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ANDREW LO: Last
time when we met,

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00:00:26,250 --> 00:00:28,041
we saw that the yield
curve was somewhere--

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00:00:28,041 --> 00:00:33,720
the short end was somewhere at
the 30 to 40 basis point level.

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00:00:33,720 --> 00:00:35,520
And let's see where it is today.

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00:00:35,520 --> 00:00:40,030
The yield on a three
month treasury bill,

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00:00:40,030 --> 00:00:45,314
according to this, is at
71 to 72 basis points.

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00:00:45,314 --> 00:00:46,230
So that's pretty good.

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00:00:46,230 --> 00:00:49,440
That's better than
it was last week.

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00:00:49,440 --> 00:00:52,950
There was a point, actually,
earlier this morning,

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00:00:52,950 --> 00:00:54,450
that the yield curve was--

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00:00:54,450 --> 00:00:58,170
the short end was
slightly above 1%.

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00:00:58,170 --> 00:01:01,740
But it's now come back down,
because of additional trading

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00:01:01,740 --> 00:01:04,349
and demand for these securities.

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00:01:04,349 --> 00:01:08,850
But that suggests that at least
the panic is not as severe

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as it was last week.

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00:01:09,857 --> 00:01:11,190
Things are getting a bit better.

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00:01:11,190 --> 00:01:13,830
And not surprisingly, the reason
they're getting a bit better,

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00:01:13,830 --> 00:01:15,972
is because there's
more certainty now

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that something was
going to happen.

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00:01:17,430 --> 00:01:21,030
When we met last, it seemed
as if there was a possibility

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00:01:21,030 --> 00:01:22,742
that this wasn't going
to happen at all,

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00:01:22,742 --> 00:01:25,200
that there was going to be some
breakdown between Democrats

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00:01:25,200 --> 00:01:28,320
and Republicans, and that
there was an impasse.

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Fortunately, that got
resolved over the weekend.

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00:01:30,900 --> 00:01:31,980
At least it seems to be.

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00:01:31,980 --> 00:01:35,010
It's going to be voted
on as we speak actually.

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00:01:35,010 --> 00:01:36,780
So hopefully, we'll
find out by the end

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00:01:36,780 --> 00:01:40,200
of class or end of today
whether or not it happens.

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00:01:40,200 --> 00:01:41,620
If it doesn't
happen, what do you

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00:01:41,620 --> 00:01:45,140
think is going to happen
to the three month?

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00:01:45,140 --> 00:01:47,930
Yeah, so you could actually
look at this as a thermometer.

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00:01:47,930 --> 00:01:49,840
Check the temperature
of our economy.

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00:01:49,840 --> 00:01:52,010
It's pretty amazing, isn't it?

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00:01:52,010 --> 00:01:55,640
It tells you that financial
markets are very dynamic,

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00:01:55,640 --> 00:01:58,730
and that you actually can
learn a lot from market prices.

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00:01:58,730 --> 00:02:01,940
Again, are market
prices correct?

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00:02:01,940 --> 00:02:03,530
No, there's no such
thing as correct.

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00:02:03,530 --> 00:02:06,620
I want you to get away from
that notion of correct.

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00:02:06,620 --> 00:02:09,199
There is a market
price that reflects

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00:02:09,199 --> 00:02:13,070
the aggregate sentiment of the
economy and the participants

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00:02:13,070 --> 00:02:15,230
on a given day, at a
given point in time,

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00:02:15,230 --> 00:02:17,290
with a certain set
of market conditions.

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00:02:17,290 --> 00:02:19,040
And then you have to
decide whether or not

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00:02:19,040 --> 00:02:22,550
that set of prices is something
that you would like to use

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00:02:22,550 --> 00:02:24,380
in your own calculations.

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00:02:24,380 --> 00:02:26,237
So right now, these
are the prices

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00:02:26,237 --> 00:02:28,070
that reflect what's
going on in the economy.

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00:02:28,070 --> 00:02:29,810
By the way, at the
long end, last time

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00:02:29,810 --> 00:02:34,280
we saw that two weeks ago, the
long end of the yield curve

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00:02:34,280 --> 00:02:37,067
was pretty high, because
of concerns that there

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00:02:37,067 --> 00:02:38,150
was going to be inflation.

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00:02:38,150 --> 00:02:40,490
And then last week, we
saw that it went down.

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00:02:40,490 --> 00:02:41,300
What is it now?

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00:02:41,300 --> 00:02:44,840
Well, if you take a look at the
30 year, the yield is at 422.

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00:02:44,840 --> 00:02:47,180
That's slightly
lower, not by much,

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but it's slightly lower
than what we saw last time.

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00:02:49,555 --> 00:02:51,680
And certainly lower than
what it was two weeks ago.

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00:02:51,680 --> 00:02:55,220
So the concerns about inflation,
while they're still there,

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00:02:55,220 --> 00:02:57,110
at least from the
data here it looks

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like they're a little bit less.

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00:02:59,480 --> 00:03:04,010
So are people right today
and were wrong last week?

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00:03:04,010 --> 00:03:04,910
Who knows.

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00:03:04,910 --> 00:03:08,090
The point is that this reflects
what the current market

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00:03:08,090 --> 00:03:09,650
sentiment is.

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00:03:09,650 --> 00:03:12,560
And so at every point in time,
when you look at market prices,

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00:03:12,560 --> 00:03:16,670
what you're getting is a
window on current expectations

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00:03:16,670 --> 00:03:20,830
and current information, and you
have to make the best of that.

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00:03:20,830 --> 00:03:21,664
Any other questions?

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00:03:21,664 --> 00:03:22,163
Yup?

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STUDENT: I just have
sort of two questions.

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One is that, when the three
months treasuries are so high,

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we said it was just a
couple basis points,

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00:03:32,562 --> 00:03:34,967
why wouldn't you
just short those?

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Because don't you
have a [INAUDIBLE],,

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00:03:36,810 --> 00:03:39,620
they can't go above 0.

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So you have a couple
basis points downside,

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00:03:42,940 --> 00:03:45,630
and [INAUDIBLE]
basis points upside.

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00:03:45,630 --> 00:03:46,630
ANDREW LO: That's right.

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00:03:46,630 --> 00:03:47,949
You could have shorted them.

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00:03:47,949 --> 00:03:49,115
Andy, do you want to answer?

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00:03:49,115 --> 00:03:51,642
ANDY: I'm not sure I agree
that you can short them.

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00:03:51,642 --> 00:03:52,600
ANDREW LO: OK, why not?

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00:03:52,600 --> 00:03:54,100
ANDY: Because going
short that means

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00:03:54,100 --> 00:03:56,464
that you want to
borrow money at 3 basis

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00:03:56,464 --> 00:04:00,422
points for three months, but
you're not the US Government.

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00:04:00,422 --> 00:04:01,994
And no on will allow
you to do that.

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00:04:04,660 --> 00:04:08,050
ANDREW LO: Well, it would be
hard to borrow the securities

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00:04:08,050 --> 00:04:09,580
and then sell them, right?

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00:04:09,580 --> 00:04:12,850
And unfortunately, you can't
manufacture the pieces of paper

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00:04:12,850 --> 00:04:14,950
the way the US Government can.

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00:04:14,950 --> 00:04:16,510
It's kind of hard
to do the printing

99
00:04:16,510 --> 00:04:18,920
press in just the same way.

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00:04:18,920 --> 00:04:22,620
In fact, I think it
may even be illegal.

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00:04:22,620 --> 00:04:26,129
But you're right that if--

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00:04:26,129 --> 00:04:27,670
it's such a low
level, what you would

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00:04:27,670 --> 00:04:29,128
like to be able to
do is you'd like

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00:04:29,128 --> 00:04:31,010
to be able to issue that stuff.

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00:04:31,010 --> 00:04:33,070
And by the way,
the US Government

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00:04:33,070 --> 00:04:36,370
did take the opportunity to
issue some paper last week

107
00:04:36,370 --> 00:04:37,500
to take advantage of this.

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00:04:37,500 --> 00:04:39,208
Because it's a great
way to do it, right?

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00:04:39,208 --> 00:04:41,350
You borrow money at
virtually zero interest

110
00:04:41,350 --> 00:04:43,054
rate because you are
the US Government,

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00:04:43,054 --> 00:04:44,470
and all you need
to do is print up

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00:04:44,470 --> 00:04:46,005
these wonderful certificates.

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00:04:46,005 --> 00:04:47,630
But I think the issue
is exactly right.

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00:04:47,630 --> 00:04:49,227
If you wanted to
short it, you've

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00:04:49,227 --> 00:04:51,810
got to be able to borrow it from
somebody else and then short,

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00:04:51,810 --> 00:04:53,920
and they have to let
you borrow it from them

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00:04:53,920 --> 00:04:56,260
at appropriate premium.

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00:04:56,260 --> 00:04:58,510
So there's a risk
and a price for that.

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00:04:58,510 --> 00:05:03,140
But if you could do it, it
was a pretty good trade.

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00:05:03,140 --> 00:05:05,320
On the other hand, think
about what you're saying.

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00:05:05,320 --> 00:05:07,510
What you're saying
is that you would

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00:05:07,510 --> 00:05:10,330
like to be able to allow
people who want liquidity

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00:05:10,330 --> 00:05:11,380
to have liquidity.

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00:05:11,380 --> 00:05:14,350
You would like to provide them
with that kind of a liquidity.

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00:05:14,350 --> 00:05:16,690
If everybody is panicking
and wanting liquidity,

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00:05:16,690 --> 00:05:18,700
then that might be
a very good strategy

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00:05:18,700 --> 00:05:21,760
because when markets
calm down, eventually,

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00:05:21,760 --> 00:05:23,680
you will do quite well.

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00:05:23,680 --> 00:05:25,720
In effect, that's
what the US Government

130
00:05:25,720 --> 00:05:28,654
is hoping to do with
this so-called bailout

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00:05:28,654 --> 00:05:30,070
package, which is
what I mentioned

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00:05:30,070 --> 00:05:32,800
last week that bailout is
probably not the right term.

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00:05:32,800 --> 00:05:34,960
It's a rescue
package undoubtedly.

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00:05:34,960 --> 00:05:38,020
But whether or not it's
a bailout or a very

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00:05:38,020 --> 00:05:41,850
savvy investment depends
simply on the price--

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00:05:41,850 --> 00:05:43,480
on the price that
you can get it at,

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00:05:43,480 --> 00:05:45,790
and the price that you
ultimately sell it for.

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00:05:45,790 --> 00:05:48,330
So that remains to be seen.

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00:05:48,330 --> 00:05:49,914
Other questions?

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00:05:49,914 --> 00:05:50,414
Yep?

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00:05:50,414 --> 00:05:52,910
STUDENT: I don't know the
details of the [INAUDIBLE],,

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00:05:52,910 --> 00:05:57,640
but I'm wondering,
this crises is

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00:05:57,640 --> 00:06:03,790
based on the whole economy is
leveraged on some assets that

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00:06:03,790 --> 00:06:07,210
are not really working
or are worth less

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00:06:07,210 --> 00:06:10,584
than they were supposed to.

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00:06:10,584 --> 00:06:15,708
And I wonder, at the
end, would the people

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00:06:15,708 --> 00:06:20,010
that have credit, but
bad credit, suffer?

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00:06:20,010 --> 00:06:23,870
Will they save
their homes or not?

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00:06:23,870 --> 00:06:26,600
I don't see--
because the only way

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00:06:26,600 --> 00:06:31,320
I see for this to be corrected
is to go to [INAUDIBLE]..

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00:06:31,320 --> 00:06:35,830
There's a lot of people
leveraged that cannot pay

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00:06:35,830 --> 00:06:39,600
so how will this get to--

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00:06:39,600 --> 00:06:40,670
Am I explaining myself?

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00:06:40,670 --> 00:06:41,330
ANDREW LO: I think so.

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00:06:41,330 --> 00:06:41,830
I think so.

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00:06:41,830 --> 00:06:44,990
I think you're expressing
the same kind of concern

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00:06:44,990 --> 00:06:47,420
and confusion that the
American public has expressed

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00:06:47,420 --> 00:06:48,620
at the bailout package.

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00:06:48,620 --> 00:06:52,490
Because it doesn't
seem like the bailout

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00:06:52,490 --> 00:06:56,550
is really applying to the
ultimate root cause of this,

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00:06:56,550 --> 00:06:59,000
which is the home owners.

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00:06:59,000 --> 00:07:01,424
The politicians would say
that you're bailing out

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00:07:01,424 --> 00:07:02,840
Wall Street when
you should really

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00:07:02,840 --> 00:07:05,210
be bailing out Main Street.

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00:07:05,210 --> 00:07:08,030
Let me hold off on answering
that, because it turns out that

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00:07:08,030 --> 00:07:12,050
this Thursday, October
2nd, from 5:30 to 7:00,

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00:07:12,050 --> 00:07:13,850
the Sloan School
will be organizing

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00:07:13,850 --> 00:07:16,670
a panel discussion
of the bailout,

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00:07:16,670 --> 00:07:19,060
as well as the root causes
of some of these issues.

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00:07:19,060 --> 00:07:21,770
So rather than take up
any more class time,

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00:07:21,770 --> 00:07:25,100
let me defer that question
to that Thursday panel,

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00:07:25,100 --> 00:07:27,570
and then I'd be happy to
talk about it afterwards.

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00:07:27,570 --> 00:07:29,510
But I'd rather make
sure that we stay

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00:07:29,510 --> 00:07:31,370
on track with our
curriculum and just use

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00:07:31,370 --> 00:07:32,480
this as an illustration.

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00:07:32,480 --> 00:07:34,688
But let me give you the
short answer to the question.

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00:07:34,688 --> 00:07:36,500
The short answer
is that the idea

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00:07:36,500 --> 00:07:40,340
is that you have to deal with
the current crisis right now.

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00:07:40,340 --> 00:07:43,100
So it's sort of like having a
patient come into the emergency

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00:07:43,100 --> 00:07:48,080
room and they're bleeding
out, and it turns out

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00:07:48,080 --> 00:07:51,500
that the reason they're bleeding
out is they've abused drugs

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00:07:51,500 --> 00:07:53,810
and they've done all
sorts of bad things

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00:07:53,810 --> 00:07:56,020
to their diet and health.

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00:07:56,020 --> 00:07:57,650
Now, at that time,
you probably don't

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00:07:57,650 --> 00:07:59,390
want to give a lecture
on good nutrition

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00:07:59,390 --> 00:08:04,157
and the dangers of
recreational pharmaceuticals.

187
00:08:04,157 --> 00:08:05,490
You've got to stop the bleeding.

188
00:08:05,490 --> 00:08:07,948
And then, over the course of
the next few weeks and months,

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00:08:07,948 --> 00:08:09,570
you try to rehabilitate
the patient.

190
00:08:09,570 --> 00:08:12,080
So what the package is
meant to do, first of all,

191
00:08:12,080 --> 00:08:13,192
is to stop the bleeding.

192
00:08:13,192 --> 00:08:15,650
And then, over time, we're
going to have to address exactly

193
00:08:15,650 --> 00:08:16,910
the issues that you raised.

194
00:08:16,910 --> 00:08:20,270
And that's part of what the
proposal was trying to do.

195
00:08:20,270 --> 00:08:23,420
That's why it took them
time to put it together.

196
00:08:23,420 --> 00:08:25,910
It's easy to figure out
how to stop the bleeding.

197
00:08:25,910 --> 00:08:28,370
Money will stop the bleeding.

198
00:08:28,370 --> 00:08:31,130
But the problem is that
throwing money, good money,

199
00:08:31,130 --> 00:08:34,070
at bad assets is not necessarily
the long run solution.

200
00:08:34,070 --> 00:08:37,130
You have to figure out what
the ultimate causes are dealing

201
00:08:37,130 --> 00:08:40,190
with foreclosures, dealing
with all of these very

202
00:08:40,190 --> 00:08:43,789
complex securities, figuring
out how to value them,

203
00:08:43,789 --> 00:08:46,460
coming up with proper
insurance agreements

204
00:08:46,460 --> 00:08:49,340
to be able to create stability
across the entire market.

205
00:08:49,340 --> 00:08:51,830
And that's what the various
aspects of the bailout package

206
00:08:51,830 --> 00:08:52,952
are designed to do.

207
00:08:52,952 --> 00:08:54,410
So we'll talk about
it on Thursday,

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00:08:54,410 --> 00:08:55,909
and I would encourage
all of you who

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00:08:55,909 --> 00:08:57,660
are interested to
come to that session.

