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ANDREW LO: Last
time when we met,

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we saw that the yield
curve was somewhere--

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the short end was somewhere at
the 30 to 40 basis point level.

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And let's see where it is today.

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The yield on a three
month treasury bill,

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according to this, is at
71 to 72 basis points.

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So that's pretty good.

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That's better than
it was last week.

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There was a point, actually,
earlier this morning,

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that the yield curve was--

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the short end was
slightly above 1%.

00:00:58.170 --> 00:01:01.740
But it's now come back down,
because of additional trading

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and demand for these securities.

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But that suggests that at least
the panic is not as severe

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as it was last week.

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Things are getting a bit better.

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And not surprisingly, the reason
they're getting a bit better,

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is because there's
more certainty now

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that something was
going to happen.

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When we met last, it seemed
as if there was a possibility

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that this wasn't going
to happen at all,

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that there was going to be some
breakdown between Democrats

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and Republicans, and that
there was an impasse.

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Fortunately, that got
resolved over the weekend.

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At least it seems to be.

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It's going to be voted
on as we speak actually.

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So hopefully, we'll
find out by the end

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of class or end of today
whether or not it happens.

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If it doesn't
happen, what do you

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think is going to happen
to the three month?

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Yeah, so you could actually
look at this as a thermometer.

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Check the temperature
of our economy.

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It's pretty amazing, isn't it?

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It tells you that financial
markets are very dynamic,

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and that you actually can
learn a lot from market prices.

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Again, are market
prices correct?

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No, there's no such
thing as correct.

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I want you to get away from
that notion of correct.

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There is a market
price that reflects

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the aggregate sentiment of the
economy and the participants

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on a given day, at a
given point in time,

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with a certain set
of market conditions.

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And then you have to
decide whether or not

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that set of prices is something
that you would like to use

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in your own calculations.

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So right now, these
are the prices

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that reflect what's
going on in the economy.

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By the way, at the
long end, last time

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we saw that two weeks ago, the
long end of the yield curve

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was pretty high, because
of concerns that there

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was going to be inflation.

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And then last week, we
saw that it went down.

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What is it now?

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Well, if you take a look at the
30 year, the yield is at 422.

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That's slightly
lower, not by much,

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

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And certainly lower than
what it was two weeks ago.

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So the concerns about inflation,
while they're still there,

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at least from the
data here it looks

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like they're a little bit less.

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So are people right today
and were wrong last week?

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Who knows.

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The point is that this reflects
what the current market

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sentiment is.

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And so at every point in time,
when you look at market prices,

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what you're getting is a
window on current expectations

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and current information, and you
have to make the best of that.

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Any other questions?

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Yup?

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STUDENT: I just have
sort of two questions.

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

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we said it was just a
couple basis points,

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why wouldn't you
just short those?

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

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they can't go above 0.

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So you have a couple
basis points downside,

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and [INAUDIBLE]
basis points upside.

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ANDREW LO: That's right.

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You could have shorted them.

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Andy, do you want to answer?

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ANDY: I'm not sure I agree
that you can short them.

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ANDREW LO: OK, why not?

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ANDY: Because going
short that means

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that you want to
borrow money at 3 basis

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points for three months, but
you're not the US Government.

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And no on will allow
you to do that.

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ANDREW LO: Well, it would be
hard to borrow the securities

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and then sell them, right?

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And unfortunately, you can't
manufacture the pieces of paper

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the way the US Government can.

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It's kind of hard
to do the printing

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press in just the same way.

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In fact, I think it
may even be illegal.

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But you're right that if--

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it's such a low
level, what you would

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like to be able to
do is you'd like

00:04:29.128 --> 00:04:31.010
to be able to issue that stuff.

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And by the way,
the US Government

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did take the opportunity to
issue some paper last week

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to take advantage of this.

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Because it's a great
way to do it, right?

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You borrow money at
virtually zero interest

00:04:41.350 --> 00:04:43.054
rate because you are
the US Government,

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and all you need
to do is print up

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these wonderful certificates.

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But I think the issue
is exactly right.

00:04:47.630 --> 00:04:49.227
If you wanted to
short it, you've

00:04:49.227 --> 00:04:51.810
got to be able to borrow it from
somebody else and then short,

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and they have to let
you borrow it from them

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at appropriate premium.

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So there's a risk
and a price for that.

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But if you could do it, it
was a pretty good trade.

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On the other hand, think
about what you're saying.

00:05:05.320 --> 00:05:07.510
What you're saying
is that you would

00:05:07.510 --> 00:05:10.330
like to be able to allow
people who want liquidity

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to have liquidity.

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You would like to provide them
with that kind of a liquidity.

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If everybody is panicking
and wanting liquidity,

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then that might be
a very good strategy

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because when markets
calm down, eventually,

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you will do quite well.

00:05:23.680 --> 00:05:25.720
In effect, that's
what the US Government

00:05:25.720 --> 00:05:28.654
is hoping to do with
this so-called bailout

00:05:28.654 --> 00:05:30.070
package, which is
what I mentioned

00:05:30.070 --> 00:05:32.800
last week that bailout is
probably not the right term.

00:05:32.800 --> 00:05:34.960
It's a rescue
package undoubtedly.

00:05:34.960 --> 00:05:38.020
But whether or not it's
a bailout or a very

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savvy investment depends
simply on the price--

00:05:41.850 --> 00:05:43.480
on the price that
you can get it at,

00:05:43.480 --> 00:05:45.790
and the price that you
ultimately sell it for.

00:05:45.790 --> 00:05:48.330
So that remains to be seen.

00:05:48.330 --> 00:05:49.914
Other questions?

00:05:49.914 --> 00:05:50.414
Yep?

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STUDENT: I don't know the
details of the [INAUDIBLE],,

00:05:52.910 --> 00:05:57.640
but I'm wondering,
this crises is

00:05:57.640 --> 00:06:03.790
based on the whole economy is
leveraged on some assets that

00:06:03.790 --> 00:06:07.210
are not really working
or are worth less

00:06:07.210 --> 00:06:10.584
than they were supposed to.

00:06:10.584 --> 00:06:15.708
And I wonder, at the
end, would the people

00:06:15.708 --> 00:06:20.010
that have credit, but
bad credit, suffer?

00:06:20.010 --> 00:06:23.870
Will they save
their homes or not?

00:06:23.870 --> 00:06:26.600
I don't see--
because the only way

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I see for this to be corrected
is to go to [INAUDIBLE]..

00:06:31.320 --> 00:06:35.830
There's a lot of people
leveraged that cannot pay

00:06:35.830 --> 00:06:39.600
so how will this get to--

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Am I explaining myself?

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ANDREW LO: I think so.

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I think so.

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I think you're expressing
the same kind of concern

00:06:44.990 --> 00:06:47.420
and confusion that the
American public has expressed

00:06:47.420 --> 00:06:48.620
at the bailout package.

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Because it doesn't
seem like the bailout

00:06:52.490 --> 00:06:56.550
is really applying to the
ultimate root cause of this,

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which is the home owners.

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The politicians would say
that you're bailing out

00:07:01.424 --> 00:07:02.840
Wall Street when
you should really

00:07:02.840 --> 00:07:05.210
be bailing out Main Street.

00:07:05.210 --> 00:07:08.030
Let me hold off on answering
that, because it turns out that

00:07:08.030 --> 00:07:12.050
this Thursday, October
2nd, from 5:30 to 7:00,

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the Sloan School
will be organizing

00:07:13.850 --> 00:07:16.670
a panel discussion
of the bailout,

00:07:16.670 --> 00:07:19.060
as well as the root causes
of some of these issues.

00:07:19.060 --> 00:07:21.770
So rather than take up
any more class time,

00:07:21.770 --> 00:07:25.100
let me defer that question
to that Thursday panel,

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and then I'd be happy to
talk about it afterwards.

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But I'd rather make
sure that we stay

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on track with our
curriculum and just use

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this as an illustration.

00:07:32.480 --> 00:07:34.688
But let me give you the
short answer to the question.

00:07:34.688 --> 00:07:36.500
The short answer
is that the idea

00:07:36.500 --> 00:07:40.340
is that you have to deal with
the current crisis right now.

00:07:40.340 --> 00:07:43.100
So it's sort of like having a
patient come into the emergency

00:07:43.100 --> 00:07:48.080
room and they're bleeding
out, and it turns out

00:07:48.080 --> 00:07:51.500
that the reason they're bleeding
out is they've abused drugs

00:07:51.500 --> 00:07:53.810
and they've done all
sorts of bad things

00:07:53.810 --> 00:07:56.020
to their diet and health.

00:07:56.020 --> 00:07:57.650
Now, at that time,
you probably don't

00:07:57.650 --> 00:07:59.390
want to give a lecture
on good nutrition

00:07:59.390 --> 00:08:04.157
and the dangers of
recreational pharmaceuticals.

00:08:04.157 --> 00:08:05.490
You've got to stop the bleeding.

00:08:05.490 --> 00:08:07.948
And then, over the course of
the next few weeks and months,

00:08:07.948 --> 00:08:09.570
you try to rehabilitate
the patient.

00:08:09.570 --> 00:08:12.080
So what the package is
meant to do, first of all,

00:08:12.080 --> 00:08:13.192
is to stop the bleeding.

00:08:13.192 --> 00:08:15.650
And then, over time, we're
going to have to address exactly

00:08:15.650 --> 00:08:16.910
the issues that you raised.

00:08:16.910 --> 00:08:20.270
And that's part of what the
proposal was trying to do.

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That's why it took them
time to put it together.

00:08:23.420 --> 00:08:25.910
It's easy to figure out
how to stop the bleeding.

00:08:25.910 --> 00:08:28.370
Money will stop the bleeding.

00:08:28.370 --> 00:08:31.130
But the problem is that
throwing money, good money,

00:08:31.130 --> 00:08:34.070
at bad assets is not necessarily
the long run solution.

00:08:34.070 --> 00:08:37.130
You have to figure out what
the ultimate causes are dealing

00:08:37.130 --> 00:08:40.190
with foreclosures, dealing
with all of these very

00:08:40.190 --> 00:08:43.789
complex securities, figuring
out how to value them,

00:08:43.789 --> 00:08:46.460
coming up with proper
insurance agreements

00:08:46.460 --> 00:08:49.340
to be able to create stability
across the entire market.

