 The Financial Crisis. What Happened and Why? Lecture 3 Alright, let's get started. I want to start off by, we ended last time talking about FETI and Fannie and about their growing role in the housing market and about the accounting problems they had and the kind of the political backing they got. I just thought I'd read you a quote from Bonnie Frank from 2003 to give you a sense of what was going on. This is Bonnie. Fannie Mae and Fannie Mac have played a very useful role in helping make housing more affordable. Critics exaggerate a threat of safety and conjure up the possibility of serious financial losses to the Treasury which I do not see. And he goes on to say, I would like to get Fannie and Fannie more deeply into helping low income housing and possibly moving into something that is more explicitly a subsidy. I want to roll the dice a little more in this situation towards subsidized housing. So Bonnie rolled the dice. He used Fannie and Fannie to roll the dice and we are paying the price, at least partially for that rolling of the dice. You can see here that Fannie and Fannie initiated this idea of buying up mortgages. This was something that they really started after the Great Depression. It's something that grew over time and really as they became private in the 60s, this whole idea grew dramatically of buying up mortgages. And you can see that in 1980, 84.5% of all mortgages in the United States were kept by the banks. They held onto them so they had a clear interest in making sure that these mortgages paid back because they were the beneficiaries directly. By 2008, second quarter of 2008, 59% of all mortgages are already being sold. They are being shifted to the Fannie's, the Fannie's, but also to the investment banks. The investment banks are now competing openly with Fannie and Fannie and we'll see what they do with the securities in a little while. We'll see what they do once they buy these mortgages and why they're buying them. But there's a whole industry now dedicated to buying these mortgages and that includes the subprime. These are subprime. These are the really risky mortgages and this is a number of them that are securitized. Again, we'll talk about what securitized is, but the idea is they're being barred by others so the bank itself is not holding on to them and you can see the sharp increase into the mid-2000s, even as late as the middle of 2008. A huge number, a huge percentage of all subprime mortgages are being bought by Wall Street and by Fannie and Fannie and then securitized. This is the amount of money people are taking out of their homes. Probably should have showed it to you earlier. This is the amount of money people are taking out of their homes in home equity. This is cashing out of home equity during this period. Just look again at what happens starting in 2003 and then certainly in 2005 and 2006 and 2007. This is where a lot of that consumption comes from. This is what I was talking about in terms of people using their home basically as an ATM machine to generate this. One other element of Fannie and Fannie, which is really crucial, we talked about leverage last time. We talked about the fact that as you become more and more leverage, you become what? More and more leverage means what? More risk because you've got more debt, more and more debt, which makes you more vulnerable. You've got less equity and you gave the example of the house. If you put down $3,000 for $100,000 house, then all that has to happen is the house has to drop by $3,000 in value and you're wiped out and you still owe the $97,000. But if you put down $50,000 and $100,000 house, the $3,000 drop in the value of the house is no big deal. You've lost 6%, but it's not a huge loss. You can still survive. You only owe $50,000 in the house. You still have $47,000 worth of equity in the house. A leverage makes things much more risky, but of course, much more profitable on the upside, right? Because if you make $10,000 in the house, you took $3,000 invested. That's the $3,000 of equity you have in the house and you've tripled it, more than tripled it. If you have $50,000 in the house, the $10,000 increases 20%. That's nice, but that's not tripling your money. So leverage dramatically increases risk and increases return if things go well. Now, leverage is used very creatively in financial markets and some really, really aggressive players like hedge funds get to the point where they have 30 times more debt than equity. That's huge, right? So 30 times for every dollar of equity they have, they have $30 of debt, okay? That's hugely risky, right? And they manage that risk. They take positions where they can manage that risk. They can do so in financial markets. So they're very, very sophisticated investors who know what they're doing, at least. Most of them do and at least most of them think they do. Some of them discover later on that they don't. And then they get wiped out and they go out of business. And a hedge fund business is a pretty volatile business. Long-term capital, remember long-term capital? Long-term capital was a hedge fund that when basically bankrupted in 1998 was bailed out by the banks under the guidance of the Federal Reserve. Long-term capital was leveraged 90 to 1. I mean, unbelievable. $90 of debt for every $1 of equity. And something crazy happened to the world and they lost enough to really get wiped out, but it doesn't take much to get wiped out when you're 90 to 1. And these were really smart investors. Yeah? Sometimes it's a limited 12 to 1 after the big crash factor. 12 to 1 is the limit that commercial banks have. Long-term capital is a hedge fund. It's not regulated. It's not limited. The market limits it. The market should limit it. But of course, when these things keep getting bailed out, it's hard for the market to have much discipline. But no, there's no regulatory limit on hedge funds. And again, most hedge funds can handle it. They deal with it. They've got very sophisticated methodologies and long-term capital certainly thought they could deal with it. They had two Nobel Prize, a lot of it's in economics, on their board of directors and they had all the mathematical models and they thought they could deal with it. Okay, so long-term capital, 90 to 1. Fannie Mae, 244 to 1. 244 to 1. So the riskiest hedge funds that we know of, the one that took on the most leverage ever that I know of was 90 to 1 and that was long-term capital. Gamma-sponsored entity, guaranteed by the US Treasury, regulated like crazy by all kinds of government regulators. 244 to 1, the more conservative. Freddie was only 167 to 1. I mean, this is the kind of nuttiness that you get when the government interferes in markets. And people were throwing money at these entities, right? They were throwing money at them. Why? Because it was guaranteed. They believed it was guaranteed. It was like deposit insurance. Are those ratios today or before the government? Those ratios, let's see. Green is Q2 of 2008. 2006, Fannie was 58 to 1 and Freddie was something around the same, in the 50s to 1. Yes, repeat the question. Okay, so the question was, were those ratios today? Were those ratios as of the beginning of 2008? Okay, yeah. Go back to the securitization. No. In a free market, wouldn't securitize? I haven't gotten to securitization. Let me get to securitization, then you can deal with securitization. The ratio in and of itself is scary, but isn't the underlying equity also less secure by the nature of what it's a factor to? Yes, I mean the backing mortgages, and we know what happened to the mortgages, right? And of course, what happened to the equity of Freddie and Fannie? It got wiped out. It got wiped out, went to zero. The equity got wiped out in Freddie and Fannie because the government took them over. Wiped out the equity, wiped out what's called the preferred shares, which a lot of banks around the country actually held, which hurt, one of the things that really hurt the banking industry was when the government wiped out the preferred shares that banks were holding, they viewed a secured capital because they believed the government would never let that Freddie and Fannie go bust. But they lost a lot of community banks, smaller banks around the country lost a huge amount of their capital when those shares were wiped out. And all the government paid out, all the government secured really, were the debt holders. And the debt holders were pension plans, insurance companies, and a lot of Chinese and Japanese and foreigners who had bought this like they would buy government treasuries because they viewed them as equally secure. Just here there was a slightly higher return because remember the guarantee was implicit, not explicit, right? Everybody assumed the government would bail all the debt holders out, but it wasn't 100% so there was a slightly higher return that they got on Freddie and Fannie. So that's Freddie and Fannie Mac. You can see the kind of risks they took, the kind of political incentive they had, you know, the number, the amount of mortgages they were taking on. And we'll see the private markets participated in this as well to a large extent because Freddie and Fannie created this market and facilitated this market. You know, a high would have evolved without them is really hard to tell. But that's not the whole story, of course. The government intervened in housing in many different ways. Freddie and Fannie was just one of them. We've talked about the mortgage insurance last time. But there's also, and you hear about this a lot, the Community Reinvestment Act. That Community Reinvestment Act was passed originally in 1977 by the Carter administration with the idea that banks were redlining. That