[User] Please transcribe this text

[Assistant] The interest rate we said was 6%, so that means there's a one-year bond that pays 106 in these two cases.


[User] Please transcribe this text

[Assistant] There's the 30-year bond where $140 could be worth this in the two cases.


[User] Please transcribe this text

[Assistant] And the, you know, the long bond market and the short bond market. So let's call this the long bond market and the short bond market.


[User] Please transcribe this text

[Assistant] Any thoughts here? So let me repeat the problem.


[User] Please transcribe this text

[Assistant] Are gonna be very fat. They're gonna, you know, the people know how to prepay. The rest of the market, it hasn't occurred to them yet that people can prepay. They're over, grossly overpaying for the mortgage, paying $120.


[User] Please transcribe this text

[Assistant] So you go and sell the mortgage short. Now that means you have to deliver whatever anyone else with the mortgage is paying. You have to deliver it to other people.


[User] Please transcribe this text

[Assistant] Okay, so that's a lot to take on, but I say that you can sell this bond for 120, put 21.7 in your pocket, take the remaining 98.84 dollars,


[User] Please transcribe this text

[Assistant] And now buy the cash flows that you're going to have to deliver in the future.


[User] Please transcribe this text

[Assistant] How do you know you can buy all the cash flows? There are 30 years of cash flows. There are coupon payments, there are pre-payments. There are all kinds of complicated payments for the cash flows. How with this 98.84 dollars you can be able to buy them all exactly?


[User] Please transcribe this text

[Assistant] All you can do is trade by the long bond and by the short bond. Or maybe sell the long bond short or sell the short bond short.


[User] Please transcribe this text

[Assistant] So how by trading these two securities can, over and over again, can you replicate the cash flows of the mortgage? That way you will have hedged out your risk.


[User] Please transcribe this text

[Assistant] And you'll have the 21.7 locked in with ever having to worry about anything in the future, provided your pre-payment calculations are correct.


[User] Please transcribe this text

[Assistant] You know, if you're wrong about pre-payments, then you're gonna be in big trouble. So you're betting on knowing what the pre-payments are. So what should you do?


[User] Please transcribe this text

[Assistant] Here they're worth, let's just do the real thing, never mind that stuff. Here they're worth 107.11. Okay, now you know that a half


[User] Please transcribe this text

[Assistant] Times, you know, a half times one over one plus r zero of 106 plus a half over one plus .06 times 107.


[User] Please transcribe this text

[Assistant] Uh, is 98.84, so the average of these discounted is that number. Okay, so.


[User] Please transcribe this text

[Assistant] And you know that the average of these numbers, uhm,


[User] Please transcribe this text

[Assistant] So this is a non-callable bond, so it's not these numbers, it's this number plus 9.


[User] Please transcribe this text

[Assistant] And this number plus 9 is paid a coupon, so the average of these numbers discounted by 6% is that.


[User] Please transcribe this text

[Assistant] Okay, so, so what does that tell you you should do?


[User] Please transcribe this text

[Assistant] Well, I claim by combining this bond and this bond, you can produce 100.6 and 107.11 here. So, so.


[User] Please transcribe this text

[Assistant] We know that this top bond is going to pay you 130.4.


[User] Please transcribe this text

[Assistant] The short bond is going to pay you 106 in both cases. So if you bought x units of the short bond, that's what your payoff would be. And you want the payoff to be, you want the payoff to be 100.6 and 107.11.


[User] Please transcribe this text

[Assistant] Okay, so there must be an XL and an XS that equals that. How do you know there has to be? Because it's two equations and two unknowns, and these are independent equations. In fact, you can tell what XL has to be. This gap.


[User] Please transcribe this text

[Assistant] Between 100.6, oh no, and 107, that gap is about 7, and this gap is about 38. Okay, so 7 is like a fifth of 38, so XL is going to have to be a fifth.


[User] Please transcribe this text

[Assistant] So I know in advance that this is going to turn out to be about 7 over 38. Okay, and x is 0.


[User] Please transcribe this text

[Assistant] Just by general principles, you know there's a solution for XL and XS. Okay, now.


[User] Please transcribe this text

[Assistant] Okay, so I know there's a solution to that because it's two linear equations and two unknowns and they're not degenerate, so I know there has to be a solution to that.


[User] Please transcribe this text

[Assistant] Okay, and I also can tell you what XL has to be because the gap, that's the difference between the top number and the bottom number is 7, that gap over there is 38. So obviously the middle gap, 106 and 106 is 0.


[User] Please transcribe this text

[Assistant] So if I take XL to be 738 of that number, the gap is going to go down from 38 to 7. And then I'll just have to find the right XS to make that equal.


[User] Please transcribe this text

[Assistant] Okay, so that combination of XL and XS will produce this payoff here and this payoff there.


[User] Please transcribe this text

[Assistant] Okay, so I know what combination the long bond and the short bond to hold so I produce exactly these things. So I'm gonna get a cash flow of, uh, you know, 100.6 and 107.11 and I'll be able to use that to make the coupon payment of 8 in both cases.


[User] Please transcribe this text

[Assistant] And on top of that, have enough money to continue buying future cash flows.


[User] Please transcribe this text

[Assistant] Uh, short B. It'll be XL. I'll have to pay $100 for the XL.


[User] Please transcribe this text

[Assistant] Uh, and it's clear that there is an xs here, okay, and an xl here, such that


[User] Please transcribe this text

[Assistant] I get the payoffs I want of 100 and 107.


[User] Please transcribe this text

[Assistant] But the last thing to notice is the cost of this XL and this XS.


[User] Please transcribe this text

[Assistant] Okay, which is going to be 140 times XL plus 100 times XS. That cost will be exactly 98.84.


[User] Please transcribe this text

[Assistant] Okay, how do I know that? And therefore I'll just be able to do it. Okay, so I'll ask you that question in a second.


[User] Please transcribe this text

[Assistant] Only worth 98.8. Someone's handing you $120 in exchange for making those mortgage cash flows.


[User] Please transcribe this text

[Assistant] Okay, so how can you put yourself in a position to have $100.6 here and $107.11 here?


[User] Please transcribe this text

[Assistant] Can you use this amount of money to buy these?


[User] Please transcribe this text

[Assistant] This value at the next step. Well we saw in the derivatives market, yes you can. But even if you can't trade in the derivatives market, you don't need to if you could trade a short bond and a long bond.


[User] Please transcribe this text

[Assistant] You know that there's some XL and some XS that will solve that. Cause it's two equations and two unknowns, so I'm repeating myself. You even know what XL is without writing down the equations. Because the gap has to be, you know, one thing there's no risk and the other thing there's a big risk. The only risk in the payoff


[User] Please transcribe this text

[Assistant] So that gap of 38, if you take 7 30 eighths of that, you're gonna get the gap to go down to 7. So the XL is gonna turn out to be 7 30 eighths. XS you have to solve by algebra.


[User] Please transcribe this text

[Assistant] Okay, so that's what you hold. That combination of XL and XS, you hold here and you get exactly the payoff. And then the final step is to notice


[User] Please transcribe this text

[Assistant] Okay, what you're buying, you're buying two things together, which are,


[User] Please transcribe this text

[Assistant] Whose payoffs together are worth 98.84. So therefore the cost of the two things separately have to be worth 98.84.


[User] Please transcribe this text

[Assistant] Okay, so it will turn out when you solve for XL and XS, you'll exactly be able to afford it with this amount of cash.


[User] Please transcribe this text

[Assistant] Okay, and so you can just do that going forward all the time, constantly re-hedging your portfolio.


[User] Please transcribe this text

[Assistant] So that's the essence of dynamic hedging.


[User] Please transcribe this text

[Assistant] Beautiful idea, which I probably haven't explained in an optimal way, but the point is that, uhm,


[User] Please transcribe this text

[Assistant] To summarize the whole thing again, the point is that you take, you know something about a bond, but you're subject to more risk besides what you know.


[User] Please transcribe this text

[Assistant] You hedge out the extra risk, still relying on yourself to be right about what you know. You relied on your being right about the prepayments, you don't know anything about the future interest rates.


[User] Please transcribe this text

[Assistant] But there's another guy, like the trader in the World Series, the broker in the World Series, who's willing to make bets on the interest rate with you. Okay, or to say the same thing, who's been calculating the values of the bond.


[User] Please transcribe this text

[Assistant] As if, you know, the short and the long bond, as if he was making bets.


[User] Please transcribe this text

[Assistant] On the interest rate. He's calculated the same 50-50 odds


[User] Please transcribe this text

[Assistant] So because there are all these guys on the market who are willing to make these game by game bets, either directly, I'm almost done, they're either to make the game by game bets on the interest rate directly in the derivatives market, or what's equivalent to that, they've used that calculus to figure out the value of these long and short bonds.


[User] Please transcribe this text

[Assistant] So by trading through the long and short bonds, you're effectively doing the same interest rate bet. So either way by trading through the two bonds or trading directly in the interest rate derivative market, you're able to buy by going game at a time, year by year, you're able to buy all the cash flows


[User] Please transcribe this text

[Assistant] Of your mortgage. The cash flows that you're predicting it's gonna have. And therefore, you can make the profit for sure.


[User] Please transcribe this text

[Assistant] Okay, so it's predicting something, being confident in your prediction, then being able to buy what you've predicted the cash flows are for a smaller price than you can sell the security for. That's how you locked in your profit. Okay.


[User] Please transcribe this text

[Assistant] And many of the new things that you'll learn has to do with uhm, building products at first. And I've just talked to you about building products.


[User] Please transcribe this text

[Assistant] Soon you'll be talking about and learning about building companies. And building companies means


[User] Please transcribe this text

[Assistant] It's mechanical. It's interesting. Uhm, lots of trial and error. It's organic. People matter. Personalities matter.


[User] Please transcribe this text

[Assistant] So I'm going to talk about what led up to the crisis and how


[User] Please transcribe this text

[Assistant] The crisis makes us realize that the things about the theory that we've been learning all semester that ought to be slightly different.


