 Things can be coded as capital with the right legal coding. Coding capital means taking an object, a promise or an idea, and grafting legal protections onto that asset to flip it into a capital asset. So let's think about a promise. If I promise to you to give you 100 bucks tomorrow, you may trust me that I will do this. We don't need the law to enter into this agreement. I might just give you the $100 tomorrow. But if you want to take my promise and sell it to somebody else, I give you the promise that I just got from Katarina and you pay me 90 bucks. I give you a discount because maybe she won't pay, but give me 90 bucks for that promise. Will you pay 90 bucks for this promise? Well, probably not, especially not if you don't know me, if you don't know my asset base, if you don't know whether I'm credit worthy. The Latin word, credere, is behind credit, it's to trust. And so the substitute for personal trust is the law. If we had entered into a written agreement and I had issued an IOU for 100 bucks that was clearly written on this note that then you hand over to somebody else to sell that note, maybe that person would have paid you 90, maybe 80, maybe $70 depending on what they think the market would bear. But the likelihood that somebody else would buy that promise is much higher if they know that if I don't pay, they can enforce it in a court of law. On top of that, maybe to make this asset even more attractive vis-à-vis others, you might say, well, maybe you can also hand over your watch. So I have that watch in case you don't pay. I can take the watch to the market and sell the watch and make money out of that or I can just keep it because I like that watch, right? So we can collateralize a promise, making it more likely that others will pay money for it and making it more likely that you will get your due because if I can't pay, not only because I don't want to pay because for some reasons I just cannot pay, you still have my watch. So as you can see, we can use a simple promise and it's a contract between two parties. It can be a formal agreement, doesn't have to be a binding contract, but if it was a binding contract, it would be much more likely that others will buy it and if you collateralize it on top of that, if you create a secured interest in it, it's even more likely that you can make money off it. So debt or credit, these are two sides of the same. Coin are important assets and nowadays in our financialized global world, financial assets are really the most important way in which people make money. It is the primary source of wealth, but what I'm trying to say is that that kind of instrument, this promise itself is also coded in law and without the legal system, it would not exist. Financial assets, just as intellectual property rights that we discussed earlier, are themselves creatures in the law and then they will be dressed up with the help of legal instruments to make them even more viable as capital assets. So today the IMF estimates that there is 226 trillion US dollars outstanding in debt, 50% of which is issued by public entities and 50% of which is issued by private entities. That is 2.5 times our GDP, the gross domestic product at a global level that we're producing. So we have debt in the amount of 2.5 of GDP. Now of course not all debt will be always repaid. We can refinance debt as a future date. Some debt will be written off and nobody gets hurt too much by this. But I think we also should be concerned about the fact that by making so many promises on an uncertain future, we're also forcing ourselves to try to produce enough so that people at least are reasonably assured that most of the debt will be repaid most of the time. If circumstances change, markets can unravel. And the last time we saw this in a really dramatic fashion was in 2008 with a great financial crisis when all of a sudden the creditors were no longer sure that homeowners and others would really be able to pay back their debt because there were some increasing default rates and it wasn't so clear that things would pan out this time around and what did they do? They then run for the exit. They will enforce their rights against existing debtors as fast as they can and that basically means you're setting in motion a system that will self-destroy. We can see how a system can unravel because legal commitments that are coded in law as enforceable commitments will be used at a moment when the system can't really sustain this and this can bring down the entire system to its knees. Let's step back a little bit and ask ourselves how a simple promise to pay became a financial asset and the kinds of financial assets that we have created with debt. So if you go back in history, before the 12th century people reasonably thought that actually debt contract is a contract between an agreement between two people and it cannot be traded. Not even the creditor can say pay to somebody else. Certainly the debtor even today has a harder time saying I just want to give my obligation to somebody else and wiggle out of my debt contract, right? Back then the idea was you have a personal relationship, that's a debt contract. But then we discovered some notes, some written notes in Genova on the western coast of Italy from the 12th century where somebody said you can pay me the creditor or my assignee, you can also pay somebody else. So all of a sudden you're creating a mechanism that somebody else can get the payment that the debtor owes and courts apparently upheld this because this became a very common practice. We basically developed a simple IOU into