is, banks were saying the certain ethnic groups that we don't want to lend to, the certain neighborhoods we don't want to go into. But for Congress thought that it would step in and force them to lend into those neighborhoods. And each bank would get a rating by the regulator in terms of whether it's satisfied a requirement of a certain percentage being lent to, you know, particular ethnic groups, particular neighborhoods, low-income people. Now, originally, this thing didn't have much teeth and it wasn't a big deal and the banks found ways around it. They found out maybe branches in some areas they wouldn't have otherwise. They made a few loans they wouldn't have otherwise. But generally, it wasn't followed much. People didn't pay much attention to that. That started a change in the 1990s. In 1989, they made the CRA rating, the Community Reinvestment Act's rating public so everybody could see it. It was required that banks, you know, let in part of their public disclosures, let everybody know what it is. But really, the big change was in 1995 under Clinton when they gave the bill some teeth. Basically, the regulators were now required to take into account a bank's CRA rating whenever a merger was being considered. So they would not approve a merger if either the buyer or the seller didn't have an adequate CRA rating. And this is 1995, probably among the most intense merger activity among banks in American history. In 1994, there was a bill passed that allowed for the first time in American history interstate banking. You could, for the first time, open a branch or buy banks anywhere in the country except the one state that opted out of this bill was Texas. Which today is under the bill but it got a certain extension. It's typical of Texans. They wanted, Texans want Texas banks owned by Texans. We don't want to, you know, they don't want to have foreigners owning their banks. Having lived in Texas, that's really their attitude. So banks are consolidating a crazy through the 90s. Suddenly, a bank has to face this barrier of the CRA rating and there's a group out there, there's community, leftist community group out there that Glenn Beck makes a big deal out of and has done a number of shows on them called Acorn. And Acorn's whole stick during the 90s was stopping bank mergers and squeezing the banks for everything they could in order to withdraw their objection to the merger. And the whole objection, the basis of the objective, they would dig up statistics to show that the bank wasn't doing enough community reinvestment stuff. And this was going on throughout the 80s and Acorn made hundreds of millions of dollars because they cut deals with the banks where the banks would pay them off or the banks would set up a fund that the bank and Acorn managed together to distribute mortgages and loans in low income neighborhoods. And there was a whole array of programs. They set up in order not to face this obstruction in order not to face the slowdown. Fleet, you remember Fleet Bank here in Boston in Massachusetts, I think Bank of America bought Fleet. And when Bank of America bought Fleet, that merger was slowed down because of CRA and they had to cut a deal. They had to cut a deal with the regulators, they had to cut a deal with Acorn in order to get that deal approved around this community, around allocating more funds in the new mojo bank for low income lending, for lending in certain neighborhoods. And this accelerated during the 90s and banks turned it into just part of the business. You put certain money aside for those kind of neighborhoods. And I think again that did CRA play a huge role in this? No, we talked about the things that I think played a huge role in it. But just at the margin, it put more money at play in those neighborhoods where people could not afford to pay back their mortgages. It put more into subprime, it put more into what's called LTA mortgages, the non-prime mortgages. Just at the margin, there's more of it. So when the crash happens, it's more dramatic. Now, a lot of people say, well, CRA only affects banks. And yet, a lot of the mortgages that were issued, particularly subprime mortgages, were not done by banks. They were not done by mortgage brokers who don't fall under CRA. And that is true. But that doesn't mean they weren't regulated and that doesn't mean they weren't political pressure on them to do CRA type lending. And indeed, there was. And starting in 1993, HUD, the Housing and Open Development Department, began bringing legal action to mortgage bankers who were found to have too little, you know, minority lending. So if your portfolio was composed primarily of white people and mortgages, you know, issued to whites, you were sued under a variety of civil rights laws for discrimination. Now, again, it depended on where you were. Of course, the population was all 100% white in your area. That was one thing. But if you were in a more mixed area, you were sued under civil rights legislation. So there was intensifying pressure throughout the 1990s on everyone in this business to deal with lower-income populations. This came from Congress, but it also came from the White House. I mean, George Bush in 1903... 1903. I told you this conference. It's about the right time for it to end. 2003 went to Atlanta. And a big, you made a major speech in Atlanta about housing policy and about the importance of housing to values and to the ownership society. And therefore, how important it was for minorities to own homes. And while whites had already achieved about 70% home ownership rates, blacks and Latinos were lagging, and how his administration was dedicated to achieving home ownership among minorities. And therefore, you know, there's a lot of use of the bully pulpit, if you will, to try to get people to lend into those neighborhoods, to encourage people. And they even said, look, if the lending standards are what's holding this back, things like documenting income and things like, you know, any other things like whether you have 20% to put down. If those are barriers, then we need to loosen those barriers. We need to loosen those constraints. Those are unjust constraints. And if somebody can afford a mortgage, why bother with income verification? I don't know what afford a mortgage means if you can't verify income. If somebody can afford the monthly payments, why worry about a down payment? You know, not understanding the whole impact leverage has. And you could see after this rhetoric how across the entire spectrum of entities, from banks to mortgage brokers, and of course guided by FHA and by Freddie Mac and Freddie May, how the standards start getting looser and looser. The requirements for documentations get looser and looser. And again, Bonnie Frank and all these guys, they're encouraging this. They're preaching it. They're telling the bankers to do this. And they're promising to go after them if they don't. How the standards documentation gets looser down payments. You get mortgages where there's no down payment or there's three and a half percent. Some of them can get insurance from the government. So more and more money flows into these risky sectors. Into people who can't afford them and more and more into the hands of speculators. Like as I told you last time, the woman will cut my hair. Okay, so what have we seen so far? We've seen, we've talked about the importance of interest rates. We've talked about how interest rates, this crucial price in the economy that coordinates almost everything that happens. All investment decisions, saving decisions and consumption decisions are based on interest rates. And we talked about the fact that when the Fed sets the interest rate, the very existence of the Fed causes that interest rate to be an artificial interest rate. Not to reflect the true preferences of the investing, saving, consuming consumers out there in the public. In the economy. And that that creates an illusion because there's a price but that price is not being dictated by supply and demand. That price is being dictated by Alan Greenspan or Ben Anki, by Fiat, by some random rule of thumb that they happen to have. And that that price now distorts all investment and consumption choices that people have. And I want to emphasize that is really at the core. That is the fundamental problem here. Those low interest rates. Early in starting in 2001 really hitting bottom in 2003 staying at the bottom in 2004. That is the real cause of the problem here. All the distortions. Everything that's happened since then. The primary cause of that is are the distortions created by a wrong industry. And we know it's wrong in this case. We know it's too low because as we said we don't know what the real interest rate is because we don't have supply and demand. We don't have an alternative universe where people are freed actually in loadable funds. All we have is this false price but we know in this case that it was too low because of what? It was a negative real rate of return. It was a negative real interest rate. It was below the rate of inflation which is just crazy. Which would never happen in a free market. So we know it was too low and we know in part when interest rates are too low you get lots of consumption and you get long term investment and we saw that both in the internet bubble and we saw it in the housing bubble. We also see that part of the reason it went into housing is not just because low interest rates, mortgages, variable rate mortgages, all of that you know encourages that kind of debt taking out that kind of debt particularly the existence of adjustable rate mortgages but also government policy. Government policy during the late 90s was pushing people into housing. Low