 24:26.919 Prof: Okay now, let's stop and see what we got 24:26.920 --> 24:30.940 for a diagram here, Sharon. 24:30.940 --> 24:33.930 Student: > 24:33.930 --> 24:36.000 Prof: Unpack your diagram. 24:36.000 --> 24:37.050 Student: Okay, so I guess this is... 24:37.048 --> 24:38.638 Prof: I knew you'd be good at diagrams. 24:38.640 --> 24:40.710 Student: Our game of Pictionary. 24:40.710 --> 24:44.130 So, I'm trying to map out what exactly went wrong, 24:44.130 --> 24:48.520 and I would start with a home in the Slavic community and then 24:48.519 --> 24:50.709 I would end, maybe, here with Bank of 24:50.714 --> 24:51.184 Scotland. 24:51.180 --> 24:58.640 And between "Joe six pack" purchasing a home 24:58.643 --> 25:05.613 with a $22,000 yearly income, which was the average I saw, 25:05.612 --> 25:10.542 that was misrepresented as being worth about $80,000 from 25:10.536 --> 25:15.826 the broker who works with a-- I figured we could have 25:15.827 --> 25:19.597 everyone fill in the parts for me. 25:19.598 --> 25:23.688 Like, how do we get from the home to the international 25:23.685 --> 25:24.375 crisis? 25:24.380 --> 25:30.280 Prof: Okay, so who's < 25:32.288 chat>>. 25:32.288 --> 25:38.188 What's the next step in the chain to the right of broker? 25:38.190 --> 25:41.910 Student: Probably someone will give a 25:41.913 --> 25:46.933 rating for this mortgage so that the broker will be able to 25:46.934 --> 25:52.044 package it with other mortgages and sell it to an investment 25:52.044 --> 25:53.174 banker. 25:53.170 --> 25:55.330 Prof: Okay, so there's a credit rating 25:55.330 --> 25:58.280 story, but there's also another story that's closer to ground 25:58.278 --> 25:58.768 level. 25:58.769 --> 26:07.549 It concerns the house itself. 26:07.548 --> 26:10.138 Student: Need an evaluation of the 26:10.136 --> 26:12.656 house, like, what the house value is. 26:12.660 --> 26:14.160 Prof: Okay. 26:14.160 --> 26:18.970 And there's a saying in real estate "appraise as 26:18.971 --> 26:20.731 instructed." 26:20.730 --> 26:30.460 And it's not altogether false that whoever hires--think about 26:30.461 --> 26:33.221 the incentives. 26:33.220 --> 26:37.460 You're an appraiser, and Paul here hires you to do 26:37.461 --> 26:42.651 an appraisal and you're going to get a fee of 1,100 bucks for 26:42.654 --> 26:43.784 doing it. 26:43.779 --> 26:48.629 And Paul lets it be known that he thinks this house really 26:48.626 --> 26:52.706 ought to be worth something north of $200,000. 26:52.710 --> 26:56.470 And you go out in the field, do the comparables and the 26:56.470 --> 26:58.560 number comes up at $140,000. 26:58.558 --> 27:04.238 Tim, what thought might cross your mind if you were--I 27:04.240 --> 27:09.280 understand in your case it, of course, wouldn't, 27:09.278 --> 27:11.958 but in, say, my case? 27:11.960 --> 27:14.110 Student: It might cross your mind to 27:14.107 --> 27:16.817 trust all and just go with the $200,000 prediction. 27:16.819 --> 27:18.899 Prof: Okay. 27:18.900 --> 27:21.290 And the second step in the reasoning is? 27:21.288 --> 27:24.008 Student: No-one will ever know. 27:24.009 --> 27:27.369 Prof: No-one will ever know and next time Paul goes to 27:27.372 --> 27:29.392 the Yellow Pages for an appraisal? 27:29.390 --> 27:31.000 Student: He'll come to you. 27:31.000 --> 27:33.280 Prof: He'll come to you or he's more likely to. 27:33.279 --> 27:36.469 He's a damn sight less likely to if you undercut his deal. 27:36.470 --> 27:39.960 I'll tell you a Yale story about appraisals: 27:39.963 --> 27:44.763 when I was in city government we leased High Street and Wall 27:44.758 --> 27:48.088 Street to Yale for ninety-nine years; 27:48.089 --> 27:50.349 we were broke, we needed money. 