210
00:08:57,660 --> 00:09:02,030
We've got a number of economists
and accounting faculty

211
00:09:02,030 --> 00:09:05,150
and other folks who are
going to be there to present.

212
00:09:05,150 --> 00:09:08,267
You'll get a notice about that
probably later this afternoon.

213
00:09:08,267 --> 00:09:09,266
STUDENT: One more thing.

214
00:09:09,266 --> 00:09:13,260
On the Wachovia deal, what's
going to happen with the bank?

215
00:09:13,260 --> 00:09:16,370
Is it going to
continue the same?

216
00:09:16,370 --> 00:09:19,590
ANDREW LO: Well, obviously
that's a work in progress.

217
00:09:19,590 --> 00:09:22,310
It looks like most of
the units of Wachovia

218
00:09:22,310 --> 00:09:25,220
will be sold off to
Citigroup, but there

219
00:09:25,220 --> 00:09:28,340
are a few units of Wachovia,
including AG Edwards, which

220
00:09:28,340 --> 00:09:30,290
is a broker dealer,
and Evergreen, which

221
00:09:30,290 --> 00:09:32,750
is another broker dealer,
that will remain separate

222
00:09:32,750 --> 00:09:33,920
and will be freestanding.

223
00:09:33,920 --> 00:09:36,140
So that will not be
acquired by Citigroup.

224
00:09:36,140 --> 00:09:38,390
But apart from that, all
the other units of Wachovia

225
00:09:38,390 --> 00:09:40,566
will be taken on by
Citigroup, and that there

226
00:09:40,566 --> 00:09:43,910
will be a backstop provided
by the FDIC in case

227
00:09:43,910 --> 00:09:46,857
the losses exceed
more than $40 billion.

228
00:09:46,857 --> 00:09:48,440
So Citigroup will
be able to take that

229
00:09:48,440 --> 00:09:49,820
onto its balance sheets.

230
00:09:49,820 --> 00:09:52,460
And in exchange
for taking on all

231
00:09:52,460 --> 00:09:54,500
of these bad debts
and other problems,

232
00:09:54,500 --> 00:09:57,386
Citigroup gets the
retail access to all

233
00:09:57,386 --> 00:09:58,760
of the various
different channels

234
00:09:58,760 --> 00:10:00,260
that Wachovia has set up.

235
00:10:00,260 --> 00:10:03,140
So now, Citigroup
has the ability

236
00:10:03,140 --> 00:10:07,550
to compete head-to-head with
Merrill Lynch having been

237
00:10:07,550 --> 00:10:09,410
acquired by Bank of America.

238
00:10:09,410 --> 00:10:11,850
Whereas before, they wouldn't
have been able to do that.

239
00:10:11,850 --> 00:10:13,850
So you see, this is what
I was saying last time,

240
00:10:13,850 --> 00:10:17,180
that with every kind of crisis,
with every kind of dislocation,

241
00:10:17,180 --> 00:10:19,610
there are opportunities
that are created.

242
00:10:19,610 --> 00:10:23,180
And so when you have
one door closing,

243
00:10:23,180 --> 00:10:25,849
three other doors
open for opportunities

244
00:10:25,849 --> 00:10:27,140
that can be taken advantage of.

245
00:10:27,140 --> 00:10:28,973
And by the way, let we
mention, this is also

246
00:10:28,973 --> 00:10:30,020
true for your careers.

247
00:10:30,020 --> 00:10:32,737
You might be discouraged
about financial services.

248
00:10:32,737 --> 00:10:34,070
I would argue just the opposite.

249
00:10:34,070 --> 00:10:36,980
Right now, all of you are
at an excellent position

250
00:10:36,980 --> 00:10:39,290
as first year students,
because first of all, you're

251
00:10:39,290 --> 00:10:43,100
here in school waiting out
the passage of the storm.

252
00:10:43,100 --> 00:10:45,790
And when the storm
passes, believe me,

253
00:10:45,790 --> 00:10:47,670
there are going to be
tons of opportunities.

254
00:10:47,670 --> 00:10:51,950
In fact, typically the
largest growth period for jobs

255
00:10:51,950 --> 00:10:54,860
is not at business cycle
peaks, but its exactly

256
00:10:54,860 --> 00:10:57,560
after these kinds of
troughs that occur.

257
00:10:57,560 --> 00:10:59,139
So within the next
6 to 12 months,

258
00:10:59,139 --> 00:11:01,180
there's going to be tons
of career opportunities.

259
00:11:01,180 --> 00:11:02,570
In fact, for those
of you who are

260
00:11:02,570 --> 00:11:04,550
interested in going to
the New York Banking Day,

261
00:11:04,550 --> 00:11:06,800
and you really should if
you're interested in a career

262
00:11:06,800 --> 00:11:07,820
in finance.

263
00:11:07,820 --> 00:11:11,120
My guess is if you visit
Goldman Sachs, Morgan Stanley,

264
00:11:11,120 --> 00:11:13,550
as difficult as a
set of circumstances

265
00:11:13,550 --> 00:11:15,900
they're in right now, my
guess is every single one

266
00:11:15,900 --> 00:11:17,702
of these firms will be hiring.

267
00:11:17,702 --> 00:11:19,410
And the reason they're
going to be hiring

268
00:11:19,410 --> 00:11:22,320
is because they want to take
advantage of the opportunity

269
00:11:22,320 --> 00:11:25,410
to cut costs and to
hire younger, more

270
00:11:25,410 --> 00:11:30,420
energetic employees to
be able to really beef up

271
00:11:30,420 --> 00:11:34,740
their future generations
of human capital.

272
00:11:34,740 --> 00:11:37,030
So they're going to be
making an investment in that.

273
00:11:37,030 --> 00:11:39,734
So I think that's a good example
of how it's true that you're

274
00:11:39,734 --> 00:11:40,900
going to have consolidation.

275
00:11:40,900 --> 00:11:42,390
So now, after
this, there's going

276
00:11:42,390 --> 00:11:47,130
to be three major money center
banks, JP Morgan Chase, Bank

277
00:11:47,130 --> 00:11:50,700
of America, and Citigroup,
which is astonishing

278
00:11:50,700 --> 00:11:53,400
because just a few months ago
there were quite a few others.

279
00:11:53,400 --> 00:11:54,817
So the landscape has changed.

280
00:11:54,817 --> 00:11:56,400
But the competitive
landscape changing

281
00:11:56,400 --> 00:11:58,940
means that opportunities
get created along the way.

282
00:11:58,940 --> 00:12:03,090
STUDENT: I was just wondering
from your point of view.

283
00:12:03,090 --> 00:12:07,562
Why is it better to have the
banking industry consolidated

284
00:12:07,562 --> 00:12:08,680
into three buckets?

285
00:12:08,680 --> 00:12:10,221
In that, wouldn't
it have been better

286
00:12:10,221 --> 00:12:13,744
to let Wachovia fail and
let the regional [INAUDIBLE]

287
00:12:13,744 --> 00:12:17,894
pick up the slack instead of
now having literally JP, B of A,

288
00:12:17,894 --> 00:12:24,260
and CitiGroup dominate
the entire landscape

289
00:12:24,260 --> 00:12:27,810
and be in a position to
monopolize [INAUDIBLE]

290
00:12:27,810 --> 00:12:29,730
going forward.

291
00:12:29,730 --> 00:12:33,270
ANDREW LO: Well, so that's
an interesting thought,

292
00:12:33,270 --> 00:12:36,350
letting Wachovia fail.

293
00:12:36,350 --> 00:12:38,855
Obviously, you're not
a Wachovia customer.

294
00:12:42,380 --> 00:12:44,750
I think that what's
happening right now

295
00:12:44,750 --> 00:12:48,410
is that there's a great
deal of sensitivity,

296
00:12:48,410 --> 00:12:52,460
not only on the part of
Wall Street, but regulators,

297
00:12:52,460 --> 00:12:57,320
to stem the tide of
mass financial panic.

298
00:12:57,320 --> 00:12:58,940
We talked a bit
about that last time.

299
00:12:58,940 --> 00:13:01,940
The reason that regulators
and the government

300
00:13:01,940 --> 00:13:06,200
sprang into action was not
because Lehman went under,

301
00:13:06,200 --> 00:13:08,370
or AIG went under, or
any of these other large

302
00:13:08,370 --> 00:13:09,020
organizations.

303
00:13:09,020 --> 00:13:12,890
The reason that finally got
them over the edge of moving

304
00:13:12,890 --> 00:13:16,340
to do something substantial
is because the reserve

305
00:13:16,340 --> 00:13:19,970
fund, a retail money market
fund, broke the buck.

306
00:13:19,970 --> 00:13:24,320
And if that happens on a regular
basis beyond the reserve fund,

307
00:13:24,320 --> 00:13:27,560
you will have a very, very
significant financial market

308
00:13:27,560 --> 00:13:29,030
dislocation.

309
00:13:29,030 --> 00:13:32,550
It turns out that Wachovia is
part of that retail network.

310
00:13:32,550 --> 00:13:35,600
And if you let
Wachovia fail, you

311
00:13:35,600 --> 00:13:42,080
risk igniting further problems
in that retail sector.

312
00:13:42,080 --> 00:13:44,210
Citigroup is perfectly
happy to take them over

313
00:13:44,210 --> 00:13:46,190
and are able to
given their balance

314
00:13:46,190 --> 00:13:48,680
sheet-- are able to manage
that without any problem.

315
00:13:48,680 --> 00:13:50,480
So that seemed like
an ideal solution

316
00:13:50,480 --> 00:13:52,400
from everybody's perspective.

317
00:13:52,400 --> 00:13:55,340
Because if you allow
Wachovia to fail, remember,

318
00:13:55,340 --> 00:13:59,900
the FDIC is on the hook to pay
all the depositors their FDIC

319
00:13:59,900 --> 00:14:04,200
deposit insurance up to
$100,000 per name, per account.

320
00:14:04,200 --> 00:14:08,520
That could be a very substantial
number by letting the bank fail

321
00:14:08,520 --> 00:14:12,020
and by having all of its
value completely lost.

322
00:14:12,020 --> 00:14:14,630
This way, they actually
preserve a fair amount of value,

323
00:14:14,630 --> 00:14:17,360
because as an ongoing
concern, Wachovia has

324
00:14:17,360 --> 00:14:19,520
quite a lot of good business.

325
00:14:19,520 --> 00:14:23,030
So it actually is the
cost minimizing solution,

326
00:14:23,030 --> 00:14:24,980
but at the same time
it also preserves

327
00:14:24,980 --> 00:14:29,840
the current fragile integrity
of financial markets at least

328
00:14:29,840 --> 00:14:34,070
until the bailout fund is set.

329
00:14:34,070 --> 00:14:38,360
My guess is that in about three
or four weeks, if we have banks

330
00:14:38,360 --> 00:14:41,049
that end up not being able
to make their commitments,

331
00:14:41,049 --> 00:14:42,590
they are going to
be allowed to fail.

332
00:14:42,590 --> 00:14:44,131
Because at that
point, those failures

333
00:14:44,131 --> 00:14:46,220
won't jeopardize the
entire financial system,

334
00:14:46,220 --> 00:14:49,950
they'll be dealt with by
this bailout organization.

335
00:14:49,950 --> 00:14:51,902
So I think that
that's the logic.

336
00:14:51,902 --> 00:14:53,360
Yeah, last question,
let's move on.

337
00:14:53,360 --> 00:14:54,734
STUDENT: Is that
the same thought

338
00:14:54,734 --> 00:14:59,770
process as freezing Washington
Mutual's failure [INAUDIBLE]..

339
00:14:59,770 --> 00:15:01,020
ANDREW LO: Well, that's right.

340
00:15:01,020 --> 00:15:03,830
But the difference there is
that Washington Mutual has

341
00:15:03,830 --> 00:15:07,460
much bigger exposure to
these subprime loans,

342
00:15:07,460 --> 00:15:09,410
and so I think in that
case, there really

343
00:15:09,410 --> 00:15:10,910
wasn't much of a choice.

344
00:15:10,910 --> 00:15:13,520
And very much so transferring
the business units

345
00:15:13,520 --> 00:15:17,060
that are able to be moved
over JP Morgan Chase

346
00:15:17,060 --> 00:15:19,900
would make a fair bit of sense.

347
00:15:19,900 --> 00:15:21,650
So there's a lot of
consolidation going on

348
00:15:21,650 --> 00:15:24,850
in this industry, but
once again, consolidation,

349
00:15:24,850 --> 00:15:27,956
while it seems like
it's a big upheaval,

350
00:15:27,956 --> 00:15:30,330
and it is for the people that
are at these organizations,

351
00:15:30,330 --> 00:15:32,240
it's very disruptive,
the fact is

352
00:15:32,240 --> 00:15:33,830
that these kind
of disruptions are

353
00:15:33,830 --> 00:15:37,130
part and parcel of how
businesses grow and develop

354
00:15:37,130 --> 00:15:39,810
and morph over time.

355
00:15:39,810 --> 00:15:42,950
In fact, if you went
back to the 1960s,

356
00:15:42,950 --> 00:15:45,710
and you looked at a Wall
Street Journal on microfiche--

357
00:15:45,710 --> 00:15:47,780
I happened to do
that just because I

358
00:15:47,780 --> 00:15:50,480
was looking for a particular
citation at one point--

359
00:15:50,480 --> 00:15:53,270
if you look at the
advertisements in the 1960s

360
00:15:53,270 --> 00:15:56,720
or even 15 years ago, you
look at the advertisements

361
00:15:56,720 --> 00:15:58,672
in the Wall Street
Journal in those days,

362
00:15:58,672 --> 00:16:01,130
there are names of financial
institutions that you've never

363
00:16:01,130 --> 00:16:05,870
heard of, that were really
big institutions back then.

364
00:16:05,870 --> 00:16:08,270
So it's rare that we
have institutions that

365
00:16:08,270 --> 00:16:11,510
survive for 50, 75, 100 years.

366
00:16:11,510 --> 00:16:14,450
It's part and parcel of
how businesses develop.

367
00:16:14,450 --> 00:16:19,400
And the key is to focus on the
process by which businesses

368
00:16:19,400 --> 00:16:20,330
change.

369
00:16:20,330 --> 00:16:23,180
So when we start talking
about equity evaluation,

370
00:16:23,180 --> 00:16:25,610
we're going to see that by
looking at income statements

371
00:16:25,610 --> 00:16:28,024
and balance sheets together,
we can see not only what's

372
00:16:28,024 --> 00:16:29,690
a good business and
what a bad business,

373
00:16:29,690 --> 00:16:32,990
we can also see how
businesses evolve over time.

374
00:16:32,990 --> 00:16:35,060
And it's that
evolution that we hope

375
00:16:35,060 --> 00:16:37,970
to try to bring across
to you in this course.

376
00:16:37,970 --> 00:16:40,520
I want to show you how it
is that you can understand

377
00:16:40,520 --> 00:16:44,480
the dynamics of changes
in business conditions,

378
00:16:44,480 --> 00:16:48,410
because that really is, I think,
the key to a lot of what you

379
00:16:48,410 --> 00:16:50,797
can use in your own careers.

380
00:16:50,797 --> 00:16:52,130
I know there are more questions.

381
00:16:52,130 --> 00:16:57,539
But let me hold off on those
and start on the lecture today

382
00:16:57,539 --> 00:17:00,080
and then we can cover those a
little bit later on after we've

383
00:17:00,080 --> 00:17:02,780
made some progress.

384
00:17:02,780 --> 00:17:05,660
So this is a continuation
of last lecture

385
00:17:05,660 --> 00:17:09,380
where we were talking about
convexity and duration

386
00:17:09,380 --> 00:17:13,579
as two measures of the
riskiness of a bond portfolio.

387
00:17:13,579 --> 00:17:17,839
And I concluded last lecture
by talking about the fact

388
00:17:17,839 --> 00:17:21,800
that if you think about
a bond as a function

389
00:17:21,800 --> 00:17:26,720
of the underlying yield, then
you can use an approximation

390
00:17:26,720 --> 00:17:31,700
result that says that the bond
price, as a function of yield,

391
00:17:31,700 --> 00:17:33,830
is approximately
going to be given

392
00:17:33,830 --> 00:17:37,640
by a linear function
of its duration

393
00:17:37,640 --> 00:17:41,690
and a quadratic function
of its convexity.