income housing was pushing people to you know the banks and the financial institutions to make housing a big deal and again the bubble piggybacked off of that trend that was already happening. We saw tax policy geared towards more housing and of course Freddie and Fannie Community Reinvestment Act risk is going up and this interest rate environment piggybacks off of that and really blows this up. Could you at some appropriate time sort of delineate the difference between what might be called progressive economists say like Truman and your views I'm sure that everybody would agree on the facts, the historical facts but somehow they reached a different solution. I don't have time unfortunately to go into you know the nonsense that is Keynesian economics and I think it's a compliment called Krugman an economist. So the question is can I go into can I go into kind of what would the opposition say what would Krugman say to what I'm arguing and just don't have time to do that Keynesian economics is pretty complex but the bottom line let me tell you though what Milton Friedman would say or what a monetist would say because I think that's more interesting and I think that's where we are different than a Milton Friedman and I think I mentioned this Milton Friedman would say that when you increase the money supply that money very quickly goes into the economy spreads throughout and causes a rise in prices. Okay? So if you increase the money supply at a greater pace than the number of goods being created than productivity something like that then what happens is you get price inflation and we saw that in the 70s right in the 70s we also have these negative interest rates and prices went up that's how it manifested itself what the Austrians say is that certainly can happen but that's not necessarily the way it happens that is that when when money supply is increased it doesn't necessarily spread in a sense evenly through the economy sometimes it goes into a particular industry or a particular area in a more intense way and indeed when interest rates are very low they have this idea that it goes into consumption and it's a long-term investment first and that it can take a long time years for the inflation in those two areas in consumption and a long-term investment to manifest in higher price inflation and that's why it's so deceptive to the market and to the Fed because the Fed targets price inflation yet so they increase the money supply no price inflation they increase it more no price inflation and the bubble that's happening over here whether it's in dot-coms or whether it's in housing doesn't play into the equation at all because A the danger of course is that the Fed now takes into account bubbles but then they have to start defining when a bubble is a bubble and they have no clue how to define when a bubble is a bubble so the monitors believe that I mean Keynes believes just briefly that the essence of an economy is consumption that what happens under capitalism is you get overproduction you get too much stuff and people don't want the stuff and the way and therefore that's when you have a recession there's stuff that people don't want to buy so the way you get out of a recession you stimulate demand aggregate demand you stimulate them people to buy this is a very simplistic Keynesian view right or my view of Keynesian and they go in and you know you give them money you lower interest rates really really low yes that's supposed consumption but that's a good thing because without it the economy wouldn't function so he views a lot of these facts as positives you know we want to get people to buy homes we want to increase spending we want people to consume okay and that the problem is the government doesn't do enough of that you know the Kugman now is attacking has been attacking Obama for the last few months for the stimulus package being too small right he believes that we got out of the great depression in World War II when we massively spent a huge percentage of GDP on a stimulus package and that with a problem with FDR the reason FDR nothing he did worked is because it was too small he was too he was naive and he was too too much of a fee marketer he didn't go all out didn't take Keynes seriously enough yeah the Fed artificially sets interest rates based on fiat or whatever whatever models they use how much is there rational hedge of sorts that are market driven would be the currency trade how where does rationality come around so if the Fed sets interest rates can the markets adjust to that that is to what extent can the markets take into account the fact that the Fed is setting them wrong and adjust to it and counteract it which is really the school that comes out of Friedman it's called rational expectations would say it doesn't matter what the Fed does we're all smart the markets are really really smart and what they'll do is they'll neutralize it through their impact on financial markets they'll raise long-term rates or they'll do something else and I used to believe that and I don't anymore and I think once you understand the complexity or the destructive nature of what the Fed does I think you realize that there is no way to neutralize it that is yes if the Fed lowers interest rates to 1% and I know that the real rate should be 4 maybe I can do something but I don't know what the real rate should be it's like if Gammon imposed a price control tomorrow on bread and they said all bread should sell for $1 right and there are droughts and there's rainy seasons and there's all you know logistical issues and stuff and we don't know what the real price of I mean we can look at history but of course we don't have a history with no Fed anymore we don't know what the real price of bread should be given supply and demand it's $1 it's easy but it's a very easy price it's easy to set it's easy to figure out supply and demand relative to interest rates interest rates are really complex price so we have no idea what it would be without the Fed reserve so that's problem one problem number two is most rational expectations thinkers agree with that is they believe that when the money supply increases it manifests itself in inflation but the fact that you're against that is by demanding a higher return on long term bonds because the idea is that over the long term you need greater competition because of this inflation and because long term bonds become much more expensive the short term that offsets some of what's going on with mortgages but the fact is that price inflation doesn't go up so you'd be stupid to price it up I mean if you could there are plenty of people pricing it down because they look and they say look in the Greenspan era there was no inflation so he knows what he's doing so and the third part is the markets would have to have deep deep knowledge of economics which I don't think they do I don't think they do to figure out the outcome of what particular government policy is going to be able to trade on it requires real understanding of what are the consequence of that outcome is and I believe nobody knows even the best economist in the world can say all he can say sitting Q1 2003 can say this is bad interest rates are 1% something bad is going to happen it could be price inflation it could be a bubble I don't know where the bubble is going to be but it could be a bubble those are the two things that are likely to happen but where is it going to happen what's going to happen I talked a little bit about this how do you tell when the bubble you are because you could short when if you notice that it's housing you could go in and sell houses you could go in and short stocks of home builders you can go in and but that is incredibly risky because what if you're at the middle of the bubble or three quarters of a bubble so these are really difficult things to fix through market processes I think I told the other class did I give you the example out of the internet bubble of shorting a bank here we made $200,000 in a short position and we lost a million bucks on it because in a period of two days people decided it was worth five times because they were in the midst of the hysteria so while we were right long term you have to be willing to suffer real real short term pain and that is very difficult and again there's so much arbitrariness and we'll talk about we'll end with a bigger discussion of government and what it really does so let's let's move on I want to talk about securitization because what happens so we've got all this government policy but why won't the markets better let's put it that way they couldn't fix it why weren't they better at controlling this because you know we've heard about the securitization market and how so many of these investment banks lost so much money I mean these are smart people why did they lose so much money why couldn't they get it so let's look first at what they did so this is some of the the collapse but let's start with these you know the variety of different ways to measure leverage but just to give you a sense of leverage again Feddy was 68 the bulkage houses were around 30 to 1 which is interesting because the bulkage houses in Wall Street were close in terms of leverage to hedge funds and it's really interesting how the bulkage business the investment banking business became sometime in the 2000s shifted their model their business model they never used to be hedge funds they used to make money mostly on transactions on buying and selling cutting deals and suddenly they started making money off of leverage and off of trading off of taking positions in the market off of actual trying to make money on their own capital actual become hedge funds you know most of