[User] Please transcribe this text

[Assistant] You could say three and a half, or you could also say three and a quarter, because if you said three and a quarter, you'd make, you'd become closer on all the low rolls of the dice, and be a little further off on all the high rolls, and you'd get exactly the same error. So you could say any number between three and four.


[User] Please transcribe this text

[Assistant] Uhm, so that, that's connected to a mathematical thing and, you know, and orthogonal vectors and all that.


[User] Please transcribe this text

[Assistant] Uh, the error we talk about always is the squared error. So that's whenever we're measuring uncertainty, we're going to talk about the


[User] Please transcribe this text

[Assistant] Okay, I have one more minute to just finish this. So this is, I'm assuming you all, uh, know that. Okay, or can learn that. Okay, one more thing that I'm going to assume you know. The last thing is the covariance.


[User] Please transcribe this text

[Assistant] What does it mean to say that random variables x and y move in the same direction? So this is quite a brilliant thought. So what it means is that


[User] Please transcribe this text

[Assistant] To move in the same direction means if x surprises you by being above what you would have expected, so if the expectation of x is x-bar and the expectation of y is y-bar, if you multiply the two and they're both higher than you expected, you'll get a positive number. If they're both lower than expected, you'll also get a positive number.


[User] Please transcribe this text

[Assistant] So by taking this sum, the expected deviation from the expectation multiplied, you get a number which when it's very positive, it means they're either both positive together or both negative together. So they're going in the same direction. If one of them is above the average while the other one's below the average, then you'll get a negative number. So big covariance means


[User] Please transcribe this text

[Assistant] They move in the same direction, big negative covariance means they move in the negative direction, okay? So, I'm gonna take it for granted you know this and we're gonna take this up starting right after the exam, which is on Tuesday.


[User] Please transcribe this text

[Assistant] I was afraid someone was going to do that. Okay, so let's just see where I got this equation from.


[User] Please transcribe this text

[Assistant] Let's do the present value of the discounted dividend. What would it be?


[User] Please transcribe this text

[Assistant] How about the Pine Hotel? It's $80 a night. I don't want to waste too much on accommodations.


[User] Please transcribe this text

[Assistant] What about the Sunrise Hotel? It usually costs $140 a night, but now they're running a promotion and we can stay one night for $90.


[User] Please transcribe this text

[Assistant] It's between the beach and downtown. Plus, it has free wifi.


[User] Please transcribe this text

[Assistant] How about the Pine Hotel? It's $80 a night. I don't want to waste too much on accommodations.


[User] Please transcribe this text

[Assistant] What about the Sunrise Hotel? It usually costs $140 a night, but now they're running a promotion and we can stay one night for $90.


[User] Please transcribe this text

[Assistant] It's between the beach and downtown. Plus, it has free wifi.


[User] Please transcribe this text

[Assistant] Well, there's going to be a group session first, so let's separate the tables into four sections. Four people will be seated in each group.


[User] Please transcribe this text

[Assistant] Thank you. And we'll have a short presentation at the beginning of the session, so we need a projector here.


[User] Please transcribe this text

[Assistant] What about putting the whiteboard at the other end of the room? That makes sense.


[User] Please transcribe this text

[Assistant] After the meeting, we need to put everything back where it was, in four rows of two tables per row.


[User] Please transcribe this text

[Assistant] Well, there's going to be a group session first, so let's separate the tables into four sections. Four people will be seated in each group.


[User] Please transcribe this text

[Assistant] And we'll have a short presentation at the beginning of the session, so we need a projector here.


[User] Please transcribe this text

[Assistant] How about putting the whiteboard at the other end of the room? That makes sense.


[User] Please transcribe this text

[Assistant] After the meeting, we need to put everything back where it was, in four rows of two tables per row.


[User] Please transcribe this text

[Assistant] Okay, that sounds good. Well, starting with the paper, it looks like there's only one box left.


[User] Please transcribe this text

[Assistant] Okay, the printer is out of color ink. Should we order that?


[User] Please transcribe this text

[Assistant] Okay, looks like these whiteboard markers are running out of ink.


[User] Please transcribe this text

[Assistant] Okay, and while we're at it, can we order a mouse? Sometimes it works, but sometimes it doesn't.


[User] Please transcribe this text

[Assistant] Sure. Well, we have three batteries here.


[User] Please transcribe this text

[Assistant] Okay, that sounds good. Well, starting with the paper, it looks like there's only one box left.


[User] Please transcribe this text

[Assistant] Okay, the printer is out of color ink.


[User] Please transcribe this text

[Assistant] Okay, looks like these whiteboard markers are running out of ink.


[User] Please transcribe this text

[Assistant] Okay, and while we're at it, can we order a mouse? Sometimes it works, but sometimes it doesn't.


[User] Please transcribe this text

[Assistant] Sure. Well, we have three batteries here.


[User] Please transcribe this text

[Assistant] Sure, there are a few ways. If you take bus number one, it takes about one and a half hours to the airport. It's the least expensive way.


[User] Please transcribe this text

[Assistant] Bus number two is a non-stop bus. It's more expensive and leaves once every hour, but it only takes 50 minutes. I see. What about taxis?


[User] Please transcribe this text

[Assistant] There's a taxi stand in front of the building, and they take about an hour.


[User] Please transcribe this text

[Assistant] But they use the expressway and charge extra for a lot of luggage, so it's going to be a lot more expensive than the bus.


[User] Please transcribe this text

[Assistant] You didn't by chance buy anything at Shopping World while you were here. They offer complimentary shuttle service to the airport for customers who make a purchase there.


[User] Please transcribe this text

[Assistant] Sure, there are a few ways. If you take bus number one, it takes about one and a half hours to the airport. It's the least expensive way.


[User] Please transcribe this text

[Assistant] Bus number two is a non-stop bus. It's more expensive and leaves once every hour, but it only takes 50 minutes. I see.


[User] Please transcribe this text

[Assistant] What about taxis? There's a taxi stand in front of the building and they take about an hour.


[User] Please transcribe this text

[Assistant] But they use the expressway and charge extra for a lot of luggage, so it's going to be a lot more expensive than the bus.


[User] Please transcribe this text

[Assistant] You didn't by chance buy anything at Shopping World while you were here. They offer complimentary shuttle service to the airport for customers who make a purchase there.


[User] Please transcribe this text

[Assistant] Red and green sweaters. Actually, we're running low on green sweaters and we're waiting on some green yarn from our supplier. We'll get you started with the red sweaters though.


[User] Please transcribe this text

[Assistant] Okay, I think we can get 200 of the green sweaters to you on time. Which size has higher priority?


[User] Please transcribe this text

[Assistant] Alright, we'll do our best. We'll get those green sweaters to you along with all the red sweaters you ordered.


[User] Please transcribe this text

[Assistant] Red and green sweaters. Actually, we're running low on green sweaters and we're waiting on some green yarn from our supplier. We'll get you started with the red sweaters though.


[User] Please transcribe this text

[Assistant] Okay, I think we can get 200 of the green sweaters to you on time. Which size has higher priority?


[User] Please transcribe this text

[Assistant] Alright, we'll do our best. We'll get those green sweaters to you along with all the red sweaters you ordered.


[User] Please transcribe this text

[Assistant] Well then, I'll explain the rules to you. You can borrow up to six books and five CDs or DVDs at a time per person.


[User] Please transcribe this text

[Assistant] But you can only borrow up to 10 items in total at a time.


[User] Please transcribe this text

[Assistant] Everything needs to be returned in two weeks, and if you'd like to renew, please let us know before then.


[User] Please transcribe this text

[Assistant] You can't borrow newspapers, but you can borrow magazines except for the latest issue.


[User] Please transcribe this text

[Assistant] We can't accept returns through the mail. Please come to the library to return them. After hours, you can put them in the box next to the entrance. But items that are overdue, please return them directly to this desk.


[User] Please transcribe this text

[Assistant] Well then, I'll explain the rules to you. You can borrow up to six books and five CDs or DVDs at a time per person.


[User] Please transcribe this text

[Assistant] But you can only borrow up to 10 items in total at a time.


[User] Please transcribe this text

[Assistant] Everything needs to be returned in two weeks, and if you'd like to renew, please let us know before then.


[User] Please transcribe this text

[Assistant] You can't borrow newspapers, but you can borrow magazines except for the latest issue.


[User] Please transcribe this text

[Assistant] We can't accept returns through the mail. Please come to the library to return them. After hours, you can put them in the box next to the entrance. But items that are overdue, please return them directly to this desk.


[User] Please transcribe this text

[Assistant] I'm going scuba diving. Since I'll be bringing all my own equipment, I'm a bit worried about getting it stolen.


[User] Please transcribe this text

[Assistant] Plan A is the most expensive one, right? What's the difference between Plan B and Plan C?


[User] Please transcribe this text

[Assistant] I see. If I get the special contractor scuba diving equipment and add it to plan B or plan C, would it be more expensive than plan A?


[User] Please transcribe this text

[Assistant] Okay, by the way, is there any plan that's cheaper than plan C?


[User] Please transcribe this text

[Assistant] Got it. I agree that I need coverage, but I don't think I need coverage for family plane tickets. So, I'll take this plan and combine it with the insurance for scuba diving equipment.


[User] Please transcribe this text

[Assistant] I'm going scuba diving. Since I'll be bringing all my own equipment, I'm a bit worried about getting it stolen.


[User] Please transcribe this text

[Assistant] Plan A is the most expensive one, right? What's the difference between Plan B and Plan C?


[User] Please transcribe this text

[Assistant] I see. If I get the special contractor's scuba diving equipment and add it to plan B or plan C, would it be more expensive than plan A?


[User] Please transcribe this text

[Assistant] Okay, by the way, is there any plan that's cheaper than plan C?


[User] Please transcribe this text

[Assistant] Got it. I agree that I need coverage, but I don't think I need coverage for family plane tickets. So, I'll take this plan and combine it with the insurance for scuba diving equipment.


[User] Please transcribe this text

[Assistant] Did you tally up the results for the A and B branches separately?


[User] Please transcribe this text

[Assistant] So, employees in both branches answered about one to two hours the most. Looks like they're exercising about once a week.


[User] Please transcribe this text

[Assistant] Hmm, not even 10% of employees at the B branch exercise more than 6 hours.