00:08:49.340 --> 00:08:51.830
And that's what the various
aspects of the bailout package

00:08:51.830 --> 00:08:52.952
are designed to do.

00:08:52.952 --> 00:08:54.410
So we'll talk about
it on Thursday,

00:08:54.410 --> 00:08:55.909
and I would encourage
all of you who

00:08:55.909 --> 00:08:57.660
are interested to
come to that session.

00:08:57.660 --> 00:09:02.030
We've got a number of economists
and accounting faculty

00:09:02.030 --> 00:09:05.150
and other folks who are
going to be there to present.

00:09:05.150 --> 00:09:08.267
You'll get a notice about that
probably later this afternoon.

00:09:08.267 --> 00:09:09.266
STUDENT: One more thing.

00:09:09.266 --> 00:09:13.260
On the Wachovia deal, what's
going to happen with the bank?

00:09:13.260 --> 00:09:16.370
Is it going to
continue the same?

00:09:16.370 --> 00:09:19.590
ANDREW LO: Well, obviously
that's a work in progress.

00:09:19.590 --> 00:09:22.310
It looks like most of
the units of Wachovia

00:09:22.310 --> 00:09:25.220
will be sold off to
Citigroup, but there

00:09:25.220 --> 00:09:28.340
are a few units of Wachovia,
including AG Edwards, which

00:09:28.340 --> 00:09:30.290
is a broker dealer,
and Evergreen, which

00:09:30.290 --> 00:09:32.750
is another broker dealer,
that will remain separate

00:09:32.750 --> 00:09:33.920
and will be freestanding.

00:09:33.920 --> 00:09:36.140
So that will not be
acquired by Citigroup.

00:09:36.140 --> 00:09:38.390
But apart from that, all
the other units of Wachovia

00:09:38.390 --> 00:09:40.566
will be taken on by
Citigroup, and that there

00:09:40.566 --> 00:09:43.910
will be a backstop provided
by the FDIC in case

00:09:43.910 --> 00:09:46.857
the losses exceed
more than $40 billion.

00:09:46.857 --> 00:09:48.440
So Citigroup will
be able to take that

00:09:48.440 --> 00:09:49.820
onto its balance sheets.

00:09:49.820 --> 00:09:52.460
And in exchange
for taking on all

00:09:52.460 --> 00:09:54.500
of these bad debts
and other problems,

00:09:54.500 --> 00:09:57.386
Citigroup gets the
retail access to all

00:09:57.386 --> 00:09:58.760
of the various
different channels

00:09:58.760 --> 00:10:00.260
that Wachovia has set up.

00:10:00.260 --> 00:10:03.140
So now, Citigroup
has the ability

00:10:03.140 --> 00:10:07.550
to compete head-to-head with
Merrill Lynch having been

00:10:07.550 --> 00:10:09.410
acquired by Bank of America.

00:10:09.410 --> 00:10:11.850
Whereas before, they wouldn't
have been able to do that.

00:10:11.850 --> 00:10:13.850
So you see, this is what
I was saying last time,

00:10:13.850 --> 00:10:17.180
that with every kind of crisis,
with every kind of dislocation,

00:10:17.180 --> 00:10:19.610
there are opportunities
that are created.

00:10:19.610 --> 00:10:23.180
And so when you have
one door closing,

00:10:23.180 --> 00:10:25.849
three other doors
open for opportunities

00:10:25.849 --> 00:10:27.140
that can be taken advantage of.

00:10:27.140 --> 00:10:28.973
And by the way, let we
mention, this is also

00:10:28.973 --> 00:10:30.020
true for your careers.

00:10:30.020 --> 00:10:32.737
You might be discouraged
about financial services.

00:10:32.737 --> 00:10:34.070
I would argue just the opposite.

00:10:34.070 --> 00:10:36.980
Right now, all of you are
at an excellent position

00:10:36.980 --> 00:10:39.290
as first year students,
because first of all, you're

00:10:39.290 --> 00:10:43.100
here in school waiting out
the passage of the storm.

00:10:43.100 --> 00:10:45.790
And when the storm
passes, believe me,

00:10:45.790 --> 00:10:47.670
there are going to be
tons of opportunities.

00:10:47.670 --> 00:10:51.950
In fact, typically the
largest growth period for jobs

00:10:51.950 --> 00:10:54.860
is not at business cycle
peaks, but its exactly

00:10:54.860 --> 00:10:57.560
after these kinds of
troughs that occur.

00:10:57.560 --> 00:10:59.139
So within the next
6 to 12 months,

00:10:59.139 --> 00:11:01.180
there's going to be tons
of career opportunities.

00:11:01.180 --> 00:11:02.570
In fact, for those
of you who are

00:11:02.570 --> 00:11:04.550
interested in going to
the New York Banking Day,

00:11:04.550 --> 00:11:06.800
and you really should if
you're interested in a career

00:11:06.800 --> 00:11:07.820
in finance.

00:11:07.820 --> 00:11:11.120
My guess is if you visit
Goldman Sachs, Morgan Stanley,

00:11:11.120 --> 00:11:13.550
as difficult as a
set of circumstances

00:11:13.550 --> 00:11:15.900
they're in right now, my
guess is every single one

00:11:15.900 --> 00:11:17.702
of these firms will be hiring.

00:11:17.702 --> 00:11:19.410
And the reason they're
going to be hiring

00:11:19.410 --> 00:11:22.320
is because they want to take
advantage of the opportunity

00:11:22.320 --> 00:11:25.410
to cut costs and to
hire younger, more

00:11:25.410 --> 00:11:30.420
energetic employees to
be able to really beef up

00:11:30.420 --> 00:11:34.740
their future generations
of human capital.

00:11:34.740 --> 00:11:37.030
So they're going to be
making an investment in that.

00:11:37.030 --> 00:11:39.734
So I think that's a good example
of how it's true that you're

00:11:39.734 --> 00:11:40.900
going to have consolidation.

00:11:40.900 --> 00:11:42.390
So now, after
this, there's going

00:11:42.390 --> 00:11:47.130
to be three major money center
banks, JP Morgan Chase, Bank

00:11:47.130 --> 00:11:50.700
of America, and Citigroup,
which is astonishing

00:11:50.700 --> 00:11:53.400
because just a few months ago
there were quite a few others.

00:11:53.400 --> 00:11:54.817
So the landscape has changed.

00:11:54.817 --> 00:11:56.400
But the competitive
landscape changing

00:11:56.400 --> 00:11:58.940
means that opportunities
get created along the way.

00:11:58.940 --> 00:12:03.090
STUDENT: I was just wondering
from your point of view.

00:12:03.090 --> 00:12:07.562
Why is it better to have the
banking industry consolidated

00:12:07.562 --> 00:12:08.680
into three buckets?

00:12:08.680 --> 00:12:10.221
In that, wouldn't
it have been better

00:12:10.221 --> 00:12:13.744
to let Wachovia fail and
let the regional [INAUDIBLE]

00:12:13.744 --> 00:12:17.894
pick up the slack instead of
now having literally JP, B of A,

00:12:17.894 --> 00:12:24.260
and CitiGroup dominate
the entire landscape

00:12:24.260 --> 00:12:27.810
and be in a position to
monopolize [INAUDIBLE]

00:12:27.810 --> 00:12:29.730
going forward.

00:12:29.730 --> 00:12:33.270
ANDREW LO: Well, so that's
an interesting thought,

00:12:33.270 --> 00:12:36.350
letting Wachovia fail.

00:12:36.350 --> 00:12:38.855
Obviously, you're not
a Wachovia customer.

00:12:42.380 --> 00:12:44.750
I think that what's
happening right now

00:12:44.750 --> 00:12:48.410
is that there's a great
deal of sensitivity,

00:12:48.410 --> 00:12:52.460
not only on the part of
Wall Street, but regulators,

00:12:52.460 --> 00:12:57.320
to stem the tide of
mass financial panic.

00:12:57.320 --> 00:12:58.940
We talked a bit
about that last time.

00:12:58.940 --> 00:13:01.940
The reason that regulators
and the government

00:13:01.940 --> 00:13:06.200
sprang into action was not
because Lehman went under,

00:13:06.200 --> 00:13:08.370
or AIG went under, or
any of these other large

00:13:08.370 --> 00:13:09.020
organizations.

00:13:09.020 --> 00:13:12.890
The reason that finally got
them over the edge of moving

00:13:12.890 --> 00:13:16.340
to do something substantial
is because the reserve

00:13:16.340 --> 00:13:19.970
fund, a retail money market
fund, broke the buck.

00:13:19.970 --> 00:13:24.320
And if that happens on a regular
basis beyond the reserve fund,

00:13:24.320 --> 00:13:27.560
you will have a very, very
significant financial market

00:13:27.560 --> 00:13:29.030
dislocation.

00:13:29.030 --> 00:13:32.550
It turns out that Wachovia is
part of that retail network.

00:13:32.550 --> 00:13:35.600
And if you let
Wachovia fail, you

00:13:35.600 --> 00:13:42.080
risk igniting further problems
in that retail sector.

00:13:42.080 --> 00:13:44.210
Citigroup is perfectly
happy to take them over

00:13:44.210 --> 00:13:46.190
and are able to
given their balance

00:13:46.190 --> 00:13:48.680
sheet-- are able to manage
that without any problem.

00:13:48.680 --> 00:13:50.480
So that seemed like
an ideal solution

00:13:50.480 --> 00:13:52.400
from everybody's perspective.

00:13:52.400 --> 00:13:55.340
Because if you allow
Wachovia to fail, remember,

00:13:55.340 --> 00:13:59.900
the FDIC is on the hook to pay
all the depositors their FDIC

00:13:59.900 --> 00:14:04.200
deposit insurance up to
$100,000 per name, per account.

00:14:04.200 --> 00:14:08.520
That could be a very substantial
number by letting the bank fail

00:14:08.520 --> 00:14:12.020
and by having all of its
value completely lost.