these a big chunk of their business is just running a hedge fund which is their own capital so we'll talk a little bit about that happened I've got a theory which is not I don't know if I got enough evidence to conclude that this is this is actually what happened but my estimate my guess right now is that Spitzer is actually responsible for that that when Spitzer went after the investment banks in 2002-2003 after the dot com bubble collapsed Spitzer was the attorney general of New York and he decided that the investment banks were responsible for the internet bubble in some way they were giving advice and issuing stock and there were conflicts of interest and was researching that whole business model he did not like and he sued a bunch of these investment banks and they never went to court but what they agreed to was they paid him a huge amount of money A. that depleted capital that reduced the amount of capital all these banks had which meant that it was harder for them to make money they became more leveraged because they gave out a chunk of equity a chunk of capital but second they needed a new business model and the deal was that they had a separate research from underwriting they had to do all these changes to their business model that had worked for them for 150 years something like that and suddenly that business model was not acceptable to the justice department and to you know Elliott Spitzer and they went out and they you know I don't have any evidence that they actually did this but my guess is they sat down and said okay how do we make money the way we used to make money is not working you know and you can add Sarbanes oxy to this because American companies started going public and you know the underwriting fees were gone and there's a whole change in the environment in which and I think they chose in some way whether it was explicit or implicitly to become more like hedge funds and away from what they traditionally were as investment banks yeah in the back so yeah so was there not a trend towards ETFs and away from paying fees I think most of the fees the investment bank has made and again this is not any of my expertise was not from individuals trading but it was from deals M&A deals underwriting things like that that had disappeared but for other reasons yeah Adam banks were doing hedge funds became a much larger percentage of that so that banks were making their traditional trading fees off of the hedge funds and were setting up hedge funds within their own shop within a shop that led to the same people saying haha yeah so they were dealing primarily with hedge funds in this trading volume and they were saying wait a minute why why these guys are not any smarter than us indeed most of them are former us right they're us five years so now we're not just through it in-house and some of them set up their own hedge funds but more than just setting up their own hedge funds they started behaving like hedge funds and I think they started taking on risk leverage and a lot of the characteristics of hedge funds and you can see commercial banks are about 10 to 1 which is where the regulators allow them to be and that's where they are and these are the pure smaller commercial banks credit unions, saving and loans they're all regulated about the same and all are going to be at about 10 to 1 ok now even 10 to 1 as we talked about when we talked about factional reserve, no banking is nuts no way in a free market would you get a depository institution an institution that takes in deposits and checking accounts having a debt to equity ratio of 10 to 1 you know that would be incredibly risky and therefore depositors would have had a huge interest rate but deposit insurance wipes that market discipline out ok so let's talk about securitization so if any buy these mortgages, Goldman Sachs you know JP Morgan they buy these mortgages, what do they do with these mortgages well they don't actually sell the mortgage themselves what they do is they create a pool of these mortgages and then they slice it up and in this graph they have 5 slices it's what they do is say look we're going to take we're going to sell you a security, not a mortgage but a security and the first dollar that comes when these mortgages are paid they're paying interest people are paying off, people are paying their mortgages they're paying interest plus principal every month into this pool the first dollar that comes into this pool you get and you get all the money that comes into the pool until you are fully satisfied let's say your return is 5% until 5% of the dollars come in to satisfy 5% return you get it then they sell the next layer and the next layer gets the next dollar that comes in until they're satisfied and then the next one gets and you can see the 5 tranches, the bottom tranche was called an equity tranche and it was the riskiest one because it got the last dollar everybody else had to be satisfied before the equity tranche got any money ok so you got a security that said you will get x% a month so however they were structured right up until and you had this kind of preference you would get the first dollars into this pool or the second dollars into this pool or the third bunch of dollars these were then rated the first dollar is the least riski because somebody is going to pay their mortgage it's not 100% going to go bust somebody is going to pay their mortgage and you're going to get the money from that mortgage no matter who it is in the pool it could be the subprime really really safe one it could be anybody in that pool of mortgages the pool would have all kinds of mortgages the first dollar paid in you got and then the second one was pretty safe because you're getting the second mortgage and again the real risk supposedly was being held at the bottom because let's say if 10% foreclosed if 10% stop paying these guys would still get everything they'd get everything it's just the bottom of their money and this was a way to take a basket of mortgages some of them prime some of them subprime some of them all in the middle of a whole variety and splice up the cash flows from those mortgages for a variety of different investments and adjusted for risk and you know this is a reasonable way to allocate risk to allocate cash flows there's nothing wrong with a structure like this now and then you could take these securities that you got let's say you got the top tranches AAA and you could take those securities and then let's say this was the Goldman Sachs and they went to Joe P. Morgan and bought a security from them and then from somebody else and you could create another basket not a mortgages but of these securities and you could do the same thing to that you could tranche that into different levels of cash flow and you know and those would be called CDOs collateralized data obligations and you could you know and you could then the CDOs could get tranched and then you could do there's something called CDO squared it gets pretty complicated and then the math gets pretty complicated just to track these things but the idea is pretty simple right you take a basket of a wide variety of mortgages and you split it up and you can allocate different risks and again you know the first layer as long as most people are paying their mortgages you'll find even if a minority of people are only paying their mortgages you'll probably find so this people can choose their risk if you want single A single A is more risky than triple A you can get that if you want the real risky stuff which is the equity you can hold that the banks typically the people who did the securities typically held the equity themselves okay so this is just a financial way of allocating risk and allocating cash flows to a variety of different entities now who would buy some of these tranches well the buyers were typically pension plans, insurance companies, institutional investors out there and those institutional investors particularly those that were buying kind of the triple A and the higher rated ones are heavily regulated pension plans are heavily regulated can only buy certain types of securities and they have to have those securities rated by specific rating agencies and we'll get the rating agencies in a minute but they have to so they can buy triple A securities they can buy the equity portion the regulatory prohibitive from doing that and they can only buy securities that are rated by the rating agencies they're not allowed to buy these securities they want out there it has to be rated by specific rating agencies okay so a lot of these securities are now being held by pension plans, by others there's also European banks bought these a lot of the problems we're seeing in European banks is because they held a lot of these securities and you can see what happens when the foreclosures happen and home prices go down and the riskiness of all this changes suddenly the A and AA might not get the money because money's not, people are not paying the mortgages anymore, things are looked safe or not safe anymore but one of the ways in which one of the ways you could take something that was more risky not a triple A and turn it into in a sense a triple A was to buy insurance on it so let's say you're a pension and you've got some securities that are not the highest rated securities how do you get them to be safer well one way to get a risky asset to be safest is to buy insurance so if these assets fail you get the money back right, the difference between what you collect when they go bankrupt and what you would have collected if they hadn't gone bankrupt and that insurance again, to simplify that insurance policy is a CDS it's a credit default swap put aside the language and