[User] Please transcribe this text

[Assistant] That's a good idea. It'd give employees a good chance to socialize too. I'll leave it to you.


[User] Please transcribe this text

[Assistant] Did you tally up the results for the A and B branches separately?


[User] Please transcribe this text

[Assistant] So, employees in both branches answered about one to two hours the most. Looks like they're exercising about once a week.


[User] Please transcribe this text

[Assistant] Hmm, not even 10% of employees at the B branch exercise more than 6 hours.


[User] Please transcribe this text

[Assistant] That's a good idea. It'd give employees a good chance to socialize too. I'll leave it to you.


[User] Please transcribe this text

[Assistant] I haven't decided yet either. I'm interested in environmental issues, so I'm looking for something in a nature conservation group.


[User] Please transcribe this text

[Assistant] Well, that'd be okay, actually, but I'm looking for a group activity. I want to learn more about a leadership role in this kind of organization as well, if possible.


[User] Please transcribe this text

[Assistant] Yeah, that sounds good, thanks. It'd also be a great opportunity to interact with children. Do you want to do this too?


[User] Please transcribe this text

[Assistant] Oh, my mother is helping out at the local senior center. Would that be interesting to you?


[User] Please transcribe this text

[Assistant] I haven't decided yet either. I'm interested in environmental issues, so I'm looking for something in a nature conservation group.


[User] Please transcribe this text

[Assistant] Well, that'd be okay, actually, but I'm looking for a group activity. I want to learn more about a leadership role in this kind of organization as well, if possible.


[User] Please transcribe this text

[Assistant] Yeah, that sounds good, thanks. It'd also be a great opportunity to interact with children. Do you want to do this too?


[User] Please transcribe this text

[Assistant] Oh, my mother is helping out at the local senior center. Would that be interesting to you?


[User] Please transcribe this text

[Assistant] Hmm, maybe it's too high for some people. They probably can't see it. Then let's put it on the middle shelf. Sounds good. They'll see it when they first come into the store.


[User] Please transcribe this text

[Assistant] And why don't we put a red cloth on this shelf so that they know it's our new bread?


[User] Please transcribe this text

[Assistant] Looks good. Let's see how it goes for a week and then decide if we need to make any adjustments.


[User] Please transcribe this text

[Assistant] Maybe it's too high for some people. They probably can't see it. Then let's put it on the middle shelf. Sounds good. They'll see it when they first come into the store.


[User] Please transcribe this text

[Assistant] And why don't we put a red cloth on this shelf so that they know it's our new bread?


[User] Please transcribe this text

[Assistant] Looks good. Let's see how it goes for a week and then decide if we need to make any adjustments.


[User] Please transcribe this text

[Assistant] Uh, this is John Shinakopoulos again. I'm here to give a lecture that I gave one evening.


[User] Please transcribe this text

[Assistant] Uh, that we couldn't record, so I'm going to try and reproduce the lecture as faithfully as I can.


[User] Please transcribe this text

[Assistant] Uh, it's a historical lecture, I hope you find it interesting, about the history of the mortgage market.


[User] Please transcribe this text

[Assistant] And I call it a personal history because by some accident I participated


[User] Please transcribe this text

[Assistant] Uh, using mathematics to study economics and staying really pretty much as far from the real world as I could.


[User] Please transcribe this text

[Assistant] But for some reason I decided that I wanted to see what was going on on Wall Street. The most interesting mathematical modeling of that day was being done on Wall Street.


[User] Please transcribe this text

[Assistant] In Mathematical Modeling and Finance, that is, in Economics, and so I decided why not go see it.


[User] Please transcribe this text

[Assistant] And so I visited a bunch of investment banks. A number of my friends, including one from Yale, had worked at Goldman Sachs. So that was the natural thing to do.


[User] Please transcribe this text

[Assistant] But I had a little cousin who had just been hired, uh, recently, a little bit before that.


[User] Please transcribe this text

[Assistant] Uh, fellow Ed Cirillo who ran fixed income at the time.


[User] Please transcribe this text

[Assistant] And they persuaded me that it would be much more interesting to go to Kidder Peabody and to talk to people like Ed Cirillo than go to Goldman Sachs and be one of a hundred visiting professors. So I decided that the firm was a little bit smaller, but I'd see more of it.


[User] Please transcribe this text

[Assistant] And why not do something a little bit different? So they've never had an academic visitor, I think, like me.


[User] Please transcribe this text

[Assistant] And, uh, while I was there, I talked a lot to Ed Cirillo and to the traders and to a bunch of other people. And at the end of the, my sabbatical, Ed Cirillo came to me and he said,


[User] Please transcribe this text

[Assistant] You know, I've come to realize that our fixed income research department isn't very mathematical.


[User] Please transcribe this text

[Assistant] Why don't you hire a research department for me? And I'll help you along, but you find the people, you know the subject. You can judge, you know, your business is judging people doing research. Why don't you hire me a research department? So I...


[User] Please transcribe this text

[Assistant] Hired him a research department, which ultimately grew to 75 people.


[User] Please transcribe this text

[Assistant] Why don't you run the research department? You can do it from Yale. And, uh, as a consultant.


[User] Please transcribe this text

[Assistant] And so I became the head of fixed income research at Kidder Peabody.


[User] Please transcribe this text

[Assistant] Uh, from Yale and I, uh, it was quite an experience. I hadn't realized when I accepted the job just how many


[User] Please transcribe this text

[Assistant] Complications, uh, would arise. How many people would get job offers from other places and want to leave and...


[User] Please transcribe this text

[Assistant] Uh, one of the, what, that would become one of the key players in the mortgage market. Now, in the mortgage market, well, who are the players? Well, the homeowners you all know about. They're the banks who are giving mortgage loans.


[User] Please transcribe this text

[Assistant] But then, there are a number of other players that are invisible to much of the public, which really dominate the market. There are the government agencies, Fannie Mae and Freddie Mac, which you'll hear a lot about.


[User] Please transcribe this text

[Assistant] They're the investment banks like Kidder Peabody and Goldman Sachs and a bunch of others. They're the hedge funds and they're other investors. And this, uh, group of people creates


[User] Please transcribe this text

[Assistant] What's an important financial market? They would have said the stock market. What's another important financial market? Corporate bond market. What's another one?


[User] Please transcribe this text

[Assistant] What's another one? Options market. I don't think anyone would have said


[User] Please transcribe this text

[Assistant] The mortgage market, or at least they wouldn't have put that very early on in the, in the, in their list of important, uh, financial markets. But in fact, as I'm going to try and tell you during this class,


[User] Please transcribe this text

[Assistant] The mortgage market is on the same, not only on the same scale as the stock market, but actually quite a bit more complicated than the stock market, more mathematical than the stock market, and in some ways more interesting than the stock market. As we'll see at the end of the course, it was the mortgage market that led to the greatest crisis we've had since the Depression, and in fact caused several similar crises before that. So, uh, mortgages


[User] Please transcribe this text

[Assistant] Up here at the bottom, you have homeowners living in their houses who need to borrow the money


[User] Please transcribe this text

[Assistant] To buy the house. Before they can live in the house, they have to get the money to buy the house, so they borrow the money by taking out a mortgage, and it's a bank or a thrift or somebody like that who lends them the money. That's the first step.


[User] Please transcribe this text

[Assistant] So a mortgage is just a promise to pay the loan back over a long period of time using your house as collateral.


[User] Please transcribe this text

[Assistant] Uh, an important part of mortgages is that you have an option to pre-pay the mortgage. I mean, what if you move? The mortgage is, say, a 30-year promise, and after three years you might want to move.


[User] Please transcribe this text

[Assistant] If you're gone from the house, the house can no longer serve as collateral because you don't live in it anymore, so there has to be some way of getting out of the mortgage, and so there's an option to prepay it.


[User] Please transcribe this text

[Assistant] Now in the United States that option can be used even if you stay in the house and it turns out to be one of the


[User] Please transcribe this text

[Assistant] More problematic, uh, aspects of valuing mortgages and one of the most interesting aspects of my valuing mortgages, but we'll come to that later.


[User] Please transcribe this text

[Assistant] So this idea of a mortgage, uh, those three ideas were already known to the Babylonians more than three thousand years ago.


[User] Please transcribe this text

[Assistant] Uh, you know, after the Industrial Revolution it was invented more than 3,000 years ago near the Middle East. So, uh, it stayed pretty much the same.


[User] Please transcribe this text

[Assistant] For most of those 3,000 years until the 1930s when the amortizing mortgage was invented.


[User] Please transcribe this text

[Assistant] So what happened in the 1930s? That was the time of the Great Depression and farmers had lots of mortgages and they would owe


[User] Please transcribe this text

[Assistant] $7 a year, say, is their interest payment and at the end of 10 or 15 years,


[User] Please transcribe this text

[Assistant] mortgage loan where the payment was say $8 a year for all of 30 years.


[User] Please transcribe this text

[Assistant] You can get the same, uh, present discounted value of paying 729 years and 107 the 30th year. That's called the amortizing mortgage. It makes


[User] Please transcribe this text

[Assistant] The lender much safer because after a bunch of years have gone by.


[User] Please transcribe this text

[Assistant] And so, actually to get out of your mortgage, you need to pay less than a hundred dollars back.


[User] Please transcribe this text

[Assistant] So this amortizing mortgage is something we're going to study mathematically in the next lecture, but now I just mentioned that was one of the big


[User] Please transcribe this text

[Assistant] Well, so things continued pretty much the same from the 1930s all the way to the 1970s when we had securitization.


[User] Please transcribe this text

[Assistant] Like many of the great financial innovations in history, this one was created by the government.


[User] Please transcribe this text

[Assistant] So, uh, Fannie Mae and Freddie Mac were government agencies, and they had a, they were given the job, they were created by the government, uh, they then, uh, became eventually separate from the government, but they had the, they were given the task, they were created for the purpose of making mortgage pass-throughs. So we're in the 1970s.


[User] Please transcribe this text

[Assistant] So mortgage fast lose of the second tier of this hierarchy.