27:50.348 --> 27:57.298 And the Mayor sat down with Benno Schmidt, 27:57.299 --> 28:01.949 and Benno said, "Well, the University will handle the 28:01.945 --> 28:04.575 appraisal for you," and they did. 28:04.578 --> 28:08.278 The two streets together leased for one million dollars for 28:08.275 --> 28:09.545 ninety-nine years. 28:09.548 --> 28:15.638 It should have been a lot more than that and there were those, 28:15.641 --> 28:20.431 in city government, who thought I was the guy who 28:20.433 --> 28:23.233 got the number that low. 28:23.230 --> 28:27.570 I was actually pulling hard on making the number at least one 28:27.567 --> 28:30.097 zero or a zero-and-a-half higher. 28:30.098 --> 28:33.468 I'd allow the Law School to build that gorgeous underground 28:33.474 --> 28:36.914 library, because the ground rights went with the streets. 28:36.910 --> 28:41.680 And so "appraise as instructed" 28:41.680 --> 28:46.690 is an important component in this story. 28:46.690 --> 28:51.250 We had the appraiser there. 28:51.250 --> 28:58.810 So, who else is involved and what are their incentives? 28:58.809 --> 29:10.789 Paul? 29:10.788 --> 29:13.018 Student: Well, you've got the local bank 29:13.021 --> 29:14.771 that's actually doing the lending. 29:14.769 --> 29:16.329 Prof: Okay. 29:16.328 --> 29:19.088 Student: And they probably will get a 29:19.092 --> 29:23.142 fee for the loan that they take and then if they can package and 29:23.138 --> 29:26.958 sell it off to someone else, they don't end up with the loan 29:26.961 --> 29:30.231 on their books so they couldn't, probably, care less how it 29:30.230 --> 29:31.740 performs over the long run. 29:31.740 --> 29:32.910 Prof: Okay. 29:32.910 --> 29:37.420 So--terrific, so, the lender is also 29:37.417 --> 29:45.147 fee-driven and is inclined to think that she or he can escape 29:45.145 --> 29:51.195 accountability when the property defaults, 29:51.200 --> 29:52.270 if it defaults. 29:52.269 --> 29:55.049 And why would that be? 29:55.048 --> 29:58.398 What are the--what do we turn these loans into at the next 29:58.398 --> 29:58.868 stage? 29:58.868 --> 30:04.168 Student: Usually it's sold off to a big 30:04.172 --> 30:11.362 investment bank or basically a financial powerhouse where they 30:11.358 --> 30:16.188 pull the mortgages into these giant, 30:16.190 --> 30:20.780 collateralized debt obligations or > 30:20.778 --> 30:23.008 Prof: Okay, CDOs, famous acronym. 30:23.009 --> 30:24.529 Do you want to add anything to this? 30:24.529 --> 30:24.779 Jaan Elias: Not really. 30:24.779 --> 30:25.619 Prof: Okay. 30:25.618 --> 30:30.808 So you've got the banks creating these huge bundles, 30:30.808 --> 30:36.738 and the bundles--what story could you tell to say that 30:36.737 --> 30:43.447 bundling these mortgages from all across the country might be 30:43.446 --> 30:49.036 a good thing from the economy's point of view. 30:49.039 --> 30:52.569 Is there anything you could say? 30:52.569 --> 30:56.959 30:56.960 --> 30:58.210 Student: It diversifies the risk for 30:58.213 --> 30:59.173 those who are taking them out. 30:59.170 --> 31:00.160 Prof: Okay. 31:00.160 --> 31:02.580 It diversifies the risk, say a little more. 31:02.578 --> 31:04.278 Student: Well, presumably, 31:04.282 --> 31:07.532 the people who are packaging them can take out a bunch of-- 31:07.528 --> 31:11.968 do a lot of financial analysis and determine that the risk of 31:11.974 --> 31:16.424 the number of defaults would be lower than the benefit of the 31:16.420 --> 31:19.680 people actually paying their loans back. 31:19.680 --> 31:22.720 So, the people who take out the package would have a favorable 31:22.721 --> 31:23.421 risk return. 31:23.420 --> 31:24.870 Prof: Okay. 31:24.868 --> 31:26.718 And part--were you about to say something? 