[User] Please transcribe this text

[Assistant] And I've been working on a new version of the theory for the last ten years, what I call the Leverage Cycle.


[User] Please transcribe this text

[Assistant] Which I have to say didn't get very much attention ten years ago, but which now, uhm, seems to be...


[User] Please transcribe this text

[Assistant] I don't know, it seems to be getting more attention. It's almost like, uh, life imitated art, really. It couldn't have turned out more like the theory than I would have expected.


[User] Please transcribe this text

[Assistant] So I'm gonna tell you the facts and then try to fit a theory to it and probably will spill over until Thursday and I think Thursday I won't spend that much time finishing.


[User] Please transcribe this text

[Assistant] I'll have a review class if anyone's interested for the whole material.


[User] Please transcribe this text

[Assistant] When you see the critique of the theory, it might help put the theory in a little bit more perspective. But anyway, nothing of what I say these last two days you should feel is going to be on the exam. It's just, uh, more information that you might find interesting.


[User] Please transcribe this text

[Assistant] We talked last time, remember, at one of those special classes about


[User] Please transcribe this text

[Assistant] That you would pull together a bunch of loans. These are the, uh,


[User] Please transcribe this text

[Assistant] I can do this. I guess you'd pull together a bunch of individual mortgages like this.


[User] Please transcribe this text

[Assistant] And then you put them in a giant pool and then cut the pool up into a triple A bond, a double A bond, a single A bond, a triple B bond.


[User] Please transcribe this text

[Assistant] And this is the over-collateralization of the residual. I'm not going to go through the whole structure, but suffice it to say that the idea that you take


[User] Please transcribe this text

[Assistant] Individual loans which are very risky, after all these are subprime borrowers, so everyone knew that they were risky.


[User] Please transcribe this text

[Assistant] And you create what's supposed to be an incredibly safe bond. The definition of AAA bond is that it has a 1 in 10,000 chance of going bankrupt in 10 years, of losing any principal in 10 years. That was the definition they claimed.


[User] Please transcribe this text

[Assistant] I heard a talk about power failures last night, by the way, and the power grid, which went out all across from Cleveland to, uh, Manhattan in 2003, and they said that was an event that should happen once every ten years. And then when you hear what happened in the event, you know, the, someone didn't trim a tree in the


[User] Please transcribe this text

[Assistant] You know, it seems like it could happen much more often than once every ten years, but anyway, it's the same, same thing here. This is supposed to be once every...


[User] Please transcribe this text

[Assistant] So the idea of a AAA is that they're supposed to be very safe because if the first house, uh, defaults, the first homeowner defaults,


[User] Please transcribe this text

[Assistant] Instead of paying back the hundred he owes, let's say he just stops paying. And then you throw the guy out of the house, but then you get to sell the house. The house is there as collateral for the, for the loan.


[User] Please transcribe this text

[Assistant] Now the loan should have been a hundred. The house should have been worth much more than the hundred. That's why it should have been collateral. So you should have had, you know, $120 of the house to sell. So even if the house went down by 33% to 80, that's still only a $20.


[User] Please transcribe this text

[Assistant] Dollar loss, or let's say 20 cent loss on the dollar loan, and that 20 cents comes out of the triple BP.


[User] Please transcribe this text

[Assistant] You notice how many, uh, losses you have to have if you're losing 20 cents on a house.


[User] Please transcribe this text

[Assistant] To have five dollars worth of losses, you've got to have twenty-five of a hundred houses go down, then another twenty-five of a hundred dollars of the...


[User] Please transcribe this text

[Assistant] Houses have to go down to lose this one, and then another whole bunch of them, 35 more to go down. So you've got to have like 85 houses going down before you touch the triple A, because the losses always come from the bottom and work their way up.


[User] Please transcribe this text

[Assistant] So when they made these deals, they thought it was inconceivable that you'd have 85% of the houses defaulting or that you'd lose so much more than 20% on each house because things like that just hadn't happened before. And so it seemed like they were incredibly safe.


[User] Please transcribe this text

[Assistant] Okay, so, uh, that was the structure, and the idea again was to take risky securities, and by securitizing them, create a whole bunch of apparently perfectly safe securities.


[User] Please transcribe this text

[Assistant] Because as we said, the goal of most investors is to invest in something that's completely safe. They don't have to worry about getting more in one state or more in another state. And this seemed like an ingenious way of turning a trillion dollars of very risky subprime loans


[User] Please transcribe this text

[Assistant] into, this is 81%, into 800 billion of very safe bonds and maybe riskier bonds down below that.


[User] Please transcribe this text

[Assistant] You could never find a trillion dollars worth of people willing to lend.


[User] Please transcribe this text

[Assistant] So you could put it a little bit more generally. I should have had this picture before. You could say,


[User] Please transcribe this text

[Assistant] If you're here today and you might have many of these different states of the world tomorrow,


[User] Please transcribe this text

[Assistant] Some people know that they're going to be rich in some states and poor in other states. What they'd like to do is get the same amount in every state. They can do that by directly buying safe bonds. That's what everybody's trying to do. They're trying to hedge themselves to get completely safe bonds. Most people don't know how to hedge, so the financial system creates safe bonds for them.


[User] Please transcribe this text

[Assistant] Other people, they do know how to hedge, but their, their cash flows are different in the different states, because for example, they run a business, and if interest rates go up, that might be bad for their business. If interest rates go down, it might be good for their business, so they've got different amounts of money in the different states.


[User] Please transcribe this text

[Assistant] And then to create hedging instruments for these people, you'd like to create securities that pay a lot


[User] Please transcribe this text

[Assistant] Cash flows in states that people want them. For the majority of people that's the same thing in every state.


[User] Please transcribe this text

[Assistant] For other people, it's something like the arrow securities, so they can buy money in the states when they're running short.


[User] Please transcribe this text

[Assistant] And why is this connected to mortgages? Because how do you know that anyone's gonna keep their promise to deliver money in those different states?


[User] Please transcribe this text

[Assistant] Well you don't. That's why you need collateral. And the best collateral in the country is the, is the houses. So.


[User] Please transcribe this text

[Assistant] The purpose of the financial systems we said all through the course is to create securities that pay off in different states of nature of the type people want and that are guaranteed


[User] Please transcribe this text

[Assistant] You know, so people keep their promises guaranteed by collateral.


[User] Please transcribe this text

[Assistant] Houses is the best collateral, made it inevitable that the most sophisticated part of the market


[User] Please transcribe this text

[Assistant] But no, it turns out that collateral is the key because without


[User] Please transcribe this text

[Assistant] And so, uh, houses are the best collateral.


[User] Please transcribe this text

[Assistant] We'll see now that the change in the theory that I want to describe is what happens when you


[User] Please transcribe this text

[Assistant] Suppose people might break their promises and you have to take into account collateral. Alright, so let's get back to the facts. So there are a trillion dollars of these subprime mortgages around. So then what happened? I want to skip through this pretty quickly.


[User] Please transcribe this text

[Assistant] People, you know, thought that it might be dangerous and they wrote insurance on the subprime mortgages.


[User] Please transcribe this text

[Assistant] So, on insurance on a subprime mortgage, CDS, credit default swap would say, if a dollar of the principal of the triple B


[User] Please transcribe this text

[Assistant] Uh, bond disappears, and we saw how that could happen. You take one homeowner who loses 20 cents, I mean that will come out of this first, but after all this stuff is wiped out, 20 cents of the losses because the homeowner, instead of paying his dollar, you know, doesn't pay at all, the house is sold, you only get 80 cents back.


[User] Please transcribe this text

[Assistant] That twenty cents comes out of the triple B. So the insurance would then say, the buyer of insurance would get to collect the twenty cents.


[User] Please transcribe this text

[Assistant] So this seemed like another way for people even in the triple B range to guarantee their payments. Well it turned out that


[User] Please transcribe this text

[Assistant] The triple B, that the writers of insurance didn't just write 20 cents in case it was a 20 cent loss, they might write 10 dollars of insurance on the 10, 20 cent loss.


[User] Please transcribe this text

[Assistant] So, these, uh, credit default swaps are getting very close to arrow security.


[User] Please transcribe this text

[Assistant] So the theoretically inclined economist who didn't think very far ahead in the Clinton administration, namely Larry Summers and people like that,


[User] Please transcribe this text

[Assistant] Bob Rubin, they were ecstatic about these credit default swabs because to them it reminded them of arrow securities and they thought, my gosh, the market is coming close to creating arrow securities.


[User] Please transcribe this text

[Assistant] And isn't it great that people will now be able to hedge much better because they've got these aero securities that they can trade.


[User] Please transcribe this text

[Assistant] Okay, now the problem was that who's writing the insurance? The people writing the insurance are big banks and people like AIG. So they're saying if you lose 20 cents, we'll pay the insurance. Now of course that's a promise, just like the promise to repay is, and that should have been collateralized. The trouble is that


[User] Please transcribe this text

[Assistant] When AIG, as a AAA rated company, wrote its promises, many of the people who bought the insurance just figured


[User] Please transcribe this text

[Assistant] You know, that's such a great company, it's obviously gonna have the money. Probably isn't gonna happen anyway.


[User] Please transcribe this text

[Assistant] Uh, so I'm not going to worry about the collateral. And they managed to make all these promises without putting up collateral to guarantee that they are going to keep their promises.


[User] Please transcribe this text

[Assistant] This, this, uh, mistake that people make, well it's probably not going to happen anyway, that we're going to even collect the insurance. You shouldn't have bought the insurance if you didn't think you were going to collect it. So obviously, even though it's a low probability event, you have to think, what will happen when it comes time to collect the insurance? Are they going to have the money? Now, many banks in Europe bought these things, and


[User] Please transcribe this text

[Assistant] They're accused of having realized that they wouldn't be paid off. They only bought it so they could convince their regulators that they actually had a very sound bank and therefore didn't have to, you know, set aside capital.