[User] Please transcribe this text

[Assistant] So the banks who had lent the mortgage, remember when you take out a mortgage as a homeowner, you're selling your promise. You're getting the money by selling your promise to pay back later. So those promises are collected by the banks, and instead of just sitting on the promises, the banks now, with Fannie Mae and Freddie Mac,


[User] Please transcribe this text

[Assistant] ...could sell their promises, uh, to Fannie Mae and Freddie Mac. And Fannie Mae and Freddie Mac would put them together in gigantic pools called pass-through pools.


[User] Please transcribe this text

[Assistant] Why were they called pass-throughs? Because the mortgage payments the homeowners made would go to the banks and the banks would just pass them on to the


[User] Please transcribe this text

[Assistant] And so they collect the money from the homeowner and they send it on to the actual lender who's the shareholder in the pool. And the banks are also, they're the servicer really, they're getting paid a fee for collecting the money and writing threatening letters if the homeowner stops paying and as we'll see later,


[User] Please transcribe this text

[Assistant] Strict criterion. You had to have a good credit rating, you had to have a job, you had to have, uhm, all sorts of, uh,


[User] Please transcribe this text

[Assistant] So, and the, uh, the loan to value of the mortgage had to be, that is, if the house is worth 100, the loan could only be 80% of it.


[User] Please transcribe this text

[Assistant] Uh, you had to have a record of the job you had.


[User] Please transcribe this text

[Assistant] Very standardized and very high performing loan. You could contrast this


[User] Please transcribe this text

[Assistant] No, I haven't built a house yet. I'm, you know, trying to build a house.


[User] Please transcribe this text

[Assistant] Do you have a record of employment? No, I've just moved here. I don't have, you know, I don't even have a job yet. Uhm, do you have someone who can vouch for you? No. Uhm, do you have a credit rating? No, there is no such thing as credit rating. So then Jimmy Stewart looks into his eyes and realizes this is a good honest person and gives him a loan.


[User] Please transcribe this text

[Assistant] Well, that doesn't happen in the Fannie Mae and Freddie Mac pools. They're very standardized criterion and, uh, very, that guy, Martone, who got the loan from Jimmy Stewart, would never have gotten a conforming Fannie or Freddie loan in the 1980s or 90s.


[User] Please transcribe this text

[Assistant] Might have gotten one in the 2000s though, but we'll come back to that. So that kind of, uh, market,


[User] Please transcribe this text

[Assistant] Name I've forgotten at the moment, but that evil banker basically is creating the kind of loans almost that we're talking about now. Everything's mechanized and standardized, but of course with standardization, you get tremendous advantages. For one thing, uhm, these loans, uh,


[User] Please transcribe this text

[Assistant] The Ibu pool together, and being of the same general good quality, they allow the lenders, instead of lending to a bunch of homeowners in Peoria like the bank would do, now all those Peoria loans are stuck with a bunch of other loans from all over the country in the same big, fanny pool, and so the lenders, who are the shareholders, have diversified their risk.


[User] Please transcribe this text

[Assistant] If the big businesses in Peoria, Illinois go under, it might be that all the homeowners in Peoria will default on their mortgages.


[User] Please transcribe this text

[Assistant] But not in the Fannie and Freddie pools because those are loans from all over the country. So you don't, it would have to be that businesses all over the country went bad for those loans all to go bad.


[User] Please transcribe this text

[Assistant] So secondly, if you're getting a whole pool and there's an automatic criterion for getting into the pool, you don't have to worry that you're getting the worst loans or the cheatiest loans or something. You know the quality, the general quality of all the loans. And once you have shares in a pool,


[User] Please transcribe this text

[Assistant] Uhm, you can resell the shares. So a bank who has to study the homeowner and, and, uh, you know, have, have meetings with them and, you know, Jimmy Stewart had to look into his eyes. So Jimmy Stewart may have convinced himself the guy is a good risk. But how could Jimmy Stewart ever sell the loan to somebody else?


[User] Please transcribe this text

[Assistant] The other buyer who hasn't looked into Martone's eyes, he's never going to believe Jimmy Stewart that that's a good loan. So Jimmy Stewart's going to be stuck with that loan for 30 years. In the Fannie and Freddie pool,


[User] Please transcribe this text

[Assistant] The shareholder who buys the loans and knows they're standardized knows exactly the same thing as the next guy who might buy his shares from him. So if the shareholder will be willing to pay more for the loan, because he knows that if he needs cash, he doesn't have to wait 30 years, he can just sell his shares to somebody else.


[User] Please transcribe this text

[Assistant] So because of the diversification, because of the reduction in adverse selection, and because of this ability to resell the shares, lenders


[User] Please transcribe this text

[Assistant] I've estimated that this operation together with the next one I'm going to talk about has reduced mortgage rates


[User] Please transcribe this text

[Assistant] So if you think the average loan is 200,000, you're talking about


[User] Please transcribe this text

[Assistant] Uhm, you know, two thousand dollars a year that the average homeowner saved by this financial innovation.


[User] Please transcribe this text

[Assistant] So you see that, you know, the stock market was around 15 trillion and the mortgages were around 7 trillion at the time.


[User] Please transcribe this text

[Assistant] And, you know, that compares to two trillion for corporate bonds.


[User] Please transcribe this text

[Assistant] So uhm, you know, many, well, I'm not going to talk, I don't have time to talk about this, but of course, of the mortgage market, some of it is commercial, some of it is residential, the vast majority is residential, but there's a very big commercial mortgage market. I'm going to be talking mostly about the, the, uh, the residential mortgage market.


[User] Please transcribe this text

[Assistant] But there's, uh, another part of it, there was another part of it, which were jumbo loans. So there was a size limit. The loans couldn't be too small and couldn't be too big for these Fannie and Freddie pools. Uh, we were trying to, the government was trying to appeal to the middle class, establish home ownership in the reliable middle class.


[User] Please transcribe this text

[Assistant] And so the wealthy were buying million dollar homes, weren't able to, uh, get their loans sold into a Fannie or Freddie pool.


[User] Please transcribe this text

[Assistant] And so those loans were securitized the same way, but by private agencies and not by, by banks, uhm, by investment banks and not by


[User] Please transcribe this text

[Assistant] So, the next innovation after the 1970s came in the 80s, and that's the collateralized mortgage obligation market. CMOs, they're called.


[User] Please transcribe this text

[Assistant] So the investment banks like Kidder Peabody and Lehman Brothers, uhm, for example, would buy some of these big pools and then they would cut the pool


[User] Please transcribe this text

[Assistant] Say Kidder Peabody might buy a pool, promising a thousand dollars a month to the shareholders, and then cut the promise into two pieces.


[User] Please transcribe this text

[Assistant] And, uh, so when the interest rate went up, the payments would go up, that's why it's called a floater, and maybe a second piece called an inverse floater, which is $500 minus the interest rate.


[User] Please transcribe this text

[Assistant] So as the interest rate went up, the payments would get smaller, but as the interest rate went down, the payments would get bigger. That's called an inverse floater.


[User] Please transcribe this text

[Assistant] So that way the two add up to a thousand dollars, but now you can appeal to two different buyers. A buyer who needs the money when interest rates go up.


[User] Please transcribe this text

[Assistant] Two more tailored promises, you can target, uh, uh, uh, more sharply a clientele and therefore get probably more than half the money for each of the two pieces.


[User] Please transcribe this text

[Assistant] And that way, of course competition in the CMO market raises the


[User] Please transcribe this text

[Assistant] The amount, uh, people are willing to pay for the pass-throughs because they can then buy them and split them up.


[User] Please transcribe this text

[Assistant] And sell them for big, uh, for more, that raises the price of the pass through, which in turn raises the price the mortgage, the homeowners can sell their mortgage, which in turn lowers the interest rate that the homeowners have to pay. So again, it's another one, another reason why this whole operation of securitization improved the welfare of almost everybody. So, the piece has gradually got more complicated.


[User] Please transcribe this text

[Assistant] So, you know, if there was default or somebody prepaid, as we talked about, used their option to pay early, instead of getting the money you expected, you get


[User] Please transcribe this text

[Assistant] Extra or less money than you expected and that created risk and some of these buyers didn't want to bear the risk. So maybe you'd make the pieces 400 plus the interest rate and 400 minus the interest rate and leave $200


[User] Please transcribe this text

[Assistant] To what might be called a residual piece or a derivative or something.


[User] Please transcribe this text

[Assistant] Uh, split up again made the float and inverse floater safer and encouraged people to buy it. But of course, somebody had to buy the residual piece, which was more complicated.


[User] Please transcribe this text

[Assistant] So, as I said, uhm, this whole operation was a way of accomplishing two things. It made homeowners able to sell their promises for more, so they effectively were paying a lower interest rate, so it made it easier to move into houses. And that's precisely what the government intended by creating these agencies. It also allowed


[User] Please transcribe this text

[Assistant] Buyers and investors to get money in the cases they needed it, in the states they needed it, because the pieces were tailor-made for them.


[User] Please transcribe this text

[Assistant] So I realized while I was there at Kidder Peabody that this whole multi-trillion dollar operation behind the scenes was, as I said, invisible to everybody and was worth writing about.


[User] Please transcribe this text

[Assistant] And, uh, it, it was bringing, uh, great welfare gain to the country and, and nobody quite knew about it. So for me it crystallized what the essence of finance is. The essence of finance is


[User] Please transcribe this text

[Assistant] You're trying to create promises, the financial system is creating promises that deliver money to people in circumstances, or states as I call it, that they really need the money.


[User] Please transcribe this text

[Assistant] You have to guarantee that the money is going to be paid to them. So in order to do that, you have to have collateral. So this entire system is a way of creating promises and backing them with collateral.


[User] Please transcribe this text

[Assistant] So if you remember, so here are the potential promises, and maybe some people want money down here, that's when the interest rates go up, they're buying the floaters, way over there, the money's going down, the interest rates are going down, that's the people who buy the inverse floaters, that's when they're getting most of their money.


[User] Please transcribe this text

[Assistant] But these promises, you have a reason to expect to get paid because they're backed by the collateral.


[User] Please transcribe this text

[Assistant] Okay, so the, not a very good picture, the houses back the promises of the homeowners, like in Babylonian times, if the homeowner doesn't pay, he loses his house.


[User] Please transcribe this text

[Assistant] But those shares are backing the CMOs, which are making more complicated promises.