00:14:12.020 --> 00:14:14.630
This way, they actually
preserve a fair amount of value,

00:14:14.630 --> 00:14:17.360
because as an ongoing
concern, Wachovia has

00:14:17.360 --> 00:14:19.520
quite a lot of good business.

00:14:19.520 --> 00:14:23.030
So it actually is the
cost minimizing solution,

00:14:23.030 --> 00:14:24.980
but at the same time
it also preserves

00:14:24.980 --> 00:14:29.840
the current fragile integrity
of financial markets at least

00:14:29.840 --> 00:14:34.070
until the bailout fund is set.

00:14:34.070 --> 00:14:38.360
My guess is that in about three
or four weeks, if we have banks

00:14:38.360 --> 00:14:41.049
that end up not being able
to make their commitments,

00:14:41.049 --> 00:14:42.590
they are going to
be allowed to fail.

00:14:42.590 --> 00:14:44.131
Because at that
point, those failures

00:14:44.131 --> 00:14:46.220
won't jeopardize the
entire financial system,

00:14:46.220 --> 00:14:49.950
they'll be dealt with by
this bailout organization.

00:14:49.950 --> 00:14:51.902
So I think that
that's the logic.

00:14:51.902 --> 00:14:53.360
Yeah, last question,
let's move on.

00:14:53.360 --> 00:14:54.734
STUDENT: Is that
the same thought

00:14:54.734 --> 00:14:59.770
process as freezing Washington
Mutual's failure [INAUDIBLE]..

00:14:59.770 --> 00:15:01.020
ANDREW LO: Well, that's right.

00:15:01.020 --> 00:15:03.830
But the difference there is
that Washington Mutual has

00:15:03.830 --> 00:15:07.460
much bigger exposure to
these subprime loans,

00:15:07.460 --> 00:15:09.410
and so I think in that
case, there really

00:15:09.410 --> 00:15:10.910
wasn't much of a choice.

00:15:10.910 --> 00:15:13.520
And very much so transferring
the business units

00:15:13.520 --> 00:15:17.060
that are able to be moved
over JP Morgan Chase

00:15:17.060 --> 00:15:19.900
would make a fair bit of sense.

00:15:19.900 --> 00:15:21.650
So there's a lot of
consolidation going on

00:15:21.650 --> 00:15:24.850
in this industry, but
once again, consolidation,

00:15:24.850 --> 00:15:27.956
while it seems like
it's a big upheaval,

00:15:27.956 --> 00:15:30.330
and it is for the people that
are at these organizations,

00:15:30.330 --> 00:15:32.240
it's very disruptive,
the fact is

00:15:32.240 --> 00:15:33.830
that these kind
of disruptions are

00:15:33.830 --> 00:15:37.130
part and parcel of how
businesses grow and develop

00:15:37.130 --> 00:15:39.810
and morph over time.

00:15:39.810 --> 00:15:42.950
In fact, if you went
back to the 1960s,

00:15:42.950 --> 00:15:45.710
and you looked at a Wall
Street Journal on microfiche--

00:15:45.710 --> 00:15:47.780
I happened to do
that just because I

00:15:47.780 --> 00:15:50.480
was looking for a particular
citation at one point--

00:15:50.480 --> 00:15:53.270
if you look at the
advertisements in the 1960s

00:15:53.270 --> 00:15:56.720
or even 15 years ago, you
look at the advertisements

00:15:56.720 --> 00:15:58.672
in the Wall Street
Journal in those days,

00:15:58.672 --> 00:16:01.130
there are names of financial
institutions that you've never

00:16:01.130 --> 00:16:05.870
heard of, that were really
big institutions back then.

00:16:05.870 --> 00:16:08.270
So it's rare that we
have institutions that

00:16:08.270 --> 00:16:11.510
survive for 50, 75, 100 years.

00:16:11.510 --> 00:16:14.450
It's part and parcel of
how businesses develop.

00:16:14.450 --> 00:16:19.400
And the key is to focus on the
process by which businesses

00:16:19.400 --> 00:16:20.330
change.

00:16:20.330 --> 00:16:23.180
So when we start talking
about equity evaluation,

00:16:23.180 --> 00:16:25.610
we're going to see that by
looking at income statements

00:16:25.610 --> 00:16:28.024
and balance sheets together,
we can see not only what's

00:16:28.024 --> 00:16:29.690
a good business and
what a bad business,

00:16:29.690 --> 00:16:32.990
we can also see how
businesses evolve over time.

00:16:32.990 --> 00:16:35.060
And it's that
evolution that we hope

00:16:35.060 --> 00:16:37.970
to try to bring across
to you in this course.

00:16:37.970 --> 00:16:40.520
I want to show you how it
is that you can understand

00:16:40.520 --> 00:16:44.480
the dynamics of changes
in business conditions,

00:16:44.480 --> 00:16:48.410
because that really is, I think,
the key to a lot of what you

00:16:48.410 --> 00:16:50.797
can use in your own careers.

00:16:50.797 --> 00:16:52.130
I know there are more questions.

00:16:52.130 --> 00:16:57.539
But let me hold off on those
and start on the lecture today

00:16:57.539 --> 00:17:00.080
and then we can cover those a
little bit later on after we've

00:17:00.080 --> 00:17:02.780
made some progress.

00:17:02.780 --> 00:17:05.660
So this is a continuation
of last lecture

00:17:05.660 --> 00:17:09.380
where we were talking about
convexity and duration

00:17:09.380 --> 00:17:13.579
as two measures of the
riskiness of a bond portfolio.

00:17:13.579 --> 00:17:17.839
And I concluded last lecture
by talking about the fact

00:17:17.839 --> 00:17:21.800
that if you think about
a bond as a function

00:17:21.800 --> 00:17:26.720
of the underlying yield, then
you can use an approximation

00:17:26.720 --> 00:17:31.700
result that says that the bond
price, as a function of yield,

00:17:31.700 --> 00:17:33.830
is approximately
going to be given

00:17:33.830 --> 00:17:37.640
by a linear function
of its duration

00:17:37.640 --> 00:17:41.690
and a quadratic function
of its convexity.

00:17:41.690 --> 00:17:43.850
So we have an
approximation that says

00:17:43.850 --> 00:17:46.700
that the price of
the bond at a yield y

00:17:46.700 --> 00:17:50.030
prime, is going to be equal
to the price of the bond

00:17:50.030 --> 00:17:56.330
at a yield y multiplied by this
linear quadratic expression.

00:17:56.330 --> 00:17:58.520
And really, the
purpose of this is just

00:17:58.520 --> 00:18:01.550
to give you a way of
thinking about how

00:18:01.550 --> 00:18:06.810
changes in the fluctuations
of a bond portfolio,

00:18:06.810 --> 00:18:10.220
as well as the curvature
of that bond portfolio,

00:18:10.220 --> 00:18:13.970
will affect its value and
therefore its riskiness.

00:18:13.970 --> 00:18:17.030
These are just two measures
that will allow you to capture

00:18:17.030 --> 00:18:20.340
the risk of a bond portfolio.

00:18:20.340 --> 00:18:22.640
So I have a numerical
example here

00:18:22.640 --> 00:18:24.800
that you can take a
look at and work out,

00:18:24.800 --> 00:18:28.040
and you can see how good
that approximation is.

00:18:28.040 --> 00:18:32.870
This is an approximate result
that the price at a yield of 8%

00:18:32.870 --> 00:18:35.660
is going to be given as
a function of the price

00:18:35.660 --> 00:18:38.360
of the bond and a
yield of 6% multiplied

00:18:38.360 --> 00:18:41.270
by this linear
quadratic expression.

00:18:41.270 --> 00:18:44.000
And the actual result
of the bond price,

00:18:44.000 --> 00:18:47.240
now that we have high speed
digital computers that

00:18:47.240 --> 00:18:49.760
can calculate all of this
at a moment's notice,

00:18:49.760 --> 00:18:51.170
you can see the difference.

00:18:51.170 --> 00:18:54.520
It differs basically
by about a penny.

00:18:54.520 --> 00:18:56.494
A penny it's not a big deal.

00:18:56.494 --> 00:18:58.910
But when you're dealing with
billions of dollars actually,

00:18:58.910 --> 00:19:01.737
a penny is a pretty
significant amount.

00:19:01.737 --> 00:19:03.320
So what you want to
do is to make sure

00:19:03.320 --> 00:19:05.750
that you use the right
formula to calculate it.

00:19:05.750 --> 00:19:08.930
I wouldn't argue that you should
use convexity and duration

00:19:08.930 --> 00:19:11.840
to do any kind of
bond pricing analysis,

00:19:11.840 --> 00:19:16.580
but for a quick and dirty
method for getting intuition

00:19:16.580 --> 00:19:20.540
about how risky a bond portfolio
is, the two questions you ought

00:19:20.540 --> 00:19:23.980
to ask somebody is,
what's the duration

00:19:23.980 --> 00:19:25.510
and what's the convexity.

00:19:25.510 --> 00:19:29.770
And what those two numbers, you
can develop a kind of intuition

00:19:29.770 --> 00:19:32.110
for how the bond
price is going to move

00:19:32.110 --> 00:19:35.500
in response to underlying
changes in the yield curve.

00:19:35.500 --> 00:19:38.890
And right now, we
see that the yields

00:19:38.890 --> 00:19:40.210
are changing pretty rapidly.

00:19:40.210 --> 00:19:43.360
The Treasury yield curve,
at least at the short end,

00:19:43.360 --> 00:19:45.370
is bouncing around
depending on what happens

00:19:45.370 --> 00:19:47.120
every day in Washington.

00:19:47.120 --> 00:19:51.280
And so if you have that sense
of short term yields changing,

00:19:51.280 --> 00:19:53.530
by looking at
convexity and duration

00:19:53.530 --> 00:19:56.410
you can get a sense of how
sensitive your portfolio might

00:19:56.410 --> 00:20:00.850
be to those kinds of exposures.

00:20:00.850 --> 00:20:06.010
The last topic I'm going to
take on is now corporate bonds.