31:26.720 --> 31:29.180 Student: I think it also increase the 31:29.175 --> 31:31.545 market of potential buyers, because now, 31:31.553 --> 31:34.593 rather than owning a mortgage and having to deal with an 31:34.593 --> 31:37.153 investor one-on-one, you have a pooling and 31:37.154 --> 31:40.244 servicing agreement that has a company as a servicer who 31:40.243 --> 31:43.443 handles all the collection of payments and distribution of 31:43.444 --> 31:45.584 money into different investments. 31:45.579 --> 31:46.699 Prof: Okay. 31:46.700 --> 31:50.740 So, you've got an institutional mechanism that makes this work 31:50.737 --> 31:55.467 relatively smoothly, and you're interested, 31:55.473 --> 32:02.763 when you create these bundles, in having the risks have 32:02.761 --> 32:07.661 relatively low correlation with one another. 32:07.660 --> 32:13.700 What would be a bad bundle is one where we can know that some 32:13.695 --> 32:19.225 of the mortgages are defaulting and infer from that, 32:19.230 --> 32:22.090 that lots of others are likely to default. 32:22.088 --> 32:25.638 And a bundle that was geographically concentrated, 32:25.640 --> 32:29.320 on Slavic Village for example, would have that second 32:29.316 --> 32:32.636 characteristic and that would be a bad thing. 32:32.640 --> 32:41.550 So, there is a story about risk management that makes that work. 32:41.548 --> 32:45.688 Now, are the agencies, like Moody's, 32:45.690 --> 32:50.890 these outfits that judge credit-worthiness of companies 32:50.890 --> 32:54.550 and other financial intermediaries, 32:54.549 --> 32:56.549 are they in this story anywhere? 32:56.548 --> 32:59.788 I don't know if they--Jaan, does Moody's get into your 32:59.790 --> 33:00.220 case? 33:00.220 --> 33:01.510 I don't think I found it. 33:01.509 --> 33:04.699 Jaan Elias: Just as a kind of footnote. 33:04.700 --> 33:06.860 There are bating the CDOs. 33:06.859 --> 33:10.549 Prof: Okay. 33:10.548 --> 33:12.498 So, everybody know what Moody's and its rivals do? 33:12.500 --> 33:36.490 Anybody want to help us with that? 33:36.490 --> 33:37.990 Student: Moody's and its rivals are-- 33:37.990 --> 33:41.620 essentially collect a fee from anyone who wants to spin-off an 33:41.621 --> 33:45.131 asset or a debt obligation to actually rate the soundness of 33:45.133 --> 33:48.113 the security for whatever it's supposed to be. 33:48.108 --> 33:50.918 They sign a rating like Triple A or Single A. 33:50.920 --> 33:51.130 Prof: Okay. 33:51.130 --> 33:55.790 And if I'm--Yale was Triple A, and I think we're now Double A, 33:55.792 --> 34:00.612 what's a Triple A--what's the advantage of a Triple A rating? 34:00.608 --> 34:02.978 Student: If you have a higher rating 34:02.980 --> 34:06.030 then that means you can get a lower cost of capital. 34:06.028 --> 34:08.778 So, if you actually want to raise some money you can raise 34:08.782 --> 34:10.862 it for a lot less--a lower interest rate. 34:10.860 --> 34:13.550 Prof: So, it reduces the cost of capital, 34:13.552 --> 34:15.962 and it therefore has great value to you. 34:15.960 --> 34:21.450 Now, if you could bribe Moody's, if you were completely 34:21.447 --> 34:27.337 amoral and you could bribe Moody's to make something Triple 34:27.344 --> 34:33.804 A when it was really B, it would be worth paying a lot, 34:33.795 --> 34:34.605 right? 34:34.610 --> 34:40.690 The actual economic value of those ratings is huge. 34:40.690 --> 34:53.770 What keeps Moody's honest? 34:53.768 --> 34:55.608 Student: Their reputation; 34:55.610 --> 34:59.250 the fact that they have, for years, made sure that the 34:59.248 --> 35:03.368 ratings that they're giving are actually safe investments. 35:03.369 --> 35:04.859 Prof: Okay. 35:04.860 --> 35:08.470 And in general, people on the buy side are 35:08.467 --> 35:13.217 going to want the rating agencies to tell the truth and 35:13.217 --> 35:18.407 people on the sell side will be ambivalent about that, 35:18.409 --> 35:23.029 so there are cross-pressures there. 35:23.030 --> 35:29.830 And there is patent evidence of great inflation in the ratings 35:29.829 --> 35:32.839 that these firms produce. 