[User] Please transcribe this text

[Assistant] And uh, they knew very well that they probably wouldn't be paid off. They just didn't think that uh, it mattered because things wouldn't go that bad. So in any case,


[User] Please transcribe this text

[Assistant] We've got, uh, the, circle back, we've got the subprime mortgages where you've written a bunch of apparently safe bonds, a lot of people, but not many, you know, 20% holding dangerous bonds, realizing that they're dangerous, and you've got a bunch of insurance written on the dangerous bonds, but of a bit much bigger, five times as big as the amount of, uh, dangerous bonds.


[User] Please transcribe this text

[Assistant] So all these things, you know, are, if, if something goes wrong with that pool, these ones are gonna lose and then the writers of insurance are also gonna lose a huge amount of money. Okay, so, what happened? Well, on top of that, you know, there was a CDO market, uhm, where,


[User] Please transcribe this text

[Assistant] You took the triple B pieces and broke those up like you did before into, uh, into bonds, more triple A's and so on. So if something happened to this original pool and the


[User] Please transcribe this text

[Assistant] You know, a lot of people, homes started defaulting, that would wipe out all the triple B's, forcing all these people to pay insurance. And on top of that, the CDO market, which is just the same thing done again, but using the triple B's as collateral.


[User] Please transcribe this text

[Assistant] All these things would get wiped out, including the AAAs here.


[User] Please transcribe this text

[Assistant] On the triple B and A pieces of the CDOs. Alright, so we talked all about this last time. So now I want to get into what, uh, happened. Any questions? Yea.


[User] Please transcribe this text

[Assistant] Now, a buyer knows very well where his AAA is coming from. A buyer has access to all, so if you were a buyer, so my, the hedge fund I work with, Ellington, was a big buyer of these kinds of things, and also, you'll see what our strategy was, but we, uh, knew very well that, uh, so we didn't, we didn't, okay, so,


[User] Please transcribe this text

[Assistant] Let's go back to this. We're a big buyer of, uh, of things here, like these triple B's we bought a lot of.


[User] Please transcribe this text

[Assistant] So we could get for every single home in this pool, we knew the history, we know the loan to value, the income of the borrower.


[User] Please transcribe this text

[Assistant] What zip code the borrower lives in, we know a tremendous amount of information about each one of these individual houses, how they've paid before, what kind of credit rating they have, all that information we have, and so we, you know, build a model of how reliable we think these borrowers are and what they're gonna do.


[User] Please transcribe this text

[Assistant] And so on the basis of that information we can predict what we think the value of the triple B is going to be and whether it makes sense to buy insurance on it or not.


[User] Please transcribe this text

[Assistant] Take a pool where we think that the pool is really a good pool by the riskiest piece, which is down here, the residual that I described last time, for which there's no insurance.


[User] Please transcribe this text

[Assistant] Okay, now it may be that the whole world goes to hell and we lose all-


[User] Please transcribe this text

[Assistant] And we bought, we don't buy the residual, in fact we do the opposite, we buy the insurance.


[User] Please transcribe this text

[Assistant] On the triple B, there is no insurance on the residual. So for the bad pool, we've bought the insurance. For the good pool, we've bought the residual.


[User] Please transcribe this text

[Assistant] And so if we're right, the residual is going to pay a lot of money because these people aren't going to default. And if the bad pulls as bad as we think, they're going to default and we're going to collect the insurance. So we're going to win on both. And if the whole market collapses, well, our residual will go to zero.


[User] Please transcribe this text

[Assistant] But so will the triple B and the bad fool and we'll collect insurance and so we'll be protected. So that was our strategy. So yes, the answer is you have a lot of information about what you're buying.


[User] Please transcribe this text

[Assistant] Yeah, this up here is the AAA of a bad pool, but the people buying the AAA know exactly what's in the pool.


[User] Please transcribe this text

[Assistant] Okay, now they may be dumb and not bother to think about it and just trust the AAA rating without thinking about it, but probably a lot of them did think about it.


[User] Please transcribe this text

[Assistant] Okay, and if we take this pool, the CDO, these AAAs were held mostly by big banks.


[User] Please transcribe this text

[Assistant] And you would have thought they were the most sophisticated of all the buyers because they're the ones creating the pool.


[User] Please transcribe this text

[Assistant] So they certainly know what's in the pool. They're the ones who created


[User] Please transcribe this text

[Assistant] Alright, so that was the basis of the market. Now, what happened?


[User] Please transcribe this text

[Assistant] Okay, so I can describe our hedging strategy in our model, but I'm not going to do that. Okay, so this is our strategy. You go along the residual, short the bad pool. Okay, now what happened? I'll just, here's what happened.


[User] Please transcribe this text

[Assistant] There was an index that was created in the beginning of 2006. You just put together a huge number of triple B bonds and triple A bonds of different pools and average their prices. That's the index.


[User] Please transcribe this text

[Assistant] And so, it's, uh, they're all a hundred, you see.


[User] Please transcribe this text

[Assistant] Just like that. In a few months it went from 100 to 60. 100 here, three or four months later it's 60. This is March of 2007.


[User] Please transcribe this text

[Assistant] Okay now, what was the stock market doing then? You might remember the stock market, uhm, S&P. So here's the stock market, uh, too, too far in historical time.


[User] Please transcribe this text

[Assistant] It's October 31st, 2007. So ten months or nine months later, the stock market reaches its peak.


[User] Please transcribe this text

[Assistant] So all this time, from here up, the stock market is climbing and climbing and climbing. So the subprime mortgage market has collapsed.


[User] Please transcribe this text

[Assistant] Okay, so now just to put everything in perspective, what else, uh, where else are we? What other big, uhm, housing, let's look at housing prices. Here, we're gonna come back to this graph as you can see it.


[User] Please transcribe this text

[Assistant] So this is 2000 here, this is 2009 here. Green is the housing, this is Shiller's housing index. So if you set it at 100 in 2000, up here at the very top, that's the middle of 2006. Okay, it hit its peak.


[User] Please transcribe this text

[Assistant] And then started to come. So housing hit its peak in the middle of 2006, you know, third quarter of 2006. Subprime mortgages.


[User] Please transcribe this text

[Assistant] And then sort of didn't come down very fast, but started to come down.


[User] Please transcribe this text

[Assistant] Subprime mortgages collapsed in January of 2007, and the stock market started its very quick collapse in, you know, October, November 2007. So first housing prices turned, then subprime mortgages collapsed, then the stock market ten months later collapsed.


[User] Please transcribe this text

[Assistant] Okay, so subprime market collapse. Why did this market collapse? What happened to make them collapse? This is actually an example


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[Assistant] Okay, what was the information that made people think that things were going to go down?


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[Assistant] This information can be lost by reporting one.


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[Assistant] Let's look at some. These are countrywide. They're one of the bad guys. This is country that is, they're one of the ones whose loans went bad in the company.


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[Assistant] So look at delinquencies historically. So for 2003, these are countrywide loans given in 2003. Okay, it's the brown thing.


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[Assistant] And they stay there as a function of the pool.


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[Assistant] You know, some of those guys are defaulting and being thrown out of the pool. That's how delinquencies can go down. Also, people can start paying after being delinquent. Delinquent just means you're missing some payments. Okay, look at it, 2004. Okay? They're still hardly doing anything.


[User] Please transcribe this text

[Assistant] Nobody's lost anything, they've just been delinquent for a little while.


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[Assistant] Walla means weighted, uh, average age. Okay, so look at the monk.


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[Assistant] So you take things that were issued in, uh, you know, uh, this is a securitization. They're bundled together in the beginning of 2006.


[User] Please transcribe this text

[Assistant] This is the second half of 2006, but the loans actually started in 2005. They just didn't get bumped. The homeowners got their mortgages in 2005. They got securitized in 2006.


[User] Please transcribe this text

[Assistant] If you look at the, uh, delinquencies and you see that, you know, nothing happens the first 12 months. These are losses. And then eventually it goes to 1%. The losses go to 1%. We're not talking about giant numbers.


[User] Please transcribe this text

[Assistant] Well, everybody saw that. Then they looked at the losses for things issued in 2000, second half of 2006. Okay, and the losses, that's the blue line.


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[Assistant] They, uh, you know, are going to, we're talking about, you know,


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[Assistant] 20 months later, they're going to 1%, or 1.2%. You look at the things issued in 2007, which means that the loans you're really measuring from somewhere in the middle of 2006, okay, at, at, uh,


[User] Please transcribe this text

[Assistant] You know, a year, you're at half a percent. And in the second half of 2007, you're, you know, you're at .2% losses. So no losses at all.


[User] Please transcribe this text

[Assistant] And so it's on that basis, just seeing things getting worse before there are any losses.


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[Assistant] Remember these are very sophisticated people betting hundreds of millions of dollars. They're thinking hard about this. Even though nothing had happened yet, the market collapsed. Okay, so this collapse


[User] Please transcribe this text

[Assistant] That happens here is before anybody's lost any money. Hardly anyone's been thrown out of their house. Nothing's happened in the economy, but the traders have already figured out things are on a bad course.


[User] Please transcribe this text

[Assistant] Things are going to look really bad and the market collapsed, okay? So we had warning, this is the beginning of 2007, we're almost at the end of 2002, this is almost three years ago, nearly three years ago, everybody should have known


[User] Please transcribe this text

[Assistant] You can't, you know, it's a huge number of people have to get thrown out of their houses and you have to lose a huge amount of money on each house in order to get losses of 40%. Like I said, if you lose 50% on every loan, you have to throw 80% of the people out of their houses to get 40% losses. So this meant that people were expecting


[User] Please transcribe this text

[Assistant] Gigantic catastrophe. By the way, that was an exaggeration, because this was a triple B piece. It meant the triple B piece was going to lose 40%.


[User] Please transcribe this text

[Assistant] You know, the triple bead piece is only protected by six or eight percent, so it means the total losses would be ten percent, which means that, uh,


[User] Please transcribe this text

[Assistant] Ten or fifteen percent, which means if you're losing fifty percent on a house, thirty percent of the people are going to be thrown out of their houses. Okay? So it's like...