00:20:06.010 --> 00:20:09.640
Up until this point, the
only thing that we focused on

00:20:09.640 --> 00:20:13.300
has been default free
securities, namely

00:20:13.300 --> 00:20:16.300
government securities,
because governments can always

00:20:16.300 --> 00:20:18.370
print money and
therefore they can always

00:20:18.370 --> 00:20:21.670
make good on the claim that
they will pay you a face

00:20:21.670 --> 00:20:24.970
value of $1,000 in 27 years.

00:20:24.970 --> 00:20:28.830
There's no risk that they can't
run those printing presses.

00:20:28.830 --> 00:20:33.180
What I want to turn
to now is risky debt,

00:20:33.180 --> 00:20:35.460
and in particular
I want to point out

00:20:35.460 --> 00:20:39.990
that risky debt is fundamentally
different in the sense

00:20:39.990 --> 00:20:42.780
that there is a chance that
you don't get paid back.

00:20:42.780 --> 00:20:45.180
So one of the most
significant concerns

00:20:45.180 --> 00:20:49.110
of pricing corporate
bonds is default risk.

00:20:49.110 --> 00:20:52.170
And the market has
created its own mechanism

00:20:52.170 --> 00:20:55.890
for trying to get a sense of
what the default risk really

00:20:55.890 --> 00:20:56.550
is.

00:20:56.550 --> 00:20:58.590
Namely, credit ratings.

00:20:58.590 --> 00:21:02.550
These are ratings put out
by a variety of services.

00:21:02.550 --> 00:21:04.140
The services that
are most popular

00:21:04.140 --> 00:21:08.220
are Moody's, S&P, and Fitch.

00:21:08.220 --> 00:21:13.350
And these services do
analyzes on various companies,

00:21:13.350 --> 00:21:17.910
and then they issue reports,
and ultimately ratings,

00:21:17.910 --> 00:21:18.780
on those companies.

00:21:18.780 --> 00:21:22.950
They'll say this company
is rated AAA, AAA being

00:21:22.950 --> 00:21:24.630
the highest category.

00:21:24.630 --> 00:21:27.990
And I've listed the
different ratings categories

00:21:27.990 --> 00:21:29.760
for the three
different agencies here

00:21:29.760 --> 00:21:32.341
so you can get a sense
of how they compare.

00:21:32.341 --> 00:21:33.840
Typically, these
ratings are grouped

00:21:33.840 --> 00:21:39.474
into two categories, investment
grade and non-investment grade.

00:21:39.474 --> 00:21:40.890
And really, the
difference is just

00:21:40.890 --> 00:21:43.890
the nature of the default
risk or the speculativeness

00:21:43.890 --> 00:21:49.540
of the default probability.

00:21:49.540 --> 00:21:52.150
Bonds that are below
investment grade

00:21:52.150 --> 00:21:55.270
have a higher default rate,
and bonds that are supposedly

00:21:55.270 --> 00:21:56.740
investment grade
are ones that are

00:21:56.740 --> 00:22:02.170
appropriate for prudent and
conservative investments.

00:22:02.170 --> 00:22:04.030
STUDENT: Do you mind
maximizing the slide?

00:22:04.030 --> 00:22:05.571
It's a little hard
to read back here.

00:22:05.571 --> 00:22:08.080
ANDREW LO: Oh, sorry about that.

00:22:08.080 --> 00:22:09.380
Thank you.

00:22:09.380 --> 00:22:11.260
Yeah, that's better.

00:22:11.260 --> 00:22:19.930
So investment grade for Moody's
is AAA, high quality is AA,

00:22:19.930 --> 00:22:25.360
upper medium quality is A,
and then medium grade is BAA,

00:22:25.360 --> 00:22:28.210
and then anything
below BAA is considered

00:22:28.210 --> 00:22:29.827
non-investment grade.

00:22:29.827 --> 00:22:32.410
Now, the one thing you have to
keep in mind about fixed income

00:22:32.410 --> 00:22:35.800
securities is that
apart from some

00:22:35.800 --> 00:22:40.420
of the more esoteric strategies
that we talked about last time

00:22:40.420 --> 00:22:44.110
like fixed income arbitrage,
this idea of taking

00:22:44.110 --> 00:22:46.610
a bunch of bonds and figuring
out which ones are mispriced

00:22:46.610 --> 00:22:49.660
and trading them, apart
from those strategies,

00:22:49.660 --> 00:22:52.870
most people invest in
bonds not because they

00:22:52.870 --> 00:22:55.180
want exciting returns.

00:22:55.180 --> 00:22:57.190
If you want exciting
returns, you put your money

00:22:57.190 --> 00:23:01.000
in the stock market or real
state or private equity

00:23:01.000 --> 00:23:04.180
or other kinds of
exciting ventures.

00:23:04.180 --> 00:23:07.510
Bonds are supposed to be boring.

00:23:07.510 --> 00:23:10.300
You put your money in, and five
years later you get your money

00:23:10.300 --> 00:23:11.560
out with a little extra.

00:23:11.560 --> 00:23:14.580
That's what bonds
are supposed to do.

00:23:14.580 --> 00:23:21.110
And it wasn't until the 1970s,
when the era of junk bonds

00:23:21.110 --> 00:23:25.460
came on the scene, 70s and 80s,
with Michael Milken and Drexel,

00:23:25.460 --> 00:23:28.250
Burnham, Lambert,
that you really

00:23:28.250 --> 00:23:33.230
had a very different face
of fixed income markets.

00:23:33.230 --> 00:23:37.670
By and large, fixed income
markets dwarf equity markets.

00:23:37.670 --> 00:23:39.350
But the reason that
they're so large

00:23:39.350 --> 00:23:43.250
is because most people use
them as a kind of a safe haven.

00:23:43.250 --> 00:23:46.190
And as you get
riskier and riskier,

00:23:46.190 --> 00:23:51.260
it starts to look less like
bonds and more like equity.

00:23:51.260 --> 00:23:53.720
In fact, if you think about
the bankruptcy process,

00:23:53.720 --> 00:23:58.090
if you've got a risky corporate
bond, you're the bond holder,

00:23:58.090 --> 00:24:00.130
and the company
declares bankruptcy,

00:24:00.130 --> 00:24:04.280
they can't pay your interest
payments that are due to you,

00:24:04.280 --> 00:24:07.520
when they declare
bankruptcy, then

00:24:07.520 --> 00:24:10.460
at least from a
theoretical perspective,

00:24:10.460 --> 00:24:13.910
you the bondholder now
become equity holders.

00:24:13.910 --> 00:24:15.500
You own the assets.

00:24:15.500 --> 00:24:17.420
Because they can't
pay you, so they're

00:24:17.420 --> 00:24:20.750
obligated to give you
control of their company.

00:24:20.750 --> 00:24:23.120
So as bonds become
more risky, they

00:24:23.120 --> 00:24:26.630
start to look more and more
not like debt, but like equity.

00:24:26.630 --> 00:24:29.190
That is, the returns
are random and you don't

00:24:29.190 --> 00:24:30.440
know what you're going to get.

00:24:30.440 --> 00:24:32.270
It's sort of a
surprise every day.

00:24:32.270 --> 00:24:36.260
It's the gift that
keeps on giving.

00:24:36.260 --> 00:24:39.350
But for the most part, investors
that are invested in bonds

00:24:39.350 --> 00:24:40.370
aren't looking for that.

00:24:40.370 --> 00:24:42.912
We're looking for safe returns.

00:24:42.912 --> 00:24:44.370
And they're looking
for the highest

00:24:44.370 --> 00:24:48.180
yield that is a safe return.

00:24:48.180 --> 00:24:51.720
So investment grade
is the category

00:24:51.720 --> 00:24:55.230
that typically pension
funds, endowments,

00:24:55.230 --> 00:24:59.220
and other relatively
conservative institutions

00:24:59.220 --> 00:25:00.570
look to.

00:25:00.570 --> 00:25:02.670
Within that category,
they would like

00:25:02.670 --> 00:25:04.800
to get as much
yield as possible.

00:25:04.800 --> 00:25:06.660
So which of these
different grades

00:25:06.660 --> 00:25:08.400
do you think offers
the highest yield?

00:25:11.200 --> 00:25:12.540
Why is that?

00:25:12.540 --> 00:25:13.290
Yes, you're right.

00:25:13.290 --> 00:25:14.407
Why is that?

00:25:14.407 --> 00:25:15.490
What's the logic for that?

00:25:18.454 --> 00:25:21.420
STUDENT: [INAUDIBLE]

00:25:21.420 --> 00:25:22.260
Exactly.

00:25:22.260 --> 00:25:24.300
Given that it's lower
rated, that means

00:25:24.300 --> 00:25:26.130
it's got a higher
probability of default,

00:25:26.130 --> 00:25:29.160
you've got to pay investors a
little bit of extra for them

00:25:29.160 --> 00:25:30.990
to bear that risk.

00:25:30.990 --> 00:25:32.376
Simple as that.

00:25:32.376 --> 00:25:34.625
So the reason that there are
multiple categories, even

00:25:34.625 --> 00:25:36.360
in investment
grade, is that there

00:25:36.360 --> 00:25:39.780
are different levels
of risk aversion

00:25:39.780 --> 00:25:41.580
that investors want to take on.

00:25:41.580 --> 00:25:43.740
Some investors are
highly risk averse,

00:25:43.740 --> 00:25:47.490
and for the very, very
risk averse investors,

00:25:47.490 --> 00:25:49.612
they're going to take on AAA.

00:25:49.612 --> 00:25:51.820
And for those that are a
little bit more adventurous,

00:25:51.820 --> 00:25:53.920
they'll take on lower grade.

00:25:53.920 --> 00:25:57.790
And for those hedge funds, who
are looking for lots of risk

00:25:57.790 --> 00:25:59.980
and lots of return,
they're the ones

00:25:59.980 --> 00:26:03.310
that are dealing in the
non-investment grade issues.

00:26:03.310 --> 00:26:08.200
Those are the ones where you
have relatively large returns,

00:26:08.200 --> 00:26:10.000
15% or 20% returns,
you didn't think

00:26:10.000 --> 00:26:12.430
you can get a return of
15% to 20% for bonds,

00:26:12.430 --> 00:26:15.280
but you can if
there is a 5% or 10%

00:26:15.280 --> 00:26:18.100
chance that you
won't get anything.