394
00:17:41,690 --> 00:17:43,850
So we have an
approximation that says

395
00:17:43,850 --> 00:17:46,700
that the price of
the bond at a yield y

396
00:17:46,700 --> 00:17:50,030
prime, is going to be equal
to the price of the bond

397
00:17:50,030 --> 00:17:56,330
at a yield y multiplied by this
linear quadratic expression.

398
00:17:56,330 --> 00:17:58,520
And really, the
purpose of this is just

399
00:17:58,520 --> 00:18:01,550
to give you a way of
thinking about how

400
00:18:01,550 --> 00:18:06,810
changes in the fluctuations
of a bond portfolio,

401
00:18:06,810 --> 00:18:10,220
as well as the curvature
of that bond portfolio,

402
00:18:10,220 --> 00:18:13,970
will affect its value and
therefore its riskiness.

403
00:18:13,970 --> 00:18:17,030
These are just two measures
that will allow you to capture

404
00:18:17,030 --> 00:18:20,340
the risk of a bond portfolio.

405
00:18:20,340 --> 00:18:22,640
So I have a numerical
example here

406
00:18:22,640 --> 00:18:24,800
that you can take a
look at and work out,

407
00:18:24,800 --> 00:18:28,040
and you can see how good
that approximation is.

408
00:18:28,040 --> 00:18:32,870
This is an approximate result
that the price at a yield of 8%

409
00:18:32,870 --> 00:18:35,660
is going to be given as
a function of the price

410
00:18:35,660 --> 00:18:38,360
of the bond and a
yield of 6% multiplied

411
00:18:38,360 --> 00:18:41,270
by this linear
quadratic expression.

412
00:18:41,270 --> 00:18:44,000
And the actual result
of the bond price,

413
00:18:44,000 --> 00:18:47,240
now that we have high speed
digital computers that

414
00:18:47,240 --> 00:18:49,760
can calculate all of this
at a moment's notice,

415
00:18:49,760 --> 00:18:51,170
you can see the difference.

416
00:18:51,170 --> 00:18:54,520
It differs basically
by about a penny.

417
00:18:54,520 --> 00:18:56,494
A penny it's not a big deal.

418
00:18:56,494 --> 00:18:58,910
But when you're dealing with
billions of dollars actually,

419
00:18:58,910 --> 00:19:01,737
a penny is a pretty
significant amount.

420
00:19:01,737 --> 00:19:03,320
So what you want to
do is to make sure

421
00:19:03,320 --> 00:19:05,750
that you use the right
formula to calculate it.

422
00:19:05,750 --> 00:19:08,930
I wouldn't argue that you should
use convexity and duration

423
00:19:08,930 --> 00:19:11,840
to do any kind of
bond pricing analysis,

424
00:19:11,840 --> 00:19:16,580
but for a quick and dirty
method for getting intuition

425
00:19:16,580 --> 00:19:20,540
about how risky a bond portfolio
is, the two questions you ought

426
00:19:20,540 --> 00:19:23,980
to ask somebody is,
what's the duration

427
00:19:23,980 --> 00:19:25,510
and what's the convexity.

428
00:19:25,510 --> 00:19:29,770
And what those two numbers, you
can develop a kind of intuition

429
00:19:29,770 --> 00:19:32,110
for how the bond
price is going to move

430
00:19:32,110 --> 00:19:35,500
in response to underlying
changes in the yield curve.

431
00:19:35,500 --> 00:19:38,890
And right now, we
see that the yields

432
00:19:38,890 --> 00:19:40,210
are changing pretty rapidly.

433
00:19:40,210 --> 00:19:43,360
The Treasury yield curve,
at least at the short end,

434
00:19:43,360 --> 00:19:45,370
is bouncing around
depending on what happens

435
00:19:45,370 --> 00:19:47,120
every day in Washington.

436
00:19:47,120 --> 00:19:51,280
And so if you have that sense
of short term yields changing,

437
00:19:51,280 --> 00:19:53,530
by looking at
convexity and duration

438
00:19:53,530 --> 00:19:56,410
you can get a sense of how
sensitive your portfolio might

439
00:19:56,410 --> 00:20:00,850
be to those kinds of exposures.

440
00:20:00,850 --> 00:20:06,010
The last topic I'm going to
take on is now corporate bonds.

441
00:20:06,010 --> 00:20:09,640
Up until this point, the
only thing that we focused on

442
00:20:09,640 --> 00:20:13,300
has been default free
securities, namely

443
00:20:13,300 --> 00:20:16,300
government securities,
because governments can always

444
00:20:16,300 --> 00:20:18,370
print money and
therefore they can always

445
00:20:18,370 --> 00:20:21,670
make good on the claim that
they will pay you a face

446
00:20:21,670 --> 00:20:24,970
value of $1,000 in 27 years.

447
00:20:24,970 --> 00:20:28,830
There's no risk that they can't
run those printing presses.

448
00:20:28,830 --> 00:20:33,180
What I want to turn
to now is risky debt,

449
00:20:33,180 --> 00:20:35,460
and in particular
I want to point out

450
00:20:35,460 --> 00:20:39,990
that risky debt is fundamentally
different in the sense

451
00:20:39,990 --> 00:20:42,780
that there is a chance that
you don't get paid back.

452
00:20:42,780 --> 00:20:45,180
So one of the most
significant concerns

453
00:20:45,180 --> 00:20:49,110
of pricing corporate
bonds is default risk.

454
00:20:49,110 --> 00:20:52,170
And the market has
created its own mechanism

455
00:20:52,170 --> 00:20:55,890
for trying to get a sense of
what the default risk really

456
00:20:55,890 --> 00:20:56,550
is.

457
00:20:56,550 --> 00:20:58,590
Namely, credit ratings.

458
00:20:58,590 --> 00:21:02,550
These are ratings put out
by a variety of services.

459
00:21:02,550 --> 00:21:04,140
The services that
are most popular

460
00:21:04,140 --> 00:21:08,220
are Moody's, S&P, and Fitch.

461
00:21:08,220 --> 00:21:13,350
And these services do
analyzes on various companies,

462
00:21:13,350 --> 00:21:17,910
and then they issue reports,
and ultimately ratings,

463
00:21:17,910 --> 00:21:18,780
on those companies.

464
00:21:18,780 --> 00:21:22,950
They'll say this company
is rated AAA, AAA being

465
00:21:22,950 --> 00:21:24,630
the highest category.

466
00:21:24,630 --> 00:21:27,990
And I've listed the
different ratings categories

467
00:21:27,990 --> 00:21:29,760
for the three
different agencies here

468
00:21:29,760 --> 00:21:32,341
so you can get a sense
of how they compare.

469
00:21:32,341 --> 00:21:33,840
Typically, these
ratings are grouped

470
00:21:33,840 --> 00:21:39,474
into two categories, investment
grade and non-investment grade.

471
00:21:39,474 --> 00:21:40,890
And really, the
difference is just

472
00:21:40,890 --> 00:21:43,890
the nature of the default
risk or the speculativeness

473
00:21:43,890 --> 00:21:49,540
of the default probability.

474
00:21:49,540 --> 00:21:52,150
Bonds that are below
investment grade

475
00:21:52,150 --> 00:21:55,270
have a higher default rate,
and bonds that are supposedly

476
00:21:55,270 --> 00:21:56,740
investment grade
are ones that are

477
00:21:56,740 --> 00:22:02,170
appropriate for prudent and
conservative investments.

478
00:22:02,170 --> 00:22:04,030
STUDENT: Do you mind
maximizing the slide?

479
00:22:04,030 --> 00:22:05,571
It's a little hard
to read back here.

480
00:22:05,571 --> 00:22:08,080
ANDREW LO: Oh, sorry about that.

481
00:22:08,080 --> 00:22:09,380
Thank you.

482
00:22:09,380 --> 00:22:11,260
Yeah, that's better.

483
00:22:11,260 --> 00:22:19,930
So investment grade for Moody's
is AAA, high quality is AA,

484
00:22:19,930 --> 00:22:25,360
upper medium quality is A,
and then medium grade is BAA,

485
00:22:25,360 --> 00:22:28,210
and then anything
below BAA is considered

486
00:22:28,210 --> 00:22:29,827
non-investment grade.

487
00:22:29,827 --> 00:22:32,410
Now, the one thing you have to
keep in mind about fixed income

488
00:22:32,410 --> 00:22:35,800
securities is that
apart from some

489
00:22:35,800 --> 00:22:40,420
of the more esoteric strategies
that we talked about last time

490
00:22:40,420 --> 00:22:44,110
like fixed income arbitrage,
this idea of taking

491
00:22:44,110 --> 00:22:46,610
a bunch of bonds and figuring
out which ones are mispriced

492
00:22:46,610 --> 00:22:49,660
and trading them, apart
from those strategies,

493
00:22:49,660 --> 00:22:52,870
most people invest in
bonds not because they

494
00:22:52,870 --> 00:22:55,180
want exciting returns.

495
00:22:55,180 --> 00:22:57,190
If you want exciting
returns, you put your money

496
00:22:57,190 --> 00:23:01,000
in the stock market or real
state or private equity

497
00:23:01,000 --> 00:23:04,180
or other kinds of
exciting ventures.

498
00:23:04,180 --> 00:23:07,510
Bonds are supposed to be boring.

499
00:23:07,510 --> 00:23:10,300
You put your money in, and five
years later you get your money

500
00:23:10,300 --> 00:23:11,560
out with a little extra.

501
00:23:11,560 --> 00:23:14,580
That's what bonds
are supposed to do.

502
00:23:14,580 --> 00:23:21,110
And it wasn't until the 1970s,
when the era of junk bonds

503
00:23:21,110 --> 00:23:25,460
came on the scene, 70s and 80s,
with Michael Milken and Drexel,

504
00:23:25,460 --> 00:23:28,250
Burnham, Lambert,
that you really

505
00:23:28,250 --> 00:23:33,230
had a very different face
of fixed income markets.

506
00:23:33,230 --> 00:23:37,670
By and large, fixed income
markets dwarf equity markets.

507
00:23:37,670 --> 00:23:39,350
But the reason that
they're so large

508
00:23:39,350 --> 00:23:43,250
is because most people use
them as a kind of a safe haven.

509
00:23:43,250 --> 00:23:46,190
And as you get
riskier and riskier,

510
00:23:46,190 --> 00:23:51,260
it starts to look less like
bonds and more like equity.

511
00:23:51,260 --> 00:23:53,720
In fact, if you think about
the bankruptcy process,

512
00:23:53,720 --> 00:23:58,090
if you've got a risky corporate
bond, you're the bond holder,

513
00:23:58,090 --> 00:24:00,130
and the company
declares bankruptcy,

514
00:24:00,130 --> 00:24:04,280
they can't pay your interest
payments that are due to you,

515
00:24:04,280 --> 00:24:07,520
when they declare
bankruptcy, then

516
00:24:07,520 --> 00:24:10,460
at least from a
theoretical perspective,

517
00:24:10,460 --> 00:24:13,910
you the bondholder now
become equity holders.

518
00:24:13,910 --> 00:24:15,500
You own the assets.

519
00:24:15,500 --> 00:24:17,420
Because they can't
pay you, so they're

520
00:24:17,420 --> 00:24:20,750
obligated to give you
control of their company.

521
00:24:20,750 --> 00:24:23,120
So as bonds become
more risky, they

522
00:24:23,120 --> 00:24:26,630
start to look more and more
not like debt, but like equity.

523
00:24:26,630 --> 00:24:29,190
That is, the returns
are random and you don't

524
00:24:29,190 --> 00:24:30,440
know what you're going to get.

525
00:24:30,440 --> 00:24:32,270
It's sort of a
surprise every day.

526
00:24:32,270 --> 00:24:36,260
It's the gift that
keeps on giving.

527
00:24:36,260 --> 00:24:39,350
But for the most part, investors
that are invested in bonds

528
00:24:39,350 --> 00:24:40,370
aren't looking for that.

529
00:24:40,370 --> 00:24:42,912
We're looking for safe returns.

530
00:24:42,912 --> 00:24:44,370
And they're looking
for the highest

531
00:24:44,370 --> 00:24:48,180
yield that is a safe return.

532
00:24:48,180 --> 00:24:51,720
So investment grade
is the category

533
00:24:51,720 --> 00:24:55,230
that typically pension
funds, endowments,

534
00:24:55,230 --> 00:24:59,220
and other relatively
conservative institutions

535
00:24:59,220 --> 00:25:00,570
look to.

536
00:25:00,570 --> 00:25:02,670
Within that category,
they would like

537
00:25:02,670 --> 00:25:04,800
to get as much
yield as possible.

538
00:25:04,800 --> 00:25:06,660
So which of these
different grades

539
00:25:06,660 --> 00:25:08,400
do you think offers
the highest yield?

540
00:25:11,200 --> 00:25:12,540
Why is that?

541
00:25:12,540 --> 00:25:13,290
Yes, you're right.

542
00:25:13,290 --> 00:25:14,407
Why is that?

543
00:25:14,407 --> 00:25:15,490
What's the logic for that?

544
00:25:18,454 --> 00:25:21,420
STUDENT: [INAUDIBLE]

545
00:25:21,420 --> 00:25:22,260
Exactly.

546
00:25:22,260 --> 00:25:24,300
Given that it's lower
rated, that means

547
00:25:24,300 --> 00:25:26,130
it's got a higher
probability of default,

548
00:25:26,130 --> 00:25:29,160
you've got to pay investors a
little bit of extra for them

549
00:25:29,160 --> 00:25:30,990
to bear that risk.

550
00:25:30,990 --> 00:25:32,376
Simple as that.

551
00:25:32,376 --> 00:25:34,625
So the reason that there are
multiple categories, even

552
00:25:34,625 --> 00:25:36,360
in investment
grade, is that there

553
00:25:36,360 --> 00:25:39,780
are different levels
of risk aversion

554
00:25:39,780 --> 00:25:41,580
that investors want to take on.

555
00:25:41,580 --> 00:25:43,740
Some investors are
highly risk averse,

556
00:25:43,740 --> 00:25:47,490
and for the very, very
risk averse investors,

557
00:25:47,490 --> 00:25:49,612
they're going to take on AAA.

558
00:25:49,612 --> 00:25:51,820
And for those that are a
little bit more adventurous,

559
00:25:51,820 --> 00:25:53,920
they'll take on lower grade.

560
00:25:53,920 --> 00:25:57,790
And for those hedge funds, who
are looking for lots of risk

561
00:25:57,790 --> 00:25:59,980
and lots of return,
they're the ones

562
00:25:59,980 --> 00:26:03,310
that are dealing in the
non-investment grade issues.

563
00:26:03,310 --> 00:26:08,200
Those are the ones where you
have relatively large returns,

564
00:26:08,200 --> 00:26:10,000
15% or 20% returns,
you didn't think

565
00:26:10,000 --> 00:26:12,430
you can get a return of
15% to 20% for bonds,

566
00:26:12,430 --> 00:26:15,280
but you can if
there is a 5% or 10%

567
00:26:15,280 --> 00:26:18,100
chance that you
won't get anything.

568
00:26:18,100 --> 00:26:20,680
So when you do get
paid, you get paid well,

569
00:26:20,680 --> 00:26:23,530
but you don't always get paid.

570
00:26:23,530 --> 00:26:26,740
So that's the
categories that are

571
00:26:26,740 --> 00:26:30,580
developed by the various
different ratings institutions.

572
00:26:30,580 --> 00:26:33,850
And once you get a rating,
that allows you to approach

573
00:26:33,850 --> 00:26:36,100
investors and say,
OK, this is what

574
00:26:36,100 --> 00:26:41,470
I'm looking to get
for my corporate bond,

575
00:26:41,470 --> 00:26:45,550
and what I'm hoping to get is
commensurate with the risks

576
00:26:45,550 --> 00:26:47,460
that we're bearing.

577
00:26:47,460 --> 00:26:54,010
Here's a little history of the
yields on Moody's BAA bonds

578
00:26:54,010 --> 00:26:57,380
minus the US 10
year treasury yield.

579
00:26:57,380 --> 00:27:00,230
So this spread tells
you what the difference

580
00:27:00,230 --> 00:27:04,270
is between a very
safe asset and a BAA

581
00:27:04,270 --> 00:27:08,320
asset, which in this
category, is just

582
00:27:08,320 --> 00:27:10,810
above non-investment grade.

583
00:27:10,810 --> 00:27:14,890
So it's the lowest grade
that you can get and still

584
00:27:14,890 --> 00:27:16,050
be passing.

585
00:27:16,050 --> 00:27:18,700
This is sort of like
the 65 or something

586
00:27:18,700 --> 00:27:21,730
of junior high school
and high school.