[User] Please transcribe this text

[Assistant] 30% losses and 30% of the people thrown out of their houses. That was the expectation then. But that's still terrible. There were 5 million.


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[Assistant] Subprime people. So the market at this point is expecting 30% of them to be thrown out of their houses with 30% losses. Even though the losses are 1% or less. So you can see how far-sighted the, uh, the market is.


[User] Please transcribe this text

[Assistant] So our government, everybody should have been warned right at this point that something was going to happen. Now, did the stock market realize this was such a catastrophe? Absolutely not, because the stock market waited


[User] Please transcribe this text

[Assistant] To give you an example of the losses, this is only up to December 2007, people kept announcing losses. You know, Maryland announced 9 billion, Citicorp announced 10 billion, then the next week another 10 million, UBS announced 3.7 billion, then another 10 billion.


[User] Please transcribe this text

[Assistant] Goldman announced 5 billion, Morgan Stanley 4 billion. Every other day someone was coming out saying that they lost all these billions.


[User] Please transcribe this text

[Assistant] Okay, and that was only in December 2007. The losses accelerated like crazy through 2008. So there were hundreds of billions of dollars lost.


[User] Please transcribe this text

[Assistant] Now the whole subprime market is only a trillion, but remember, there was all that insurance written on it, and who was writing the insurance? These very same people were the ones writing the insurance. So you not only lost,


[User] Please transcribe this text

[Assistant] The hundreds of billions in the subprime market, but also the, multiply that by five, the hundreds of billions all these guys wrote in insurance and in CDS, AAAs that they held. Okay, so uhm, alright, now let's see one other, uh, fact that's quite interesting.


[User] Please transcribe this text

[Assistant] Okay, so, I told you that in subprime loans,


[User] Please transcribe this text

[Assistant] For the first two years, the subprime loan, you'd be locked into the loan. A huge penalty if you prepaid. But between year two and year three, you could prepay, you know, get a new loan, refinance it. And then in year three, the interest rate would jump.


[User] Please transcribe this text

[Assistant] So what would people do? Well, people who made all their payments the first two years would be regarded as reliable payers, and so of course they would, they would refinance. They'd no longer be such subprime people. They'd refinance into, into, uhm,


[User] Please transcribe this text

[Assistant] Screwed up with their credit cards and things like that, and after they paid for a while, people would realize that, you know, they'd settle down and give them a new loan.


[User] Please transcribe this text

[Assistant] All these things just collapse. No more prepayments. And once there are no more prepayments, that means the lenders


[User] Please transcribe this text

[Assistant] Don't get their 70% back. So if you're a hedge fund figuring, you know, how much can I lose if I buy one of these subprime things? You know that between year two and year three, you're gonna get 70% of your money back.


[User] Please transcribe this text

[Assistant] Uhm, so you can't lose more than 30%. All of a sudden, you're getting 10% of your money back, which means you could lose 90%. Okay, so why would that have happened? Uhm, well, we're gonna come to that. Okay, so that's, uh, those are the basic


[User] Please transcribe this text

[Assistant] Okay, I'm not gonna, I don't have time to say more of that. Okay, so any questions about those basic facts? Now we need something to explain how they happened. Yeah.


[User] Please transcribe this text

[Assistant] You know, we know that, that losses are going to increase, but you know, they're probably not going to get very far. You know, historically they get to 3% or 4% or something like that. That's it. That's all we have to worry about.


[User] Please transcribe this text

[Assistant] And it's early on, so it's not like we've seen any losses, but they just seem to be happening so much faster than they did before. Let's extrapolate that curve. Now how do you extrapolate a curve like that? You know, there's so many ways you could extrapolate it. So they, the market extrapolated and thought, gosh, things are getting just much worse.


[User] Please transcribe this text

[Assistant] And the market started to collapse. You see, in real trading markets, people respond very quickly to very little information. I mean, their whole livelihood depends on it. It's all they're thinking about. And so they're coming up with quick


[User] Please transcribe this text

[Assistant] Conclusions, which, you know, in this case, like in many others, they're not so crazy. They're realizing something bad is happening. And they're acting very quickly.


[User] Please transcribe this text

[Assistant] Okay, so huge billions of dollars are being lost just on the basis of this amount of evidence. It's real, you know, I think it brings home how


[User] Please transcribe this text

[Assistant] Fast the market acts and how expectations about the future are driving prices.


[User] Please transcribe this text

[Assistant] And therefore, how much information? Remember we said that if you just pay attention to the market, you can learn a lot. Well, we didn't learn that much. The whole stock market, they weren't paying attention to what was happening. The mortgage market was collapsing. That should have meant something, but they weren't paying attention to it. You know, nothing in the world seemed to change because there were no people on the streets yet.


[User] Please transcribe this text

[Assistant] of, uh, guys on the street pretty soon. Homeowners on the street.


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[Assistant] Uhm, and of course now the stock market's caught on that things are really bad. Alright, so let me, so any more questions about this?


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[Assistant] So now I wanna talk about a way of understanding what happened, and then I'm gonna end, so I'm gonna go from more general to more specific. So I'm gonna talk about a way of understanding what happened, and then we're going to talk concretely about, uh,


[User] Please transcribe this text

[Assistant] How you would change the mathematics we've been doing all semester.


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[Assistant] My view of all this is that it's the leverage cycle.


[User] Please transcribe this text

[Assistant] Okay, which is the leverage cycle, as I'll define in a second, has to do with putting up collateral to make sure that you're going to pay, and so far in the course we've paid no attention to that, and in all of economic


[User] Please transcribe this text

[Assistant] Uh, that you were on the reading list, you know, by all the great Nobel Prize winners and all the great financial economists, and you'll never see the word


[User] Please transcribe this text

[Assistant] Hardly ever see the word collateral and what the, you'll never see what's the equilibrium amount of collateral.


[User] Please transcribe this text

[Assistant] Okay, and so uhm, that's been entirely missing.


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[Assistant] So, in fact, if you think about macroeconomics and the Fed, they always tell you that if things go bad in the economy, reduce the interest rate. That's the way we can stimulate investment.


[User] Please transcribe this text

[Assistant] It should be managing collateral rates and not interest rates. And in fact it has the power to manage, it's been given the authority to manage collateral rates when it was created, but it just never exercises that authority.


[User] Please transcribe this text

[Assistant] As I said in class, you know, Shakespeare already had this idea.


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[Assistant] The impatience theory of interest in Shylock.


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[Assistant] Well, you know, in the modern reading of, uh, the Merchant of Venice is that it's about anti-Semitism and Shylock's supposed to be a bad guy. I don't think Shylock, or Shakespeare intended that at all. In fact, Shylock is much more sophisticated by far, much better understanding what's going on in the world than either Antonia or...


[User] Please transcribe this text

[Assistant] Well, certainly than Antonio, who is the merchant of Venice, and Bassanio is actually, I think, quite clever, although...


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[Assistant] Harold Bloom makes Bassanio out to be an idiot and a dupe and can't imagine how Porsche could possibly marry such a guy. But anyway, I think that Bassanio is a very attractive guy and I think that, uh,


[User] Please transcribe this text

[Assistant] Uhm, Shylock is, he's the only one who really understands what's going on, so he explains the entire modern theory of impatience to, uh,


[User] Please transcribe this text

[Assistant] Okay, and remember that the play ends with, uh, you know, the ships all sinking, apparently, and so whether, you know, should Shylock be, take his collateral or not,


[User] Please transcribe this text

[Assistant] And, uh, the court rules not that you should reduce the collateral or you shouldn't take the collateral, but you should have a different collateral. Should have been a pound of flesh, but not a drop of blood. So it's the responsibility of the judicial system and the regulatory body to monitor not the interest rate, not the amount of the borrowing, but the collateral that's put up for it.


[User] Please transcribe this text

[Assistant] And that's exactly what my message is going to be. We have to manage the collateral.


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[Assistant] Okay, and so I wrote about this starting in 1997 and, uh, 2003 and then again 2008.


[User] Please transcribe this text

[Assistant] And, uh, I've written with a bunch of people and I have students who wrote on it and Arugio and Pesco were


[User] Please transcribe this text

[Assistant] Two Brazilians who wrote about it, I gave a talk there in 1997, I got them going on it.


[User] Please transcribe this text

[Assistant] And then, uh, Bernanke himself wrote about collateral, uh, in the 90s, same time, even earlier than I was, but he didn't have the idea of leverage, okay, and by


[User] Please transcribe this text

[Assistant] It's collateral for a loan, because if you don't pay the loan, they can take your house.


[User] Please transcribe this text

[Assistant] Okay, so that's called no recourse collateral if they take your house but they can't go after you for anything more. Now that in fact is not by law what happens, but in practice what happens. If you default on your mortgage, they'll take your house


[User] Please transcribe this text

[Assistant] You steal all the money, but they always just say, forget about it, we're just taking your house. So I'm going to assume that you just, they take your house and no more. Now if the house is worth $100, and you borrow $80, then the, the collateral rate


[User] Please transcribe this text

[Assistant] Is a hundred twenty five percent, because a hundred dollar house is protecting, uh, an eighty dollar loan. So it's a hundred twenty five percent. The loan to value, it's an eighty dollar loan on a hundred dollar house, is eighty percent.


[User] Please transcribe this text

[Assistant] It's the margin of safety. It's a hundred dollar house. So the lender thinks that he's protected because he's got, he's holding a hundred dollar house and he only gave you twenty dollars.


[User] Please transcribe this text

[Assistant] Okay, so it's twenty percent, and the leverage is five, because with twenty dollars of cash, you've managed to buy a house worth five times as much, a hundred. So these numbers are all the same thing, you know, it's just different ways of saying the same thing. So I prefer leverage, but uh, collateral rates are all the same thing.