35:32.840 --> 35:41.990 Does that surprise you, Paul? 35:41.989 --> 35:42.989 Student: Not really, no, 35:42.994 --> 35:45.044 because they get paid by the sell side not by the buy side. 35:45.039 --> 35:46.599 Prof: Absolutely. 35:46.599 --> 35:50.979 So, they are doing--they are, in a sense, appraising as 35:50.978 --> 35:56.168 instructed and that's a pretty scary part of this whole thing. 35:56.170 --> 36:05.760 Let's reach all the way back to Adam Smith for a minute, 36:05.760 --> 36:09.930 and Smith's story, not just of the invisible hand, 36:09.929 --> 36:14.429 but of the generally benign working of markets. 36:14.429 --> 36:21.759 In everything Smith says is embedded a basic norm of truth 36:21.762 --> 36:29.612 that I'm not selling you a false mirage of a loaf of bread; 36:29.610 --> 36:31.590 I'm selling you an actual loaf of bread. 36:31.590 --> 36:37.810 I'm not selling you coffee or a substance that looks like 36:37.809 --> 36:40.179 coffee; I'm selling you coffee. 36:40.179 --> 36:44.619 And the basic accountability in bilateral trade, 36:44.619 --> 36:47.739 where you're buying something from me or I'm buying something 36:47.744 --> 36:50.434 from you, we keep each other honest, 36:50.434 --> 36:50.994 right? 36:50.989 --> 36:54.639 Where it's two parties and there's no information 36:54.635 --> 36:56.075 asymmetry, right? 36:56.079 --> 36:59.339 Where there are two parties with symmetrical information. 36:59.340 --> 37:04.170 The most foundational aspect of a market system is that buyer 37:04.172 --> 37:08.362 and seller are equipped to keep each other honest. 37:08.360 --> 37:12.190 And where there is a huge information asymmetry, 37:12.190 --> 37:20.240 we invent things like Moody's or appraisals of real estate as 37:20.242 --> 37:24.942 a substitute, a way of creating or simulating 37:24.940 --> 37:26.750 information symmetry. 37:26.750 --> 37:35.740 But if the third party agencies act like sellers to the side 37:35.737 --> 37:42.287 that pays them, the information asymmetry is 37:42.286 --> 37:47.006 actually made worse, right. 37:47.010 --> 37:54.480 And the strongest case for increased government regulation 37:54.478 --> 38:00.108 of the finance industry generally, actually, 38:00.112 --> 38:06.012 is the difficulty of policing the police; 38:06.010 --> 38:12.500 of tracking the integrity of estimates put out there by 38:12.501 --> 38:19.121 people who are in the business of correcting information 38:19.115 --> 38:21.035 asymmetries. 38:21.039 --> 38:32.739 Jaan, are there aspects of the case that you would urge us to 38:32.742 --> 38:38.012 pay greater attention to? 38:38.010 --> 38:43.260 Jan Elias: > 38:43.260 --> 38:45.680 Well, first of all, on the Triple A story, 38:45.682 --> 38:48.052 and this may not be in the case, per say, 38:48.045 --> 38:50.465 but it's certainly part of the thing. 38:50.469 --> 38:54.279 Not only is there a nice little boost to the true cost of 38:54.280 --> 38:56.800 capital if you get rated Triple A, 38:56.800 --> 38:59.740 but there are certain funds and certain buyers, 38:59.739 --> 39:02.789 like money market funds and other funds, 39:02.789 --> 39:04.549 that only can buy Triple A bonds. 39:04.550 --> 39:08.310 So once you've crossed that threshold, you have just 39:08.311 --> 39:12.221 absolutely increased the number of people and possible 39:12.219 --> 39:14.359 purchasers of your funds. 39:14.360 --> 39:16.650 Because if you put money in a money market fund, 39:16.646 --> 39:19.076 you want a reasonably liquid investment, you want a 39:19.079 --> 39:20.539 reasonably assured return. 39:20.539 --> 39:24.529 These are not supposed to be risky investments and therefore 39:24.532 --> 39:27.512 money market funds, all kinds of other funds, 39:27.509 --> 39:29.809 are limited to Triple A bonds. 