a payment system. Rather than paying in coins, silver coins or gold coins, people paid in IOUs. We just write a little note IOU this and then you can transfer it to somebody else and that person might take it maybe at a discount but then use it even to pay his or her own obligations. And as a result we can create something that is now known as the bill of exchange. A bill of exchange is basically an IOU on legal steroids. What are these legal steroids? Somebody issues an IOU, IOU 100 bucks, you take it, you put your own name on it and basically use it to pay your own obligations to somebody else. And that person puts his own name on it and pays his own obligations for buying some goods, some services, whatever. And so we have a chain of payment relations that is all based on a simple IOU. The merchant bankers came up with them, the traders came up with them but ultimately to be viable in the economic organization in long-distance trade they had to be recognized in law. And here the most important mechanism. One is that whoever holds the note at some point in time, a note written $100 on it, can enforce it against anyone who has put his or her name on it. Not only the original debtor but everyone who put their name on it. Second, if I ask you to pay that note, you can't say, by the way, the goods that I got in return for this note were really defective. So I don't want to pay because I have claims against my contracting party. You cannot raise these objections because a bill of exchange is what we call negotiable. It's abstracted from the underlying contract. It becomes a means of payment. One of the most important means of payment. So we're transforming a simple IOU which already is a legal construct into something that has a lot of qualities of money and is widely used as a payment system just by adding a couple of additional legal steroids. And we can go even further. So we just jump now into the 20th and 21st century. Let me tell you how securitization works. Securitization of mortgages work. So when somebody wants to buy a home and doesn't have enough money to afford the purchasing price, then the person will get a loan. And the bank or whoever they negotiate with will typically say, well, you know, we're looking at your finances, etc. You might be able to pay back the loan. But what we really would like to do is take a mortgage so that if you don't pay back your loan, we can go and take your house. And we sell the house on the market and we can satisfy our claims against the house and thereby also by the way we will lower the cost of credit for you because we have this additional surety. We have this secured interest in your house called a mortgage, right? So in the early 1970s, a major securitization industry was jump-started by the government, not the private sector. It was actually Fannie Mae, a government-sponsored entity that had been created in the 1930s and it's spin-off still government-owned entity, Genie Mae, that started the early securitization of mortgages. Why did they do this? Well, the government decided that more people in this country should have access to housing. They thought we should make housing more affordable and they chose credit as the means for making it more affordable to own houses. You could have done something else. You could have built more buildings by the government. You could have supported a rental market. They decided it should be credit. And the way they tried to make credit more affordable for lower-income families, minority households, et cetera, was to say, we allow the private sector to originate the mortgages. So they go out and say, I want your mortgage, but they don't have to hold this mortgage for 30 years anymore because that exposes them to the entire risk that somebody might not be able to pay back the money. Instead, they can sell this mortgage to us, to a government-sponsored entity. That government-sponsored entity buys thousands of mortgages and, in fact, the originators that increasingly just originated multiple mortgages sold them back to an entity such as Fannie Mae, or later Freddie Mac after it had been founded. And these entities would then create a trust. A trust is also a legal institution. I'll talk about this later. But it's basically a way to separate pools of assets from other owners or other claimants. So you basically create an artificial vessel. You throw all these mortgages into that vessel. And then you issue claims to investors against the future cash flow that comes out of this vessel. What goes into the vessel? The monthly mortgage payments that the homeowners are making, wherever they're located. And what comes out is basically a share of the money that goes into the vessel to the investors, depending on the size of the claim that they have bought. So that's what securitization is really all about. You just pool a lot of mortgages and then you package them up in a legal fashion so that you only have the trust and the assets in the pool to think about. So let me tell you the whole story how this has evolved over several decades. So very often these markets evolve over time. Once they're there, we think it's just all natural. But unpacking how they have evolved is really quite important to understand what happened and maybe also to understand a little bit what the legal institutions are that made these markets possible. So let me tell you a story about homeowners in California out there in 2006 or so. They all wanted to buy houses and they needed money to fund the houses and so they got a loan and then they handed over a mortgage and there was a