[User] Please transcribe this text

[Assistant] So with twenty dollars of cash, you can manage to own a hundred dollar asset. So the leverage is five.


[User] Please transcribe this text

[Assistant] Okay, so people who borrow a lot can own huge quantities of things even though they had hardly any money.


[User] Please transcribe this text

[Assistant] The leverage, you know, how much cash do you have to put down in order to get the house? How much can you borrow using the house as collateral? Now in the standard theory that Fisher taught that we've described in this class, you've got supply and demand determining the interest rate.


[User] Please transcribe this text

[Assistant] So in my theory, supply and demand are going to determine both the interest rate and the leverage. Now that seems a little shocking because how can


[User] Please transcribe this text

[Assistant] One equation determines two variables. So I think it's for this reason that economists basically all these years ignored leverage because they just didn't see any way


[User] Please transcribe this text

[Assistant] Okay, now, what is it that's going to determine leverage? Well, this is common sense, you know, as Fisher and Shakespeare before him said that interest rates are determined by impatience.


[User] Please transcribe this text

[Assistant] The volatility of the asset price. Why is that? Because if you've got a house of a hundred protecting the eighty dollar loan, if you think the housing price is going up and down and might, you know, fall below eighty, then you're not going to feel very safe.


[User] Please transcribe this text

[Assistant] If you think the housing price is rock solid at a hundred, you're gonna be feel very safe and you'll even loan more than eighty. Okay, so the volatility of the housing price


[User] Please transcribe this text

[Assistant] Obviously is what controls how safe the lender feels, and so volatility has got to be the most important determinant of leverage.


[User] Please transcribe this text

[Assistant] So the theory, my theory, is going to be that the higher the leverage is, which supply and demand is going to determine, the higher the asset prices are, and the lower leverage is, the lower the asset prices are. Now why, why should this be the case? Well, in, in, you know, as,


[User] Please transcribe this text

[Assistant] In my view, there are many different potential buyers, you know, let's say continuous potential buyers.


[User] Please transcribe this text

[Assistant] Let's, for simplicity even, suppose that everyone has a number in his head about what the asset's worth. That's what we did on the very first day. Everyone had a reservation price of the asset.


[User] Please transcribe this text

[Assistant] And let's say though that they're willing to buy more than one football ticket. They're willing to buy as many football tickets as they can get as long as the price is less than the reservation price.


[User] Please transcribe this text

[Assistant] So what happens, the people who have the highest valuation,


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[Assistant] You know, he's marginal precisely because he's the difference between being a buyer or seller, which means the price for him is just right. These guys up here think the price is too low. That's why they're buyers. These guys down here think the price is too high. That's why they're sellers. So this is all consistent with what we've


[User] Please transcribe this text

[Assistant] So on the football ticket example, now one little twist is,


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[Assistant] How many, where does this have to be? Well, it depends on how much money these guys up here have. So Fischer actually said this, if you make people who are


[User] Please transcribe this text

[Assistant] If you make the natural buyers richer, you're not going to need as many of them to buy the assets, and the marginal guy will go up here, and the price will rise, not because the payoffs of the assets have changed, but because the marginal buyer has gone up. So to put it another way, more important way,


[User] Please transcribe this text

[Assistant] If it's easier to borrow because leverage is higher, so you can buy that $100 house with only $10 down instead of $20 down, then each of these natural buyers, instead of being able to afford to buy one house, can buy two houses or two mortgage securities or buy a house that's twice as big.


[User] Please transcribe this text

[Assistant] So the natural buyers with a lot of leverage, you'll only have, a few of them will be able to buy all the assets and the marginal buyer will be very high and the price will be very high. If there's no leverage and no borrowing, it's going to take a lot of them to buy all the assets and the marginal buyer will be down here and the price will be very low. So leverage is clearly going to affect the price. Uhm, and notice how shocking this is.


[User] Please transcribe this text

[Assistant] You know, what would Fisher say about this? So this sounds like such common sense. How could this be wrong? It sounds like so obvious. Okay, but now why didn't anybody say this before? Why didn't, uh, Fisher say this? Because remember what Fisher said. He said the price of every asset is the fundamental value of the, uhm,


[User] Please transcribe this text

[Assistant] of the cash flows. You take the future cash flows and you discount them by the interest rate, say, and that's what the price is.


[User] Please transcribe this text

[Assistant] I'm saying even if the interest rate doesn't change, you just change the amount of leverage. So these natural buyers at the top are going to be able, fewer of them are going to be able to buy all the assets.


[User] Please transcribe this text

[Assistant] Then that's going to make the price higher. So the price is not going to be equal to the fundamental value. In fact, there isn't a fundamental value. It all depends on the different opinions of the different people.


[User] Please transcribe this text

[Assistant] So what are the reasons they differ? Why should there be people who disagree about what the value is? I think that there are basically four


[User] Please transcribe this text

[Assistant] Let's say are more risk tolerant than the people down here.


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[Assistant] So the people down here are so scared to hold these assets because they might pay low numbers, low payoffs in some states and high payoffs in other states. Okay, so that


[User] Please transcribe this text

[Assistant] That assumes that they can't insure themselves against everything.


[User] Please transcribe this text

[Assistant] So that's another, another crucial ingredient to my theory, which I'm not gonna, you know, in the background here is the idea that there's not insurance for everything. So the asset here is going to be regarded as risky if it pays


[User] Please transcribe this text

[Assistant] Another reason is these people might just be more optimistic than these people.


[User] Please transcribe this text

[Assistant] So far, we've assumed that everybody believed in the same probability. What if these guys' probability of the upstate is always higher than these guys' probability of the upstate? Then they're going to be willing to pay more than these guys are.


[User] Please transcribe this text

[Assistant] Another reason might be these people simply like the assets. They like living in the house. These people are the New York bankers. They're just lending money. They couldn't care less about living in the house. The house to them is just a source of income. For these people, they really want to live in the house.


[User] Please transcribe this text

[Assistant] So another thing could be some people just have more expertise. They know how to read all these, you know,


[User] Please transcribe this text

[Assistant] Okay, so these are all different reasons why some people would be willing to pay more than other people. Okay, and so uhm,


[User] Please transcribe this text

[Assistant] So therefore, as I say, in the standard theory, the asset price is supposed to be the fundamental value. We don't talk very much about the heterogeneity of the people and how that makes the definition of fundamental value hard to maintain. So in my theory, in short,


[User] Please transcribe this text

[Assistant] In equilibrium, in normal times or, you know, good times, there's going to be too much leverage and therefore too high asset prices.


[User] Please transcribe this text

[Assistant] And in bad times, there's going to be too little leverage and therefore too low asset prices.


[User] Please transcribe this text

[Assistant] And this recurs over and over again, and it's what I call the Leverage Cycle, what I call the Leverage Cycle. Now let me give you an example of what people really had to pay for these things.


[User] Please transcribe this text

[Assistant] For a bank buying a AAA security, the, uh, there's regulation which forces them to put a certain amount of cash down.


[User] Please transcribe this text

[Assistant] Okay, so, you know, they have their depositors' money, so they can buy things with depositors' money, but they have to put some of their own capital down. So how much do they have to put down? 1.6%.


[User] Please transcribe this text

[Assistant] So they could leverage 60 to 1, $100 asset, they only paid $1.6 in cash.


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[Assistant] If you look at all the so-called toxic mortgage securities, of which there were 2.5 trillion, these are the things that crushed all the banks,


[User] Please transcribe this text

[Assistant] That they suppose, that they held, I went through security by security and made a guess as to how much cash was put down by the buyer of each of those securities and on average I got, so this is not absolutely accurate, there are a lot of guesses, but I got 16 to 1 as the leverage. So that meant that


[User] Please transcribe this text

[Assistant] If that number's right, it means 150 billion dollars of cash was paid, and 2.35 trillion was borrowed.


[User] Please transcribe this text

[Assistant] Okay, that's 16 to 1 leverage. So that means that, you know, think about it. Bill Gates and Warren Buffett, two people by themselves,


[User] Please transcribe this text

[Assistant] In 2006, had almost 150 billion dollars. That means two guys in the whole economy could have bought every single toxic mortgage security because they could have borrowed the rest of the money they needed to buy.


[User] Please transcribe this text

[Assistant] So when you think of where this line is, what I'm saying is that for all the mortgage securities, all the toxic mortgage securities, the subprime, the, you know, the alt-A, all those supposedly dangerous securities, you could have had the marginal buyer way up here. That's all that was required. Those are the only number of people.


[User] Please transcribe this text

[Assistant] The top little echelon of people bought all those securities. Could have bought all those securities because they had enough money to do it. Okay, and they hardly had to put anything down.


[User] Please transcribe this text

[Assistant] Sorry, I could have put this in a better thing. Okay, so I give all these talks with Schiller for alumni.


[User] Please transcribe this text

[Assistant] Lots of them, like every month or two months we'd be giving one of these talks and they'd bring in all these donors to say, you know, you'll need your money now. And they'd say, we don't have any money.


[User] Please transcribe this text

[Assistant] Anyhow, I'm just joking. So we'd have a lot of these talks, and Schiller would always put up the green graph. So on the right hand side, I showed you this before, it's his famous diagram, he did a brilliant thing. He decided to collect


[User] Please transcribe this text

[Assistant] Data on every transaction, every time someone purchased a house, he'd keep track of it because it's all public information and then compare it to the same house that was sold before and do a few other tricks I don't have time to explain to make an index of the housing prices in the whole country.


[User] Please transcribe this text

[Assistant] But starting in 2000, the thing that he called attention to before anybody, he said, look at this, look at this line, the housing price index from 2000 to 2006, it's gone up.


[User] Please transcribe this text

[Assistant] By almost 100%. The housing index was 102,000 when it started.


[User] Please transcribe this text

[Assistant] That's 110. Sorry, this is 100. 100 when it started here in 2000.


[User] Please transcribe this text

[Assistant] To almost double in 6 years, that means it's gone up, uhm, you know, 12% a year or something.