587
00:27:21,730 --> 00:27:26,890
So that spread between
BAA and US treasuries

588
00:27:26,890 --> 00:27:31,540
is an indication of the risk
premium implicit in the default

589
00:27:31,540 --> 00:27:33,640
potential of a BAA bond.

590
00:27:33,640 --> 00:27:35,890
And look at how it's changed.

591
00:27:35,890 --> 00:27:41,530
In the 1930s, this spread was
about 7 and 1/2 percentage

592
00:27:41,530 --> 00:27:44,240
points.

593
00:27:44,240 --> 00:27:47,980
That's a big spread
by today's standards.

594
00:27:47,980 --> 00:27:49,810
Now of course, by
today's standards,

595
00:27:49,810 --> 00:27:52,270
literally today,
things are different,

596
00:27:52,270 --> 00:27:54,705
and we may be getting
up there soon.

597
00:27:54,705 --> 00:27:56,080
But let's take a
look at where we

598
00:27:56,080 --> 00:28:02,650
were at least where the data
ended, which is back in 2005.

599
00:28:02,650 --> 00:28:06,520
At the end of this
dataset, the credit spread

600
00:28:06,520 --> 00:28:11,770
was maybe 1 and 1/2 to 2%.

601
00:28:11,770 --> 00:28:14,830
That's at a near historic low.

602
00:28:14,830 --> 00:28:17,304
Now, you can see that there
are a little bit of a blip

603
00:28:17,304 --> 00:28:18,220
every once in a while.

604
00:28:18,220 --> 00:28:19,240
December.

605
00:28:19,240 --> 00:28:25,630
1987, this is after the stock
market crash of October 87.

606
00:28:25,630 --> 00:28:27,700
You see a big blip going up.

607
00:28:27,700 --> 00:28:32,350
And September of 1998
after LTCM, that goes up.

608
00:28:32,350 --> 00:28:35,500
And then of course credit
spreads widen over here.

609
00:28:35,500 --> 00:28:39,910
September 11 happened,
2001, over here.

610
00:28:39,910 --> 00:28:42,520
And so credit spreads got
as high as something like 3-

611
00:28:42,520 --> 00:28:46,120
3 1/2% percent, and now,
prior to what's happened over

612
00:28:46,120 --> 00:28:49,930
the last several weeks, credit
spreads were at a close to all

613
00:28:49,930 --> 00:28:51,830
time low.

614
00:28:51,830 --> 00:28:54,230
What does it mean when credit
spreads are really low?

615
00:28:54,230 --> 00:28:56,370
What does that tell you?

616
00:28:56,370 --> 00:28:57,890
What does it say?

617
00:28:57,890 --> 00:28:59,062
Yeah.

618
00:28:59,062 --> 00:29:04,420
STUDENT: [INAUDIBLE]

619
00:29:04,420 --> 00:29:05,150
ANDREW LO: Right.

620
00:29:05,150 --> 00:29:07,390
That's one interpretation,
that the market

621
00:29:07,390 --> 00:29:12,370
is perceiving the default
risk as not as significant

622
00:29:12,370 --> 00:29:13,120
as it used to be.

623
00:29:13,120 --> 00:29:14,740
Another way of
interpreting that is

624
00:29:14,740 --> 00:29:17,980
that the investment
population is

625
00:29:17,980 --> 00:29:22,180
less concerned about the default
risk than back in the 1930s.

626
00:29:22,180 --> 00:29:22,960
Not surprisingly.

627
00:29:22,960 --> 00:29:25,082
Something did
happen in the 1930s

628
00:29:25,082 --> 00:29:26,290
that was kind of significant.

629
00:29:26,290 --> 00:29:28,910
What was that?

630
00:29:28,910 --> 00:29:30,890
The crash of 29, and
then the depression

631
00:29:30,890 --> 00:29:34,350
that led from that crash.

632
00:29:34,350 --> 00:29:38,510
So that tells you that at
least at the end of 2005,

633
00:29:38,510 --> 00:29:43,150
beginning in 2006, people were
less risk averse, at least

634
00:29:43,150 --> 00:29:45,890
on paper what this shows.

635
00:29:45,890 --> 00:29:51,090
What else does it tell you
about the probability of credit?

636
00:29:51,090 --> 00:29:52,339
STUDENT: [INAUDIBLE]

637
00:29:52,339 --> 00:29:53,130
ANDREW LO: Exactly.

638
00:29:53,130 --> 00:29:54,117
Lots of money.

639
00:29:54,117 --> 00:29:56,700
Another way of interpreting this
is that there's lots of money

640
00:29:56,700 --> 00:29:57,540
out there.

641
00:29:57,540 --> 00:30:00,420
Lots of money willing
to be lent out

642
00:30:00,420 --> 00:30:04,650
to all sorts of risky
ventures without much

643
00:30:04,650 --> 00:30:07,170
in the way of expectation
that they should get

644
00:30:07,170 --> 00:30:11,690
paid a much larger premium.

645
00:30:11,690 --> 00:30:16,010
So those two interpretations
are likely to be both true.

646
00:30:16,010 --> 00:30:18,650
That is, the
population of investors

647
00:30:18,650 --> 00:30:21,770
did seem less risk averse, and
there is empirical evidence

648
00:30:21,770 --> 00:30:23,040
to support that.

649
00:30:23,040 --> 00:30:25,220
But on top of that,
it also suggests

650
00:30:25,220 --> 00:30:28,100
that there's tons of
money out there being lent

651
00:30:28,100 --> 00:30:31,010
to various different
projects, and because there's

652
00:30:31,010 --> 00:30:36,220
so much money, there's such an
increase in supply of funds,

653
00:30:36,220 --> 00:30:40,240
the extra premium that is
commanded by those funds

654
00:30:40,240 --> 00:30:43,930
could not be that great, simply
because of the competition

655
00:30:43,930 --> 00:30:48,250
to supply funds to these
various risky ventures.

656
00:30:48,250 --> 00:30:50,530
So if you wanted
to do a startup,

657
00:30:50,530 --> 00:30:54,232
the time to have
done it was in 2006,

658
00:30:54,232 --> 00:30:56,440
because you would have gotten
great deals since there

659
00:30:56,440 --> 00:30:59,370
was so much capital out there.

660
00:30:59,370 --> 00:31:00,910
Now that's changed.

661
00:31:00,910 --> 00:31:02,830
But part of the
reason it's changed,

662
00:31:02,830 --> 00:31:05,320
part of the reason that we're
in the current financial

663
00:31:05,320 --> 00:31:08,190
difficulties that we're
in, is because there

664
00:31:08,190 --> 00:31:12,160
was too much money
chasing too few genuinely

665
00:31:12,160 --> 00:31:13,990
good opportunities.

666
00:31:13,990 --> 00:31:16,960
And so we're seeing
now the after effects

667
00:31:16,960 --> 00:31:20,440
of some of those
poorer investments

668
00:31:20,440 --> 00:31:23,210
in those opportunities.

669
00:31:23,210 --> 00:31:26,350
So this kind of
credit spread picture

670
00:31:26,350 --> 00:31:29,740
can give you a sense of
the dynamics of money flows

671
00:31:29,740 --> 00:31:31,990
within the economy,
and definitely

672
00:31:31,990 --> 00:31:34,510
worth keeping track of.

673
00:31:34,510 --> 00:31:37,420
Now, there are a number of
things that are in that spread,

674
00:31:37,420 --> 00:31:38,710
in that premium.

675
00:31:38,710 --> 00:31:43,240
Obviously, there's an
expected default loss,

676
00:31:43,240 --> 00:31:46,390
but there's also tax effects.

677
00:31:46,390 --> 00:31:50,140
There's also some other kind
of systematic risk premium

678
00:31:50,140 --> 00:31:54,010
that has to do with
aggregate risk exposure.

679
00:31:54,010 --> 00:31:57,430
And a variety of
other academic studies

680
00:31:57,430 --> 00:32:00,790
have been done to
decompose that spread

681
00:32:00,790 --> 00:32:02,970
into different components.

682
00:32:02,970 --> 00:32:10,160
Graphically, you can see
that if you look at--

683
00:32:10,160 --> 00:32:13,670
if you take a look at the
composition of that premium,

684
00:32:13,670 --> 00:32:17,780
you can show that part of it
is due to default, part of it

685
00:32:17,780 --> 00:32:21,920
is due to the riskiness of
the particular investment,

686
00:32:21,920 --> 00:32:24,830
and then the other part is
simply the default free.

687
00:32:24,830 --> 00:32:27,810
That's the part that we've
studied up until today.

688
00:32:27,810 --> 00:32:31,460
So the other two parts, the
other extra risk premium,

689
00:32:31,460 --> 00:32:35,240
is really decomposed into a
default risk premium, but also

690
00:32:35,240 --> 00:32:36,950
a market risk premium.

691
00:32:36,950 --> 00:32:40,490
That is, just general riskiness
and price fluctuation.

692
00:32:40,490 --> 00:32:42,230
People don't like
that kind of risk,

693
00:32:42,230 --> 00:32:44,021
and they're going to
have to be compensated

694
00:32:44,021 --> 00:32:46,130
for that risk
irrespective of default.

695
00:32:46,130 --> 00:32:48,620
Just the fact that
prices move around

696
00:32:48,620 --> 00:32:52,220
will require you to reward
investors for holding

697
00:32:52,220 --> 00:32:53,780
these kind of instruments.

698
00:32:53,780 --> 00:32:57,770
And in the slides, I give you
some citations for studies

699
00:32:57,770 --> 00:33:00,350
on how you might go
about decomposing

700
00:33:00,350 --> 00:33:01,880
those kind of risk premiums.

701
00:33:01,880 --> 00:33:04,650
So you can take a look
at that on your own.

702
00:33:04,650 --> 00:33:06,830
But the last topic
that I want to turn to,

703
00:33:06,830 --> 00:33:09,260
in just a few minutes
today, before we

704
00:33:09,260 --> 00:33:12,110
move on to the pricing
of equity securities.

705
00:33:12,110 --> 00:33:14,630
The last topic I want to
turn to is directly related

706
00:33:14,630 --> 00:33:16,640
to the problem of
subprime mortgages.

707
00:33:16,640 --> 00:33:18,710
I promised you that I
would touch upon this.

708
00:33:18,710 --> 00:33:20,960
I'm not going to go through
it in detail, because this

709
00:33:20,960 --> 00:33:23,420
is the kind of material
that we will go through

710
00:33:23,420 --> 00:33:27,920
in other sessions on the
current financial crisis.

711
00:33:27,920 --> 00:33:29,660
But I want to at least
tell you about one

712
00:33:29,660 --> 00:33:33,110
aspect of bond markets
that's been really important

713
00:33:33,110 --> 00:33:35,660
over the last 10 years.

714
00:33:35,660 --> 00:33:38,700
And that is, securitization.

715
00:33:38,700 --> 00:33:42,270
Now, when you want to
issue a risky bond,

716
00:33:42,270 --> 00:33:45,250
as a corporation or
even as an individual,

717
00:33:45,250 --> 00:33:48,570
you have to deal with a
counterparty, a bank typically.

718
00:33:48,570 --> 00:33:52,410
Banks were the traditional
means of borrowing and lending

719
00:33:52,410 --> 00:33:58,540
for most of the 20th century,
and up until the last 10 years.

720
00:33:58,540 --> 00:34:04,664
But about 10 years ago, an
innovation was really created.

721
00:34:04,664 --> 00:34:06,330
Actually, it wasn't
created 10 years ago

722
00:34:06,330 --> 00:34:08,580
but it really took
off 10 years ago,

723
00:34:08,580 --> 00:34:13,230
where instead of borrowing
from financial institutions

724
00:34:13,230 --> 00:34:18,040
like banks, you were able
to tap into the borrowing

725
00:34:18,040 --> 00:34:20,949
power of financial markets.

726
00:34:20,949 --> 00:34:24,130
This is what's often
called disintermediation.

727
00:34:24,130 --> 00:34:26,020
Banks are considered
intermediaries.

728
00:34:26,020 --> 00:34:30,370
They serve as a conduit between
us, the retail investor,

729
00:34:30,370 --> 00:34:34,120
and financial markets or
other counter-parties.

730
00:34:34,120 --> 00:34:35,260
They stand in the middle.

731
00:34:35,260 --> 00:34:37,120
They take money from
us, put it in deposits,

732
00:34:37,120 --> 00:34:39,909
they take those deposits,
lend it out to corporations,

733
00:34:39,909 --> 00:34:42,070
and they take money
from corporations,

734
00:34:42,070 --> 00:34:44,080
and bring it into their
bank, and lend it to us

735
00:34:44,080 --> 00:34:46,420
in the form of mortgage
payments-- mortgages,

736
00:34:46,420 --> 00:34:49,320
so that we can buy our house.

737
00:34:49,320 --> 00:34:52,889
About 10 years
ago, intermediation

738
00:34:52,889 --> 00:34:59,970
started to unwind because of
innovations in securitization.

739
00:34:59,970 --> 00:35:04,260
The idea being that we are going
to instead of dealing directly

740
00:35:04,260 --> 00:35:09,150
with banks, tap into the
power of financial markets

741
00:35:09,150 --> 00:35:10,650
in borrowing and lending.

742
00:35:10,650 --> 00:35:13,230
And so I want to give you an
example of how that works.

743
00:35:13,230 --> 00:35:16,766
Something that I went
over in the Pro Seminar.

744
00:35:16,766 --> 00:35:18,390
But for those of you
who didn't attend,

745
00:35:18,390 --> 00:35:21,330
I want to show it to you because
it's such an important idea.

746
00:35:21,330 --> 00:35:25,800
And this is an idea
that is best done

747
00:35:25,800 --> 00:35:29,760
through a very simple
numerical example.

748
00:35:29,760 --> 00:35:32,730
So in about 10 or
15 minutes, I'm

749
00:35:32,730 --> 00:35:34,500
going to illustrate
to all of you

750
00:35:34,500 --> 00:35:38,310
the nature of problems in
the subprime mortgage market.

751
00:35:38,310 --> 00:35:40,200
That's all it'll take.

752
00:35:40,200 --> 00:35:42,940
To get to the bottom
of it could take years.

753
00:35:42,940 --> 00:35:45,450
But at least to understand
what's going on,

754
00:35:45,450 --> 00:35:48,340
I'm going to do this
very simple example.

755
00:35:48,340 --> 00:35:53,360
Suppose that I have a bond,
which is a risky bond.

756
00:35:53,360 --> 00:35:59,460
It's an IOU that pays $1,000
if it pays off at all.

757
00:35:59,460 --> 00:36:03,290
So the face value of
this bond is $1,000.

758
00:36:03,290 --> 00:36:06,830
But this is a risky
bond in the sense

759
00:36:06,830 --> 00:36:10,940
that it pays off $1,000
with a certain probability,

760
00:36:10,940 --> 00:36:14,360
and it pays off nothing
with another probability,

761
00:36:14,360 --> 00:36:18,240
let's say 90 10.

762
00:36:18,240 --> 00:36:25,470
So the simple expected
value of this is $900.

763
00:36:25,470 --> 00:36:29,280
And so you might think
that that should be

764
00:36:29,280 --> 00:36:30,870
a proxy for the market price.

765
00:36:30,870 --> 00:36:34,840
And in fact, that would be
a pretty good approximation.

766
00:36:34,840 --> 00:36:37,200
Now, right there is
an interesting insight

767
00:36:37,200 --> 00:36:38,880
into the pricing of risky bonds.

768
00:36:38,880 --> 00:36:44,850
Because if we have a security
that has $1,000 face value,

769
00:36:44,850 --> 00:36:47,670
but it's got a
probability of default,

770
00:36:47,670 --> 00:36:52,530
and you compute the
current value as $900,

771
00:36:52,530 --> 00:36:57,960
then that gives you an
implicit yield for the bond.

772
00:36:57,960 --> 00:36:58,730
What yield is it?

773
00:36:58,730 --> 00:37:03,840
It's whatever number, one
point something multiply by 900

774
00:37:03,840 --> 00:37:06,150
gives you $1,000.

775
00:37:06,150 --> 00:37:09,750
So the very fact
that it defaults, now

776
00:37:09,750 --> 00:37:12,450
allows us to compute a
yield without reference

777
00:37:12,450 --> 00:37:15,030
to the time value of money.

778
00:37:15,030 --> 00:37:17,940
The time value of money
can add an additional piece

779
00:37:17,940 --> 00:37:19,050
into this calculation.