[User] Please transcribe this text

[Assistant] So the collateral you see is used once by the homes, once by the pools, once for the CMOs, and then it will turn out as we'll see, uh, in a few minutes that the investors who buy are borrowing money, buying on margin using the CMO pieces they buy as collateral for their purchases. So the collateral is being used and reused.


[User] Please transcribe this text

[Assistant] And so in fact the entire system is stretching the available collateral as much as possible.


[User] Please transcribe this text

[Assistant] So collateral is a very scarce resource. It's very important to running a financial system. Many developing countries don't have any collateral and therefore they have a primitive financial system.


[User] Please transcribe this text

[Assistant] Here, there's a tremendous incentive to stretch the collateral as much as possible. You can stretch it by using it over and over again.


[User] Please transcribe this text

[Assistant] Or by letting the same collateral back many promises. And we saw both of those, the tranching, the different CMO pieces.


[User] Please transcribe this text

[Assistant] So I wrote my first paper, published it in 1997 while I was, uh, I had written it while I was at Kidder Peabody, and one of the questions I asked was when you take out a loan,


[User] Please transcribe this text

[Assistant] Not only what interest rate you have to pay, but how much collateral do you have to put up? And that was a question that nobody seemed to have asked really before.


[User] Please transcribe this text

[Assistant] Uh, in a general equilibrium model, and so I, that was my first paper on the subject. Now I want to get back to Kidder Peabody. Kidder Peabody, as I said when I started, it was a sleepy, uh, number seven ranked investment bank. Didn't dominate any market, but


[User] Please transcribe this text

[Assistant] So this, as I said, was a multi-trillion dollar market.


[User] Please transcribe this text

[Assistant] And if you look at all the pieces, uh, that are being promised here


[User] Please transcribe this text

[Assistant] What Kidder decided to do was, uh, you know, things got more and more complicated. There weren't just two pieces. There weren't just three pieces. There were ninety pieces, typically, at that time. And so, a typical, uh,


[User] Please transcribe this text

[Assistant] Uhm, investment bank that wanted to sell, you know, buy a pool and then sell VCMO pieces, like let's say


[User] Please transcribe this text

[Assistant] They would try to line up 90 buyers and figure out what each of the 90 were willing to pay. And then when they added up the prices each of the 90 were willing to pay, they'd go and if they thought the sum of those was bigger than the price of the pool, they'd go to the pool and buy the pool and then immediately make a profit by selling off the 90 pieces. Well at Kidder, uhm,


[User] Please transcribe this text

[Assistant] The head of mortgages, who by this time, by the way, was my, uh, young little cousin who, uhm,


[User] Please transcribe this text

[Assistant] Well, not accident after another, but anyway, through hard work, had worked his way up to running the small CMO operation.


[User] Please transcribe this text

[Assistant] He got the idea that what Kidder could do was to find a buyer for the riskiest piece. The one that I've put in yellow, remember? The residual, which was maybe called an inverse I or it had different names but the riskiest pieces.


[User] Please transcribe this text

[Assistant] Once he finds, found a buyer or a place to put the riskiest piece, he would borrow the money.


[User] Please transcribe this text

[Assistant] Buy the pass-through and hold an inventory of all the other pieces.


[User] Please transcribe this text

[Assistant] So, he knew that eventually we would be able to sell off all the other pieces. And so,


[User] Please transcribe this text

[Assistant] We had a tremendous advantage. While everyone else was looking for buyers for ninety pieces, we had to find a buyer for one piece or two pieces. So we then had uhm,


[User] Please transcribe this text

[Assistant] Of course, the downside to all of that is we had to be very careful that the pieces we held, we knew how to hedge. We had to be very careful that when we held these pieces, between the time we held them and finally sold them, we didn't lose a lot of money. So we had to figure, and sometimes we were the ones who held the most dangerous piece too.


[User] Please transcribe this text

[Assistant] So we had to figure out what were gonna be the cash flows of these pieces and how to model them. And that's what we're gonna mathematically talk about the next few days, but I'm gonna give you a hint of this, uhm, now.


[User] Please transcribe this text

[Assistant] So, we had to predict, among other things, what the pre-payments would be. Okay? And so, if you talk to a...


[User] Please transcribe this text

[Assistant] Macroeconomist, especially in those days and you say


[User] Please transcribe this text

[Assistant] You know, what do you think is going to happen in the world?


[User] Please transcribe this text

[Assistant] Two quarters unemployment is gonna go up half a percent and then maybe things are gonna get better for the next year and beyond that it's too hard to tell.


[User] Please transcribe this text

[Assistant] So these mortgages are 30-year mortgages. You can't have a prediction that lasts a year and a half. You have to have a 30-year prediction. And the macroeconomists, by the way, are typically wrong, even in their two-month prediction or six-month prediction. So how could we risk billions of dollars holding an instrument that's 30 years long, which depends on what people are going to do over the next 30 years?


[User] Please transcribe this text

[Assistant] Well the answer is, you can't make a prediction and expect it to be right, but you can make a conditional prediction. You can say, if interest rates do such and such for the next four years, then prepayments, and housing prices do such and such for the next four years, then in that fifth year, prepayments will be so and so.


[User] Please transcribe this text

[Assistant] That's a conditional prediction. It's much easier to make a conditional prediction than an act than an unconditional prediction. It's shocking that so many economists


[User] Please transcribe this text

[Assistant] It's not a business we should be in. We should always be making conditional predictions. Well I learned that lesson at, uh, at Kidder.


[User] Please transcribe this text

[Assistant] And we'd have to go thirty years into the future, so you can imagine, and this is just


[User] Please transcribe this text

[Assistant] Uh, actually much smaller group of possibilities than


[User] Please transcribe this text

[Assistant] Uh, than we used to consider, but you see all the possibilities that could unfold over the next twelve months, and you see the blue line is one of those possible paths.


[User] Please transcribe this text

[Assistant] So we have to predict, if we knew which path interest rates and housing prices were going to take, like that blue line, could we then predict, at the end of the blue line, what pre-payments would be? Of course, if you followed another path down to here, we'd make a different prediction about pre-payments.


[User] Please transcribe this text

[Assistant] So the cash flows are the pre-payments and defaults. That's what we have to predict.


[User] Please transcribe this text

[Assistant] You might say what good is it to predict a different number on each of these trees? Then you just basically don't, you're saying you don't know what's going to happen. But that's far from the truth. If you know what the payments are on each of the paths, and then you can hedge


[User] Please transcribe this text

[Assistant] So for example, suppose the payment is very low here and very high at the top. Well, if you can buy another instrument that pays you something at the bottom,


[User] Please transcribe this text

[Assistant] And, and, and you pay at the top, you can offset the variation in cash flows on the mortgage by that other instrument and guarantee yourself the same safe payment all the way through.


[User] Please transcribe this text

[Assistant] So that's the sort of thing that we did at Kidder Peabody, which we're going to study in great detail. We held these complicated pieces whose payments would vary tremendously, so we ran a huge risk of losing all our money, but then we would hedge them with some other instrument. So in the end, we got a pretty safe return.


[User] Please transcribe this text

[Assistant] Because we knew the return was safe, we felt we could pay a good amount of money for it, whereas other buyers who couldn't hedge it wouldn't want to buy it at all.


[User] Please transcribe this text

[Assistant] Something like that. So it's uh, 10 years, 11 years of prepayment. So that's the percentage of people.


[User] Please transcribe this text

[Assistant] 86 mortgages with an 8% coupon issued by Fannie Mae or some big pool of them anyway.


[User] Please transcribe this text

[Assistant] As you see, sometimes the prepayments are very low, sometimes they're incredibly high. How, standing at the bottom, at the back there in 88, say, would you possibly have predicted that prepayment?


[User] Please transcribe this text

[Assistant] Uhm, in, in those other months when free payments are very low, the interest rates were higher. So, uhm,


[User] Please transcribe this text

[Assistant] So clearly there's a connection between, uh, the mortgage rate you got in your original mortgage and the new rate that you can refinance into and that is part of your conditional prediction. But another thing that's interesting is, is burnout. So if you look at two pools,


[User] Please transcribe this text

[Assistant] And with exactly the same coupons, you'll see that the older one is always prepaying less than the new one. Okay, at least starting from 95 onward. So it's as if


[User] Please transcribe this text

[Assistant] The old one burns out. Once it has an opportunity to prepay, you see a lot of prepayments and then they slow down. Okay, so that's another thing people have observed.


[User] Please transcribe this text

[Assistant] So you might have thought the standard way of modeling things


[User] Please transcribe this text

[Assistant] at that time was to just do a regression. You say, well, we figured out that prepayments depend on the new interest rate and how much


[User] Please transcribe this text

[Assistant] So I, so we got the idea, or I got the idea of trying to model all you care about is aggregate prepayment.


[User] Please transcribe this text

[Assistant] Try and put ourselves in the mind of every homeowner in the country. Why are they prepaying or not prepaying? Well, they're prepaying if they get an opportunity to save some money.


[User] Please transcribe this text

[Assistant] But you know, we know from that graph that lots of people, uh,


[User] Please transcribe this text

[Assistant] Don't prepay. Even when there's a tremendous opportunity, only 60% of the people are prepaying in a whole year. So that means the whole year goes by and only 60% of them have prepaid. So every month, you know, 8 or 10% are prepaying. So the other 90% haven't seen their opportunity. They've missed it. Or they've waited.


[User] Please transcribe this text

[Assistant] I imagine that different people have a different cost of prepaying. It's a hassle to prepay. Maybe you literally have to pay some money to prepay. Maybe you have to take a day off from your job.


[User] Please transcribe this text

[Assistant] Uhm, some people have other things to do. They're not that alert because they're paying attention to their kids or they're paying attention to their work.


[User] Please transcribe this text

[Assistant] So not everybody has the same alertness. Not everyone follows financial matters as closely as everybody else does.


[User] Please transcribe this text

[Assistant] Also over time, people are getting more rational. They're beginning to understand the market and prepaying more and more. And of course, people hear from their friends. If their friends are all prepaying, it's more likely that they'll think about it and prepay themselves. So I, so I will build a model. I built a model.


[User] Please transcribe this text

[Assistant] Together with the researchers at Kidder Peabody and then later we built the model of


[User] Please transcribe this text

[Assistant] Pre-payment based on every individual making a different decision. So an individual is characterized by his cost and his alertness.