[User] Please transcribe this text

[Assistant] Okay, so a staggering increase in the price of housing.


[User] Please transcribe this text

[Assistant] Everybody's nuts, you know, the people, Americans, irrational exuberance and people are so crazy that they just think things are always going to go up and the price is going up higher and higher and higher.


[User] Please transcribe this text

[Assistant] And then, you know, when it got so high, the narrative changed, people started getting worried, and they started telling everyone the world was coming to an end, and the prices went down and down and down, because we have irrational exuberance, and you know, things are picking up a little bit, but we don't know whether people are irrationally exuberant, or pessimistic, or they're blipping, but anyway, they're irrational.


[User] Please transcribe this text

[Assistant] So I say, uh, so that's a story that has a certain compelling nature to it, and he deserves a lot of credit for calling attention to it.


[User] Please transcribe this text

[Assistant] Wasn't a government loan. These are private loans. You can't get the data on government loans. So on private loans, you know, every time someone took out a mortgage, you have to, you know, they put it into a...


[User] Please transcribe this text

[Assistant] You know, they were selling the loans, so therefore they published the data. You know what the appraised value of the house was, or the sale price if they were buying it for the first time, and you know what all the loans are. So I added up the value of all the loans.


[User] Please transcribe this text

[Assistant] And I divided it by the price of the house and I subtracted it off to get what the down payment was, the cash down payment.


[User] Please transcribe this text

[Assistant] So this is 2% down, 4% down, 6% down, or if you, you know, you take 100% minus this, this is...


[User] Please transcribe this text

[Assistant] You know, the loan to value, so this is 100%, you borrowed everything. Here you borrowed 98% of the value, 96% of the house, 94% of the house, etc.


[User] Please transcribe this text

[Assistant] They're amazingly, they're putting down 14%.


[User] Please transcribe this text

[Assistant] Okay, not amazing. We've been putting down 14%, so it's 7 to 1 leverage.


[User] Please transcribe this text

[Assistant] But then look what happened. The leverage went up and up and up and up and up and up. And then, it was in 2006.


[User] Please transcribe this text

[Assistant] Less than 3% down. These people were 30 to 1 leveraged. I said the securities market was 16 to 1 leveraged. The AAA part, 60 to 1 leveraged.


[User] Please transcribe this text

[Assistant] Here, there are 30 to 1 leverage. And so the prices went up. But yes, the prices went up because the leverage went up. It was so, you hardly had to put any money down. That's why people were willing to pay to buy such expensive houses because they weren't actually putting that much money down. Okay? And then leverage collapsed like this and you had to put more and more money down.


[User] Please transcribe this text

[Assistant] And so leverage collapsed, and the housing prices went down, you know, leverage was collapsing faster and in front of housing prices. So I think it's the leverage which is a crucial determinant of the price, and not irrational exuberance, although I think there is irrational exuberance, but I think leverage is what's underneath it and more basic. Now let's do the same thing with prices.


[User] Please transcribe this text

[Assistant] You're talking about things at the very, not subprime homeowners, but prime, people with brilliant credit ratings and stuff.


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[Assistant] So even now, you know, years, three years after the crisis has started, the losses on these pools are still on the single digits.


[User] Please transcribe this text

[Assistant] Uh, 8% maybe, and most of these, these are the top piece of a pool of prime borrowers. So most of these loans are, uhm,


[User] Please transcribe this text

[Assistant] You know, they're protected by 8% of, uh, you know, the bottom piece. So you have to go through 8% losses before you touch them at all.


[User] Please transcribe this text

[Assistant] So it's, it's just inconceivable that you'd see 40% losses. But so what happened? These bonds were at 100, this is 100 over here, the price is 100.


[User] Please transcribe this text

[Assistant] Okay, they're at a hundred. Now the interest rate is changing and the prices are going up and down because they're supposed to be floaters, which always pay more or less depending on the interest rate. So they should be locked in at a hundred, but they're not floating exactly.


[User] Please transcribe this text

[Assistant] On the same time, you know, they don't change their flow so fast. So the price is going up and down because of that.


[User] Please transcribe this text

[Assistant] These prices collapse, and they collapse all the way to 60. Shocking. It's just inconceivable, I think, that people could have thought there were going to be 40% losses or that.


[User] Please transcribe this text

[Assistant] Everybody could have thought there were going to be 40% losses. And then they shot back up to 80. So it's been a huge gain. If you look at a typical hedge fund...


[User] Please transcribe this text

[Assistant] Okay, now, where did uh, so that was not brilliant hedging, but uh, anyway.


[User] Please transcribe this text

[Assistant] So, but now why did these prices collapse and go back up? Is it that people just got totally irrationally pessimistic and then some, and then they said oh things can't really be that bad and things got better? Well let's look at


[User] Please transcribe this text

[Assistant] And they're still not keeping these numbers. So I, I testified in front of Ben Bernanke and the Board of Governors in October 2008. Uh, there were several of us, but it was for four and a half hours. And to, you know, and I showed them this graph.


[User] Please transcribe this text

[Assistant] So this graph is at my hedge fund, Ellington.


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[Assistant] Uh, for just a bunch of securities that were used to trading, it's how much they were offering to lend us what the down payment was they were insisting if we wanted to leverage as much as we could.


[User] Please transcribe this text

[Assistant] So we didn't leverage anything like that, but this is what they were offering us on the kinds of securities that we're interested in.


[User] Please transcribe this text

[Assistant] Okay, so this is not the greatest data because we're only looking at what we're interested in and we're only looking at the offers made to us.


[User] Please transcribe this text

[Assistant] So, but look what happened in 98 when there was a leverage crisis. That was the last one. I must have skipped the slide where I said the last leverage cycle ended in 98.


[User] Please transcribe this text

[Assistant] It was 10% down, that means 10 to 1 leverage, then suddenly it went to 40% down. So leverage drastically dropped, the down payment, the margin radically increased for a few months during the crisis, then it went back to 10%.


[User] Please transcribe this text

[Assistant] Then we had 10% down for a long time, that's 10 to 1 leverage. And then for a couple years, it became 5 to 1 leverage. So 20 to 1, a 5 to 1, sorry, 5% down means 20 to 1 leverage.


[User] Please transcribe this text

[Assistant] Okay? And so, you know, the leverage had drastically increased. And then...


[User] Please transcribe this text

[Assistant] Leverage suddenly started collapsing and lenders asked for more and more down payments, more and more down payments, and leverage was just collapsing.


[User] Please transcribe this text

[Assistant] And then leverage actually picked up here and went down again and then this graph is quite old now, May, I should have updated it, leverage has gone way up again, and the prices have gone way up. So you see leverage goes down, the prices go down, leverage goes up, the prices go up, and leverage is still heading up and the prices are much higher.


[User] Please transcribe this text

[Assistant] So that's my, my view, it's leverage that's determining a lot of these things. Okay, and uh,


[User] Please transcribe this text

[Assistant] Alright, so as I said, there's recurring leverage cycles in 1998.


[User] Please transcribe this text

[Assistant] There was a leverage cycle that's when long-term capitals, there was a book on the collapse of long-term capital that Lowenstein wrote that's on the reading list. Before that was Orange County. Remember my firm Kidder Peabody went out of business, uh, in 1994.


[User] Please transcribe this text

[Assistant] And, uh, in the end of 94, the beginning of 94, Orange County got bankrupted.


[User] Please transcribe this text

[Assistant] Uhm, partly thanks to buying securities from Killer Peabody.


[User] Please transcribe this text

[Assistant] And, uh, so that was, you know, some of you may live in Orange County. In any case, that was the derivatives crisis and there was a 1987, there was a stock market crash. So anyway, it's hard to document, document all the historical leverage cycles.


[User] Please transcribe this text

[Assistant] Because the Fed has never kept this data and most other firms don't keep their historical data. We at Ellington realized after 98 that this was a huge problem, leverage, and so we kept all the historical data. That's why I wrote my first paper on leverage and collateral and that being a crucial ingredient of the department. So we have this data and practically nobody else has.


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[Assistant] So for me, the most important thing, the first step the Fed should do is keep track of the leverage that's being


[User] Please transcribe this text

[Assistant] Ask, you know, allowed for the margins that are being demanded on every security, housing and security.


[User] Please transcribe this text

[Assistant] I heard this talk, I told you last night, on the collapse of the electric grid in, in, uh, 2003.


[User] Please transcribe this text

[Assistant] And so I said, well, you know, what was your, what have you done, obviously, obvious question, everyone wanted to know. So what have you done to make it safer? And they said the one thing they did is now they've spent


[User] Please transcribe this text

[Assistant] Tens and tens of millions of dollars getting more data. So they now monitor every single power line in real time.


[User] Please transcribe this text

[Assistant] They were, they had farmed that out to other people before and they weren't very careful about it. Now they're incredibly careful about monitoring every single line. So as soon as one line goes down, they switch the electricity and they move it evenly across a bunch of other lines. In the old days when a power line went down, the grid automatically, the sort of electricity went, the power went


[User] Please transcribe this text

[Assistant] So the next closest place and that would overload the next closest one and maybe make that one go down. Now if they know it's gone down,


[User] Please transcribe this text

[Assistant] But the point is you can't do all that without information. And they're spending tens of millions of dollars monitoring everything, and we still are not monitoring what leverage is. I think it's a shocking, uh, shocking thing. We should be monitoring leverage and then we should be regulating it. And instead we haven't even begun to monitor it, much less to figure out how to regulate it. Now why was the leverage cycle


[User] Please transcribe this text

[Assistant] I said this recurs over and over again. So why was the leverage cycle so bad in this time than it was before?


[User] Please transcribe this text

[Assistant] Uh, version of this. The short version is because


[User] Please transcribe this text

[Assistant] Leverage got higher than it ever did before. And there are lots of reasons why leverage got higher than it ever did before. We had this period of low volatility for a long time.