780
00:37:19,050 --> 00:37:21,990
I decide to ignore it
just for simplicity.

781
00:37:21,990 --> 00:37:23,970
But suppose the
interest rate was 5%,

782
00:37:23,970 --> 00:37:27,240
the risk free interest rate
was 5%, then what I might do

783
00:37:27,240 --> 00:37:31,460
is to say, OK, $900 is what I
expect to get out of the bond.

784
00:37:31,460 --> 00:37:33,660
I'm going to take that
$900 and discount it back

785
00:37:33,660 --> 00:37:38,800
a year by 1.05, and
that will give me

786
00:37:38,800 --> 00:37:41,380
a number such that
when I compute

787
00:37:41,380 --> 00:37:45,370
the yield on that number
relative to $1,000,

788
00:37:45,370 --> 00:37:48,680
it will have the total
yield of this bond.

789
00:37:48,680 --> 00:37:52,990
5% of which is the risk free
part, and the other part

790
00:37:52,990 --> 00:37:54,790
is the default part.

791
00:37:54,790 --> 00:37:56,980
But I want to keep
the example simple.

792
00:37:56,980 --> 00:38:00,520
So let's just assume that the
risk free rate of interest

793
00:38:00,520 --> 00:38:02,640
is zero 0.

794
00:38:02,640 --> 00:38:07,320
So I've got my bond that
pays off $1,000 next period

795
00:38:07,320 --> 00:38:09,150
with probability 90%.

796
00:38:09,150 --> 00:38:13,310
So the expected value is 0.9
times 1,000 plus 0.10 times

797
00:38:13,310 --> 00:38:14,570
nothing.

798
00:38:14,570 --> 00:38:17,400
$900 for this bond.

799
00:38:17,400 --> 00:38:20,160
Now let's suppose that I have
not just one of these bonds,

800
00:38:20,160 --> 00:38:22,180
but I have two of them.

801
00:38:22,180 --> 00:38:26,040
And they're absolutely
identical in every respect.

802
00:38:26,040 --> 00:38:27,715
They're just two
of the same bonds.

803
00:38:31,900 --> 00:38:35,860
For each of the bonds, you
might think that it's not

804
00:38:35,860 --> 00:38:37,780
that easy to find a buyer.

805
00:38:37,780 --> 00:38:43,120
And you're right, because a 10%
default rate is pretty risky.

806
00:38:43,120 --> 00:38:45,370
In a minute, I'll
show you how risky

807
00:38:45,370 --> 00:38:48,940
when we look at the default
rates, historical default

808
00:38:48,940 --> 00:38:53,140
rates, of bonds with various
different credit ratings.

809
00:38:53,140 --> 00:38:55,240
But right now,
with a 10% rating,

810
00:38:55,240 --> 00:38:58,600
this bond would be
rated below BAA.

811
00:38:58,600 --> 00:39:00,994
It would be below
investment grade.

812
00:39:00,994 --> 00:39:03,660
So you're not going to get a lot
of people that want to buy one.

813
00:39:03,660 --> 00:39:05,970
In fact, we can auction
it off in this class

814
00:39:05,970 --> 00:39:07,720
right now to figure
out what the price is.

815
00:39:07,720 --> 00:39:09,850
My guess is that
I may not even get

816
00:39:09,850 --> 00:39:14,320
$900 for that in this class,
given your current mood

817
00:39:14,320 --> 00:39:16,490
and liquidity issues.

818
00:39:19,030 --> 00:39:23,700
But I'm going to show
you some magic that

819
00:39:23,700 --> 00:39:28,140
will make this incredibly
interesting to a large number

820
00:39:28,140 --> 00:39:31,440
of investors,
including all of you.

821
00:39:31,440 --> 00:39:33,570
I'm going to take
these two bonds

822
00:39:33,570 --> 00:39:36,960
and put them together
in a portfolio.

823
00:39:36,960 --> 00:39:38,499
Now, what exactly
does that mean?

824
00:39:38,499 --> 00:39:39,540
So far I've said nothing.

825
00:39:39,540 --> 00:39:42,630
I've drawn a circle
around the bonds.

826
00:39:42,630 --> 00:39:44,370
By portfolio, I
mean that I'm going

827
00:39:44,370 --> 00:39:49,130
to create an entity, a
corporation, whose sole purpose

828
00:39:49,130 --> 00:39:51,510
it is to buy these two bonds.

829
00:39:51,510 --> 00:39:54,750
And therefore, the
fortunes of the corporation

830
00:39:54,750 --> 00:39:59,650
are tied not to the performance
of any one or two bonds,

831
00:39:59,650 --> 00:40:03,840
but to the performance of the
collective portfolio of bonds.

832
00:40:03,840 --> 00:40:06,280
So that's what I mean when
I say, form a portfolio.

833
00:40:06,280 --> 00:40:08,590
I mean, consider a
single entity that

834
00:40:08,590 --> 00:40:11,500
will hold both of these bonds.

835
00:40:11,500 --> 00:40:15,160
And let's assume, for
the sake of argument,

836
00:40:15,160 --> 00:40:20,780
that the default of these
two bonds is uncorrelated.

837
00:40:20,780 --> 00:40:22,460
In fact, I'm going
to assume that these

838
00:40:22,460 --> 00:40:26,990
are two separate coin flips,
and they're different coins,

839
00:40:26,990 --> 00:40:30,560
they have the same probability
of coming up heads 90%,

840
00:40:30,560 --> 00:40:33,140
10% tails, but they're
different coins.

841
00:40:33,140 --> 00:40:35,040
They have nothing to
do with each other.

842
00:40:35,040 --> 00:40:36,170
So they're independent.

843
00:40:36,170 --> 00:40:38,557
Whether or not one
bond fails has nothing

844
00:40:38,557 --> 00:40:39,640
to do with the other bond.

845
00:40:42,880 --> 00:40:45,760
When I put this
into a portfolio,

846
00:40:45,760 --> 00:40:48,640
how does the portfolio
behave looking at it

847
00:40:48,640 --> 00:40:50,800
as a single entity?

848
00:40:50,800 --> 00:40:54,090
There are three
possible outcomes.

849
00:40:54,090 --> 00:40:56,090
Actually, there are four,
but only three of them

850
00:40:56,090 --> 00:40:57,770
are really distinct.

851
00:40:57,770 --> 00:41:04,210
Both bonds will pay off,
or both bonds will default,

852
00:41:04,210 --> 00:41:07,660
or one bond pays off
and the other defaults.

853
00:41:07,660 --> 00:41:11,130
Those are the only three
outcomes that are possible.

854
00:41:11,130 --> 00:41:13,400
And the payoffs
and probabilities,

855
00:41:13,400 --> 00:41:17,930
assuming that they are separate
and independent coin tosses,

856
00:41:17,930 --> 00:41:20,200
is given in that table.

857
00:41:20,200 --> 00:41:22,310
$2000 if they both pay off.

858
00:41:22,310 --> 00:41:26,930
And the probability of
that is 81%, 0.9 times 0.9.

859
00:41:26,930 --> 00:41:30,780
And I'm multiplying, because I'm
assuming they're independent.

860
00:41:30,780 --> 00:41:34,640
The probability that they both
don't pay off, in which case

861
00:41:34,640 --> 00:41:42,160
my portfolio is worth
nothing, is 1%, 10% times 10%.

862
00:41:42,160 --> 00:41:44,620
And then whatever's left
over is in the middle.

863
00:41:44,620 --> 00:41:47,107
That is, there's a
chance that one of them

864
00:41:47,107 --> 00:41:48,940
pays off but the other
one doesn't, and then

865
00:41:48,940 --> 00:41:51,040
the portfolio is worth
$1,000, and there's

866
00:41:51,040 --> 00:41:52,320
an 18% chance of that.

867
00:41:55,120 --> 00:41:57,990
So here's the stroke of genius.

868
00:41:57,990 --> 00:42:00,630
The stroke of genius
is to say, I've

869
00:42:00,630 --> 00:42:03,120
got these two securities
that are not particularly

870
00:42:03,120 --> 00:42:05,370
popular on their own.

871
00:42:05,370 --> 00:42:08,320
What I'm going to do is to
stick them in a portfolio,

872
00:42:08,320 --> 00:42:12,340
and then I'm going to issue
two new pieces of paper,

873
00:42:12,340 --> 00:42:15,940
each with $1,000 face value.

874
00:42:15,940 --> 00:42:18,670
So they're just like
the old pieces of paper,

875
00:42:18,670 --> 00:42:21,660
but there's one difference.

876
00:42:21,660 --> 00:42:23,780
They have different priority.

877
00:42:23,780 --> 00:42:27,530
Meaning there is a
senior piece of paper

878
00:42:27,530 --> 00:42:29,400
and there is a junior
piece of paper.

879
00:42:29,400 --> 00:42:31,920
The senior piece of
paper gets paid first,

880
00:42:31,920 --> 00:42:35,580
and the junior paper only
gets paid if and when

881
00:42:35,580 --> 00:42:38,910
the senior paper gets paid.

882
00:42:38,910 --> 00:42:42,720
So I'm going to issue
two pieces of paper.

883
00:42:42,720 --> 00:42:48,300
The blue is the senior
and the red is the junior.

884
00:42:48,300 --> 00:42:52,200
The senior paper I'm going
to call the senior tranche.

885
00:42:52,200 --> 00:42:56,220
Tranche, I believe is the
French word for trench,

886
00:42:56,220 --> 00:42:58,410
which seems much more
appropriate today than it

887
00:42:58,410 --> 00:42:59,740
did before.

888
00:42:59,740 --> 00:43:02,300
We're digging our
own trenches here.

889
00:43:02,300 --> 00:43:05,600
The senior paper
is going to have

890
00:43:05,600 --> 00:43:08,790
first dibs on that portfolio.

891
00:43:08,790 --> 00:43:10,380
And the junior
paper will only get

892
00:43:10,380 --> 00:43:13,790
paid after the senior
paper gets paid.

893
00:43:13,790 --> 00:43:16,100
And so let's see what
happens with that.

894
00:43:16,100 --> 00:43:19,290
Remember, they're both
$1,000 face values.

895
00:43:19,290 --> 00:43:22,550
So on paper, I've
done nothing in terms

896
00:43:22,550 --> 00:43:28,700
of creating or destroying the
total claims on the asset pool.

897
00:43:28,700 --> 00:43:32,630
The portfolio has claims
at $2000 of face value,

898
00:43:32,630 --> 00:43:36,920
and my new securities has
claims on $2000 at face value.

899
00:43:36,920 --> 00:43:41,540
But all I've done is to change
the order, the priority,

900
00:43:41,540 --> 00:43:43,100
of the payout.

901
00:43:43,100 --> 00:43:44,420
Here's the table.

902
00:43:44,420 --> 00:43:48,340
I have three values for my
portfolio, $2000, $1,000,

903
00:43:48,340 --> 00:43:50,600
and nothing.

904
00:43:50,600 --> 00:43:53,990
Now let's see what happens
to each of those two

905
00:43:53,990 --> 00:43:57,200
claims, the senior claim
and the junior claim,

906
00:43:57,200 --> 00:44:00,320
of my new securities
that I've issued

907
00:44:00,320 --> 00:44:03,740
The senior claim
gets paid $1,000

908
00:44:03,740 --> 00:44:07,130
if both bonds in my
portfolio pay off.

909
00:44:07,130 --> 00:44:09,950
But the senior claim
also gets paid $1,000

910
00:44:09,950 --> 00:44:13,480
if only one of those
bonds pays off.

911
00:44:13,480 --> 00:44:16,770
So two out of the
three outcomes are

912
00:44:16,770 --> 00:44:20,160
good news for the senior debt.

913
00:44:20,160 --> 00:44:22,950
And in the third case, where
both of them don't pay off,

914
00:44:22,950 --> 00:44:25,110
then the senior
paper is out of luck.

915
00:44:27,620 --> 00:44:30,160
Now, the junior paper
is exactly the reverse.

916
00:44:30,160 --> 00:44:34,810
The junior paper only will get
paid if both bonds pay off,

917
00:44:34,810 --> 00:44:37,060
because in that case,
the senior guy gets paid

918
00:44:37,060 --> 00:44:39,870
and then there's money
left for the junior guy.

919
00:44:39,870 --> 00:44:43,300
In the latter two cases,
if only one bond fails

920
00:44:43,300 --> 00:44:47,390
or both bonds fail, then the
junior claim gets paid nothing.

921
00:44:51,110 --> 00:44:56,480
So what I've done is to
take two identical bonds,

922
00:44:56,480 --> 00:45:02,080
and I've created two
non-identical claims,

923
00:45:02,080 --> 00:45:05,020
such that one is a lot
safer than the other.

924
00:45:05,020 --> 00:45:06,250
How much safer?

925
00:45:06,250 --> 00:45:13,480
Well, the bond that is senior
has a 1% chance of default, 1%,

926
00:45:13,480 --> 00:45:17,530
because both bonds have to fail
before the senior guy doesn't

927
00:45:17,530 --> 00:45:20,360
get paid.

928
00:45:20,360 --> 00:45:22,550
1%, what was it before?

929
00:45:22,550 --> 00:45:24,770
It was 10% for both bonds.

930
00:45:24,770 --> 00:45:27,510
But because I stuck
it in a portfolio,

931
00:45:27,510 --> 00:45:30,120
and I changed the
priority of payouts,

932
00:45:30,120 --> 00:45:33,510
the senior claim now
looks a lot safer.

933
00:45:33,510 --> 00:45:36,890
But that's not a free lunch,
because the junior claim

934
00:45:36,890 --> 00:45:38,510
is a heck of a lot riskier.

935
00:45:38,510 --> 00:45:42,960
The junior claim now loses
money 19% of the time.

936
00:45:45,790 --> 00:45:47,980
It used to be the case
that one of these bonds

937
00:45:47,980 --> 00:45:51,430
had a 10% default rate,
but the junior claim

938
00:45:51,430 --> 00:45:57,890
has a 19% default rate, 18%
plus 1% from those two outcomes.

939
00:46:00,860 --> 00:46:03,580
As long as investors
know the structure,

940
00:46:03,580 --> 00:46:05,600
nobody's getting a good
deal or a bad deal.

941
00:46:05,600 --> 00:46:07,520
There's no cheating going on.

942
00:46:07,520 --> 00:46:09,260
We explain this to
investors, so you all

943
00:46:09,260 --> 00:46:10,850
see these probabilities.

944
00:46:10,850 --> 00:46:14,360
And now, let's calculate
what the expected

945
00:46:14,360 --> 00:46:17,680
values are for the payouts.

946
00:46:17,680 --> 00:46:20,780
The expected values--
before I do that,

947
00:46:20,780 --> 00:46:22,820
let me comment on default rates.

948
00:46:22,820 --> 00:46:27,070
So a 1% default rate
seems like a small number.

949
00:46:27,070 --> 00:46:29,850
And a 19% default rate
seems like a large number.

950
00:46:29,850 --> 00:46:32,750
Well, let's take a look at
the empirical evidence given

951
00:46:32,750 --> 00:46:34,010
debt ratings.

952
00:46:34,010 --> 00:46:36,770
These are historical
default rates

953
00:46:36,770 --> 00:46:40,100
for bonds from 1920 to 1999.

954
00:46:40,100 --> 00:46:44,720
So I've got almost an
80 year record of bonds

955
00:46:44,720 --> 00:46:46,730
that have been issued
by corporations

956
00:46:46,730 --> 00:46:50,210
and that have been stamped by
Moody's with their ratings.

957
00:46:50,210 --> 00:46:53,120
And the different
bars correspond

958
00:46:53,120 --> 00:46:57,560
to how long the bonds have been
issued and are outstanding.

959
00:46:57,560 --> 00:47:00,030
Because obviously, the
longer the bond is out there,

960
00:47:00,030 --> 00:47:02,360
the more likely it is
that it will default.

961
00:47:02,360 --> 00:47:08,330
So you have to separate them
by the years out in the market.

962
00:47:08,330 --> 00:47:12,440
If you take a look at a
five year period, that's

963
00:47:12,440 --> 00:47:14,810
the bars all the way
to the extreme left

964
00:47:14,810 --> 00:47:21,860
of each rating category, you see
that for a five year periods,

965
00:47:21,860 --> 00:47:24,980
the default rate
of AAA securities

966
00:47:24,980 --> 00:47:28,370
is well, well below 1%.

967
00:47:28,370 --> 00:47:31,850
It's measured in basis
points, that probability.