this is insurance on the default just in case the bond default and you had credit default swaps on these CDOs on these pools, what happens if these pools can't pay out now why did people want this insurance why did we have these insurance policies, well because again insurance companies, pension plans others wanted to be able to buy these securities but they needed cover, they needed to be able to treat them as if they were triple A securities when they were not for regulatory reasons, buying insurance created that you also had situations in which banks who held these CDOs they had a whole lot of reserves for them because they were risky remember the fractional reserve stuff different accounts different types of assets are going to require more reserve or less reserve depending on how risky they are one way to be able to free up capital to make other investments was to lower the risk of these CDOs and you lower the risk by buying insurance okay now again credit default swaps there's nothing wrong with credit default swaps it's an insurance policy now there might be a case to be made and I don't know the details again of this that in a completely free market you would just buy insurance and there'd be insurance products and this is kind of a way to get around certain regulations that prohibit buying insurance directly but it's basically a form of insurance that the financial markets were providing yeah maybe a few different insurance segments here it sounds like insurance companies are essentially triple risk assigned you've got mortgage insurance that's out there you've got bond insurance that's out there and in some cases the insurance companies are also purchasing some of these securities doesn't that mean that essentially if it's the same companies or related companies that they're tripling their risks yeah I mean it's going to be different companies and it's again the CDSs are not being issued aren't they tripling their risks there's mortgage insurance, there's bond insurance there's now this derivative form of insurance if the same company holds all three of them aren't they tripling their risks I think that these are different entities primarily now the derivative is something that is tradable so what happens with a credit default swap I basically say I'll make up the difference between what happens between bankruptcy and between what you would have got and you pay me a payment now anybody can issue that it doesn't have to be an insurance company and indeed most of the most of the issues, AIG happened to do it but not as part of its insurance company role it really did it out of its financial arm which was more of an investment bank than it was an insurance company the insurance companies which are heavily regulated by the states had no CDSs they all held at the holding company level which was not regulated as an insurance company and Lehman held CDSs and Goldman had CDSs and then the other thing you could do with the CDS with this type of insurance is I could say imagine it's life insurance you buy life insurance if I die I get a certain payment and in the meantime I make payments but imagine that I could then go out and say I want to buy life insurance in Evan's life if he dies I get paid right I don't I have no let's say interest in Evan's life one way or another but if he dies I get paid well you could do that with the bonds if bond A if this particular CDO is going to default I get paid and that's why people talked about this notional value being tens of trillions because there was a lot of speculation to speculate on the fate of companies so for example there was a lot of trading the CDSs market the insurance market predicted Lehman's going bankrupt well before anybody else suspected it would happen because people were buying policies on Lehman and what would happen to the price of those policies as people were buying more of them and therefore the market estimate of Lehman's bankruptcy is going up what's going to happen to the price when more expensive say originally to bet on Lehman dying cost me a million dollars then sooner went up to ten million dollars and that price said the market expects Lehman to go bankrupt it wasn't a short sellers although they were participating in shorting Lehman stock selling Lehman stock but it was in the insurance market it was like we all know something about Evan don't take this personal we know he's sick he doesn't know he's sick and we all start buying insurance policies on him and if we have that ability to have information about Evan that he doesn't have then people could look and say yeah Evan's in real trouble because all these people believe he's going to die we know there's a hit so that's the kind of what's going on and that's why this market could be huge well bigger than the actual bonds that were being insured because you could insure a bond you didn't know because the way you bet on Lehman dying was not betting on Lehman dying you were betting on a default of Lehman's bonds now usually you would do that to protect your the bond of Lehman's that you held but now you could do it without even holding the bond and that's why it was such a huge market and again there's nothing necessarily wrong with that that's a way to make money and it's a way information was conveyed to the market for example about Lehman's bankruptcy the market understood what was going on with Lehman well before and with AEG well before regulators did well before even management at Lehman did I mean it's often the case that management has its head stuck in the sand particularly as we'll see in a minute when they believe they're going to get bailed out and they're not going to get bankrupt anyway okay so this is all pretty complicated right I mean there's a lot going on here we've already talked about interest rates FETI, FANI, CRA all that stuff and then we add onto that these securitizations and collateral debt obligations and credit default swaps and so given all this complexity you know why didn't the market see it coming why were people buying these securities why were the prices of CDS not much higher you know three years ago why didn't everybody behave more you know from our perspective today looking back more rationally why is it that so many really really smart people were duped or were they just as most critics say they were just greedy they could flip these mortgages around very quickly they could mark a lot of money I mean these guys have securitized it then pushed it out to other investors by trunching it they didn't hold the default risk anymore they didn't care what happened to mortgages of course it turns out that they did because they turned out to hold a lot of this stuff and buy other investment banks stuff why was Wall Street bamboozled you know again these are really really smart people and why did they take on so much risk I mean we're not talking about one investment bank getting into trouble or two investment banks getting into trouble we're talking about the entire industry getting into trouble we came very close to Wall Street being wiped out it is wiped out in the sense that the existing investment banks have now become commercial banks why to gain the protection of you know the government right because commercial banks were being bailed out see become a commercial bank in a sense in the hope of being bailed out right and it's not just the investment bank it's the larger commercial banks got into it I mean the whole way of the Wall Street or the financial industry got into this and got into these securities and blew up and how can we explain it and you know this is what Greenspan said the bottom line is this is where it failed you know I thought that people would watch out for themselves by watching out for themselves they wouldn't take on this kind of risk they wouldn't do these really silly things and therefore this would be the correction the corrective mechanism now as you start peeling away what was going on you know and surprisingly you start finding government almost everywhere so let's start with these ratings these ratings of all these different things with all these different entities turned out to be all wrong they turned to be all wrong and the question is why why were the ratings wrong again capitalism right rating agencies are crucial for capitalism well a couple of things it turns out that if you look at the history pre the 1970s the rating agencies and the three of them today S&P, Moody's and Fitch were pretty small entities and pretty unimportant and nobody paid any attention to their ratings people do their own research it would be nice to have that research collaborated by a rating agency but it wasn't crucial to the markets people weren't buying, selling trading based on rating agencies that however in the 1970s as the major investors in the markets grew and it was clear that those major investors were all what we consider public entities they were pension plans private and public pension plans they were insurance companies they were these they were mutual funds they were these very large entities that very quickly became the dominant investors the dominant participants in the markets and the government said look we need to watch out for these guys we need to watch out for these entities we don't want pension plans to fail we don't want insurance companies to fail so what we're going to do is we're going to set some standards by which they invest and we're going to acquire them not to take on too much risk and this is part of ERISA those of you who know ERISA the whole pension structure and they set up certain criteria but they said well how do we monitor this well we're going to grant these rating agencies these three rating