00:26:18.100 --> 00:26:20.680
So when you do get
paid, you get paid well,

00:26:20.680 --> 00:26:23.530
but you don't always get paid.

00:26:23.530 --> 00:26:26.740
So that's the
categories that are

00:26:26.740 --> 00:26:30.580
developed by the various
different ratings institutions.

00:26:30.580 --> 00:26:33.850
And once you get a rating,
that allows you to approach

00:26:33.850 --> 00:26:36.100
investors and say,
OK, this is what

00:26:36.100 --> 00:26:41.470
I'm looking to get
for my corporate bond,

00:26:41.470 --> 00:26:45.550
and what I'm hoping to get is
commensurate with the risks

00:26:45.550 --> 00:26:47.460
that we're bearing.

00:26:47.460 --> 00:26:54.010
Here's a little history of the
yields on Moody's BAA bonds

00:26:54.010 --> 00:26:57.380
minus the US 10
year treasury yield.

00:26:57.380 --> 00:27:00.230
So this spread tells
you what the difference

00:27:00.230 --> 00:27:04.270
is between a very
safe asset and a BAA

00:27:04.270 --> 00:27:08.320
asset, which in this
category, is just

00:27:08.320 --> 00:27:10.810
above non-investment grade.

00:27:10.810 --> 00:27:14.890
So it's the lowest grade
that you can get and still

00:27:14.890 --> 00:27:16.050
be passing.

00:27:16.050 --> 00:27:18.700
This is sort of like
the 65 or something

00:27:18.700 --> 00:27:21.730
of junior high school
and high school.

00:27:21.730 --> 00:27:26.890
So that spread between
BAA and US treasuries

00:27:26.890 --> 00:27:31.540
is an indication of the risk
premium implicit in the default

00:27:31.540 --> 00:27:33.640
potential of a BAA bond.

00:27:33.640 --> 00:27:35.890
And look at how it's changed.

00:27:35.890 --> 00:27:41.530
In the 1930s, this spread was
about 7 and 1/2 percentage

00:27:41.530 --> 00:27:44.240
points.

00:27:44.240 --> 00:27:47.980
That's a big spread
by today's standards.

00:27:47.980 --> 00:27:49.810
Now of course, by
today's standards,

00:27:49.810 --> 00:27:52.270
literally today,
things are different,

00:27:52.270 --> 00:27:54.705
and we may be getting
up there soon.

00:27:54.705 --> 00:27:56.080
But let's take a
look at where we

00:27:56.080 --> 00:28:02.650
were at least where the data
ended, which is back in 2005.

00:28:02.650 --> 00:28:06.520
At the end of this
dataset, the credit spread

00:28:06.520 --> 00:28:11.770
was maybe 1 and 1/2 to 2%.

00:28:11.770 --> 00:28:14.830
That's at a near historic low.

00:28:14.830 --> 00:28:17.304
Now, you can see that there
are a little bit of a blip

00:28:17.304 --> 00:28:18.220
every once in a while.

00:28:18.220 --> 00:28:19.240
December.

00:28:19.240 --> 00:28:25.630
1987, this is after the stock
market crash of October 87.

00:28:25.630 --> 00:28:27.700
You see a big blip going up.

00:28:27.700 --> 00:28:32.350
And September of 1998
after LTCM, that goes up.

00:28:32.350 --> 00:28:35.500
And then of course credit
spreads widen over here.

00:28:35.500 --> 00:28:39.910
September 11 happened,
2001, over here.

00:28:39.910 --> 00:28:42.520
And so credit spreads got
as high as something like 3-

00:28:42.520 --> 00:28:46.120
3 1/2% percent, and now,
prior to what's happened over

00:28:46.120 --> 00:28:49.930
the last several weeks, credit
spreads were at a close to all

00:28:49.930 --> 00:28:51.830
time low.

00:28:51.830 --> 00:28:54.230
What does it mean when credit
spreads are really low?

00:28:54.230 --> 00:28:56.370
What does that tell you?

00:28:56.370 --> 00:28:57.890
What does it say?

00:28:57.890 --> 00:28:59.062
Yeah.

00:28:59.062 --> 00:29:04.420
STUDENT: [INAUDIBLE]

00:29:04.420 --> 00:29:05.150
ANDREW LO: Right.

00:29:05.150 --> 00:29:07.390
That's one interpretation,
that the market

00:29:07.390 --> 00:29:12.370
is perceiving the default
risk as not as significant

00:29:12.370 --> 00:29:13.120
as it used to be.

00:29:13.120 --> 00:29:14.740
Another way of
interpreting that is

00:29:14.740 --> 00:29:17.980
that the investment
population is

00:29:17.980 --> 00:29:22.180
less concerned about the default
risk than back in the 1930s.

00:29:22.180 --> 00:29:22.960
Not surprisingly.

00:29:22.960 --> 00:29:25.082
Something did
happen in the 1930s

00:29:25.082 --> 00:29:26.290
that was kind of significant.

00:29:26.290 --> 00:29:28.910
What was that?

00:29:28.910 --> 00:29:30.890
The crash of 29, and
then the depression

00:29:30.890 --> 00:29:34.350
that led from that crash.

00:29:34.350 --> 00:29:38.510
So that tells you that at
least at the end of 2005,

00:29:38.510 --> 00:29:43.150
beginning in 2006, people were
less risk averse, at least

00:29:43.150 --> 00:29:45.890
on paper what this shows.

00:29:45.890 --> 00:29:51.090
What else does it tell you
about the probability of credit?

00:29:51.090 --> 00:29:52.339
STUDENT: [INAUDIBLE]

00:29:52.339 --> 00:29:53.130
ANDREW LO: Exactly.

00:29:53.130 --> 00:29:54.117
Lots of money.

00:29:54.117 --> 00:29:56.700
Another way of interpreting this
is that there's lots of money

00:29:56.700 --> 00:29:57.540
out there.

00:29:57.540 --> 00:30:00.420
Lots of money willing
to be lent out

00:30:00.420 --> 00:30:04.650
to all sorts of risky
ventures without much

00:30:04.650 --> 00:30:07.170
in the way of expectation
that they should get

00:30:07.170 --> 00:30:11.690
paid a much larger premium.

00:30:11.690 --> 00:30:16.010
So those two interpretations
are likely to be both true.

00:30:16.010 --> 00:30:18.650
That is, the
population of investors

00:30:18.650 --> 00:30:21.770
did seem less risk averse, and
there is empirical evidence

00:30:21.770 --> 00:30:23.040
to support that.

00:30:23.040 --> 00:30:25.220
But on top of that,
it also suggests

00:30:25.220 --> 00:30:28.100
that there's tons of
money out there being lent

00:30:28.100 --> 00:30:31.010
to various different
projects, and because there's

00:30:31.010 --> 00:30:36.220
so much money, there's such an
increase in supply of funds,

00:30:36.220 --> 00:30:40.240
the extra premium that is
commanded by those funds

00:30:40.240 --> 00:30:43.930
could not be that great, simply
because of the competition

00:30:43.930 --> 00:30:48.250
to supply funds to these
various risky ventures.

00:30:48.250 --> 00:30:50.530
So if you wanted
to do a startup,

00:30:50.530 --> 00:30:54.232
the time to have
done it was in 2006,

00:30:54.232 --> 00:30:56.440
because you would have gotten
great deals since there

00:30:56.440 --> 00:30:59.370
was so much capital out there.

00:30:59.370 --> 00:31:00.910
Now that's changed.

00:31:00.910 --> 00:31:02.830
But part of the
reason it's changed,

00:31:02.830 --> 00:31:05.320
part of the reason that we're
in the current financial

00:31:05.320 --> 00:31:08.190
difficulties that we're
in, is because there

00:31:08.190 --> 00:31:12.160
was too much money
chasing too few genuinely

00:31:12.160 --> 00:31:13.990
good opportunities.

00:31:13.990 --> 00:31:16.960
And so we're seeing
now the after effects

00:31:16.960 --> 00:31:20.440
of some of those
poorer investments

00:31:20.440 --> 00:31:23.210
in those opportunities.

00:31:23.210 --> 00:31:26.350
So this kind of
credit spread picture

00:31:26.350 --> 00:31:29.740
can give you a sense of
the dynamics of money flows

00:31:29.740 --> 00:31:31.990
within the economy,
and definitely

00:31:31.990 --> 00:31:34.510
worth keeping track of.

00:31:34.510 --> 00:31:37.420
Now, there are a number of
things that are in that spread,

00:31:37.420 --> 00:31:38.710
in that premium.

00:31:38.710 --> 00:31:43.240
Obviously, there's an
expected default loss,

00:31:43.240 --> 00:31:46.390
but there's also tax effects.

00:31:46.390 --> 00:31:50.140
There's also some other kind
of systematic risk premium

00:31:50.140 --> 00:31:54.010
that has to do with
aggregate risk exposure.

00:31:54.010 --> 00:31:57.430
And a variety of
other academic studies

00:31:57.430 --> 00:32:00.790
have been done to
decompose that spread

00:32:00.790 --> 00:32:02.970
into different components.

00:32:02.970 --> 00:32:10.160
Graphically, you can see
that if you look at--

00:32:10.160 --> 00:32:13.670
if you take a look at the
composition of that premium,

00:32:13.670 --> 00:32:17.780
you can show that part of it
is due to default, part of it

00:32:17.780 --> 00:32:21.920
is due to the riskiness of
the particular investment,

00:32:21.920 --> 00:32:24.830
and then the other part is
simply the default free.

00:32:24.830 --> 00:32:27.810
That's the part that we've
studied up until today.

00:32:27.810 --> 00:32:31.460
So the other two parts, the
other extra risk premium,

00:32:31.460 --> 00:32:35.240
is really decomposed into a
default risk premium, but also

00:32:35.240 --> 00:32:36.950
a market risk premium.

00:32:36.950 --> 00:32:40.490
That is, just general riskiness
and price fluctuation.