[User] Please transcribe this text

[Assistant] Captures all the effects that we talked about already. If you have a pool of people, you can see the vertical is how many people of each type. There are different costs and different alertnesses. And so at the beginning,


[User] Please transcribe this text

[Assistant] When you have a new pool, like on the right, there are a lot of people.


[User] Please transcribe this text

[Assistant] Okay, so that was my Kidder Peabody days, and I thought, you know, my gosh, we're doing incredibly well, we're helping the country, we're


[User] Please transcribe this text

[Assistant] Doing things on a colossal scale that nobody had ever done before. I think I may have not emphasized enough that Kidder Peabody


[User] Please transcribe this text

[Assistant] came to dominate this market we control over twenty percent of all the issuance remember there were trillions of dollars of things being issued


[User] Please transcribe this text

[Assistant] So this little group of twenty year old kids basically, plus me, the old guy, and research


[User] Please transcribe this text

[Assistant] So them, the traders, they were issuing something, you know, on the scale of half a trillion to a trillion dollars with these CMOs, these, these kids in their mid-twenties, or late twenties.


[User] Please transcribe this text

[Assistant] And, and, and the world seems to be a better place for it. And I thought, my gosh, this is an untold story that needs telling, and it's an incredible success story. Well, things suddenly changed.


[User] Please transcribe this text

[Assistant] And uhm, in 1994 there was a crash. So this is the first of three crashes I've lived through.


[User] Please transcribe this text

[Assistant] There was a scandal at Kidder P. Bodding of a Joe Jett scandal who was a, a trader, a government bond trader who was accused of


[User] Please transcribe this text

[Assistant] Doctoring the books and faking his big profits. He'd been killer Peabody man of the year in 1993 and then in 1994 he was, uhm,


[User] Please transcribe this text

[Assistant] They decided that all his prophets were fictitious and that he doctored the book, and so he was fired.


[User] Please transcribe this text

[Assistant] Close the firm after 135 years, or I guess 130, 129 years, they close the firm.


[User] Please transcribe this text

[Assistant] So I had to go back one day from Yale to the Kidder Peabody and I invited those 75 people in the research department into my office and I said, you're fired.


[User] Please transcribe this text

[Assistant] And then I got up and I went to the office next door and somebody said to me, you're fired.


[User] Please transcribe this text

[Assistant] The, the head trader, uh, of mortgages and a bunch of his, uh, top lieutenants decided to form a hedge.


[User] Please transcribe this text

[Assistant] Fun. Instead of, so Kidder Peabody got closed, but actually sold, it wasn't closed, it was sold to Payne Webber. And Payne Webber dropped the name Kidder Peabody.


[User] Please transcribe this text

[Assistant] And hired many of the people from Kidder Peabody. Uhm, and in fact the second tier, the more junior group of mortgage traders at Kidder Peabody, which was the leading mortgage company at the time, they took over the desk at Payne Webber, and then Payne Webber was bought by UBS, and those same guys took over the desk at UBS. So the junior crew at Kidder Peabody,


[User] Please transcribe this text

[Assistant] Ended up, some of them were Yaleys by the way, ended up running the UBS, a big part of the UBS mortgage debt.


[User] Please transcribe this text

[Assistant] Uhm, our mortgage trader, they had guys, and, uh, decided to form a hedge fund. Instead of selling the, uh, the CMOs, they would buy the CMOs, and we called it Ellington Capital Management. So I was one of six, uh, partners. I was a small partner, because again, I stayed at Yale.


[User] Please transcribe this text

[Assistant] So this introduces the last player, the hedge fund. So what is a hedge fund?


[User] Please transcribe this text

[Assistant] You've heard the name, I'm sure a thousand times. It has a bad name now, but a hedge fund basically means four things.


[User] Please transcribe this text

[Assistant] It means it's someone who hedges, okay? You don't just buy and hold the thing and hope that the cash flows are good. You try to protect yourself against as many risks as possible. Just like I explained we were doing at Kidder when we tried to get the same cash flows in every scenario and we're gonna mathematically study that in the remaining lectures.


[User] Please transcribe this text

[Assistant] But you try to hedge. That's where the name comes from. You try and offset as many risks as you can. Of course, you still run some risks.


[User] Please transcribe this text

[Assistant] You're offsetting as many as you can. The second most important thing is most of it's done, or a lot of the buying is done, not most, but a lot of the buying is done with borrowed money. That's called leverage.


[User] Please transcribe this text

[Assistant] So you don't just take your investor capital and buy something, you take your investor capital, you borrow some extra money, and then you buy some stuff, and the stuff you buy you use as collateral to guarantee that the lenders are going to get their money paid back. So hedge funds generally leverage.


[User] Please transcribe this text

[Assistant] The third definition of a hedge fund, third characteristic, is that they're very lightly regulated. You have to be a sophisticated. So what does that mean? That means that, you know, a broker who sells something,


[User] Please transcribe this text

[Assistant] You know, with anyone we choose on behalf of our, of our clients.


[User] Please transcribe this text

[Assistant] But our clients have to be sophisticated investors, so we have to vouch that they're sophisticated. If they have enough money, like say five million dollars, to invest in a hedge fund, they're by definition sophisticated.


[User] Please transcribe this text

[Assistant] And then they don't, the idea is they don't need to be protected by having a broker who's necessarily watching out for their, to see whether an investment's appropriate. That doesn't mean that we, uh, we tell them what we're investing in, and we're, you know, of course we're obliged to explain our strategy.


[User] Please transcribe this text

[Assistant] But once they understand our strategy, we don't have to check every single, you know, we don't have to meet the same test that a simple broker meets on behalf of a


[User] Please transcribe this text

[Assistant] Let's say a retired, uh, individual, a poor retired individual. So there's less regulation.


[User] Please transcribe this text

[Assistant] And the fourth characteristic is hedge funds typically charge higher fees.


[User] Please transcribe this text

[Assistant] So that's what a hedge fund is. Now the first hedge fund was started in the 1940s, I believe, by someone named Jones.


[User] Please transcribe this text

[Assistant] Because he could lose if the whole economy went badly, Ford and every other car company would go badly. Instead he was betting that Ford would do better than the other car companies. So he was concentrating his bet on something he understood more. You can't be an expert about everything. Presumably he was an expert about cars and he knew Ford was better than General Motors. So that was a bet he wanted to take.


[User] Please transcribe this text

[Assistant] But you didn't want to take a bet on the whole economy doing well or badly. So that was the beginning of the idea of the hedge, uh, hedge fund. Now, there's so many risks that a car company or any company runs, you know,


[User] Please transcribe this text

[Assistant] Does their president know what he's doing? Is Detroit going to be a good city? Is there going to be a change in government regulation? Is some foreign competitor going to appear on the scene? Is the price of oil suddenly going to change? There's so many things that can go wrong in a company, it really is very hard to hedge. So hedging really makes much more sense when you can make the problem mathematical.


[User] Please transcribe this text

[Assistant] Well see, with mortgages, it really is a mathematical problem to a much greater extent. So it makes much more sense to hedge, and I think it makes much more sense to be a hedge fund if you're trading in the mortgage market. Anyway, that's what I found out when I visited Wall Street in those days.


[User] Please transcribe this text

[Assistant] So what did the hedge fund do? Instead of creating these CMOs, the hedge fund would buy them, and of course buy the most complicated ones. So in effect, the hedge fund


[User] Please transcribe this text

[Assistant] Would buy the most complicated, uh, the residual piece we're talking about.


[User] Please transcribe this text

[Assistant] And try to hedge that. So effectively the hedge fund by hedging it was really carving up the cash flows of that last piece into complicated ways and selling them off to stabilize its profits.


[User] Please transcribe this text

[Assistant] So really the hedge fund actually was continuing the work of the investment bank.


[User] Please transcribe this text

[Assistant] And so the hedge fund is part of the entire operation which was making this


[User] Please transcribe this text

[Assistant] We had a hard time raising money to begin with, because after all, uhm, Peter Peabody had just gone out of business. So...


[User] Please transcribe this text

[Assistant] And not only had we gone out of business, but, you know, there was a general crisis at the time. It wasn't only the trading scandal of Joe Jett, but at the same time there was a crisis in the derivatives market because all these complicated pieces that were being created were money, you know,


[User] Please transcribe this text

[Assistant] So Orange County went bankrupt in 1994, and what did Orange County do? They bought a bunch of inverse floaters.


[User] Please transcribe this text

[Assistant] So when the interest rates were going down in the early 90s, they were making a huge amount of money. And the, the, the, the fellow who ran, uh, Orange County's


[User] Please transcribe this text

[Assistant] Uh, municipal investment was, was twice municipal investor of the year. But in 1994, when everything turned around and interest rates skyrocketed for the year,


[User] Please transcribe this text

[Assistant] We were the, you know, it was some of our inverse floaters that were being bought, which helped bankrupt Orange County, plus Kidder Peabody had just gone out of business because of Joe Jett.


[User] Please transcribe this text

[Assistant] And uh, so it was very difficult for our hedge fund to raise money.


[User] Please transcribe this text

[Assistant] Uh, we almost had to, uh, our motto was, we created the mess, let us clean it up.


[User] Please transcribe this text

[Assistant] Nonetheless, we did raise some money, we had an important, uh, starting investment from the Zip brothers, and we had an incredible boom time. We made fantastic returns our first few years, 50% returns, and we grew into the biggest, uh, hedge fund, uh, mortgage hedge fund in the country.


[User] Please transcribe this text

[Assistant] What happened in this crash? Well, as I told you, we were buying mortgages


[User] Please transcribe this text

[Assistant] As a hedge fund, buying that residual piece and buying it with borrowed money. So we would buy the piece.


[User] Please transcribe this text

[Assistant] You know, let's say for $100 by borrowing $80, so we'd use $20 of investor capital, we'd buy the other, we'd borrow the other $80, we'd buy the piece for $100, and then we'd leave the piece with the lender as collateral. So if we didn't pay them back the $80, the guy could keep our piece. So his $100 piece was protecting his $80 loan.


[User] Please transcribe this text

[Assistant] So, things were, were, uh, swimming along. We're gonna talk a lot about leverage later.