968
00:47:31,850 --> 00:47:37,190
If you wait 20
years for AAA bonds,

969
00:47:37,190 --> 00:47:41,510
the default rate goes
up to maybe 2% or 3%.

970
00:47:41,510 --> 00:47:43,820
So that means that when
AAA bonds are issued

971
00:47:43,820 --> 00:47:47,460
and you wait for 20 years
to see what happens to them,

972
00:47:47,460 --> 00:47:52,290
it's a very, very small group
that ends up defaulting,

973
00:47:52,290 --> 00:47:54,030
if they have a AAA rating.

974
00:47:54,030 --> 00:48:01,159
On average, AAA bonds default
maybe 1% of the time or less.

975
00:48:01,159 --> 00:48:02,700
On the other hand,
if you take a look

976
00:48:02,700 --> 00:48:05,100
at below investment
grade-- so BAA

977
00:48:05,100 --> 00:48:13,019
is just at the borderline
of investment grade.

978
00:48:13,019 --> 00:48:14,810
And if you take a look
at the default rates

979
00:48:14,810 --> 00:48:16,640
here, lots higher.

980
00:48:16,640 --> 00:48:22,490
But by lots higher, we're
talking about 5% to 10%,

981
00:48:22,490 --> 00:48:25,390
5% to 10%.

982
00:48:25,390 --> 00:48:29,380
So based upon these
categorizations,

983
00:48:29,380 --> 00:48:33,310
we can now rate our own bonds,
what I just decided to issue

984
00:48:33,310 --> 00:48:36,440
with these securities, right?

985
00:48:36,440 --> 00:48:39,170
The senior tranche is
rated AAA, and what would

986
00:48:39,170 --> 00:48:40,355
you rate the junior tranche?

987
00:48:45,090 --> 00:48:47,120
BA maybe.

988
00:48:47,120 --> 00:48:50,910
BAA at the best, but
probably more like BA.

989
00:48:50,910 --> 00:48:54,040
So the senior tranche
looks pretty good,

990
00:48:54,040 --> 00:48:56,490
and the junior tranche
looks pretty bad,

991
00:48:56,490 --> 00:48:59,130
but you know what their
ratings are, and therefore,

992
00:48:59,130 --> 00:49:02,200
go ahead and price
them accordingly.

993
00:49:02,200 --> 00:49:04,240
So let's do that.

994
00:49:04,240 --> 00:49:06,660
If you price them
accordingly, what happens

995
00:49:06,660 --> 00:49:11,970
is that the senior tranche
gets priced at $990,

996
00:49:11,970 --> 00:49:23,100
and the junior tranche gets
priced at 810, 990 and 810.

997
00:49:23,100 --> 00:49:28,020
Now, this is very different
from what the price was before.

998
00:49:28,020 --> 00:49:31,650
The price for both
bonds was 900, right?

999
00:49:31,650 --> 00:49:35,200
The expected value
of the payout.

1000
00:49:35,200 --> 00:49:37,900
And the expected value
of each bond is 900.

1001
00:49:37,900 --> 00:49:40,430
When you add them
up, you get 1,800.

1002
00:49:40,430 --> 00:49:44,170
Here, when you add up these
two bonds, you also get 1,800.

1003
00:49:44,170 --> 00:49:47,760
So I have neither created
nor destroyed value.

1004
00:49:47,760 --> 00:49:51,640
All I've done is to
reallocate that value.

1005
00:49:51,640 --> 00:49:55,950
I've given the senior
bondholders lower default risk

1006
00:49:55,950 --> 00:50:02,190
and therefore higher likelihood
of getting their money back,

1007
00:50:02,190 --> 00:50:04,800
therefore a lower
yield is necessary

1008
00:50:04,800 --> 00:50:06,480
in order to sell that bond.

1009
00:50:06,480 --> 00:50:09,540
On the other hand,
that extra benefit

1010
00:50:09,540 --> 00:50:12,480
that we've given to
the senior claimants

1011
00:50:12,480 --> 00:50:16,440
comes from the junior
claimants, and therefore, they

1012
00:50:16,440 --> 00:50:18,720
get a lower price,
or they have to be

1013
00:50:18,720 --> 00:50:24,240
given a higher yield, to entice
them to bear that kind of risk.

1014
00:50:27,530 --> 00:50:30,940
Now, why is this such
a stroke of genius?

1015
00:50:30,940 --> 00:50:36,430
It's because what we've done is
take two identical securities

1016
00:50:36,430 --> 00:50:41,980
that nobody was
particularly excited about,

1017
00:50:41,980 --> 00:50:46,450
and we've created, by this
securitization process,

1018
00:50:46,450 --> 00:50:51,760
we've created two other
securities that actually

1019
00:50:51,760 --> 00:50:55,120
a number of communities
are very excited about.

1020
00:50:55,120 --> 00:50:58,840
For example, the pension
funds, endowments, foundations,

1021
00:50:58,840 --> 00:51:02,050
all of the very
conservative investors

1022
00:51:02,050 --> 00:51:06,070
that want a very
boring bond portfolio.

1023
00:51:06,070 --> 00:51:08,140
No excitement, no headline risk.

1024
00:51:08,140 --> 00:51:10,390
They just want their money
back with a reasonable rate

1025
00:51:10,390 --> 00:51:11,290
of return.

1026
00:51:11,290 --> 00:51:14,050
They've got it with
the senior tranche.

1027
00:51:14,050 --> 00:51:18,370
And by the way, if they're even
nervous about this very, very

1028
00:51:18,370 --> 00:51:23,320
safe structure, let's insure it.

1029
00:51:23,320 --> 00:51:25,760
Let's get a large,
stable insurance company,

1030
00:51:25,760 --> 00:51:28,690
oh I don't know, maybe
AIG, and let's get

1031
00:51:28,690 --> 00:51:32,720
them to insure that these won't
default. Because if they do,

1032
00:51:32,720 --> 00:51:35,860
AIG will pay an extra
premium on top of that.

1033
00:51:35,860 --> 00:51:39,280
So then they're called
super senior securities,

1034
00:51:39,280 --> 00:51:43,060
super senior tranche securities,
because they've got guarantees

1035
00:51:43,060 --> 00:51:46,830
on top of the
securitization features.

1036
00:51:46,830 --> 00:51:49,710
Pension funds love this.

1037
00:51:49,710 --> 00:51:54,940
They bought this in
large, large quantities.

1038
00:51:54,940 --> 00:51:58,270
Now, what about the
so-called toxic waste

1039
00:51:58,270 --> 00:52:00,000
that the junior tranche?

1040
00:52:00,000 --> 00:52:03,000
Well, we know it's toxic waste.

1041
00:52:03,000 --> 00:52:06,300
We've priced it as if
it were toxic waste.

1042
00:52:06,300 --> 00:52:11,850
And so those investors that are
looking for 15% or 20% returns,

1043
00:52:11,850 --> 00:52:16,290
that are not looking
for boring, safe assets,

1044
00:52:16,290 --> 00:52:18,330
they will go for
the junior tranche.

1045
00:52:18,330 --> 00:52:20,130
Namely, the hedge funds.

1046
00:52:20,130 --> 00:52:21,930
And as many of you
know, hedge funds

1047
00:52:21,930 --> 00:52:23,930
have grown by leaps and bounds.

1048
00:52:23,930 --> 00:52:25,705
Over just the last
10 years, they've

1049
00:52:25,705 --> 00:52:27,330
increased their assets
under management

1050
00:52:27,330 --> 00:52:30,210
by a factor of 10 to 20.

1051
00:52:30,210 --> 00:52:32,520
And that money is
looking for a home.

1052
00:52:32,520 --> 00:52:35,520
And boring, safe
investments that

1053
00:52:35,520 --> 00:52:38,640
earn 6%, 7%, 8%, that's
not for hedge funds.

1054
00:52:38,640 --> 00:52:41,410
They are looking
for 15, 20, 30 40%,

1055
00:52:41,410 --> 00:52:45,060
and they get that with
that junior tranche.

1056
00:52:45,060 --> 00:52:48,000
That's why the market, over the
last 10 years, has exploded.

1057
00:52:48,000 --> 00:52:49,050
It's twofold.

1058
00:52:49,050 --> 00:52:51,390
It's because money has
come in from pension

1059
00:52:51,390 --> 00:52:53,370
funds for the senior debt.

1060
00:52:53,370 --> 00:52:57,900
Money has come in from the hedge
funds for that junior debt.

1061
00:52:57,900 --> 00:53:01,080
And together, they brought
much, much more money

1062
00:53:01,080 --> 00:53:04,840
into this business
than ever before.

1063
00:53:04,840 --> 00:53:07,680
And the question is, how
do you take that money

1064
00:53:07,680 --> 00:53:09,600
and push it out to people.

1065
00:53:09,600 --> 00:53:13,710
Well, it turns out that because
housing markets are going up,

1066
00:53:13,710 --> 00:53:16,210
that was a perfect
way to get these

1067
00:53:16,210 --> 00:53:18,600
this money out to investors.

1068
00:53:18,600 --> 00:53:19,760
Yes?

1069
00:53:19,760 --> 00:53:22,510
STUDENT: This model is based on
the probability of the Moody's.

1070
00:53:22,510 --> 00:53:23,680
I have a question.

1071
00:53:23,680 --> 00:53:26,070
Is there any way investors
can estimate this probability

1072
00:53:26,070 --> 00:53:28,833
by themselves instead
of relying on Standard

1073
00:53:28,833 --> 00:53:30,390
and Poor's or Moody's?

1074
00:53:30,390 --> 00:53:32,310
ANDREW LO: It's very
difficult for investors

1075
00:53:32,310 --> 00:53:34,170
to estimate the
probabilities themselves,

1076
00:53:34,170 --> 00:53:36,840
because they don't have
access to the same data

1077
00:53:36,840 --> 00:53:40,024
that Moody's and
S&P and Fitch do.

1078
00:53:40,024 --> 00:53:41,940
Typically when you
estimate the probabilities,

1079
00:53:41,940 --> 00:53:44,520
you need data in terms of
the underlying portfolio

1080
00:53:44,520 --> 00:53:45,780
and the riskiness.

1081
00:53:45,780 --> 00:53:48,780
As a typical investor, certainly
as a pension fund investor,

1082
00:53:48,780 --> 00:53:50,430
you would not be given access.

1083
00:53:50,430 --> 00:53:52,440
And even if you
were given access,

1084
00:53:52,440 --> 00:53:55,756
you don't have the staff that
can actually analyze this.

1085
00:53:55,756 --> 00:53:57,630
STUDENT: So if Moody's
or Standard and Poor's

1086
00:53:57,630 --> 00:54:00,880
made a mistake, then every
pension fund or other investors

1087
00:54:00,880 --> 00:54:02,726
will made the same mistake.

1088
00:54:02,726 --> 00:54:04,350
ANDREW LO: The mistakes
can carry over.

1089
00:54:04,350 --> 00:54:04,891
That's right.

1090
00:54:04,891 --> 00:54:07,500
There is no way for
pension funds, endowments

1091
00:54:07,500 --> 00:54:10,170
and foundations, or
retail investors,

1092
00:54:10,170 --> 00:54:12,510
to do their own kind
of due diligence.

1093
00:54:12,510 --> 00:54:15,840
They're relying on those
managers of the pension funds

1094
00:54:15,840 --> 00:54:16,990
to do that.

1095
00:54:16,990 --> 00:54:20,360
And by the way, it wasn't just
pension funds that did this.

1096
00:54:20,360 --> 00:54:23,340
There was some mutual
funds that did this too.

1097
00:54:23,340 --> 00:54:26,570
And not only mutual funds,
but there were also some money

1098
00:54:26,570 --> 00:54:28,800
market funds that did this.

1099
00:54:28,800 --> 00:54:31,910
Now, money market funds you
say, why would money market

1100
00:54:31,910 --> 00:54:33,950
funds get invested in this?

1101
00:54:33,950 --> 00:54:35,660
Well remember,
money market funds

1102
00:54:35,660 --> 00:54:39,650
are supposed to be putting money
into short term, fixed income

1103
00:54:39,650 --> 00:54:41,210
instruments.

1104
00:54:41,210 --> 00:54:43,940
Well, these could be
short term, and these

1105
00:54:43,940 --> 00:54:45,350
are fixed income instruments.

1106
00:54:45,350 --> 00:54:47,370
And if you add some
insurance on top of that,

1107
00:54:47,370 --> 00:54:50,180
they're even safer,
on paper anyway,

1108
00:54:50,180 --> 00:54:53,270
than many of the other
traditional instruments.

1109
00:54:53,270 --> 00:54:57,560
So you can see now how a
wonderful idea, and this really

1110
00:54:57,560 --> 00:54:59,540
is wonderful because
it dramatically

1111
00:54:59,540 --> 00:55:03,690
increased the risk bearing
capacity of the economy.

1112
00:55:03,690 --> 00:55:06,920
And by the way, it made a
lot of people better off.

1113
00:55:06,920 --> 00:55:10,010
So right now, we're in the
midst of a financial crisis

1114
00:55:10,010 --> 00:55:13,130
and we're focusing
on the negatives.

1115
00:55:13,130 --> 00:55:17,060
But let's not be
too quick to forget

1116
00:55:17,060 --> 00:55:21,800
that these kinds of
securitization processes

1117
00:55:21,800 --> 00:55:25,040
brought in huge amounts of
money that ultimately went

1118
00:55:25,040 --> 00:55:28,641
to homeowners to be able to
buy homes that they otherwise

1119
00:55:28,641 --> 00:55:30,890
couldn't have afforded, and
maybe you would argue they

1120
00:55:30,890 --> 00:55:33,540
shouldn't have afforded,
but there are still many,

1121
00:55:33,540 --> 00:55:36,290
many homeowners out there
that have subprime loans that

1122
00:55:36,290 --> 00:55:37,992
are paying their
mortgage payments,

1123
00:55:37,992 --> 00:55:39,950
that are perfectly happy
living in their atoms,

1124
00:55:39,950 --> 00:55:42,740
and otherwise couldn't have
afforded it without it.

1125
00:55:42,740 --> 00:55:44,540
And Moreover, there
are a whole host

1126
00:55:44,540 --> 00:55:49,250
of individuals that made tons of
money because of the real state

1127
00:55:49,250 --> 00:55:51,560
boom and because they
were able to leverage

1128
00:55:51,560 --> 00:55:53,720
using these kinds of funds.

1129
00:55:53,720 --> 00:55:57,930
STUDENT: In this example, the
ones who [INAUDIBLE] are us.

1130
00:55:57,930 --> 00:55:59,169
Is that like Lehman Bothers?

1131
00:55:59,169 --> 00:56:00,210
Are those the companies--

1132
00:56:00,210 --> 00:56:01,210
ANDREW LO: That's right.

1133
00:56:01,210 --> 00:56:03,560
So an example would be some
of the investment banks,

1134
00:56:03,560 --> 00:56:05,837
as well as some of
the commercial banks.

1135
00:56:05,837 --> 00:56:07,670
Now, in a minute, I'm
going to tell you what

1136
00:56:07,670 --> 00:56:08,836
went wrong with all of this.

1137
00:56:08,836 --> 00:56:10,190
So far, the story is great.

1138
00:56:10,190 --> 00:56:14,270
This is really an innovation
in financial engineering,

1139
00:56:14,270 --> 00:56:18,260
because by securitization,
by repackaging,

1140
00:56:18,260 --> 00:56:19,790
we've done nothing dishonest.

1141
00:56:19,790 --> 00:56:22,410
We've told people
exactly what we're doing.

1142
00:56:22,410 --> 00:56:24,110
We've given them transparency.

1143
00:56:24,110 --> 00:56:27,110
And we've given the safer
asset to the community

1144
00:56:27,110 --> 00:56:28,680
that wants safer assets.

1145
00:56:28,680 --> 00:56:30,687
And we've given the
very exciting assets

1146
00:56:30,687 --> 00:56:32,270
to those who want
the exciting assets.

1147
00:56:34,800 --> 00:56:37,325
Now, where does this go wrong?

1148
00:56:37,325 --> 00:56:38,450
Question before we do that.

1149
00:56:38,450 --> 00:56:40,450
STUDENT: The assumption
that you made in this is

1150
00:56:40,450 --> 00:56:43,306
that they are not correlated?

1151
00:56:43,306 --> 00:56:47,815
Isn't there more likeliness of
correlation between the two?

1152
00:56:47,815 --> 00:56:49,190
ANDREW LO: So that
there's always

1153
00:56:49,190 --> 00:56:53,690
somebody that's ready to spoil
the party for the rest of us.