39:29.809 --> 39:34.269 So, getting to the Triple A level was really important. 39:34.268 --> 39:36.118 To say something, you could go, 39:36.121 --> 39:39.271 "I'm not a big fan of their performance in this 39:39.271 --> 39:41.741 case," but in terms of Moody's & 39:41.740 --> 39:45.320 Fitch and everything, the collusion doesn't--there 39:45.318 --> 39:49.148 doesn't have to be explicit collusion in the sense that, 39:49.150 --> 39:53.270 if I give you this bond to rate, I will never rate a bond 39:53.268 --> 39:56.578 again unless you give me a Triple A rating. 39:56.579 --> 40:00.599 What happened in this case is Moody's and Fitch and others put 40:00.597 --> 40:04.347 out fairly explicit guidelines on what they consider to be 40:04.353 --> 40:05.213 Triple A. 40:05.210 --> 40:09.540 So, you're the bond packager at the iBank, you're bringing 40:09.536 --> 40:11.886 together all these mortgages. 40:11.889 --> 40:15.679 And you say "I have to reach a fifteen percent 40:15.679 --> 40:18.629 threshold level, where it's fifteen percent over 40:18.630 --> 40:21.820 collateralized, or I have to buy CDS, 40:21.822 --> 40:26.602 which are the default swaps, in order to ensure this 40:26.601 --> 40:29.711 investment and get it over that Triple A bump," 40:29.708 --> 40:33.728 you do exactly what you need to do to get that Triple A rating. 40:33.730 --> 40:37.380 And what happened when the crisis hit is we had all of 40:37.375 --> 40:41.495 these people who are just over the Triple A rating and 40:41.501 --> 40:44.071 they-- I mean, with them just 40:44.065 --> 40:47.545 over you don't have a spread-- you don't have a usual 40:47.545 --> 40:49.285 probability distribution. 40:49.289 --> 40:53.279 All of these guys who were creating these CDOs knew exactly 40:53.275 --> 40:56.855 where the finish line was, and went just a step over that 40:56.864 --> 40:59.794 to make sure that they would get the Triple A ratings. 40:59.789 --> 41:04.669 So, the fact that they were not very well understood, 41:04.670 --> 41:08.240 that the historic data went back three years and they felt 41:08.237 --> 41:11.867 very confident in doing stuff with three years of data, 41:11.869 --> 41:13.959 I think that's an interesting way. 41:13.960 --> 41:18.900 Because, when you're looking for active collusion you expect 41:18.898 --> 41:24.528 guys in seedy bars, trading information and dollars 41:24.528 --> 41:30.258 in brown paper envelopes, and sometimes it's not that 41:30.260 --> 41:31.160 explicit. 41:31.159 --> 41:35.649 There are ways that gaming the system without having anyone do 41:35.652 --> 41:39.632 anything that even resembles something that sketchy. 41:39.630 --> 41:44.800 Prof: So, it may be that legitimate 41:44.797 --> 41:51.847 cheating, cheating in a good blue suit, is more dangerous 41:51.853 --> 41:58.663 than cheating in a seedier setting with seedier... 41:58.659 --> 42:01.309 Jaan Elias: Or you're using a formula 42:01.311 --> 42:04.331 that's really untested by a heck of a lot of data, 42:04.333 --> 42:06.003 may be also a bad idea. 42:06.000 --> 42:11.760 And to go on, I'm actually kind of surprised, 42:11.760 --> 42:15.200 Doug, given that we're at an elite university with lots of 42:15.202 --> 42:19.132 people with connections to Wall Street in some way or another, 42:19.130 --> 42:23.610 that everyone thought the zebra was the people buying the 42:23.610 --> 42:24.330 houses. 42:24.329 --> 42:29.179 If you look at the data, and you have Mark Kellogg's 42:29.175 --> 42:32.675 purchase list there, if you look at the data, 42:32.677 --> 42:35.807 you begin to notice not only is there a pattern in who the 42:35.806 --> 42:38.286 appraiser is, but there are patterns as to 42:38.286 --> 42:39.276 who the buyer is. 42:39.280 --> 42:43.500 We have this one buyer here, and I'm just looking at it in a 42:43.498 --> 42:46.208 four-year period, bought five houses, 42:46.206 --> 42:48.826 six houses, all with the same broker, 42:48.829 --> 42:51.079 all with the same appraiser. 