[User] Please transcribe this text

[Assistant] Well, in 1998, our big, uh, one of the big competitors, Long Term Capital, which was founded, as I think I've mentioned earlier in the course, by, uh,


[User] Please transcribe this text

[Assistant] Mary Weather, who's the most important, uh, famous, uh, fixed income trader on Wall Street from Solomon, and two Nobel Prize winners.


[User] Please transcribe this text

[Assistant] Uh, who I've mentioned many times, and you're gonna hear about again, Merton and Scholl.


[User] Please transcribe this text

[Assistant] And creators, especially Shoals, are the Black Shoals model, the most important tool on Wall Street for managing risk, as we'll discover in a few lectures.


[User] Please transcribe this text

[Assistant] And in fact, the government had to step in with all the big investment banks, coordinating the big investment banks to take it over so that the whole market wouldn't crash down around it.


[User] Please transcribe this text

[Assistant] Long-term capital, figuring that was one of our big competitors out of business, and now we would have an easier time.


[User] Please transcribe this text

[Assistant] So suddenly on a Friday morning in October of 98,


[User] Please transcribe this text

[Assistant] Somebody, uh, one of our lenders called us up and said, we think the prices have gone down.


[User] Please transcribe this text

[Assistant] Uh, it's not a hundred anymore, it's less than that. We need X million dollars of extra, uh, margin to put, uh, for you, for us to contribute, because the hundred dollar piece protecting the eighty dollar loan, it was no longer a hundred dollar piece, it was a lower piece, so there was less cushion. We need extra cash to have a bigger cushion.


[User] Please transcribe this text

[Assistant] So we said, oh, this is crazy, the price is having gone down that far, that's not fair.


[User] Please transcribe this text

[Assistant] And they said you have until four o'clock Friday afternoon.


[User] Please transcribe this text

[Assistant] To pay us back. And if you don't pay us back, then on the next business day, which happened to be Tuesday morning because it was Columbus Day holiday on Monday,


[User] Please transcribe this text

[Assistant] We'll just sell off all your pieces and pay ourselves back out of the proceeds, the 80, and give you whatever's left over.


[User] Please transcribe this text

[Assistant] Well, we figured what was left over wasn't going to be very much because they only needed their 80s, so why they didn't have an incentive to sell for the best possible price, although of course they would tell us they'd sell for the best possible price, they probably, you know, they wouldn't.


[User] Please transcribe this text

[Assistant] It would be a fire sale, so we, we, we, we were, uhm, we didn't know what to do.


[User] Please transcribe this text

[Assistant] And, uh, we couldn't raise the money by four o'clock on Friday, so we called up Warren Buffett and we said,


[User] Please transcribe this text

[Assistant] Well, this is so unfair. They're forcing us to sell. There's no reason why we should have to sell. The pre, you know, this margin call is not proper. It's not right. It almost isn't, you know, there's no reason we have to sell. I mean, what's going to happen is on Tuesday we're going to be forced to sell all our bonds at the same time and they're going to all sell for like 80 or something. It's going to be a terrible bloodbath, a fire sale.


[User] Please transcribe this text

[Assistant] You know, prices will go for nothing. We'll be totally wiped out so unfairly. Why don't you...


[User] Please transcribe this text

[Assistant] Buy our firm, we'll give you half our, half our firm, you know, some big percentage of our firm, you just make the margin call for us, and then you can have these, this firm with these great bonds, and you know, there's, you know, you can just, it's such a travesty, and it's gonna be such a good investment for you, and you can save us, and save the bonds, and stop this tra, travesty.


[User] Please transcribe this text

[Assistant] And he said, excuse me. And we said, well, you know, it's unfair. We're going to, they're going to force us to sell on Tuesday. The bonds will go for nothing. And uh, you know, when they're perfectly valuable bonds and they're going to wipe us out and you can prevent that from happening and own our great firm. And he said,


[User] Please transcribe this text

[Assistant] Over the weekend we managed to, uh, hold an auction and sell the bonds ourselves.


[User] Please transcribe this text

[Assistant] So in other classes in economics you find out how to conduct auctions. I don't have time to describe this in great detail but let me just say that


[User] Please transcribe this text

[Assistant] In a typical auction, you have to worry about the winner's curse. You know, everybody's thinking


[User] Please transcribe this text

[Assistant] I'd better not be the highest bidder because that means I probably overpaid because those smart guys are bidding against me.


[User] Please transcribe this text

[Assistant] So we didn't sell everything at the same time. At 12 o'clock we sold the first third of our bonds, at 2 o'clock the second third, and at 4 o'clock the third third. Actually we got a little behind schedule, but that was our plan. And so what happened is at 12 o'clock everybody basically bid 80. So we said, you know, we're one of the bidders ourselves, of course.


[User] Please transcribe this text

[Assistant] Either by someone else or by us, you've been outbid. So now these guys, one from Budapest, one from all over the world, back there thinking we're going out of business, bidding 80, they don't get to buy anything.


[User] Please transcribe this text

[Assistant] Or are they going to realize that they have to bid more in order to beat some, you know, other people? So we had no idea what was going to happen, but...


[User] Please transcribe this text

[Assistant] You know, the price was basically 95 at 2 o'clock and 99 at 4 o'clock. So we celebrated saving our firm.


[User] Please transcribe this text

[Assistant] And uhm, it turned out there was another complication after that, which I won't get into, which is that the, uh, the thing had happened over the holidays and so the next, uh, warning, uhm, the buyers, uh,


[User] Please transcribe this text

[Assistant] Didn't get their bonds. So remember, we don't have the bonds to sell them. They're sitting with the person who lent us the money.


[User] Please transcribe this text

[Assistant] And so, uh, the prime broker was supposed to vouch for all this, you know, it was a holiday for him too. And so, the whole thing was a mess, and it's actually quite an amazing story, which I don't have time to tell. But anyway, when the buyers didn't get their bonds, the next


[User] Please transcribe this text

[Assistant] All our lenders, the sort of number two people at all the big investment banks got together on the conference call.


[User] Please transcribe this text

[Assistant] And they agreed that if they all tried to get their money back at the same time, none of them would get it. And so they waited for us to gradually work ourselves out of the predicament.


[User] Please transcribe this text

[Assistant] And then after that, we had another boom year. An incredible year in 1999. And things kept booming again.


[User] Please transcribe this text

[Assistant] Uh, so before I get to that, that experience was so seared in my mind.


[User] Please transcribe this text

[Assistant] The second crisis, the 1998 crisis, was so seared in my mind that I wrote a paper called the leverage cycle in which I said what basically happens is people borrow a lot of money


[User] Please transcribe this text

[Assistant] And they're very leveraged, then something bad happens in the economy and the lenders suddenly reduce the leverage and so the big leveraged buyers, they go out of business.


[User] Please transcribe this text

[Assistant] The, the, the leverage goes way down. Lenders will ask for more collateral.


[User] Please transcribe this text

[Assistant] And there's also the bad news, and those three things together completely crush the market, and so lots of people are out of business, and the whole thing's a mess.


[User] Please transcribe this text

[Assistant] So that's what I call, and then it's going to repeat itself over and over again. So that's the leverage cycle story I told.


[User] Please transcribe this text

[Assistant] In 2003, after I wrote it right after the crisis of 98 and I said that this crisis, which in 98 seems to be so small, could be repeated on a much grander scale for the whole economy.


[User] Please transcribe this text

[Assistant] In, uh, we had these boom years right after the crisis of 98.


[User] Please transcribe this text

[Assistant] And then in 2007-8 there was another crash, this time on a grand scale, but it was exactly the same kind. And the last two lectures of this course are going to be about the most recent crisis


[User] Please transcribe this text

[Assistant] And so we're going to mathematically re-examine this entire story.


[User] Please transcribe this text

[Assistant] And again, after the 2008 crash, when we almost went out of business again, our hedge fund, in 2009, we had the best year we've ever had. Better than all those other years, even in, in 95. So we were, uhm,


[User] Please transcribe this text

[Assistant] So three times in a row, there's a crash, a boom, a crash, a boom, a crash, and a boom. We made back more money in 2009 than we lost in the crisis of 2007-2008. So the course has to end with an explanation of why these


[User] Please transcribe this text

[Assistant] Uh, pointing out one change in the market, the next big change in the market, the next wave of securitization.


[User] Please transcribe this text

[Assistant] Okay, so this is the subprime market, which we haven't mentioned yet, and which I will now describe.


[User] Please transcribe this text

[Assistant] Okay, so what is a subprime mortgage market? I already pointed out that securitization was a great idea.


[User] Please transcribe this text

[Assistant] Okay, now, it was, it was applied, remember, to prime mortgages. You had to be a very reliable homeowner to get one of those Fannie or Freddie loans.


[User] Please transcribe this text

[Assistant] A combination of things happened in the late, uh, 90s.


[User] Please transcribe this text

[Assistant] Investors began to get the idea, you know, this has worked out so well and there's so many people who don't own homes in America because they're poor. Maybe we can extend homeownership to still more people. Of course they're going to be riskier because they're poorer, they have less resources, but we'll charge them a higher interest rate and that will, that will compensate us for the extra risk. The government also saw this as a great opportunity to help the poor.


[User] Please transcribe this text

[Assistant] So this combination of investors getting the idea and the government wanting to sponsor it led to the creation of a new market, the subprime market, which is what I'm going to describe now. And I'm going to talk about what went wrong, or begin to talk about what went wrong, but I'm going to leave most of it for the last two classes.


[User] Please transcribe this text

[Assistant] So as I said, securitization is so important because, let me remind you,


[User] Please transcribe this text

[Assistant] Typically when a bank makes a loan, uhm, the bank finds out a lot of people, a lot about who it's lending to. But you know, the bank is not, the bank is a bunch of managers and stuff.


[User] Please transcribe this text

[Assistant] The shareholders of the bank are the people whose money is at risk.


[User] Please transcribe this text

[Assistant] Two years later, the bank's gonna make a loan to somebody risking your money, and you've got no idea who the guy is that the bank is lending to, or what the characteristics are of the person who's getting the loan.


[User] Please transcribe this text

[Assistant] You know, what are the characteristics of all the homeowners in the pool? It's something very concrete. A bank lends to homeowners, it lends to businesses, doing 6,000 things. Of course it's risky to have bank...