1154
00:56:53,690 --> 00:56:55,550
You're absolutely right.

1155
00:56:55,550 --> 00:56:59,340
That's where the story
gets interesting.

1156
00:56:59,340 --> 00:57:04,760
I've assumed that these
two bonds are uncorrelated.

1157
00:57:04,760 --> 00:57:07,330
What if that
assumption is wrong?

1158
00:57:07,330 --> 00:57:13,260
In fact, what happens if not
only are they uncorrelated,

1159
00:57:13,260 --> 00:57:18,930
but what happens if the bonds
are perfectly correlated?

1160
00:57:18,930 --> 00:57:19,950
Let's work that out.

1161
00:57:19,950 --> 00:57:23,420
That's a numerical example
that's not hard to do.

1162
00:57:23,420 --> 00:57:25,580
If the bonds are
perfectly correlated,

1163
00:57:25,580 --> 00:57:27,680
that means they default
at the same time

1164
00:57:27,680 --> 00:57:30,680
and they pay off at the
same time, then instead

1165
00:57:30,680 --> 00:57:34,580
of three outcomes, we
only have two outcomes.

1166
00:57:34,580 --> 00:57:38,420
Either we get paid
$2,000 in the portfolio,

1167
00:57:38,420 --> 00:57:40,670
or we get paid nothing
in the portfolio.

1168
00:57:43,410 --> 00:57:48,030
Now, what happens to the
senior and junior tranches?

1169
00:57:48,030 --> 00:57:53,370
Well, now, the senior
tranche, the tranche

1170
00:57:53,370 --> 00:57:56,760
that was AAA, the tranche
that had less than 1%

1171
00:57:56,760 --> 00:57:58,650
probability of
default, the tranche

1172
00:57:58,650 --> 00:58:02,400
that was supposed to be so
safe that all sorts of very

1173
00:58:02,400 --> 00:58:06,950
conservative institutions
could take it on, that tranche

1174
00:58:06,950 --> 00:58:11,690
has now increased in
riskiness by a factor of 10.

1175
00:58:11,690 --> 00:58:16,790
The probability of default
has gone from 1% to 10%.

1176
00:58:16,790 --> 00:58:19,760
And the junior
tranche, the tranche

1177
00:58:19,760 --> 00:58:21,980
that was supposed
to be toxic waste,

1178
00:58:21,980 --> 00:58:25,670
and that had a 90%
default rate, now it

1179
00:58:25,670 --> 00:58:28,790
looks incredibly good,
because it's gone up

1180
00:58:28,790 --> 00:58:30,170
in terms of its quality.

1181
00:58:30,170 --> 00:58:33,620
It's gone down in terms
of its default probability

1182
00:58:33,620 --> 00:58:37,200
from 19% to 10%.

1183
00:58:37,200 --> 00:58:39,290
So if you look at
the pricing, now

1184
00:58:39,290 --> 00:58:42,920
the pricing of these two
things, of course, is $900.

1185
00:58:42,920 --> 00:58:45,500
If they're perfectly
correlated, then securitization

1186
00:58:45,500 --> 00:58:46,910
does nothing.

1187
00:58:46,910 --> 00:58:49,640
All you've done is to
take two pieces of paper

1188
00:58:49,640 --> 00:58:54,090
and slice them up into two
identical pieces of paper.

1189
00:58:54,090 --> 00:58:56,560
That's what happens if
they're perfectly correlated.

1190
00:58:56,560 --> 00:59:02,560
So now, why would they
become perfectly correlated?

1191
00:59:02,560 --> 00:59:06,160
Well, this has to do with what
happened in the housing market.

1192
00:59:06,160 --> 00:59:08,080
When the housing
market turned down,

1193
00:59:08,080 --> 00:59:13,120
as it did shortly
after June of 2006,

1194
00:59:13,120 --> 00:59:18,500
that created a huge dislocation
in these credit markets,

1195
00:59:18,500 --> 00:59:21,350
because what was
uncorrelated all of a sudden

1196
00:59:21,350 --> 00:59:22,670
became highly correlated.

1197
00:59:22,670 --> 00:59:24,760
It's as if an
insurance company that

1198
00:59:24,760 --> 00:59:29,320
was insuring property and
casualty across the country,

1199
00:59:29,320 --> 00:59:32,200
all of a sudden experienced
earthquakes in every one

1200
00:59:32,200 --> 00:59:35,050
of the 50 states all at once.

1201
00:59:35,050 --> 00:59:38,140
An insurance company
cannot withstand that kind

1202
00:59:38,140 --> 00:59:41,590
of an event, unless of
course it's prepared for it.

1203
00:59:41,590 --> 00:59:44,860
And earthquake
insurers prepare for it

1204
00:59:44,860 --> 00:59:50,800
by insuring not just earthquakes
but hurricanes, fires,

1205
00:59:50,800 --> 00:59:53,140
and other natural
disasters, which

1206
00:59:53,140 --> 00:59:59,040
rarely come all at the same
time and all in the same place.

1207
00:59:59,040 --> 01:00:00,780
We weren't prepared for this.

1208
01:00:00,780 --> 01:00:03,300
The people that sold these
securities, that held them,

1209
01:00:03,300 --> 01:00:04,380
weren't prepared.

1210
01:00:04,380 --> 01:00:07,890
In fact, I skipped over a
quote at the very beginning

1211
01:00:07,890 --> 01:00:09,060
of this section.

1212
01:00:09,060 --> 01:00:14,940
This is a quote that appeared
in The Economist magazine,

1213
01:00:14,940 --> 01:00:17,310
anonymously, and it
was the Chief Risk

1214
01:00:17,310 --> 01:00:21,270
Officer of a major
financial institution.

1215
01:00:21,270 --> 01:00:29,390
And the risk manager wrote in
the first part of the article,

1216
01:00:29,390 --> 01:00:31,820
"Like most banks,
we owned a portfolio

1217
01:00:31,820 --> 01:00:33,710
of different tranches
of collateralized debt

1218
01:00:33,710 --> 01:00:38,390
obligations" that's what the
securitized set of obligations

1219
01:00:38,390 --> 01:00:41,620
are called, "which are packages
of asset-backed securities.

1220
01:00:41,620 --> 01:00:43,190
Our business and
risk strategy was

1221
01:00:43,190 --> 01:00:46,020
to buy pools of
assets, mainly bonds,

1222
01:00:46,020 --> 01:00:49,730
warehouse them on our own
balance sheet" meaning put them

1223
01:00:49,730 --> 01:00:54,440
in a portfolio in our company,
"and structure them into CDOs

1224
01:00:54,440 --> 01:00:56,690
and finally distribute
them to end investors."

1225
01:00:56,690 --> 01:00:59,780
Issue the pieces of paper
to the different investors.

1226
01:00:59,780 --> 01:01:03,260
"We were most eager to sell the
non-investment grade tranches,"

1227
01:01:03,260 --> 01:01:06,290
the toxic waste, "and
our risk approvals

1228
01:01:06,290 --> 01:01:09,140
were conditional on
reducing these to zero."

1229
01:01:09,140 --> 01:01:11,600
So they were very,
very careful to get rid

1230
01:01:11,600 --> 01:01:14,010
of all that toxic waste.

1231
01:01:14,010 --> 01:01:19,120
"We will allow positions
however of the top rated AAA

1232
01:01:19,120 --> 01:01:22,800
and super-M senior
(even better than AAA)

1233
01:01:22,800 --> 01:01:27,000
tranches to be held on
our own balance-sheets

1234
01:01:27,000 --> 01:01:30,270
as the default was deemed
to be well protected

1235
01:01:30,270 --> 01:01:32,790
by all the lower
tranches, which would have

1236
01:01:32,790 --> 01:01:34,845
to absorb any prior losses."

1237
01:01:37,940 --> 01:01:40,760
"in May of 2005 we
held AAA tranches,

1238
01:01:40,760 --> 01:01:45,650
expecting them to rise in value,
and sold non-investment grade

1239
01:01:45,650 --> 01:01:48,290
tranches, expecting
them to go down."

1240
01:01:48,290 --> 01:01:52,760
They were long the
seniors, short the juniors.

1241
01:01:52,760 --> 01:01:54,457
That's a strategy.

1242
01:01:54,457 --> 01:01:56,040
"From a risk-management
point of view,

1243
01:01:56,040 --> 01:01:59,570
this was perfect: have a long
position in the low risk asset,

1244
01:01:59,570 --> 01:02:03,150
and have a short one in
the higher-risk asset.

1245
01:02:03,150 --> 01:02:06,540
But the reverse happened
of what we had expected:

1246
01:02:06,540 --> 01:02:10,470
AAA tranches went down in
price and non-investment grade

1247
01:02:10,470 --> 01:02:13,950
tranches went up,
resulting in losses as we

1248
01:02:13,950 --> 01:02:17,880
mark the positions to market."

1249
01:02:17,880 --> 01:02:21,570
And then the risk manager,
this Chief Risk Officer

1250
01:02:21,570 --> 01:02:24,760
of a major financial
institution,

1251
01:02:24,760 --> 01:02:26,050
said the following.

1252
01:02:26,050 --> 01:02:28,900
"This was entirely
counter-intuitive.

1253
01:02:28,900 --> 01:02:30,880
Explanations of why
this had happened

1254
01:02:30,880 --> 01:02:34,180
were confusing and focused on
complicated cross-correlations

1255
01:02:34,180 --> 01:02:35,032
between tranches.

1256
01:02:35,032 --> 01:02:36,490
In essence it turned
out that there

1257
01:02:36,490 --> 01:02:38,916
had been a short squeeze in
non-investment grade tranches,

1258
01:02:38,916 --> 01:02:40,540
driving up prices
and generally selling

1259
01:02:40,540 --> 01:02:42,748
of all the more senior
[INAUDIBLE] even the very best

1260
01:02:42,748 --> 01:02:44,430
ones."

1261
01:02:44,430 --> 01:02:46,770
He still doesn't get it.

1262
01:02:46,770 --> 01:02:48,690
The numerical example
that I just showed you

1263
01:02:48,690 --> 01:02:50,790
explains what happened.

1264
01:02:50,790 --> 01:02:52,290
What happened is
the correlations,

1265
01:02:52,290 --> 01:02:55,650
that were assumed to be zero,
turned out not to be zero.

1266
01:02:55,650 --> 01:02:59,580
And when things change, when
the correlations change,

1267
01:02:59,580 --> 01:03:00,690
that changes the risk.

1268
01:03:00,690 --> 01:03:03,060
And when you change the risk,
it changes the valuation

1269
01:03:03,060 --> 01:03:04,650
because the markets
are not stupid.

1270
01:03:04,650 --> 01:03:07,290
People realize, wow, I assumed
they were uncorrelated,

1271
01:03:07,290 --> 01:03:09,150
but now these things
are very correlated.

1272
01:03:09,150 --> 01:03:11,790
I better recalculate my model
and see what it tells me.

1273
01:03:11,790 --> 01:03:14,700
And it tells me that AAA
is not AAA any longer.

1274
01:03:14,700 --> 01:03:18,300
And it tells me that the
BA is actually now BAA.

1275
01:03:18,300 --> 01:03:22,230
So what he experienced is
what every major financial

1276
01:03:22,230 --> 01:03:23,790
institution dealing
with this stuff

1277
01:03:23,790 --> 01:03:26,310
experienced over the
last couple of years.

1278
01:03:26,310 --> 01:03:29,100
It's that kind of
a double whammy,

1279
01:03:29,100 --> 01:03:32,850
because of the
default rates changing

1280
01:03:32,850 --> 01:03:37,020
in a way that was never expected
given the historical behavior

1281
01:03:37,020 --> 01:03:38,860
of the US housing market.

1282
01:03:38,860 --> 01:03:39,450
Yeah, Beta.

1283
01:03:39,450 --> 01:03:43,670
STUDENT: [INAUDIBLE]

1284
01:03:51,434 --> 01:03:53,350
ANDREW LO: It was typically
through the banks.

1285
01:03:53,350 --> 01:03:56,590
So the banks actually arrange
with the insurance companies

1286
01:03:56,590 --> 01:03:58,390
to insure those assets.

1287
01:03:58,390 --> 01:04:01,030
And then they would sell
it to the end investor.

1288
01:04:01,030 --> 01:04:03,910
The end investor wasn't
the one engaging in these.

1289
01:04:03,910 --> 01:04:06,880
Although, under
certain circumstances,

1290
01:04:06,880 --> 01:04:08,830
certain pension
funds were so risk

1291
01:04:08,830 --> 01:04:11,170
averse that they
ultimately ended up

1292
01:04:11,170 --> 01:04:14,770
buying extra insurance in the
form of credit default swaps

1293
01:04:14,770 --> 01:04:17,800
on these kinds of contracts
with other counter-parties.

1294
01:04:17,800 --> 01:04:21,100
So in many cases, some of
the insurance companies

1295
01:04:21,100 --> 01:04:24,070
actually did have relationships
with the end investors,

1296
01:04:24,070 --> 01:04:27,090
as well as with the
investment banks.

1297
01:04:27,090 --> 01:04:27,730
Yeah, Maria.

1298
01:04:27,730 --> 01:04:32,522
STUDENT: [INAUDIBLE]

1299
01:04:45,749 --> 01:04:46,540
ANDREW LO: They do.

1300
01:04:46,540 --> 01:04:47,950
They do downgrade these.

1301
01:04:47,950 --> 01:04:48,980
Absolutely.

1302
01:04:48,980 --> 01:04:52,450
And in fact, not only do
they downgrade the bonds,

1303
01:04:52,450 --> 01:04:55,090
but they also downgrade the
equity of the companies that

1304
01:04:55,090 --> 01:04:56,530
are issuing the bonds.

1305
01:04:56,530 --> 01:05:01,120
So for example,
AIG was downgraded

1306
01:05:01,120 --> 01:05:03,910
because there was
concern of whether or not

1307
01:05:03,910 --> 01:05:05,512
it could meet its obligations.

1308
01:05:05,512 --> 01:05:06,970
And because of that
downgrade, that

1309
01:05:06,970 --> 01:05:09,490
triggered a bunch of
other transactions.

1310
01:05:09,490 --> 01:05:11,870
STUDENT: And the other question
is, are they independent,

1311
01:05:11,870 --> 01:05:16,154
and are they really
objective when they are--

1312
01:05:19,010 --> 01:05:21,630
ANDREW LO: Well, so those
are two separate questions.

1313
01:05:21,630 --> 01:05:25,180
Are they independent
and are they objective?

1314
01:05:25,180 --> 01:05:27,840
Yes, they are independent,
strictly speaking, in the sense

1315
01:05:27,840 --> 01:05:31,560
that S&P and Moody's
and Fitch are not

1316
01:05:31,560 --> 01:05:36,390
owned by any of the companies
that are being rated,

1317
01:05:36,390 --> 01:05:37,650
number one.

1318
01:05:37,650 --> 01:05:39,180
Are they objective?

1319
01:05:39,180 --> 01:05:41,730
That's a different
question because remember

1320
01:05:41,730 --> 01:05:45,090
that S&P, Moody's and
Fitch are businesses,

1321
01:05:45,090 --> 01:05:47,430
and businesses generally
try to make money.

1322
01:05:47,430 --> 01:05:50,310
And in order to make money,
you have to get revenues.

1323
01:05:50,310 --> 01:05:52,260
And in order to
get revenues, you

1324
01:05:52,260 --> 01:05:54,090
have to have lots of customers.

1325
01:05:54,090 --> 01:05:57,630
And so the question
is, did they ultimately

1326
01:05:57,630 --> 01:05:59,929
end up giving ratings
out too easily

1327
01:05:59,929 --> 01:06:01,470
that they shouldn't
have because they

1328
01:06:01,470 --> 01:06:02,910
wanted to get more business?

1329
01:06:02,910 --> 01:06:04,660
I don't know the answer
to that, but there

1330
01:06:04,660 --> 01:06:07,380
is going to be a lot of
people, particularly lawyers,

1331
01:06:07,380 --> 01:06:09,690
asking those questions
in the coming months.

1332
01:06:09,690 --> 01:06:12,390
So the rating agencies
have definitely

1333
01:06:12,390 --> 01:06:15,879
been under fire by a number
of different organizations.

1334
01:06:15,879 --> 01:06:17,670
I don't know where
that's going to come out

1335
01:06:17,670 --> 01:06:20,520
and I don't know the details
of how they actually conducted

1336
01:06:20,520 --> 01:06:22,990
the ratings, but there
is definitely an issue

1337
01:06:22,990 --> 01:06:28,590
because what is AAA should
not default more than 1% or 2%

1338
01:06:28,590 --> 01:06:32,370
over the life of
the particular loan.