[User] Please transcribe this text

[Assistant] Okay, so it made it higher. We then, uhm, we then had securitization, which we didn't have before. So, you know, a, a, a subprime borrower would have


[User] Please transcribe this text

[Assistant] Had to put down a huge down payment in the old days because people would have regarded it as such a risky thing.


[User] Please transcribe this text

[Assistant] But once we packaged all the subprime loans together in a big security, and you could, you know, the AAA guy got the best of the houses, not each house, not a share of every house, but only a share of the very best houses, it all of a sudden became a much safer loan, and so you could borrow a lot more money against it.


[User] Please transcribe this text

[Assistant] Okay, against that triple A loan. So if, so the, the triple A piece, using that as collateral, you could borrow a lot of money, whereas using a single subprime, a big percentage of the price of the triple A thing, you could borrow, whereas if you had a single subprime loan, people would never lend more than, you know, 50% of the value of the house or something.


[User] Please transcribe this text

[Assistant] Okay, the second reason why things were so bad was because we had a double leverage cycle. We had leverage shooting through the roof, not just in securities as it had before, as I showed you in 98 where, you know, it was at 10% down and then the collapse to 40% down and then back to 10% down. That was a big


[User] Please transcribe this text

[Assistant] The interest rates were suddenly too high for them. Those didn't change at all. It's that the lenders suddenly demanded a much bigger down payment. Instead of 3% down, they had to put 25% down, and they couldn't afford to do it. So they couldn't refinance their loan. They didn't have the cash. So they were stuck with the old loan, and so the original lender was in much more jeopardy. Okay, and then the last thing is the CDS market.


[User] Please transcribe this text

[Assistant] So I have to explain this, this is why it's going to spill over into next time. So these insurance things...


[User] Please transcribe this text

[Assistant] They allowed people to write insurance to lose huge amounts of money.


[User] Please transcribe this text

[Assistant] Okay, so that's an obvious thing, that's why the losses were so big, but more interesting than that, they


[User] Please transcribe this text

[Assistant] They allowed the pessimists to leverage themselves, because in our old story, from way back here, in this old story, uhm, there was the old story with that. In this story,


[User] Please transcribe this text

[Assistant] Remember I said that the, you know, the natural buyers, you'd have fewer of them and they could leverage a lot.


[User] Please transcribe this text

[Assistant] Okay, so what were these guys down here doing? Well, they couldn't do anything except sell the assets and maybe make the loans. There was no way they're negative. You know, the price got higher and higher. These guys down here presumably were getting more and more disgusted and thinking, well, this market's ridiculous. I mean, the price is way too high. We don't want to buy here. And I've talked to a lot of, uh,


[User] Please transcribe this text

[Assistant] Insurance companies like Northwestern Mutual Life, the guy who runs that, uh, they, they, you know, he said we used to be a big buyer of mortgage securities and subprime mortgages and stuff in 2004 and the price got so high in 2006, to us it became ridiculous, we just dropped out of the market.


[User] Please transcribe this text

[Assistant] But dropping out of the market is one thing. What if they could bet against the market? Well, they had no opportunity to do that before. They couldn't express their negative view. But starting in 2005, where this, uh, CDS market really took off,


[User] Please transcribe this text

[Assistant] When the CDF market really took off, they could suddenly express their negative view.


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[Assistant] So in my view, in my opinion, what happened was that at the end of 2005, the pessimists for the first time were able to bet on the market going down.


[User] Please transcribe this text

[Assistant] And so that's what started to make prices go down because of the CDS market. When prices started to go down, the mortgage securities that had been sold with all that leverage for high prices started to go down in price. That meant that new securitizations


[User] Please transcribe this text

[Assistant] And then that started to make the world more dangerous and that's why then on securities, the lenders on securities reduced the leverage and then the whole thing started to spiral. That's my...


[User] Please transcribe this text

[Assistant] Story of how the thing, uh, started. So, let's, uh, say that in the bottom of the leverage cycle,


[User] Please transcribe this text

[Assistant] There's scary bad news that creates more uncertainty and more disagreement. Okay, so it wasn't just that people thought that losses were going to go from 40%


[User] Please transcribe this text

[Assistant] To 20% on subprime mortgages. It's that they went from 4% expected with a range of 1 to 5%.


[User] Please transcribe this text

[Assistant] For a decade the curves have been flat. Suddenly they're starting to accelerate. How do you know how to extrapolate them? There's huge uncertainty and because, you know, huge volatility and so naturally the lenders are going to be much more nervous and lend only with much more collateral.


[User] Please transcribe this text

[Assistant] Once the lenders lend with much more collateral, those people at the top can't afford to buy things anymore. They're gonna have to sell.


[User] Please transcribe this text

[Assistant] Okay, and, uh, so there's deleveraging, sorry, and the people at the top are gonna have to sell. But the price is gonna go down, and because they borrowed money, you know, and, and using an asset as collateral, their leverage, we talk about that, their losses are gonna be gigantic, because they're betting essentially on things going up and things are going down, so they lost a huge amount of money.


[User] Please transcribe this text

[Assistant] So what's so bad, so I, okay, so I'm going to talk for four more minutes and hand back the exams, or should I just hand back the exams right now? What do you, are you? Okay, I'll talk four more minutes, some of you aren't going to come next time.


[User] Please transcribe this text

[Assistant] Uhm, so I'm gonna do how the math, maybe most of you, so I'll do how the math changes next time. So what's so bad about the leverage cycle? So let's just think about what, all the bad things that happen. Number one,


[User] Please transcribe this text

[Assistant] You can have a tiny group of people at the top controlling the price because they can borrow so much money. Now we've always assumed that everybody was rational. What if these buyers are kind of crazy? A few guys can make the price skyrocket because they can borrow so much money.


[User] Please transcribe this text

[Assistant] Okay, now once they do that and they're making the prices of assets skyrocket, people are going to build more of those assets. So they're going to use real resources to build projects that are probably, you know, crazy and are going to be very costly to revert.


[User] Please transcribe this text

[Assistant] Okay, but let's leave aside now, people being crazy, what else happens in the leverage cycle?


[User] Please transcribe this text

[Assistant] In the leverage cycle, when you're leveraged a lot, as we, as we said, you know, that's going on the, on the Tobin diagram to the right. It's like borrowing money to bet in the, uh, in the stocks. That means if the stocks go up, you multiply your winnings, and if the stocks go down, you multiply your losses. So in the leverage cycle,


[User] Please transcribe this text

[Assistant] People who are lucky, if things keep going up, they get incredibly rich. You know, it's a tremendous mystery in economics. Why is it that inequality, uh, you know, increased so much? Well, one of the reasons, I think, is the leverage cycle. That, you know, people were betting and making more and more money, and so that's why inequality was helping to spread inequality.


[User] Please transcribe this text

[Assistant] Now another thing is, the worst, probably the biggest problem is that once the asset prices fall, everything gets hard to do. So if you want to get a new credit card,


[User] Please transcribe this text

[Assistant] Right? To a buyer. Now, why should a buyer buy your promise for a hundred


[User] Please transcribe this text

[Assistant] You know, you're promising to pay back in the future, so he's paying a hundred for you, when the very same promise that someone made six months ago,


[User] Please transcribe this text

[Assistant] It's selling for 65, because the prices of all collapse.


[User] Please transcribe this text

[Assistant] They're not going to buy the new promises when they can buy the old promises at such a low price. Who's gonna buy a new mortgage when the old mortgages are selling at 65? Who's gonna buy a new auto loan when the old auto loans are selling so low? So nobody can get a new loan, nobody can get a new, uh, you know, can sell a new promise.


[User] Please transcribe this text

[Assistant] And no business can sell its promise. They're old businesses that everybody understands, whose bonds are out there being traded at very low prices. The investors are gonna all buy the old assets, not the new assets. That's why activity collapses.


[User] Please transcribe this text

[Assistant] Okay, and then another terrible thing is that what if the optimists are indispensable to the economy? Like the big banks, they go out of business and everything topples. Well why didn't the big banks take that into account? Shouldn't they have realized the losses would be so big and try to protect themselves? Well they're not taking into account


[User] Please transcribe this text

[Assistant] That when they go under and the managers lose a lot of money that there are other people they don't care about like all their workers and the rest of the economy that's losing even more that they're not paying attention to. So they're not internalizing all the losses when they go out of business. Another incredibly bad thing is what we're suffering from now is debt overhang. There are a tremendous number of people, homeowners to name one,


[User] Please transcribe this text

[Assistant] Who are underwater. That means they owe more money than their house is worth. Or banks that have more debt.


[User] Please transcribe this text

[Assistant] Now many of these people don't just go bankrupt. They keep going because maybe they'll get lucky. You know, maybe some miracle will happen and the stuff they own is going to go up in value.


[User] Please transcribe this text

[Assistant] So they don't stop, they still exist, but they're what people have called zombies. They're not doing anything productive because what's the point in fixing up your house if more than likely you're gonna end up losing it anyway? So all these homeowners are not doing anything to take care of their houses, the banks aren't making loans,


[User] Please transcribe this text

[Assistant] You know, these firms aren't making productive investments because they know they're so far underwater.


[User] Please transcribe this text

[Assistant] Another horrible thing happens is that, you know, if you try to collect the collateral, when people default, it's a costly operation. So in subprime loans, it takes 18 months to throw somebody out of their house.


[User] Please transcribe this text

[Assistant] So during those 18 months, the guy's not paying his mortgage, he's not paying his taxes, all of which the...


[User] Please transcribe this text

[Assistant] You know, at the beginning people assumed it could never be less than 80%. Now it's one quarter. Okay, now, uhm,


[User] Please transcribe this text

[Assistant] Okay, and then there's other more complicated things that can go wrong, which I'm gonna skip over.


[User] Please transcribe this text

[Assistant] Okay, so let's just, uh, see what happens now with housing.


[User] Please transcribe this text

[Assistant] So what is it that's happening with housing? If you look at people underwater, why are people defaulting on their houses? It's because they're underwater.