[User] Please transcribe this text

[Assistant] Capital, you know, equity owns shares of the bank because you don't know what they're doing and they're doing so many different things. It's a lot.


[User] Please transcribe this text

[Assistant] You should feel a lot more comfortable if where your money is going is very well delineated. And that's the idea of a securitization. It's very, uhm, well defined where the money is going.


[User] Please transcribe this text

[Assistant] So it makes people more willing to lend. I mean, you know, corporate debt, that's another way of, uh, lending money. But you know, if you own bonds in a firm,


[User] Please transcribe this text

[Assistant] You know, you're not the first person to get paid back. The people lending with collateral get their money first. And if the firm goes bankrupt, you know, there's a big court case and it takes a long time to get your money back. Not in a securitization. So there are many ways that a securitization is, uhm, more


[User] Please transcribe this text

[Assistant] Uhm, attractive than lending money through a bank.


[User] Please transcribe this text

[Assistant] And that's the reason for the securitization. So now let, here are the current numbers, the 2007 numbers, and there haven't been much securitization since then.


[User] Please transcribe this text

[Assistant] So the agencies are now up to 4 trillion, Fanny and Freddie.


[User] Please transcribe this text

[Assistant] Now those jumbo loans I told you about, the big loans that the rich people take out, remember which was .5 trillion in 2000.


[User] Please transcribe this text

[Assistant] That's .8 trillion, but they're pretty good credit ratings, and then the subprime population of which there were a trillion loans issued by 2007, that's 1.8 trillion of lesser credit


[User] Please transcribe this text

[Assistant] Loans that didn't exist at all in 2002.


[User] Please transcribe this text

[Assistant] So, uh, you add these numbers up, 4.8.8 and 1.


[User] Please transcribe this text

[Assistant] That's 6.6 and 4 trillion of unsecured ties. The banks are just holding loans. It's over 10 trillion of loans, as I said.


[User] Please transcribe this text

[Assistant] Okay, and then you add the commercials on top of that and you're getting very close to the value of the stock market. So, uhm, alright, so we've talked about, uh, this, you know, the advantages of, uh, securitized loans.


[User] Please transcribe this text

[Assistant] Uh, alright, so how did the subprime market begin?


[User] Please transcribe this text

[Assistant] Well, you had to have a few legal hurdles. The first one, which some countries haven't managed to achieve and some people now are doubting we should have ever done, is you know, is it legal to charge a high interest rate to someone just because they're


[User] Please transcribe this text

[Assistant] Riskier. Is that usury or is that a reasonable return because you're making a bigger risk? So, you know, there are anti-usury laws.


[User] Please transcribe this text

[Assistant] Uh, on the books, and so in order to make these loans, you had to get, uh, they had to become legalized. You had to get Congress to pass a law to say that higher interest rate loans for riskier people is not usury.


[User] Please transcribe this text

[Assistant] Okay, so then, uhm, you also had to figure out the tax treatment, which happened in 1986.


[User] Please transcribe this text

[Assistant] And so the first tools were created in the late 80s, the early 90s, and Kidder Peabody, by the way, that firm that I worked for, remember at exactly that time, was one of the first creators of these subprime-like loans.


[User] Please transcribe this text

[Assistant] And as I said, by, by 2007 it had grown to a trillion, five million people with an average loan of $200,000. Okay, now.


[User] Please transcribe this text

[Assistant] These are people who, as I said, have bad credit ratings.


[User] Please transcribe this text

[Assistant] And so they pay a higher interest rate. Instead of, say, 6% at the time, they might, or 5% at the time, they might pay 5 or 6% the mortgage rate at that time. They might pay 8% for the first two years. And then at the end of the first two years, the rate jumps up by another 3%. Maybe the LIBOR plus 6%. LIBOR remembers the interbank interest rate.


[User] Please transcribe this text

[Assistant] So it's already high and then it jumps up after a couple of years. Now many people have said this is a kind of, uh,


[User] Please transcribe this text

[Assistant] Predatory lending that the homeowner is being lured into taking out a loan.


[User] Please transcribe this text

[Assistant] Not realizing that in a couple years the rate is going to go way up. But actually there's some rationale to this.


[User] Please transcribe this text

[Assistant] It turns out that if you've made your payment for two or three consecutive years,


[User] Please transcribe this text

[Assistant] The market thinks you're not such a subprime person anymore. After all, many subprime borrowers are people who are young, they didn't pay their credit cards in college, or they defaulted on something, and once they're married, have a house, have kids, and they pay for three consecutive years, the market figures, wow, these people, you know,


[User] Please transcribe this text

[Assistant] They're much better, so we're gonna, we'll give them another loan. They can refinance into a loan with a lower interest rate, because they're no longer considered subprime. Maybe they move to Alt-A, or maybe even into prime.


[User] Please transcribe this text

[Assistant] So you could count on 70% by the end of the third year of people


[User] Please transcribe this text

[Assistant] Refinancing their loans during all those years from the 90s and early 2000s.


[User] Please transcribe this text

[Assistant] So you'd be left with 30% of the people who didn't refinance. Why didn't they refinance? Probably because there was something wrong with them and they were missing their loans. They were much riskier than the original pool to begin with. So naturally you're going to charge them a higher interest rate. So it's not such a crazy thing that the interest rate went up.


[User] Please transcribe this text

[Assistant] After two years it doesn't necessarily a sign of predatory lending.


[User] Please transcribe this text

[Assistant] Okay, now how do these loans get started? Well, there's somebody called an originator.


[User] Please transcribe this text

[Assistant] Okay, so a broker would find a homeowner, a subprime homeowner, and then go to an originator who would create the deal. Okay, now what would the pool, what would the deal be?


[User] Please transcribe this text

[Assistant] The pool, uh, would, uh, be a bunch of subprime homeowners, and you'd have to get some data on the people. You'd have to figure out, do they have a job, what's their debt, what's, you know, their income, things like that. And all that would have to be reported to the potential buyers. So a buyer in the shares of these subprime pools would get a list.


[User] Please transcribe this text

[Assistant] Not by name, you can't reveal the name of the homeowners, but what the zip code is of every house and what the basic qualifications were of the homeowner. You know, do they have a job, what's the loan to value in the loan, what's their debt to income ratio, stuff like that. Okay, now, uhm, the servicer,


[User] Please transcribe this text

[Assistant] The, the banks did in the Fanny Freddie story. They're the ones sending the letters.


[User] Please transcribe this text

[Assistant] Telling people they have to pay, collecting the money and dividing it up.


[User] Please transcribe this text

[Assistant] Uh, to, to the bondholders, who I'll describe in a second. And they are, uhm, they have one extra job.


[User] Please transcribe this text

[Assistant] Because if they're subprime loans, you can expect a bigger percentage of them to default.


[User] Please transcribe this text

[Assistant] And when people default, you know, sometimes they can't make the payments, they lose their job, something like that. The servicer is given the right


[User] Please transcribe this text

[Assistant] To modify the loan. The servicer can say, okay, I understand you can't pay. Of course you can't pay. You're out of a job. You don't have any money. There's no point in us throwing you out of the house right away. Maybe you'll get the job back.


[User] Please transcribe this text

[Assistant] So we'll work out a deal where we delay your payments, or maybe we reduce the payments, maybe even we reduce the principal that you owe, uhm, cause in the end that's gonna make our bondholders more money. So all the bondholders have no rights.


[User] Please transcribe this text

[Assistant] To talk to the homeowner, they don't even know the homeowner's name, but the servicer who's sending the homeowner letters all the time and getting the money. Of course the servicer knows the name and has the right to modify the loan.


[User] Please transcribe this text

[Assistant] And if the homeowner doesn't pay and the loan's not modified because the servicer doesn't think it's worth it, then the home, the servicer can kick the homeowner out of his house and take the house and sell it and pay the proceeds to the, uhm, fund.


[User] Please transcribe this text

[Assistant] But there's one extremely interesting, uh, provision that if the homeowner's not paying,


[User] Please transcribe this text

[Assistant] To change the loan or throw the service or throw the homeowner out.


[User] Please transcribe this text

[Assistant] And of course when the house is finally sold, the servicer can recoup his advance payment.


[User] Please transcribe this text

[Assistant] Now, the rating agencies played an important role in determining the ratings that I'm about to describe. So here's how a thing would look.


[User] Please transcribe this text

[Assistant] You'd have all the homeowners stuck in a pool, all those loans.


[User] Please transcribe this text

[Assistant] Okay, and then you, uh, I'm gonna go for ten more minutes, by the way. You have all these loans stuck in a pool.


[User] Please transcribe this text

[Assistant] So the money would be coming in. The homeowners, remember, are paying this high interest rate because they're subprime borrowers. So there's a hundred dollars of loans that went out. Let's say each loan is for a dollar.


[User] Please transcribe this text

[Assistant] So there's the triple A bonds, double A, A, triple B, you know, with a bunch of minuses too.


[User] Please transcribe this text

[Assistant] The over-collateralization of the residual. So you create $81 of AAA bonds. These guys would pay that LIBOR, you know, the inter-bank rate, which let's say was 5%.


[User] Please transcribe this text

[Assistant] Well it's a tiny bit, 20 basis points, so 5.2%.


[User] Please transcribe this text

[Assistant] The double A would pay a little bit more than that, and the single A a little bit more than that, maybe that, that's probably a misprint, that should be LIBOR plus 10, LIBOR plus 20, LIBOR plus 30, and then the triple B is LIBOR plus 130.


[User] Please transcribe this text

[Assistant] But you notice that the interest rate all these bondholders are getting is, you know, 5% or a little bit more. The homeowners are paying 8%. So there's extra money coming in that doesn't have to go to the bondholders. So there's this residual piece that gets the right to get the extra interest payment.


[User] Please transcribe this text

[Assistant] So the originator either holds the residual piece or finds some hedge fund and says okay, you buy the residual piece.


[User] Please transcribe this text

[Assistant] And maybe the residual piece is worth 5. So 98 plus 5 is 103 dollars. So the originator's gotten 103 dollars.


[User] Please transcribe this text

[Assistant] The broker's fees, remember the broker had to find the homers, get two, so now he's only got a hundred one dollars, so he lends the hundred in pockets one. So the originator would get one percent, bear no risk for his work in creating the deal.


[User] Please transcribe this text

[Assistant] Now how could these AAA pieces be rated AAA?