1339
01:06:32,370 --> 01:06:33,930
And clearly, with
these securities,

1340
01:06:33,930 --> 01:06:35,596
they've defaulted at
a much higher rate.

1341
01:06:35,596 --> 01:06:40,990
STUDENT: [INAUDIBLE]

1342
01:06:40,990 --> 01:06:41,679
ANDREW LO: Yes.

1343
01:06:41,679 --> 01:06:42,220
That's right.

1344
01:06:42,220 --> 01:06:43,720
They only relied
on three companies.

1345
01:06:43,720 --> 01:06:45,100
And actually, it's
very difficult

1346
01:06:45,100 --> 01:06:47,890
to start a rating
agency now, because

1347
01:06:47,890 --> 01:06:50,470
the regulatory
authorities require

1348
01:06:50,470 --> 01:06:52,720
certain kinds of
standards to be met

1349
01:06:52,720 --> 01:06:57,190
that are virtually impossible
for a startup to be able to do.

1350
01:06:57,190 --> 01:07:00,490
So you're right, that
investors relied on this,

1351
01:07:00,490 --> 01:07:04,810
and they ultimately
were badly misled.

1352
01:07:04,810 --> 01:07:08,110
But the argument that S&P,
Moody's and Fitch would make

1353
01:07:08,110 --> 01:07:10,300
is that, we were doing
the best we could,

1354
01:07:10,300 --> 01:07:15,190
we looked at historical
default rates of mortgages,

1355
01:07:15,190 --> 01:07:17,920
and we made very
conservative assumptions.

1356
01:07:17,920 --> 01:07:21,700
In fact, if you assume that
they were zero correlation,

1357
01:07:21,700 --> 01:07:24,910
but instead you tried
to be conservative

1358
01:07:24,910 --> 01:07:28,230
and you said OK, the
correlation maybe is not zero,

1359
01:07:28,230 --> 01:07:31,480
but let's make it,
oh I don't know, 25%.

1360
01:07:31,480 --> 01:07:34,300
Even though historically,
the correlation

1361
01:07:34,300 --> 01:07:36,760
is maybe much, much
less than that.

1362
01:07:36,760 --> 01:07:40,960
If you just used an artificial
number like 25% or 30%,

1363
01:07:40,960 --> 01:07:43,360
you would still not have
had the kind of dislocation

1364
01:07:43,360 --> 01:07:45,130
that we saw over the
last couple of years,

1365
01:07:45,130 --> 01:07:47,780
because the correlation
actually has gone much,

1366
01:07:47,780 --> 01:07:49,450
much higher than
that, particularly

1367
01:07:49,450 --> 01:07:51,790
for the subprime
mortgages, as you know,

1368
01:07:51,790 --> 01:07:53,740
because the housing
market's turned down.

1369
01:07:53,740 --> 01:07:56,350
And a lot of this was
triggered by this decline

1370
01:07:56,350 --> 01:08:00,660
in housing, which has been
a very, very sharp decline.

1371
01:08:00,660 --> 01:08:03,670
And over the last 30
years, the housing market

1372
01:08:03,670 --> 01:08:06,460
in the United States has really
never gone down by more than 1%

1373
01:08:06,460 --> 01:08:08,390
or 2% in a year.

1374
01:08:08,390 --> 01:08:12,980
Never mind going down 10%
over the last 12 months.

1375
01:08:12,980 --> 01:08:16,479
That's a really big
shock to the system.

1376
01:08:16,479 --> 01:08:17,538
Yeah?

1377
01:08:17,538 --> 01:08:21,600
STUDENT: [INAUDIBLE]

1378
01:08:46,520 --> 01:08:49,189
ANDREW LO: Well, in fact they
have done that in the sense

1379
01:08:49,189 --> 01:08:52,189
that they've actually chopped
up these kinds of security

1380
01:08:52,189 --> 01:08:54,260
into five different tranches.

1381
01:08:54,260 --> 01:08:57,060
And they've done it,
they've spread it out very,

1382
01:08:57,060 --> 01:08:57,950
very broadly.

1383
01:08:57,950 --> 01:08:59,720
That's how the US
housing market was

1384
01:08:59,720 --> 01:09:02,870
able to grow as quickly as it
has over the last 10 years.

1385
01:09:02,870 --> 01:09:05,600
It's because they brought
in huge amounts of money,

1386
01:09:05,600 --> 01:09:09,710
unprecedented amounts of
money, through this mechanism.

1387
01:09:09,710 --> 01:09:12,229
And all of the
investors invested

1388
01:09:12,229 --> 01:09:14,180
based upon these
ratings, as well as

1389
01:09:14,180 --> 01:09:17,899
their sense of how secure
these markets were.

1390
01:09:17,899 --> 01:09:21,050
And in each case, there is
going to be dislocation,

1391
01:09:21,050 --> 01:09:23,180
other than perhaps
in the middle tranche

1392
01:09:23,180 --> 01:09:25,490
where it hits exactly
right and you don't

1393
01:09:25,490 --> 01:09:27,452
get any kind of dislocation.

1394
01:09:27,452 --> 01:09:28,910
But that's not the
biggest tranche.

1395
01:09:28,910 --> 01:09:31,700
The biggest tranche was by
far the most senior one,

1396
01:09:31,700 --> 01:09:34,790
because that's the one that has
the largest amounts of money

1397
01:09:34,790 --> 01:09:36,838
waiting to be invested.

1398
01:09:36,838 --> 01:09:41,083
STUDENT: [INAUDIBLE]

1399
01:09:58,050 --> 01:09:59,800
ANDREW LO: Oh yes, absolutely.

1400
01:09:59,800 --> 01:10:00,540
Yes, absolutely.

1401
01:10:00,540 --> 01:10:04,560
Hedge fund managers have
profited greatly from this,

1402
01:10:04,560 --> 01:10:07,500
because they bought the toxic
waste that nobody else wanted

1403
01:10:07,500 --> 01:10:10,440
and then the value has
gone up dramatically

1404
01:10:10,440 --> 01:10:13,200
because of these kind of
increases in default rates.

1405
01:10:13,200 --> 01:10:17,160
Because they were priced to be
much worse than they ultimately

1406
01:10:17,160 --> 01:10:19,500
ended up being.

1407
01:10:19,500 --> 01:10:23,640
So it's absolutely the
case that the money has not

1408
01:10:23,640 --> 01:10:25,560
disappeared into thin air.

1409
01:10:25,560 --> 01:10:28,240
It's gone from the
senior to the junior.

1410
01:10:28,240 --> 01:10:31,990
It's a wealth transfer in a way.

1411
01:10:31,990 --> 01:10:33,720
Sorry, Ken.

1412
01:10:33,720 --> 01:10:39,125
STUDENT: Just a comment
on why Moody's maybe rated

1413
01:10:39,125 --> 01:10:40,375
these things the way they did.

1414
01:10:40,375 --> 01:10:42,538
At least in my experience,
what would happen

1415
01:10:42,538 --> 01:10:46,655
was the structuring
teams would meet

1416
01:10:46,655 --> 01:10:52,030
with people who were going
to rate these securities

1417
01:10:52,030 --> 01:10:54,420
and explain to them,
hey, this is what we did,

1418
01:10:54,420 --> 01:10:58,000
this is why it makes sense,
and essentially convince them.

1419
01:10:58,000 --> 01:11:09,950
True earlier why the

1420
01:11:09,950 --> 01:11:10,770
ANDREW LO: Oh sure.

1421
01:11:10,770 --> 01:11:12,260
There's a lot of
research that goes on.

1422
01:11:12,260 --> 01:11:14,480
In other words, Moody's,
S&P and Fitch doesn't just

1423
01:11:14,480 --> 01:11:17,260
decide based upon how they
feel that day whether is

1424
01:11:17,260 --> 01:11:18,434
should get AAA or not.

1425
01:11:18,434 --> 01:11:19,850
They do a fair
amount of research,

1426
01:11:19,850 --> 01:11:21,892
and they go through the
details of the portfolio,

1427
01:11:21,892 --> 01:11:23,600
they look at the
seniority of the claims,

1428
01:11:23,600 --> 01:11:25,160
they look at the
legal documents,

1429
01:11:25,160 --> 01:11:26,720
they look at the
historical record,

1430
01:11:26,720 --> 01:11:29,900
they go back and go
back 30, 40, 50 years

1431
01:11:29,900 --> 01:11:31,440
and take a look at the data.

1432
01:11:31,440 --> 01:11:33,110
So that's why I
said, they actually

1433
01:11:33,110 --> 01:11:37,100
have a case for making
the ratings as they did.

1434
01:11:37,100 --> 01:11:39,274
How they could have
gone so far wrong

1435
01:11:39,274 --> 01:11:40,940
is a question that
we're going to debate

1436
01:11:40,940 --> 01:11:42,122
for the next several years.

1437
01:11:42,122 --> 01:11:43,580
And ultimately, I
think we're going

1438
01:11:43,580 --> 01:11:46,890
to learn that we need to make
our models more sophisticated.

1439
01:11:46,890 --> 01:11:49,430
We need to have parameters
that are time varying.

1440
01:11:49,430 --> 01:11:51,050
We need to have a
different approach

1441
01:11:51,050 --> 01:11:53,150
to how we do
quantitative analysis

1442
01:11:53,150 --> 01:11:54,830
for these kinds of markets.

1443
01:11:54,830 --> 01:11:57,157
But that is an open
question that I

1444
01:11:57,157 --> 01:11:59,240
think will have to be
examined in much more depth.

1445
01:11:59,240 --> 01:12:03,460
STUDENT: [INAUDIBLE]

1446
01:12:28,750 --> 01:12:31,390
ANDREW LO: Oh, in the current
situation can somebody make

1447
01:12:31,390 --> 01:12:32,350
money?

1448
01:12:32,350 --> 01:12:33,220
Absolutely.

1449
01:12:33,220 --> 01:12:33,730
Absolutely.

1450
01:12:33,730 --> 01:12:37,330
This is why I was saying at
the very start of this crisis

1451
01:12:37,330 --> 01:12:41,800
that times of crisis are
also times of opportunity.

1452
01:12:41,800 --> 01:12:45,190
You can absolutely make money,
because these securities now

1453
01:12:45,190 --> 01:12:47,140
are priced all over the place.

1454
01:12:47,140 --> 01:12:49,570
Some way to high,
some way to low.

1455
01:12:49,570 --> 01:12:51,730
And if you understand
these models

1456
01:12:51,730 --> 01:12:55,890
better than the next
person, you will make money.

1457
01:12:55,890 --> 01:12:59,250
One of the largest payouts
that has occurred in hedge fund

1458
01:12:59,250 --> 01:13:02,640
history occurred last year
to a hedge fund manager

1459
01:13:02,640 --> 01:13:05,331
in New York named John Paulson.

1460
01:13:05,331 --> 01:13:07,830
I think he was paid-- it's in
the Wall Street Journal so you

1461
01:13:07,830 --> 01:13:08,496
can look it up--

1462
01:13:08,496 --> 01:13:12,450
I think he was paid something
like $3 or $4 billion.

1463
01:13:12,450 --> 01:13:14,790
Was it $4 billion?

1464
01:13:14,790 --> 01:13:17,670
That was his take
home pay last year.

1465
01:13:17,670 --> 01:13:19,200
That was on his W-2.

1466
01:13:19,200 --> 01:13:22,680
That was not wealth,
that was income.

1467
01:13:22,680 --> 01:13:26,040
And he did it by betting
on certain movements

1468
01:13:26,040 --> 01:13:29,700
in these markets, including
these kinds of securities.

1469
01:13:29,700 --> 01:13:31,706
So there's a lot of
money to be made.

1470
01:13:31,706 --> 01:13:33,330
There's a lot of
opportunity out there.

1471
01:13:33,330 --> 01:13:36,140
But it requires an edge.

1472
01:13:36,140 --> 01:13:38,300
So you really have to
spend some time trying

1473
01:13:38,300 --> 01:13:39,650
to understand these securities.

1474
01:13:39,650 --> 01:13:43,250
And what we've done today, this
relatively simple analysis,

1475
01:13:43,250 --> 01:13:47,330
is an analysis that apparently
eluded this Chief Risk Officer.

1476
01:13:47,330 --> 01:13:51,620
Because they're focusing at
a very, very detailed level

1477
01:13:51,620 --> 01:13:53,510
on models that are
probably not as

1478
01:13:53,510 --> 01:13:56,190
relevant for the
macroscopic picture.

1479
01:13:56,190 --> 01:13:56,690
Yeah?

1480
01:13:58,825 --> 01:14:00,450
STUDENT: If no one
is able to determine

1481
01:14:00,450 --> 01:14:01,020
the right price
for these things,

1482
01:14:01,020 --> 01:14:01,972
how is the government going
to use the $700 billion

1483
01:14:01,972 --> 01:14:03,400
to buy these things?

1484
01:14:05,892 --> 01:14:07,600
ANDREW LO: Well, that's
a great question.

1485
01:14:07,600 --> 01:14:09,808
That's one of the reasons
why there's so much debate.

1486
01:14:09,808 --> 01:14:13,140
It's because the view is that
if the very best minds on Wall

1487
01:14:13,140 --> 01:14:14,700
Street couldn't get
this right, what

1488
01:14:14,700 --> 01:14:17,760
makes us think that the
Treasury can get it right,

1489
01:14:17,760 --> 01:14:19,630
which is a little scary.

1490
01:14:19,630 --> 01:14:21,000
I agree.

1491
01:14:21,000 --> 01:14:22,470
There are a couple
of things that

1492
01:14:22,470 --> 01:14:24,000
are being done to address that.

1493
01:14:24,000 --> 01:14:25,860
One is that as part
of the proposal,

1494
01:14:25,860 --> 01:14:28,560
they plan to set up an
advisory board of people that

1495
01:14:28,560 --> 01:14:31,560
are in the industry, seasoned
veterans that are engaged

1496
01:14:31,560 --> 01:14:33,600
in these transactions,
to help the government

1497
01:14:33,600 --> 01:14:34,440
price these things.

1498
01:14:34,440 --> 01:14:35,280
That's one.

1499
01:14:35,280 --> 01:14:37,650
The second approach
is that they plan

1500
01:14:37,650 --> 01:14:44,010
to engage in equity ownership
as a possible outcome for this.

1501
01:14:44,010 --> 01:14:46,260
So in other words,
it's a bailout

1502
01:14:46,260 --> 01:14:51,380
if you buy for $100
what is really worth 60.

1503
01:14:51,380 --> 01:14:53,810
But it's not nearly
as much of a bailout

1504
01:14:53,810 --> 01:14:56,870
if you buy for 50 what's 60.

1505
01:14:56,870 --> 01:14:59,870
And it could actually be
quite profitable if not only

1506
01:14:59,870 --> 01:15:02,870
do buy for 50 what's
worth 60, but you also

1507
01:15:02,870 --> 01:15:06,230
get to own 80% of the
company in the process, which

1508
01:15:06,230 --> 01:15:09,570
is kind of like the deal
that AIG has struck,

1509
01:15:09,570 --> 01:15:12,770
and not that different from
some of the discussions

1510
01:15:12,770 --> 01:15:16,760
that Warren Buffett has
had with Goldman Sachs.

1511
01:15:16,760 --> 01:15:19,370
So the idea behind
the current proposal

1512
01:15:19,370 --> 01:15:21,920
is that there will be
additional protections

1513
01:15:21,920 --> 01:15:23,480
to allow the
government to benefit

1514
01:15:23,480 --> 01:15:25,490
from the upside of
these securities,

1515
01:15:25,490 --> 01:15:28,012
and to be able to get the
expertise needed to price them.

1516
01:15:28,012 --> 01:15:30,470
And there are other protections
that would require industry

1517
01:15:30,470 --> 01:15:33,980
to pay up for additional
insurance on these portfolios,

1518
01:15:33,980 --> 01:15:36,140
and ultimately to
allow legislation

1519
01:15:36,140 --> 01:15:39,650
to recoup some of the losses,
if at the end of 5 or 10 years

1520
01:15:39,650 --> 01:15:41,420
the government ends
up losing money

1521
01:15:41,420 --> 01:15:44,300
on these kind of transactions.

1522
01:15:44,300 --> 01:15:46,860
Let me stop here, and
we'll see you on Wednesday.

1523
01:15:46,860 --> 01:15:50,170
We'll talk about common stock.