agencies the ability to rate securities and then they were going to acquire the pension plans and others to only buy securities that are rated and that will make it possible for us to assess the riskiness of their investment and we're going to actually tell them how many what AAA investments they can make and you know proportion of risk that they can take and so on but it has to be one of these three because we're going to certify these three as government certified so if I'm a pension plan and there's some other private rating agency over here that says no this is really safe but Moody, S&P and Fridge have an authorize that I can't touch it I have to follow the rating agencies that the SEC has approved the government basically created as a monopoly a monopoly of three but it's still a monopoly there's no competition they're all government certified they're all paid by the people that they're rating which in a market you know wouldn't tolerate I don't believe so there's a huge conflict of interest but nobody can compete them out of business because the SEC has only approved three so you've got a better system of rating you've got a different business model tough nobody cares, nobody's interested so surprise surprise the rating agencies don't do a good job they have no incentive no competition and this isn't the first time the rating agency screwed up they had Orange County where I live Orange County went bankrupt I think it was in 94 and they were triple A before they went bankrupt and Ron was triple A just weeks before he went bankrupt so the rating agencies have not been great for a long time people knew that and hedge funds don't use rating agencies because they don't need to the regulators don't force them to so they don't use them they don't pay attention to them and the hedge fund business has come out of this you know a lot of people lost a lot of money but relatively healthy out of this you know the average the average return for hedge fund in 2008 was negative 18% which is pretty bad but we consider what the S&P and the Dow did during 2008 it's really good and a lot of hedge funds actually had positive rates of return so the rating agencies played a huge role here in rating these securities a lot safer than they really were and that had a lot to do with their protected status now what else does protection provide you what else happens when you have protected status you're much more impacted by government influence so imagine if the rating agencies in 2004 said you know what all this mortgage stuff is way way riskier than it should be we're going to downgrade everything can you imagine what Bonnie Frank would have done you're destroying home ownership in America you're racist you're destroying the ability to put on homes there was enormous political pressure on them to keep this game going and as long as people were willing to buy because they because they trusted the rating agencies because they had to they had no choice this market kept going so the rating agencies are not an example of capitalism heavily regulated controlled only three of them now there's another element to add to this in terms of the rating and this is the kind of models they were using and this is true of the investment bank as well to a large extent one of the things that is true in math is that it's very easy for us to deal with normal distributions a lot of models that rating agencies investment bank has used our statistical based models and statistical based models you can deal with normal distributions normal distributions are pretty, they're easy you can add them up, you can subtract them there's a lot of math you can do with them and they're easy to model but life particularly in the financial markets is not a normal distribution but they're not, they tend to have they look a little normal and then they have what's called fat tails they have high probabilities of outlier events of events way out there happening you know what a normal distribution is it's a bell curve of the probabilities of an event happening an idea is that most events happen in the middle and it tapers out as you get to the more radical events it tapers out well in reality stock prices tend to function well it looks like a bell curve but then the probability of a big either downturn or upturn there's a high probability those things will happen the way they happen there's also a book called an awful book in many respects but also a very clever book in other respects called Black Swan which says there's always a Black Swan Black Swan is a freaky kind of unexpected event but the thing about freaky unexpected events they happen all the time they're just different every time it's a different freaky unexpected event but we don't know how to model that you can't put that into a mathematical formula there's no way to express that easily I mean there are ways but it's very hard to do and the mathematical models that were being used here were primarily models based on these normal distributions and things being normal based on data from history now I showed you the historical data on housing what does it show prices flat to going up never going down or if they go down they go down a little like they did in the early 90s maybe but they recover nothing happens so they're based on everything being normal right they're not based on a bubble they're not based on interest rates below the rate of return for that you have to think economically you have to add something to the model you have to bring knowledge knowledge people didn't have knowledge people didn't know they needed to look for nobody's ever taught them that there's something beyond that the economic principles would play here and numbers were plugged into models and answers came out now I'm not against mathematical models the models are very useful in this context as a first estimate they're great as a second estimate they may be great but then you have to apply judgment you have to evaluate them does this make sense what else do I know about the world reason right rationality has to be applied it's not you know you can't treat these as black boxes now they are black box models black box means you don't you don't evaluate what's going on but not in cases like this for those of you know what I'm talking about because I won't explain you know mathematical models are very useful in arbitrage you can use them to arbitrage and that's how the better mathematical models have evolved as arbitrage models but most models that just predicts into the future like capitalistic pricing model are useless unless a lot of judgment is brought into play judgment wasn't brought into play certainly not at the rating agencies you know I'm sure that some of the hedge funds did and they did better you know some banks evaluated these models better than others and some banks did better than other banks but in general there was a lot of complacency with the mathematical models so we understand what the complacency existed in the rating agencies but why did it exist in the banks and I'd argue that you know partially it's just lack of knowledge partially it's just you know they didn't know and history was the way it was and they just plugged in history and I'd also argue that they were taking on more risk than they should have they probably knew and I think they knew they were taking on a lot of risk you can see it in the leverage ratios they were behaving in a very cavalier way towards risk and I think there are two explanations for this one is what's called too big to fail too big to fail means that the Federal Reserve will not let a big bank fail in the United States the Federal Reserve or the regulatory agencies the government will not let a big financial institution fail this was a doctrine that was really established in the 1980s under Volcker and then under Greenspan the classical case of too big to fail was Continental Little Noi which was at the time the largest bank failure in American history in 1984 which was in Chicago was I think the 8th or 10th largest bank in the US at the time it failed nobody other than the shareholders no debt holders, no depositors nobody lost money in that bank you could have had $100 million under deposit and you were paid in full the government stepped in took over the bank ran it, paid off everybody and ultimately sold what remained and it was understood from that point on that no large financial institution will ever be allowed to fail and nobody really thinks about that you know when you're running a business you don't really think about that you don't sit down and say well I can never fail so this is what I'm going to do but it creeps into the decision making it creeps into your cost of capital it creeps into the amount of risk you're willing to take and it's usually not a big jump oh too big to fail let's get really risky it usually takes years and years and years but you become riskier and riskier and riskier and riskier and while shareholders often get wiped out the debt holders almost never get wiped out the government always bails them out so the debt holders who are supposed to be the ones more sensitive to risk equity shares are always riskier than debt debt has the priority in bankruptcy so debt doesn't like and debt gets no reward for risk if you take on a lot of risk you make a lot of money who gets the profit the equity the people who put up the equity the debt holders always get their return 5%, 10%, that's the coupon they get they get 5% or 10% they don't make anything on the upside on the downside they lose so the debt holders are supposed to be really really sensitive to risk, not sensitive to risk because they're going to get bailed out so it's the way they write the covenants