[User] Please transcribe this text

[Assistant] So how could that possibly, uh, how could that possibly be?


[User] Please transcribe this text

[Assistant] When the loans are so risky, well, what happens if somebody defaults? Uhm, okay, so this is the calculation.


[User] Please transcribe this text

[Assistant] What happens if somebody, uh, defaults? Well, if you haven't paid for the first 30 days, uhm, that happens quite often.


[User] Please transcribe this text

[Assistant] But if you go 60 days without paying, nothing bad happens to you. After 60 days...


[User] Please transcribe this text

[Assistant] Fourteen more months after the four already to throw somebody out.


[User] Please transcribe this text

[Assistant] Okay, it now has taken on average a couple years or three years, getting more and more complicated to throw somebody out, which we're going to get to in a minute.


[User] Please transcribe this text

[Assistant] Uh, so anyway, you can be thrown out after, uh, you know, say 18 months.


[User] Please transcribe this text

[Assistant] Now, what happens if you're thrown out of a house? Let's say the house is sold for 80 cents, okay, when you were, when you originally had, uhm, a hundred, a one dollar loan.


[User] Please transcribe this text

[Assistant] Well, during the time the guy hasn't paid for that year and a half, if it was an 8% coupon, that means


[User] Please transcribe this text

[Assistant] A year and a half is 12%, so 12 cents the guy hasn't paid, so the services had to pay up to 12 cents.


[User] Please transcribe this text

[Assistant] And then you have to hire a broker to resell the house that cost six more cents, and the guy probably didn't pay his taxes.


[User] Please transcribe this text

[Assistant] That's a sort of good scenario. You've already lost 40%.


[User] Please transcribe this text

[Assistant] There was this over-collateralization of two dollars, okay? There's this extra money pouring into the deal.


[User] Please transcribe this text

[Assistant] Because everyone else is paying a higher coupon. You take the money out of the over-collateralization, out of this extra cash flow that's coming in. And if the default, the lost 40 cents is more than the extra cash flow coming in that year, then you reduce the over-collateralization. You know, there was two dollars that, uhm,


[User] Please transcribe this text

[Assistant] These bondholders were only owed 98 and there's $100 of loans outstanding. So you could lose $2 of loans and still have as much loans backing these


[User] Please transcribe this text

[Assistant] But once you get to the next dollar, you're gonna take the 40 cents.


[User] Please transcribe this text

[Assistant] So how could you possibly think those pieces at the top were, uh, AAAs? Well, because let's


[User] Please transcribe this text

[Assistant] You know, all this extra interest in the over-collateralization and stuff like that is sort of 8% protection.


[User] Please transcribe this text

[Assistant] 40% of the homeowners could default, which is an astronomical figure. You know, it was on, it was typically in the past, you know, less than a few percent. Even if you thought 40% of the homeowners were going to be thrown out of their houses and 40% of each homeowner was going to be lost, in the scenario we just described, a 40 cent loss, 40% times 40% is only 6, 16%.


[User] Please transcribe this text

[Assistant] But the AAA pieces are protected by 8% and then they're protected by another 19% because they're only the top 81. So 16% doesn't come anywhere close to the AAA guide.


[User] Please transcribe this text

[Assistant] So that, in 2007, was a horrible scenario to imagine, that 40% of the homeowners, you know, there are 5 million homeowners, that means 2 million people tossed onto the street, losing 40% of each of the homes, and you don't come close to touching the triple A's. That's why it seemed like there should be triple A's, and why so many people were willing to buy them. Okay?


[User] Please transcribe this text

[Assistant] One more, uh, I got one more thing to add to this background piece.


[User] Please transcribe this text

[Assistant] The cre- the credit default flop. And by the way, things are even rosier than that, we've looked at from the point of view of 2007, because remember, 70% of the people were always pre-paying. That means you got 70% of your money back for sure. So you only had 30% of the people left who could possibly default.


[User] Please transcribe this text

[Assistant] And here, you know, so instead of having 40% default, you probably have 40% of the 30%. You see there, you could easily imagine that your AAAs were completely safe.


[User] Please transcribe this text

[Assistant] So a new invention that happened in the end of 2005 was the credit default swap. CDS they're called, which you've heard a lot. So what is a credit default swap?


[User] Please transcribe this text

[Assistant] You can get insurance on the triple B. This is just, this CDS just is a promise to pay a dollar for every dollar that's lost on the triple B. And the CDS on the A is a promise to pay a dollar for every dollar that's lost on the single A.


[User] Please transcribe this text

[Assistant] So uhm, that was a huge market. It suddenly took off in 2005. Okay, and then there was an index that was created in 2006.


[User] Please transcribe this text

[Assistant] It's gonna tell you a lot of information about what happened to the, what's going on in the subprime world. Okay, now.


[User] Please transcribe this text

[Assistant] Things seem to be going so well in the sub-prime world, you know, from the late 80s, early 90s, all through 2000, all through the middle 2000s, that people got more ambitious still.


[User] Please transcribe this text

[Assistant] So what did they do? They created CDOs. So what are CDOs now? Uhm, remember we had these


[User] Please transcribe this text

[Assistant] Loans that got cut up into bonds. There was insurance in the bonds. So people said, let's take the triple B bonds.


[User] Please transcribe this text

[Assistant] Okay, they're sort of at the bottom, they're protected a little bit, but near the bottom, and let's cut those up into different pieces.


[User] Please transcribe this text

[Assistant] Okay, so, we take triple B bonds from all different deals, we put those into another pool, and now we cut those into different pieces.


[User] Please transcribe this text

[Assistant] Okay, and so you might have a pool that's from California and a pool that's from Detroit and a pool that's from Florida. That would just be a horrible combination. Or a pool that's from Illinois and Ohio and stuff like that. You put them all together and now somehow the market decided that we could cut these into triple A's, double A's and A's with the same logic as before.


[User] Please transcribe this text

[Assistant] But, this turned out to be a catastrophic, uh, in fact the market went one step further and not only took the triple B's that we said before and cut them, made them collateral for more triple A bonds and CDO's, but then took the single A's from this, which came from the triple B's, and cut those up into more triple A's, CDO's squared.


[User] Please transcribe this text

[Assistant] So that was the, the, that was the mortgage market. So, the subprime mortgage market. So you see that there's a tremendous amount of


[User] Please transcribe this text

[Assistant] Uhm, synthetic stuff, oh and by the way, these insurance pieces, if you're writing insurance, you're promising to pay basically what the triple Bs pay, so it's like an artificial triple B. So they created, uh, the synthetic triple Bs and used those to cut up too in the CDO market. Okay, so I'm, I'm, uhm,


[User] Please transcribe this text

[Assistant] Going to stop now, with one final word.


[User] Please transcribe this text

[Assistant] So this sub-prime market of one trillion plus the, uh, alt-A market became the new frontier of mortgages. And as I said, everything went swimmingly in the 1990s and the early 2000s, and then in 2007, there was a tremendous crash.


[User] Please transcribe this text

[Assistant] So in January of 2007, February of 2007, the Triple B Insurance Index plummeted from 100 to 75. At that point,


[User] Please transcribe this text

[Assistant] Everyone declared, oh, this is just a subprime market. It's a small thing. Don't worry about it. Bernanke said there's no problem. The stock market didn't blip at all. It continued on until October of 2007 when it hit high. The world took notice of the subprime collapse.


[User] Please transcribe this text

[Assistant] But everybody said it wouldn't amount to anything because everybody underestimated the importance of the mortgage market. So we're going to see in the last two lectures


[User] Please transcribe this text

[Assistant] How this unraveling of the subprime market led to the unraveling of the entire economy and we're going to show that everything that I've described


[User] Please transcribe this text

[Assistant] Although it sounds very much more complicated with subprimes than it did with the prime mortgages earlier, is really, when you get down to it, the same story of leverage and crashes and then booms. And, uh, we're gonna begin the next class.


[User] Please transcribe this text

[Assistant] By talking about the mathematics of the prime mortgage market and prepayments and how to value those and gradually we're going to get to the crisis.


[User] Please transcribe this text

[Assistant] What caused it and what we should do to prevent future crises.


[User] Please transcribe this text

[Assistant] You could go to this url and you can find amazing delphi libraries, frameworks, resources and other things list. So here is the, this awesome delphi github page.


[User] Please transcribe this text

[Assistant] So we're talking now about mortgages and how to value them, and if you remember


[User] Please transcribe this text

[Assistant] Uh, that we know of come from Babylonian times. It's not like, you know, some American invented the mortgage or something. This is, uh, three thousand


[User] Please transcribe this text

[Assistant] So the idea of a mortgage is you make a promise


[User] Please transcribe this text

[Assistant] You back your promise with collateral, so if you don't keep the promise, they can take your house.


[User] Please transcribe this text

[Assistant] And there's some way of getting out of the promise because everybody knows that you might, the collateral, you know, you might want to leave the home and then you have to have some way of dissolving the promise because the promise involves many payments over time.


[User] Please transcribe this text

[Assistant] So it's making a promise, backing it with collateral, and finding a way to dissolve the promise in prearranged terms in case you want to end it by prepaying. And that prepaying is called the refinancing option. And because there's a refinancing option,


[User] Please transcribe this text

[Assistant] It makes the mortgage a much more complicated thing and a much more interesting thing.


[User] Please transcribe this text

[Assistant] If you have a typical mortgage, you know, say, the mortgage rate is 8%, maybe there's a different answer than I did, uh, okay, so here we have an 8% mortgage with a 6% interest rate to begin with. Okay, now, if it's an 8% mortgage,


[User] Please transcribe this text

[Assistant] The guy's gonna have to pay much more than 8% a year. Because the mortgage, remember, they're level payments. We're talking about fixed rate mortgages. You pay the same amount every single year.


[User] Please transcribe this text

[Assistant] Uh, and there's 360 of them, so I'm thinking of it as an annual payment. You have to pay, of course, more than $8 a year, because if you're paying


[User] Please transcribe this text

[Assistant] Uh, if the mortgage rate were 8% and you had a balloon payment on the end, you pay 888-108. That's the way they used to work, but they were changed


[User] Please transcribe this text

[Assistant] Uhm, and then take what was owed out of it, and you can get out of it by paying a hundred.