00:32:40.490 --> 00:32:42.230
People don't like
that kind of risk,

00:32:42.230 --> 00:32:44.021
and they're going to
have to be compensated

00:32:44.021 --> 00:32:46.130
for that risk
irrespective of default.

00:32:46.130 --> 00:32:48.620
Just the fact that
prices move around

00:32:48.620 --> 00:32:52.220
will require you to reward
investors for holding

00:32:52.220 --> 00:32:53.780
these kind of instruments.

00:32:53.780 --> 00:32:57.770
And in the slides, I give you
some citations for studies

00:32:57.770 --> 00:33:00.350
on how you might go
about decomposing

00:33:00.350 --> 00:33:01.880
those kind of risk premiums.

00:33:01.880 --> 00:33:04.650
So you can take a look
at that on your own.

00:33:04.650 --> 00:33:06.830
But the last topic
that I want to turn to,

00:33:06.830 --> 00:33:09.260
in just a few minutes
today, before we

00:33:09.260 --> 00:33:12.110
move on to the pricing
of equity securities.

00:33:12.110 --> 00:33:14.630
The last topic I want to
turn to is directly related

00:33:14.630 --> 00:33:16.640
to the problem of
subprime mortgages.

00:33:16.640 --> 00:33:18.710
I promised you that I
would touch upon this.

00:33:18.710 --> 00:33:20.960
I'm not going to go through
it in detail, because this

00:33:20.960 --> 00:33:23.420
is the kind of material
that we will go through

00:33:23.420 --> 00:33:27.920
in other sessions on the
current financial crisis.

00:33:27.920 --> 00:33:29.660
But I want to at least
tell you about one

00:33:29.660 --> 00:33:33.110
aspect of bond markets
that's been really important

00:33:33.110 --> 00:33:35.660
over the last 10 years.

00:33:35.660 --> 00:33:38.700
And that is, securitization.

00:33:38.700 --> 00:33:42.270
Now, when you want to
issue a risky bond,

00:33:42.270 --> 00:33:45.250
as a corporation or
even as an individual,

00:33:45.250 --> 00:33:48.570
you have to deal with a
counterparty, a bank typically.

00:33:48.570 --> 00:33:52.410
Banks were the traditional
means of borrowing and lending

00:33:52.410 --> 00:33:58.540
for most of the 20th century,
and up until the last 10 years.

00:33:58.540 --> 00:34:04.664
But about 10 years ago, an
innovation was really created.

00:34:04.664 --> 00:34:06.330
Actually, it wasn't
created 10 years ago

00:34:06.330 --> 00:34:08.580
but it really took
off 10 years ago,

00:34:08.580 --> 00:34:13.230
where instead of borrowing
from financial institutions

00:34:13.230 --> 00:34:18.040
like banks, you were able
to tap into the borrowing

00:34:18.040 --> 00:34:20.949
power of financial markets.

00:34:20.949 --> 00:34:24.130
This is what's often
called disintermediation.

00:34:24.130 --> 00:34:26.020
Banks are considered
intermediaries.

00:34:26.020 --> 00:34:30.370
They serve as a conduit between
us, the retail investor,

00:34:30.370 --> 00:34:34.120
and financial markets or
other counter-parties.

00:34:34.120 --> 00:34:35.260
They stand in the middle.

00:34:35.260 --> 00:34:37.120
They take money from
us, put it in deposits,

00:34:37.120 --> 00:34:39.909
they take those deposits,
lend it out to corporations,

00:34:39.909 --> 00:34:42.070
and they take money
from corporations,

00:34:42.070 --> 00:34:44.080
and bring it into their
bank, and lend it to us

00:34:44.080 --> 00:34:46.420
in the form of mortgage
payments-- mortgages,

00:34:46.420 --> 00:34:49.320
so that we can buy our house.

00:34:49.320 --> 00:34:52.889
About 10 years
ago, intermediation

00:34:52.889 --> 00:34:59.970
started to unwind because of
innovations in securitization.

00:34:59.970 --> 00:35:04.260
The idea being that we are going
to instead of dealing directly

00:35:04.260 --> 00:35:09.150
with banks, tap into the
power of financial markets

00:35:09.150 --> 00:35:10.650
in borrowing and lending.

00:35:10.650 --> 00:35:13.230
And so I want to give you an
example of how that works.

00:35:13.230 --> 00:35:16.766
Something that I went
over in the Pro Seminar.

00:35:16.766 --> 00:35:18.390
But for those of you
who didn't attend,

00:35:18.390 --> 00:35:21.330
I want to show it to you because
it's such an important idea.

00:35:21.330 --> 00:35:25.800
And this is an idea
that is best done

00:35:25.800 --> 00:35:29.760
through a very simple
numerical example.

00:35:29.760 --> 00:35:32.730
So in about 10 or
15 minutes, I'm

00:35:32.730 --> 00:35:34.500
going to illustrate
to all of you

00:35:34.500 --> 00:35:38.310
the nature of problems in
the subprime mortgage market.

00:35:38.310 --> 00:35:40.200
That's all it'll take.

00:35:40.200 --> 00:35:42.940
To get to the bottom
of it could take years.

00:35:42.940 --> 00:35:45.450
But at least to understand
what's going on,

00:35:45.450 --> 00:35:48.340
I'm going to do this
very simple example.

00:35:48.340 --> 00:35:53.360
Suppose that I have a bond,
which is a risky bond.

00:35:53.360 --> 00:35:59.460
It's an IOU that pays $1,000
if it pays off at all.

00:35:59.460 --> 00:36:03.290
So the face value of
this bond is $1,000.

00:36:03.290 --> 00:36:06.830
But this is a risky
bond in the sense

00:36:06.830 --> 00:36:10.940
that it pays off $1,000
with a certain probability,

00:36:10.940 --> 00:36:14.360
and it pays off nothing
with another probability,

00:36:14.360 --> 00:36:18.240
let's say 90 10.

00:36:18.240 --> 00:36:25.470
So the simple expected
value of this is $900.

00:36:25.470 --> 00:36:29.280
And so you might think
that that should be

00:36:29.280 --> 00:36:30.870
a proxy for the market price.

00:36:30.870 --> 00:36:34.840
And in fact, that would be
a pretty good approximation.

00:36:34.840 --> 00:36:37.200
Now, right there is
an interesting insight

00:36:37.200 --> 00:36:38.880
into the pricing of risky bonds.

00:36:38.880 --> 00:36:44.850
Because if we have a security
that has $1,000 face value,

00:36:44.850 --> 00:36:47.670
but it's got a
probability of default,

00:36:47.670 --> 00:36:52.530
and you compute the
current value as $900,

00:36:52.530 --> 00:36:57.960
then that gives you an
implicit yield for the bond.

00:36:57.960 --> 00:36:58.730
What yield is it?

00:36:58.730 --> 00:37:03.840
It's whatever number, one
point something multiply by 900

00:37:03.840 --> 00:37:06.150
gives you $1,000.

00:37:06.150 --> 00:37:09.750
So the very fact
that it defaults, now

00:37:09.750 --> 00:37:12.450
allows us to compute a
yield without reference

00:37:12.450 --> 00:37:15.030
to the time value of money.

00:37:15.030 --> 00:37:17.940
The time value of money
can add an additional piece

00:37:17.940 --> 00:37:19.050
into this calculation.

00:37:19.050 --> 00:37:21.990
I decide to ignore it
just for simplicity.

00:37:21.990 --> 00:37:23.970
But suppose the
interest rate was 5%,

00:37:23.970 --> 00:37:27.240
the risk free interest rate
was 5%, then what I might do

00:37:27.240 --> 00:37:31.460
is to say, OK, $900 is what I
expect to get out of the bond.

00:37:31.460 --> 00:37:33.660
I'm going to take that
$900 and discount it back

00:37:33.660 --> 00:37:38.800
a year by 1.05, and
that will give me

00:37:38.800 --> 00:37:41.380
a number such that
when I compute

00:37:41.380 --> 00:37:45.370
the yield on that number
relative to $1,000,

00:37:45.370 --> 00:37:48.680
it will have the total
yield of this bond.

00:37:48.680 --> 00:37:52.990
5% of which is the risk free
part, and the other part

00:37:52.990 --> 00:37:54.790
is the default part.

00:37:54.790 --> 00:37:56.980
But I want to keep
the example simple.

00:37:56.980 --> 00:38:00.520
So let's just assume that the
risk free rate of interest

00:38:00.520 --> 00:38:02.640
is zero 0.

00:38:02.640 --> 00:38:07.320
So I've got my bond that
pays off $1,000 next period

00:38:07.320 --> 00:38:09.150
with probability 90%.

00:38:09.150 --> 00:38:13.310
So the expected value is 0.9
times 1,000 plus 0.10 times

00:38:13.310 --> 00:38:14.570
nothing.

00:38:14.570 --> 00:38:17.400
$900 for this bond.

00:38:17.400 --> 00:38:20.160
Now let's suppose that I have
not just one of these bonds,

00:38:20.160 --> 00:38:22.180
but I have two of them.

00:38:22.180 --> 00:38:26.040
And they're absolutely
identical in every respect.

00:38:26.040 --> 00:38:27.715
They're just two
of the same bonds.

00:38:31.900 --> 00:38:35.860
For each of the bonds, you
might think that it's not

00:38:35.860 --> 00:38:37.780
that easy to find a buyer.

00:38:37.780 --> 00:38:43.120
And you're right, because a 10%
default rate is pretty risky.

00:38:43.120 --> 00:38:45.370
In a minute, I'll
show you how risky

00:38:45.370 --> 00:38:48.940
when we look at the default
rates, historical default

00:38:48.940 --> 00:38:53.140
rates, of bonds with various
different credit ratings.

00:38:53.140 --> 00:38:55.240
But right now,
with a 10% rating,

00:38:55.240 --> 00:38:58.600
this bond would be
rated below BAA.

00:38:58.600 --> 00:39:00.994
It would be below
investment grade.

00:39:00.994 --> 00:39:03.660
So you're not going to get a lot
of people that want to buy one.

00:39:03.660 --> 00:39:05.970
In fact, we can auction
it off in this class

00:39:05.970 --> 00:39:07.720
right now to figure
out what the price is.