brokerage company called New Century. New Century is no longer with us. It went bankrupt in 2007 already prior to the big crisis but it had a lot of stress. So New Century basically said we're going to these homeowners, we offer them loans, we take a mortgage, we do this a thousand times over or 4,000 times over. Now we have 4,000 loans backed by a mortgage. We're taking this entire bundle and we're selling it to Citigroup or another big bank. Citigroup of course is not a single entity. It has multiple subsidiaries, all kinds of entities around this. One that specializes in taking all these mortgages from New Century or other brokers and repackaging them into a trust. Again, so we're taking a vessel, a legal vessel. It's basically an artificial idea of separating these assets from Citigroup itself and Citigroup's other subsidiaries because this way the investors don't have to worry about what's going to happen with Citigroup. Will Citigroup go under? Well, they don't have to worry because we have a special legal entity that's a special purpose vehicle as it was called. That's the trust in which we place all these mortgages. And then we can cut up the cash flows, the future cash flows against the homeowners and sell them to different investors. And then the private sector had another idea. It realized that there are different types of investors and some investors want to have really, really safe assets and others investors like to take risk because they can make more money on it and they think they can get out in time. And that's fine, too, and there are lots of them in between. But to serve these different investors, it wasn't enough just to cut up the cash flows in a similar way, even if you have different slices, but you would take the same cross-section. But you had to reorganize the cash flow that came out of the vessel. And they called this tranching from the French verb trancher, which is to cut up. So they created senior tranches, which are safe tranches, which means you always get something. Whenever there is cash flow coming into the pool, you will be first in line to get it out. Whenever there might be any losses, you will be the last one to take any losses. And those at the bottom of the hierarchy bought the different types of interest. They said, we like risk, we want to take it, we're making more money now, we might lose in the future, but somehow this is something we want to at least risk and take a cut at this. And so they buy the junior tranches, they're risky, the senior tranches are safe. And then in between you have the mezzanine tranches. The idea of securitization was always you have to sell all these assets to future investors. Unless you sell it, you haven't really sold all the interest in these mortgages and you have a problem. Everybody along the way in sort of originating the mortgages, packaging them, selling the assets, make some fee income, you have to make sure that everybody gets that cut, you have to place them. There was a problem that emerged, namely that there weren't enough investors all the time to buy the mezzanine tranches. Those that weren't safe and those that weren't really risky and therefore attractive because you could have more profits from them. And so the finance industry came up with another idea and said, well, maybe we can create our own buyers. How do you do that? Well, you set up another legal entity, a little limited liability company in the Cayman Islands. Let's call it Claros. And Claros is now a new entity. How do you fund Claros? Well, you sell to investors a right to get future cash flow rights into certain tranches from other securitization products that you have sourced from all kinds of different trusts, not only from the first one that I had with Citigroup, but you just buy the same kind of middle layer that nobody wants to buy from multiple sources, you package them all together, you throw them into a limited liability company or a trust same principle. And then you sell the interest in the cash flows from these mezzanine tranches to investors. Because you have bought so many, you're well diversified and so the calculation suggests that the likelihood that everybody will default at the same time is relatively low. So you can even say some of them are actually safer, some of the cash flows are safer, others are not so safe. So we can tranche again and sell these assets to different types of investors. That's what we call the collateral debt obligation. There's a wonderful example if you watch the big short about what a collateralized debt obligation is. You basically take the leftover fish from the wonderful filet that you have served yesterday, you cut them up and put them all in a soup, you stir the soup and then you sell it as a wonderful new delicious soup to date to the new guests as something fresh and not just leftovers. Collateralized debt obligations really were leftovers. Now, if you were not able to sell all the leftovers to your customers, what do you do? You basically create a new soup. Now, we know of course that this market collapsed, but why did it? What I'm basically suggesting is that we are having a complex arrangement, but we can bring it back to the basic elements that I talked about before. What you can see here is that we have a couple of really important legal institutions built into this entire structure. That's IOU, security interest or collateral. It's the mortgages. We have trusts. We have the corporate form. We have bankruptcy law. I will come back to this later. I just want to flag how important each of these stages legal institutions are.