and the bonds which are the legal agreements it's in the interest rates these financial institutions take more and more and more and more and more risk so that's one and that's I think been talked about quite a bit but I think the second which is in a sense of you know bigger than too big to fail and it's called a lot of people have called it the Greenspan put the Greenspan put now what is a put a put is a type of option it's a way you make money on the downside if things go bad you make money on a put and the Greenspan put was viewed as this notion that Alan Greenspan a chairman of the Fed will not let the economy go into a major recession and if the economy never goes into a major recession none of these things that the investment bankers were doing were risky because as long as the economy was growing they'd make money somehow off of them so a depression would never happen a major recession would never happen because Alan would never let it and he was after all God the maestro he conducted the economy this is the champion of capitalism being called a maestro capitalism doesn't have a maestro that's the whole point the pricing system is the maestro of capitalism if you need a metaphor the Greenspan put said it's never going to happen and Greenspan proved that so when banks got into big trouble in the 1980s with Latin America debt what did the Treasury and the Fed do they bailed out Mexico and the idea is not so much because they cared about Mexico but because they wanted to make sure that the Wall Street firms didn't lose money on the debt to Mexico and again created the economy when 1987 and one day went down 25% October 19th I think it was 1987, one day in 25% Greenspan was on the phone immediately I will provide liquidity I will do whatever it takes I'll do whatever it takes so this isn't lasting so this is a one-time thing and indeed the market recovers almost immediately and by the end of the year this is October by the end of the year it's made most of it back earlier than that it's already over we had a session in December 1991 the US was in a recession during the period the American banking industry was in the verge of bankruptcy this time because of commercial real estate literally the FDAC was bankrupt it denied it but it had no money to pay off depositors if more banks had gone in default I remember a nightline show with the head of the FDAC and what was his name the guy who used to run Nightline Ted Carpel and they had Ed Crane who was one of the experts in the SNL crisis, a really good economist and Ed Crane is saying FDAC is bankrupt they have no money if they're more banked defaults they can't pay it out and the guy from the FDAC say oh no, well capitalizes no problem we have lots of money and if you look back they were gone they had negative balances they were already borrowing money from the treasury what did Adam Greenspan do? slashed interest rates the sharpest decline in interest rates in American history happens in early 1992 so that the banking industry is saved and the recession of 92 is a mild recession and you could argue that that slashing of interest rate in 92 and then another slashing of interest rate in 98 are really the origins of the internet bubble and then what happens after the dot-com bubble bursts and 9-11 happens and the US should go into a recession because there was huge misallocation involved in the dot-com bubble and then 9-11 was obviously an economic catastrophe and a realignment of our priorities a realignment of what's important to us a realignment of where we wanted to spend money should have happened what happened? Bush comes out and tells us to go to the mall and shop and Alan Greenspan slashes interest rates so that we don't suffer a recession so the recession was again a mild recession we came out of it the great moderation it was called the new era of moderate economic fluctuations no more volatility no more big recessions no more depressions it couldn't happen now if you believe that and I think people believed it and Greenspan did everything in his power to convince us of the truth of that and he believed it if you read his book he believed in his own greatness power and Bernanke believed it after all had done his research on the great depression he knew how to combat depressions if you believe that what are you going to do you're going to take on more risk you're not going to worry the economy is never going to go into a tailspin things will always straighten out now the Federal Reserve they know what they're doing they'll smooth it out we'll get out of it it always happened before it's going to happen again so if you take too big to fail and if you take the Greenspan put together you get people taking on huge amount of risk and it's just the incentive built into the system why would they do anything else and then if you add the rating agency you can see why the whole system is now perverted and convoluted too much risk that risk is not properly being measured not properly being conveyed and people are behaving in a sense with blindfolds on they don't really see what's in front of them not blindfolds more of a fog a really really thick fog the moral hazard all these bad government interventions that are happening here in the US are a big thing but people talk about I think they call it linkage where they're talking about it it may not be the same in the rest of the world I guess for me I'm not sure how big of a player we are compared to the rest of the world and how much moral hazard is there in the rest of the world so how much moral hazard is in the rest of the world and how big are we relative to the rest of the world in terms of the economic two things because governments mimic the Fed everywhere and you saw that in Great Britain when they nationalized the bank very very quickly when it was in trouble Northern Rock, well before the real magnitude of the problems so they already had that moral hazard monetary policy is very similar if you look at the UK central bank they mimic the federation not quite as dramatically but they mimic and that's why the UK is in more trouble than other places Europe was a little better than the Fed in the UK and Europe, mainland Europe is suffering less mainland European banks are suffering a lot because they had leverage ratios even higher than our leverage ratios they also had too big to fail they also believed in the great moderation and they you know and they were using the same kind of mathematical models and I think there are other structural reasons why in Europe they would take on even more leverage and more risk than they did in the US but what about economic linkage? well I mean think about it we were taking out billions and billions and billions of dollars out of our homes wealth there wasn't really there money that was created out of nothing and what did we do with that money we went to Walmart and we bought Chinese goods what signal did that send to the Chinese? huge demand for consumption goods so the Chinese went on a building spree and American companies went on a building spree in China to build manufacturing plants that provided us with consumer goods the consumer goods we were buying now the fact that that consumption in a sense wasn't real because again we were reacting to false incentives providing us by interest rates perverts the whole structure production in China China probably should have been investing in infrastructure and I'm talking about not roads and stuff I'm talking about industrial infrastructure infrastructure to make long term projects towards long term projects and not in consumption goods and what's happening right now in China is that they have to completely wipe out much of that consumption industry because we're not going to consume it and oriented maybe to consumption in China itself and build the infrastructure to make that consumption possible through increasing production in China and also in China and doing things like that so the linking is through the fact that we're still the largest economy in the world largest financial industry in the world by a long shot everybody's tied to us through our financial institutions and through our financial instruments and everybody's tied to us through consumption we're tied to us through consumption now when we're not consuming the rest of the world is hoarding really really bad anyway if these other countries we structure correctly but know what China's doing China's trying to manipulate that again central planners are coming out with stimulus packages and so on their stimulus package is significantly larger than ours on a relative basis much much larger than ours so they're going to distort their own economy so who knows where they're going to go yes and they're going to have to go on culturally and politically how important do you think what was going on in the equity markets was the professional investors and banks getting away from the P.E. ratio as a measurement starting to trade things on subscribers or part of the actual dynamic culturally and also the fact that I think this is the fact that more and more a percent of investment was coming from quote unquote mainstream and did that have spilled over or cross-contamination if you will into some of these other debt markets within the reserve yes I think all of that is probably true that is to what effect the changes in the way stocks were being traded and the parameters in which they were being traded had an impact but there's a you could do a whole course on how the SEC has destroyed the stock market because one of the things that happens with the SEC is we all think we're investors we all think we know how to trade stocks right because after all there's transparency