00:39:07.720 --> 00:39:09.850
My guess is that
I may not even get

00:39:09.850 --> 00:39:14.320
$900 for that in this class,
given your current mood

00:39:14.320 --> 00:39:16.490
and liquidity issues.

00:39:19.030 --> 00:39:23.700
But I'm going to show
you some magic that

00:39:23.700 --> 00:39:28.140
will make this incredibly
interesting to a large number

00:39:28.140 --> 00:39:31.440
of investors,
including all of you.

00:39:31.440 --> 00:39:33.570
I'm going to take
these two bonds

00:39:33.570 --> 00:39:36.960
and put them together
in a portfolio.

00:39:36.960 --> 00:39:38.499
Now, what exactly
does that mean?

00:39:38.499 --> 00:39:39.540
So far I've said nothing.

00:39:39.540 --> 00:39:42.630
I've drawn a circle
around the bonds.

00:39:42.630 --> 00:39:44.370
By portfolio, I
mean that I'm going

00:39:44.370 --> 00:39:49.130
to create an entity, a
corporation, whose sole purpose

00:39:49.130 --> 00:39:51.510
it is to buy these two bonds.

00:39:51.510 --> 00:39:54.750
And therefore, the
fortunes of the corporation

00:39:54.750 --> 00:39:59.650
are tied not to the performance
of any one or two bonds,

00:39:59.650 --> 00:40:03.840
but to the performance of the
collective portfolio of bonds.

00:40:03.840 --> 00:40:06.280
So that's what I mean when
I say, form a portfolio.

00:40:06.280 --> 00:40:08.590
I mean, consider a
single entity that

00:40:08.590 --> 00:40:11.500
will hold both of these bonds.

00:40:11.500 --> 00:40:15.160
And let's assume, for
the sake of argument,

00:40:15.160 --> 00:40:20.780
that the default of these
two bonds is uncorrelated.

00:40:20.780 --> 00:40:22.460
In fact, I'm going
to assume that these

00:40:22.460 --> 00:40:26.990
are two separate coin flips,
and they're different coins,

00:40:26.990 --> 00:40:30.560
they have the same probability
of coming up heads 90%,

00:40:30.560 --> 00:40:33.140
10% tails, but they're
different coins.

00:40:33.140 --> 00:40:35.040
They have nothing to
do with each other.

00:40:35.040 --> 00:40:36.170
So they're independent.

00:40:36.170 --> 00:40:38.557
Whether or not one
bond fails has nothing

00:40:38.557 --> 00:40:39.640
to do with the other bond.

00:40:42.880 --> 00:40:45.760
When I put this
into a portfolio,

00:40:45.760 --> 00:40:48.640
how does the portfolio
behave looking at it

00:40:48.640 --> 00:40:50.800
as a single entity?

00:40:50.800 --> 00:40:54.090
There are three
possible outcomes.

00:40:54.090 --> 00:40:56.090
Actually, there are four,
but only three of them

00:40:56.090 --> 00:40:57.770
are really distinct.

00:40:57.770 --> 00:41:04.210
Both bonds will pay off,
or both bonds will default,

00:41:04.210 --> 00:41:07.660
or one bond pays off
and the other defaults.

00:41:07.660 --> 00:41:11.130
Those are the only three
outcomes that are possible.

00:41:11.130 --> 00:41:13.400
And the payoffs
and probabilities,

00:41:13.400 --> 00:41:17.930
assuming that they are separate
and independent coin tosses,

00:41:17.930 --> 00:41:20.200
is given in that table.

00:41:20.200 --> 00:41:22.310
$2000 if they both pay off.

00:41:22.310 --> 00:41:26.930
And the probability of
that is 81%, 0.9 times 0.9.

00:41:26.930 --> 00:41:30.780
And I'm multiplying, because I'm
assuming they're independent.

00:41:30.780 --> 00:41:34.640
The probability that they both
don't pay off, in which case

00:41:34.640 --> 00:41:42.160
my portfolio is worth
nothing, is 1%, 10% times 10%.

00:41:42.160 --> 00:41:44.620
And then whatever's left
over is in the middle.

00:41:44.620 --> 00:41:47.107
That is, there's a
chance that one of them

00:41:47.107 --> 00:41:48.940
pays off but the other
one doesn't, and then

00:41:48.940 --> 00:41:51.040
the portfolio is worth
$1,000, and there's

00:41:51.040 --> 00:41:52.320
an 18% chance of that.

00:41:55.120 --> 00:41:57.990
So here's the stroke of genius.

00:41:57.990 --> 00:42:00.630
The stroke of genius
is to say, I've

00:42:00.630 --> 00:42:03.120
got these two securities
that are not particularly

00:42:03.120 --> 00:42:05.370
popular on their own.

00:42:05.370 --> 00:42:08.320
What I'm going to do is to
stick them in a portfolio,

00:42:08.320 --> 00:42:12.340
and then I'm going to issue
two new pieces of paper,

00:42:12.340 --> 00:42:15.940
each with $1,000 face value.

00:42:15.940 --> 00:42:18.670
So they're just like
the old pieces of paper,

00:42:18.670 --> 00:42:21.660
but there's one difference.

00:42:21.660 --> 00:42:23.780
They have different priority.

00:42:23.780 --> 00:42:27.530
Meaning there is a
senior piece of paper

00:42:27.530 --> 00:42:29.400
and there is a junior
piece of paper.

00:42:29.400 --> 00:42:31.920
The senior piece of
paper gets paid first,

00:42:31.920 --> 00:42:35.580
and the junior paper only
gets paid if and when

00:42:35.580 --> 00:42:38.910
the senior paper gets paid.

00:42:38.910 --> 00:42:42.720
So I'm going to issue
two pieces of paper.

00:42:42.720 --> 00:42:48.300
The blue is the senior
and the red is the junior.

00:42:48.300 --> 00:42:52.200
The senior paper I'm going
to call the senior tranche.

00:42:52.200 --> 00:42:56.220
Tranche, I believe is the
French word for trench,

00:42:56.220 --> 00:42:58.410
which seems much more
appropriate today than it

00:42:58.410 --> 00:42:59.740
did before.

00:42:59.740 --> 00:43:02.300
We're digging our
own trenches here.

00:43:02.300 --> 00:43:05.600
The senior paper
is going to have

00:43:05.600 --> 00:43:08.790
first dibs on that portfolio.

00:43:08.790 --> 00:43:10.380
And the junior
paper will only get

00:43:10.380 --> 00:43:13.790
paid after the senior
paper gets paid.

00:43:13.790 --> 00:43:16.100
And so let's see what
happens with that.

00:43:16.100 --> 00:43:19.290
Remember, they're both
$1,000 face values.

00:43:19.290 --> 00:43:22.550
So on paper, I've
done nothing in terms

00:43:22.550 --> 00:43:28.700
of creating or destroying the
total claims on the asset pool.

00:43:28.700 --> 00:43:32.630
The portfolio has claims
at $2000 of face value,

00:43:32.630 --> 00:43:36.920
and my new securities has
claims on $2000 at face value.

00:43:36.920 --> 00:43:41.540
But all I've done is to change
the order, the priority,

00:43:41.540 --> 00:43:43.100
of the payout.

00:43:43.100 --> 00:43:44.420
Here's the table.

00:43:44.420 --> 00:43:48.340
I have three values for my
portfolio, $2000, $1,000,

00:43:48.340 --> 00:43:50.600
and nothing.

00:43:50.600 --> 00:43:53.990
Now let's see what happens
to each of those two

00:43:53.990 --> 00:43:57.200
claims, the senior claim
and the junior claim,

00:43:57.200 --> 00:44:00.320
of my new securities
that I've issued

00:44:00.320 --> 00:44:03.740
The senior claim
gets paid $1,000

00:44:03.740 --> 00:44:07.130
if both bonds in my
portfolio pay off.

00:44:07.130 --> 00:44:09.950
But the senior claim
also gets paid $1,000

00:44:09.950 --> 00:44:13.480
if only one of those
bonds pays off.

00:44:13.480 --> 00:44:16.770
So two out of the
three outcomes are

00:44:16.770 --> 00:44:20.160
good news for the senior debt.

00:44:20.160 --> 00:44:22.950
And in the third case, where
both of them don't pay off,

00:44:22.950 --> 00:44:25.110
then the senior
paper is out of luck.

00:44:27.620 --> 00:44:30.160
Now, the junior paper
is exactly the reverse.

00:44:30.160 --> 00:44:34.810
The junior paper only will get
paid if both bonds pay off,

00:44:34.810 --> 00:44:37.060
because in that case,
the senior guy gets paid

00:44:37.060 --> 00:44:39.870
and then there's money
left for the junior guy.

00:44:39.870 --> 00:44:43.300
In the latter two cases,
if only one bond fails

00:44:43.300 --> 00:44:47.390
or both bonds fail, then the
junior claim gets paid nothing.

00:44:51.110 --> 00:44:56.480
So what I've done is to
take two identical bonds,

00:44:56.480 --> 00:45:02.080
and I've created two
non-identical claims,

00:45:02.080 --> 00:45:05.020
such that one is a lot
safer than the other.

00:45:05.020 --> 00:45:06.250
How much safer?

00:45:06.250 --> 00:45:13.480
Well, the bond that is senior
has a 1% chance of default, 1%,

00:45:13.480 --> 00:45:17.530
because both bonds have to fail
before the senior guy doesn't

00:45:17.530 --> 00:45:20.360
get paid.

00:45:20.360 --> 00:45:22.550
1%, what was it before?

00:45:22.550 --> 00:45:24.770
It was 10% for both bonds.

00:45:24.770 --> 00:45:27.510
But because I stuck
it in a portfolio,

00:45:27.510 --> 00:45:30.120
and I changed the
priority of payouts,

00:45:30.120 --> 00:45:33.510
the senior claim now
looks a lot safer.

00:45:33.510 --> 00:45:36.890
But that's not a free lunch,
because the junior claim

00:45:36.890 --> 00:45:38.510
is a heck of a lot riskier.

00:45:38.510 --> 00:45:42.960
The junior claim now loses
money 19% of the time.