42:51.079 --> 42:55.839 We go down and there are others here, seven or eight times. 42:55.840 --> 42:58.450 Just look at the names and they repeat themselves. 42:58.449 --> 43:03.749 So, I would put the question back here, who's the lion and 43:03.753 --> 43:06.643 who's the zebra in this case? 43:06.639 --> 43:08.539 Was it the iBanks? 43:08.539 --> 43:12.799 They were relying on these folks in Cleveland to do a 43:12.804 --> 43:19.084 reasonable job in appraising, in putting out the thing, 43:19.083 --> 43:22.923 and in the end, that's what went into those 43:22.923 --> 43:24.683 formulas that I was talking about. 43:24.679 --> 43:27.329 The fact that, okay, you have houses that are 43:27.326 --> 43:30.626 appraised at this much and historically they default at, 43:30.634 --> 43:32.684 let's say, a ten percent rate. 43:32.679 --> 43:36.579 But they didn't take into account the fact that you have 43:36.579 --> 43:40.409 people who are just jiggering the system and going, 43:40.409 --> 43:43.909 in a six month period, buying a house at $25,000 and 43:43.914 --> 43:47.974 selling it at $85,000 with no evidence of any remodeling. 43:47.969 --> 43:51.879 And it just goes on, you > 43:51.880 --> 43:52.830 go through with it. 43:52.829 --> 43:55.719 The sell sheet is actually fascinating if you want to play 43:55.724 --> 43:58.344 junior detective; if you want to see how these 43:58.338 --> 44:01.398 patterns--and the data, and you can look at the data, 44:01.400 --> 44:04.110 and go "You know, this can't be right. 44:04.110 --> 44:07.820 This really can't be right in terms of selling and how much 44:07.817 --> 44:10.307 they're selling the things for." 44:10.309 --> 44:12.309 And it's actually, when you look at the story of 44:12.306 --> 44:14.186 Cleveland, which wasn't a hot market, 44:14.190 --> 44:17.160 and you can't come up with a story like you might for Miami 44:17.163 --> 44:19.113 or Las Vegas and think "Well, 44:19.110 --> 44:21.960 a lot of old people are going to move here and that's the 44:21.956 --> 44:23.886 reason land value's coming up." 44:23.889 --> 44:28.179 You can't come up with a story like that for Cleveland and it's 44:28.177 --> 44:30.667 a wonderful town, don't get me wrong, 44:30.668 --> 44:32.188 but there isn't... 44:32.190 --> 44:34.490 Prof: Worst yes, they've got the Indians and the 44:34.487 --> 44:34.867 Browns. 44:34.869 --> 44:37.969 Jaan Elias: Yes and they have the Rock 44:37.972 --> 44:40.792 'n' Roll Hall of Fame but there's really, 44:40.793 --> 44:44.183 you know, it's hard to come up with a story. 44:44.179 --> 44:49.689 So, why are we getting this kind of occurrence and so on? 44:49.690 --> 44:52.390 So, that's the point I would make. 44:52.389 --> 44:54.839 Prof: Okay. 44:54.840 --> 44:56.920 Student: So, one thing that I saw was I 44:56.922 --> 44:59.612 felt like the zebra really represents potential profits and 44:59.608 --> 45:02.108 economic profit more than an individual in itself. 45:02.110 --> 45:05.510 So, if you look from each of the actors' point of views, 45:05.510 --> 45:08.250 the zebra is really what they're--the profits that 45:08.248 --> 45:11.208 they're going after under the system that's set up. 45:11.210 --> 45:14.140 So, rationally, each player is acting in their 45:14.135 --> 45:17.385 own best interests but, in the end, the big picture 45:17.385 --> 45:20.565 ends up where it hurts the system as a whole. 45:20.570 --> 45:25.220 And so, I think that it's very easy to want to put blame on a 45:25.215 --> 45:28.155 specific party or a specific group, 45:28.159 --> 45:30.869 but it's just very difficult to do because everybody's working 45:30.871 --> 45:33.541 under the incentives that has been created for that party. 