and we get all the ratios and everything's available and they have to report it they're detecting us from made off and all this stuff is happening so too many people investing too many ignorant people investing and of course the .com bubble which I again blame on interest rates led to this idea of investing based on subscriptions or based on sales or based on anything but profit or anything but actual return I think yes I think the whole mentality of how to trade in the markets is distorted by interest rates and then again interest rates too low provide two incentives the consumption but also the long-term investment and stocks equity clearly reflects the long-term investment so you get a bump up in equity prices as a consequence of money flowing in there because what happens when interest rates are low you do a discount model right stock prices look a lot cheaper than they really are when interest rates are 1% then they would be if interest rates were 5% so that a lot of the increase in market price from 93 on I showed you in the beginning those two peaks was because interest rates are so low you discount the future dividends if you will the future cash flow you get from the stocks they suddenly look very cheap everybody bought so I think it's a lot of things going yes and they're all interrelated okay let me let me wrap up with this thought because I think you see there's a lot going on but there's one uniform principle here and this goes back to Peter Schwartz's talk yesterday? I think it was yesterday when you introduce force into the equation bad stuff happens that's the simplification of this principle right when you introduce force into the equation rationality reason go out the window you can't think and here's a literal case when the Federal Reserve lowers interest rates you can't think about what the interest rates should be there's no way to go with that thought that is a thought that gets chopped off because there's no way to tell where it should be where do I look at what facts of reality can I look at to evaluate where interest rates should be so it it eliminates one's ability to think in that way so I've got this interest rates yes I know it's the Fed determining it what should it be I don't know I'm just going to have to take this price this interest rate as if it's the real interest rate I have no other choice and so somebody who is looking for examples of where force eliminates the ability to reason that's an example where force Federal Reserve setting interest rate eliminates one's ability to reason about interest rates I mean the best you can do is say it's too low but that doesn't tell you much to actually change anything okay but the same as with the rating agencies the 3A rating agencies they're the only ones some investors have to take those ratings purposefully okay are the ratings too aggressive are they too not aggressive what do they mean should I use them shouldn't I use them how should I use them who knows I mean it caps off thought if the rating agencies were private there was competition they could say well you know I can evaluate that I can tell the better competitors the worst competitors who's done better in the past I can value a track record but once you introduce force all of that goes out the window and force pervades the financial markets again banking, financial markets mortgages among the most regulated industries in the country now this isn't a failure of capitalism this is a failure of force this is everywhere here so it's no surprise that investment bankers made mistakes yes they made huge mistakes but yeah that's what happens when you introduce force into the equation through regulations people can't think properly they can't think long term they can't collect the facts because they can't tell what is a real fact on what's a pseudo fact what's a government created fact they don't know what real prices are because interest rates are set by the Fed so what are the real interest rates the more force you introduce the more perverse a market will become so the one thing to take away from this course is this idea it's not think of regulations as force think of the idea that force destroys reason and then you know if somebody says look this is actually rational here look at these mortgage bankers why were they doing this it's stupid yeah it was but what options did they face what incentives did they have how were they supposed to tell that it was stupid after the fact it's easy but given the force that they wander given the influence that they wander so nothing should surprise you when you've got this level of government involvement in a particular sector in the economy and there's no way to predict how long it's going to take to fix and how long this will happen or that will happen and this is why I believe trying to predict where were going from here is impossible you know closely impossible because all we're doing is increasing the amount of force I don't know how people are going to respond to this force where they're going to respond so we've lowered into states now to 0% we've nationalized our auto companies we've in a sense nationalized the percentage of our banking system what is that going to lead to what's Barney Fang going to come up with tomorrow in terms of what the bank shouldn't do he owns them now right he's in control and how's that going to affect inflation I don't know if he forces the banks to start lending we'll get hyperinflation but if he forces them to do something else we'll get something else it's not within the realm of reasoned rationality you can't sit down and say this is what happens because there's all this randomness that is the element of government that steps in all we can say is what's going on today is bad the outcome is going to be bad it might be inflation prices going up it might be another bubble I can't imagine where but it could be I happen to think it's probably going to be inflation it could be a depression deflation could continue you could imagine a scenario in which the banks never lend where we basically continue to spiral downwards and stay in a deflationary environment bet money on it what do we do? it's basically gambling and that's what happens in a free market you don't get into these situations in a free market yes it's not easy to predict the future but you know what the principles are that guide the future you know why things are happening but now we don't know why they're happening at the beck and call of benanqui and Geithner and the other guys are going to determine what happens and how the market responds to all that there is no one way to respond to them so all I can say about the next 2, 3, 4, 5, 6, 7, 8 years is that it's going to be a mess there's going to be a huge amount of volatility a lot which is a result of huge amounts of uncertainty people don't know and anybody who goes out and says this is what's going to happen I wouldn't trust them so prepare yourselves unfortunately I have to end on a negative note and I'm always the positive guy but prepare yourselves for a really rough ride and it's going to be a ride because I think it's going to go up and down and I think it's going to be very volatile I actually think we'll get inflation price inflation but I wouldn't put money on that and we're going to see if there is inflation what's the cure for inflation deep recession that recession the spiral into depression who knows yeah quickly a question just on top inflation Fed is now paying interest on Fed funds deposits I believe so this is a recent change in policy and look at a chart of how those Fed funds the reserves now the banks of credit a huge amount so it looks like and once they lend that out the Fed can keep those at the Fed by paying interest am I understanding that correctly so just thinking that that's a huge amount of reserves can I just sit there at the Fed and never be lent out if they just pay enough interest if they keep their interest high enough but remember even the interest rate in a sense at some point that's new money that they're putting into the economy I don't know how they can keep doing that indefinitely but so they're doing that at the same time they're buying up securities they're buying up auto loans they're buying up mortgage-backed securities they're buying up a lot of consumer loans and they're buying up government debts and they're monetizing a lot of the debt out there and holding this reserve of the banks but if they ever let that reserve shrink and the banks do start lending and I think the problem with the banks lending is not so much the banks lending we're not borrowing which is a good thing again another one of these reasons why there's a lot of uncertainty I don't know what the Fed's going to do in terms of the interest rates that pay on the deposits yeah we're going to ask about the selling of mortgages where the banks instead of lending and holding lend to sell is there anything to say that wouldn't happen in a free market and if it did is there anything wrong with it no I don't think there's anything to say it wouldn't happen, I think it would happen I think the whole securitization probably would have happened the contracts might have been written differently and there might have been an evolution so for example these things might have failed once or twice and then they evolved different contracts we don't know I mean that's a real bottom line is we don't know I think they would have still created an existence in the free market I think the contracts would have been written a little differently so that the bank held some responsibility over the loans so they suffered the originating bank so if they suffered the loan defaulted I mean if I were buying