[User] Please transcribe this text

[Assistant] These are except government loans. This is the fraction of people who default every month, not every year. And here's their loan to value. So how did I figure out the loan to value? I had to look at all the original loans. I did this house by house, or Ellington, my hedge fund, actually, the guys there who were former students.


[User] Please transcribe this text

[Assistant] Uh, here, uh, they did, they actually figured all this out. They went house by house, they got what the combined loan, you know, the loan sizes were on all the houses, and then using the Shiller index, they know what the house was bought for, and assuming the zip code index dropped by 20%, they figured every house in the index went down by 20%, they could get the current value of the house.


[User] Please transcribe this text

[Assistant] Current combined loan to value ratio. So 140 means the loans altogether, first and second loans, are 140% of what they estimate the value of the houses. So look at what happens.


[User] Please transcribe this text

[Assistant] If you're subprime and you've got that, I can't see mine, this is 140s over here somewhere, right?


[User] Please transcribe this text

[Assistant] Uhm, you're, you're defaulting more than 6% a month. If you're 160, you're defaulting at 8%. Every month, 8% of those people are becoming serious delinquent and, and probably will never repay. 8% a month. In one year, they're all gonna be gone. Okay, so you can see this is a shocking


[User] Please transcribe this text

[Assistant] You know, it's shockingly sensitive to loan to value. It's not that people are defaulting because they lost their jobs.


[User] Please transcribe this text

[Assistant] They're defaulting because it's not worth it for them to pay. They're not stupid. Why should they pay 160,000 when the house is only worth 100,000? It's just, how can they, you know...


[User] Please transcribe this text

[Assistant] Times are tough. What are they going to do? Tell their children, well, we can't go to, we can't feed you, you can't go to school because, you know, daddy and mommy have to pay this thing where we don't really have to pay it. They're not going to do it.


[User] Please transcribe this text

[Assistant] So somehow, I couldn't convince Larry Summers of this. I tried hard. I wrote an op-ed in the New York Times in October of 2000.


[User] Please transcribe this text

[Assistant] A year ago, what are we talking about? October of 2008 and March of 2009 saying that the only way to save the housing market was to write down principles.


[User] Please transcribe this text

[Assistant] Okay, now writing down principle means saying, if the loan is 160,000, maybe the house used to be 200,000, the house is only 100,000 now.


[User] Please transcribe this text

[Assistant] You just say, okay, we're writing off 80,000 of the loan. It's now only 80,000 dollars that the homeowner owes. Now who's going to pay for the lost 80,000? I say nobody has to pay for it. The government doesn't have to pay a penny.


[User] Please transcribe this text

[Assistant] The bond hold of the lender would be better off writing down the loan to 80,000 than throwing the guy out of the house and getting 40,000 in the end. Because once the loan is written down to 80,000, the homeowner now has 20,000 of equity in the house.


[User] Please transcribe this text

[Assistant] He'll either work hard, you know, to fix it up and spruce it up and sell it for $100,000, or he'll actually pay the $80,000. Either way, the lender's gonna get $80,000, not $40,000.


[User] Please transcribe this text

[Assistant] So this is a win-win, as I called it in the editorial with Susan Koniak. It's a win-win situation, and it's not happening.


[User] Please transcribe this text

[Assistant] Okay, and it's not happening because the loans are all in the hands of the servicer. So remember I said there was this big pool with all the loans in them.


[User] Please transcribe this text

[Assistant] The principle written down, but the, the bondholders don't know who the homeowners are and aren't legally allowed to talk to them. There's a servicer in the middle who's a big bang who's writing the letter saying pay up and if they pay up they distribute the money to the bondholders and if they don't pay up the servicer throws them out of the house.


[User] Please transcribe this text

[Assistant] The servicer, the big man, doesn't own the loan. They're getting paid a percentage, like 0.5% of the principal.


[User] Please transcribe this text

[Assistant] So they have no incentive to write down these loans. If they write down the loan in half, they lose half their fee. If they write down the loan to 80,000, then the guy sells the house. They don't, they don't service the house anymore. They lose all their fees.


[User] Please transcribe this text

[Assistant] Instead, Obama, thanks to, you know, my classmate Larry Summers and all his other advisors, they've given these services license not to write down any loans, but to, you know, pretend that they're writing down the interest on the loans. Now that would be great if the


[User] Please transcribe this text

[Assistant] So these people are not paying anything now. There are millions of them not paying anything. Still living in their houses. In a year or two they're gonna get thrown out. Okay, uh, but they, well of course they're not gonna pay. This is the ideal situation for the servicer because he's still collecting his C.


[User] Please transcribe this text

[Assistant] The homeowners can't sell, they don't want to leave because they're not paying anything, and the bondholders are getting screwed. So it's a catastrophe.


[User] Please transcribe this text

[Assistant] And finally, after a year, if you read the op-eds in the New York Times and the Wall Street Journal, in the last week or two, there have been deluged with people saying, why aren't they writing down principles? Okay, so this is something that a year or two ago,


[User] Please transcribe this text

[Assistant] I already advocated that anyone with any common sense would have seen that was what was inevitably going to happen and we didn't do anything about it. Okay, so I got one more minute to finish.


[User] Please transcribe this text

[Assistant] So what should we do about the leverage cycle? Well the thing to do about the leverage cycle is to, is to


[User] Please transcribe this text

[Assistant] So the bank, the Fed has to go and increase leverage. So it used to be, you know, 30 to 1 or 20 to 1. Now it's close to 1 to 1 on many assets, although it's gone up a little bit. So the Fed has actually done something about this. What does it have to do? Not lend at lower interest. The Fed cut the interest rate to zero and said, look how great we are.


[User] Please transcribe this text

[Assistant] Well that did nothing practically. All it did, the reason the Fed has cut the interest rate to zero, is to give money to the big banks. Because the banks have to pay depositors like you and me. Now in your checking account or savings account, you're getting zero practically, because the Fed lowered the interest rate to zero. That means the banks...


[User] Please transcribe this text

[Assistant] Make money because they don't have to waste any money giving it to their depositors. Okay, that's the reason why the interest rate went down to zero. And they're, they try to dupe the public into thinking it's because it's a Keynesian stimulus.


[User] Please transcribe this text

[Assistant] I'm running out of time so I can't explain how it's actually done that and that's one of the big reasons leverage is starting to go up. Secondly, you have to replace


[User] Please transcribe this text

[Assistant] Some of the natural buyers, okay, who have gone out of business, the ones at the top were doing all the buying. Without them, the price is going to be worth much less.


[User] Please transcribe this text

[Assistant] The government is going to have to do some buying. So through the PIP program and other things, it is doing some of that. And then finally, the first thing, the most important thing, the crisis began with housing. Housing is the first thing you have to do to, to, to lessen the instability and the uncertainty in the economy.


[User] Please transcribe this text

[Assistant] It's now started with housing and it's spread to other people who are underwater. That's where all the uncertainty comes from. So we have to straighten out who's going to go out of business and who's not going to go out of business.


[User] Please transcribe this text

[Assistant] We have to write down principle of the homes. That's the way to, to, to reduce that uncertainty. And in the long run, we have to prevent the next leverage cycle by never letting leverage get so high. So we have to keep the data and we have to prevent people from asking for so little margins.


[User] Please transcribe this text

[Assistant] Congratulations on learning about the foundations of diffusion models. Now, putting it all together, you're able to train a diffusion model to predict noise and iteratively subtract the predicted noise from pure noise to get a good image.


[User] Please transcribe this text

[Assistant] You're able to sample images from that trained neural network fast too with a more efficient sampler called DDIM.


[User] Please transcribe this text

[Assistant] You went through the model architecture, a unit. You put context into the model so that you could decide whether you wanted food or spells or a hero sprite out, or something quirky in between.


[User] Please transcribe this text

[Assistant] Finally, you explored and ran the code for all of this. Now, you can create your own dataset and try to generate new things.


[User] Please transcribe this text

[Assistant] Diffusion models aren't bound to images either. That's just where they've been the most popular. There are diffusion models for music, where you can give it any prompt and get music out. For proposing new molecules to accelerate drug discovery. You can also try a larger dataset. Try a new sampler. There are actually a ton out there that are even faster and better than DDIM.


[User] Please transcribe this text

[Assistant] And textual inversion, which enables the model to capture an entirely new text concept with just a few sample images.


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[Assistant] You covered the basics here, the foundations. There are other important developments in this space. For example, stable diffusion uses a method called latent diffusion, which operates on image embeddings instead of images directly to make the process even more efficient.


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[Assistant] Other cool methods to call out are cross-attention text conditioning and classifier-free guidance.


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[Assistant] All in all, this is an extremely exciting time for diffusion models and generative models as a whole, as they improve and their applications become ever more widespread.


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[Assistant] Thank you so much for joining me in this course and I look forward to seeing what you build.


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[Assistant] Hello, and welcome to Elf Learning's Big Numbers set. Can you chant along? Ten!


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[Assistant] 8, 9, 10. 11. 10 plus 1 equals 11. 12. 10 plus 2 equals 12.


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[Assistant] 13 10 plus 3 equals 13 14 10 plus 4 equals 14


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[Assistant] 15. 10 plus 5 equals 15. 16. 10 plus 6 equals 16. 17. 10 plus 7 equals 17.


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[Assistant] 18. 10 plus 8 equals 18. 19. 10 plus 9 equals 19. 20. 30 minus 10 equals 20. 30. 40 minus 10 equals 30. 40.


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[Assistant] 50 minus 10 equals 40. 50. 60 minus 10 equals 50. 60. 70 minus 10 equals 60. 70. 80 minus 10 equals 70.


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[Assistant] 80, 90 minus 10 equals 80. 90, 100 minus 10 equals 90. 100, 110 minus 10 equals 100 plus.


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[Assistant] One plus one equals two minus one minus one equals zero equals


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[Assistant] One equals one. Bigger than.


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[Assistant] Two is bigger than one. Smaller than. One is smaller than two.