45:33.539 --> 45:36.339 Jaan Elias: And may I offer another 45:36.335 --> 45:40.855 potential zebra to consider, which is the folks--let's say 45:40.860 --> 45:45.680 you're buying one of these houses and the house next to you 45:45.679 --> 45:50.919 has been bought for $25,000 and sold for $85,000 with no visible 45:50.916 --> 45:52.326 improvement. 45:52.329 --> 45:55.199 You bought your home for $30,000, you've put another 45:55.199 --> 45:59.669 $40,000 into it, you have a legitimately $70,000 45:59.672 --> 46:02.052 house, how are you going to feel when 46:02.050 --> 46:04.600 that house next to you gets boarded up and goes into 46:04.599 --> 46:07.949 foreclosure because someone has been playing the appraisal game? 46:07.949 --> 46:12.019 So, there's an externality here to consider too in the overall 46:12.018 --> 46:12.818 community. 46:12.820 --> 46:16.300 Prof: So, who's got an idea about how to 46:16.295 --> 46:17.425 fix all this? 46:17.429 --> 46:23.399 Would it be drumming truth-telling into three year 46:23.396 --> 46:24.246 olds? 46:24.250 --> 46:35.570 Would it be--yes? 46:35.570 --> 46:36.750 Student: I think there's a huge gap in 46:36.746 --> 46:38.956 government oversight, particularly with regard to the 46:38.960 --> 46:41.210 ratings that, I mean, when Moody's 46:41.208 --> 46:46.198 is--although they have the cross pressures that you talked about, 46:46.199 --> 46:49.519 but when Moody's is being paid by one side and not the other 46:49.521 --> 46:52.391 and even if we assumed that they're all inflated and 46:52.391 --> 46:55.151 therefore just interpret them to be suspect, 46:55.150 --> 46:59.960 without some third party that's completely disinterested, 46:59.960 --> 47:02.950 like the government coming in and telling you how to rate it, 47:02.949 --> 47:05.239 you're not going to get truthful ratings and therefore 47:05.239 --> 47:07.139 the whole system falls apart from the top. 47:07.139 --> 47:10.239 Prof: Yes, that sounds right. 47:10.239 --> 47:17.069 And one of my own inclinations would be to compel the initial 47:17.072 --> 47:23.112 lenders to hold a given percentage equity in each loan 47:23.108 --> 47:28.908 so that they can't utterly ignore the probability of 47:28.914 --> 47:30.514 default. 47:30.510 --> 47:44.270 On Monday I'm going to, Monday is a wildcard in the 47:44.268 --> 47:50.528 syllabus, and I had planned to use it to 47:50.529 --> 47:55.569 do the Morys business plan, but it turns out that there are 47:55.570 --> 47:59.510 people who think it would be a terrible idea if the Morys 47:59.510 --> 48:03.100 business plan got to the Yale Daily News. 48:03.099 --> 48:10.339 And while we're 110 really good friends, I think I'd be nuts to 48:10.340 --> 48:13.260 use that at this stage. 48:13.260 --> 48:16.220 We'll do that at the end of the semester when it won't be--when 48:16.221 --> 48:18.801 it will not cause bloodshed somewhere in the system. 48:18.800 --> 48:25.630 And we'll do a--I'd like to do two things with Monday. 48:25.630 --> 48:30.380 One is: I'll post a case on Vioxx, the drug which was a 48:30.380 --> 48:35.750 COX-II inhibitor and did a lot of good for people like me with 48:35.746 --> 48:39.056 knee trouble, but it killed a few of them. 48:39.059 --> 48:43.859 And there were hard feelings and a vast avalanche of 48:43.856 --> 48:47.146 lawsuits, and we'll look at that. 48:47.150 --> 48:50.240 I'm also going to post Federalist Paper number ten. 48:50.239 --> 48:53.369 Could I--hands up if you've read Federalist ten. 48:53.369 --> 48:55.999 No American, nobody who's going to do 48:56.001 --> 49:00.071 business in this country, should fail to get the idea of 49:00.070 --> 49:03.980 the fundamental design of the American political system, 49:03.980 --> 49:07.610 which is spelled out in only a few thousand words there. 49:07.610 --> 49:09.700 See you on Monday. 49:09.699 --> 49:14.999