00:45:45.790 --> 00:45:47.980
It used to be the case
that one of these bonds

00:45:47.980 --> 00:45:51.430
had a 10% default rate,
but the junior claim

00:45:51.430 --> 00:45:57.890
has a 19% default rate, 18%
plus 1% from those two outcomes.

00:46:00.860 --> 00:46:03.580
As long as investors
know the structure,

00:46:03.580 --> 00:46:05.600
nobody's getting a good
deal or a bad deal.

00:46:05.600 --> 00:46:07.520
There's no cheating going on.

00:46:07.520 --> 00:46:09.260
We explain this to
investors, so you all

00:46:09.260 --> 00:46:10.850
see these probabilities.

00:46:10.850 --> 00:46:14.360
And now, let's calculate
what the expected

00:46:14.360 --> 00:46:17.680
values are for the payouts.

00:46:17.680 --> 00:46:20.780
The expected values--
before I do that,

00:46:20.780 --> 00:46:22.820
let me comment on default rates.

00:46:22.820 --> 00:46:27.070
So a 1% default rate
seems like a small number.

00:46:27.070 --> 00:46:29.850
And a 19% default rate
seems like a large number.

00:46:29.850 --> 00:46:32.750
Well, let's take a look at
the empirical evidence given

00:46:32.750 --> 00:46:34.010
debt ratings.

00:46:34.010 --> 00:46:36.770
These are historical
default rates

00:46:36.770 --> 00:46:40.100
for bonds from 1920 to 1999.

00:46:40.100 --> 00:46:44.720
So I've got almost an
80 year record of bonds

00:46:44.720 --> 00:46:46.730
that have been issued
by corporations

00:46:46.730 --> 00:46:50.210
and that have been stamped by
Moody's with their ratings.

00:46:50.210 --> 00:46:53.120
And the different
bars correspond

00:46:53.120 --> 00:46:57.560
to how long the bonds have been
issued and are outstanding.

00:46:57.560 --> 00:47:00.030
Because obviously, the
longer the bond is out there,

00:47:00.030 --> 00:47:02.360
the more likely it is
that it will default.

00:47:02.360 --> 00:47:08.330
So you have to separate them
by the years out in the market.

00:47:08.330 --> 00:47:12.440
If you take a look at a
five year period, that's

00:47:12.440 --> 00:47:14.810
the bars all the way
to the extreme left

00:47:14.810 --> 00:47:21.860
of each rating category, you see
that for a five year periods,

00:47:21.860 --> 00:47:24.980
the default rate
of AAA securities

00:47:24.980 --> 00:47:28.370
is well, well below 1%.

00:47:28.370 --> 00:47:31.850
It's measured in basis
points, that probability.

00:47:31.850 --> 00:47:37.190
If you wait 20
years for AAA bonds,

00:47:37.190 --> 00:47:41.510
the default rate goes
up to maybe 2% or 3%.

00:47:41.510 --> 00:47:43.820
So that means that when
AAA bonds are issued

00:47:43.820 --> 00:47:47.460
and you wait for 20 years
to see what happens to them,

00:47:47.460 --> 00:47:52.290
it's a very, very small group
that ends up defaulting,

00:47:52.290 --> 00:47:54.030
if they have a AAA rating.

00:47:54.030 --> 00:48:01.159
On average, AAA bonds default
maybe 1% of the time or less.

00:48:01.159 --> 00:48:02.700
On the other hand,
if you take a look

00:48:02.700 --> 00:48:05.100
at below investment
grade-- so BAA

00:48:05.100 --> 00:48:13.019
is just at the borderline
of investment grade.

00:48:13.019 --> 00:48:14.810
And if you take a look
at the default rates

00:48:14.810 --> 00:48:16.640
here, lots higher.

00:48:16.640 --> 00:48:22.490
But by lots higher, we're
talking about 5% to 10%,

00:48:22.490 --> 00:48:25.390
5% to 10%.

00:48:25.390 --> 00:48:29.380
So based upon these
categorizations,

00:48:29.380 --> 00:48:33.310
we can now rate our own bonds,
what I just decided to issue

00:48:33.310 --> 00:48:36.440
with these securities, right?

00:48:36.440 --> 00:48:39.170
The senior tranche is
rated AAA, and what would

00:48:39.170 --> 00:48:40.355
you rate the junior tranche?

00:48:45.090 --> 00:48:47.120
BA maybe.

00:48:47.120 --> 00:48:50.910
BAA at the best, but
probably more like BA.

00:48:50.910 --> 00:48:54.040
So the senior tranche
looks pretty good,

00:48:54.040 --> 00:48:56.490
and the junior tranche
looks pretty bad,

00:48:56.490 --> 00:48:59.130
but you know what their
ratings are, and therefore,

00:48:59.130 --> 00:49:02.200
go ahead and price
them accordingly.

00:49:02.200 --> 00:49:04.240
So let's do that.

00:49:04.240 --> 00:49:06.660
If you price them
accordingly, what happens

00:49:06.660 --> 00:49:11.970
is that the senior tranche
gets priced at $990,

00:49:11.970 --> 00:49:23.100
and the junior tranche gets
priced at 810, 990 and 810.

00:49:23.100 --> 00:49:28.020
Now, this is very different
from what the price was before.

00:49:28.020 --> 00:49:31.650
The price for both
bonds was 900, right?

00:49:31.650 --> 00:49:35.200
The expected value
of the payout.

00:49:35.200 --> 00:49:37.900
And the expected value
of each bond is 900.

00:49:37.900 --> 00:49:40.430
When you add them
up, you get 1,800.

00:49:40.430 --> 00:49:44.170
Here, when you add up these
two bonds, you also get 1,800.

00:49:44.170 --> 00:49:47.760
So I have neither created
nor destroyed value.

00:49:47.760 --> 00:49:51.640
All I've done is to
reallocate that value.

00:49:51.640 --> 00:49:55.950
I've given the senior
bondholders lower default risk

00:49:55.950 --> 00:50:02.190
and therefore higher likelihood
of getting their money back,

00:50:02.190 --> 00:50:04.800
therefore a lower
yield is necessary

00:50:04.800 --> 00:50:06.480
in order to sell that bond.

00:50:06.480 --> 00:50:09.540
On the other hand,
that extra benefit

00:50:09.540 --> 00:50:12.480
that we've given to
the senior claimants

00:50:12.480 --> 00:50:16.440
comes from the junior
claimants, and therefore, they

00:50:16.440 --> 00:50:18.720
get a lower price,
or they have to be

00:50:18.720 --> 00:50:24.240
given a higher yield, to entice
them to bear that kind of risk.

00:50:27.530 --> 00:50:30.940
Now, why is this such
a stroke of genius?

00:50:30.940 --> 00:50:36.430
It's because what we've done is
take two identical securities

00:50:36.430 --> 00:50:41.980
that nobody was
particularly excited about,

00:50:41.980 --> 00:50:46.450
and we've created, by this
securitization process,

00:50:46.450 --> 00:50:51.760
we've created two other
securities that actually

00:50:51.760 --> 00:50:55.120
a number of communities
are very excited about.

00:50:55.120 --> 00:50:58.840
For example, the pension
funds, endowments, foundations,

00:50:58.840 --> 00:51:02.050
all of the very
conservative investors

00:51:02.050 --> 00:51:06.070
that want a very
boring bond portfolio.

00:51:06.070 --> 00:51:08.140
No excitement, no headline risk.

00:51:08.140 --> 00:51:10.390
They just want their money
back with a reasonable rate

00:51:10.390 --> 00:51:11.290
of return.

00:51:11.290 --> 00:51:14.050
They've got it with
the senior tranche.

00:51:14.050 --> 00:51:18.370
And by the way, if they're even
nervous about this very, very

00:51:18.370 --> 00:51:23.320
safe structure, let's insure it.

00:51:23.320 --> 00:51:25.760
Let's get a large,
stable insurance company,

00:51:25.760 --> 00:51:28.690
oh I don't know, maybe
AIG, and let's get

00:51:28.690 --> 00:51:32.720
them to insure that these won't
default. Because if they do,

00:51:32.720 --> 00:51:35.860
AIG will pay an extra
premium on top of that.

00:51:35.860 --> 00:51:39.280
So then they're called
super senior securities,

00:51:39.280 --> 00:51:43.060
super senior tranche securities,
because they've got guarantees

00:51:43.060 --> 00:51:46.830
on top of the
securitization features.

00:51:46.830 --> 00:51:49.710
Pension funds love this.

00:51:49.710 --> 00:51:54.940
They bought this in
large, large quantities.

00:51:54.940 --> 00:51:58.270
Now, what about the
so-called toxic waste

00:51:58.270 --> 00:52:00.000
that the junior tranche?

00:52:00.000 --> 00:52:03.000
Well, we know it's toxic waste.

00:52:03.000 --> 00:52:06.300
We've priced it as if
it were toxic waste.

00:52:06.300 --> 00:52:11.850
And so those investors that are
looking for 15% or 20% returns,

00:52:11.850 --> 00:52:16.290
that are not looking
for boring, safe assets,

00:52:16.290 --> 00:52:18.330
they will go for
the junior tranche.

00:52:18.330 --> 00:52:20.130
Namely, the hedge funds.

00:52:20.130 --> 00:52:21.930
And as many of you
know, hedge funds

00:52:21.930 --> 00:52:23.930
have grown by leaps and bounds.

00:52:23.930 --> 00:52:25.705
Over just the last
10 years, they've

00:52:25.705 --> 00:52:27.330
increased their assets
under management

00:52:27.330 --> 00:52:30.210
by a factor of 10 to 20.

00:52:30.210 --> 00:52:32.520
And that money is
looking for a home.

00:52:32.520 --> 00:52:35.520
And boring, safe
investments that

00:52:35.520 --> 00:52:38.640
earn 6%, 7%, 8%, that's
not for hedge funds.

00:52:38.640 --> 00:52:41.410
They are looking
for 15, 20, 30 40%,

00:52:41.410 --> 00:52:45.060
and they get that with
that junior tranche.

00:52:45.060 --> 00:52:48.000
That's why the market, over the
last 10 years, has exploded.

00:52:48.000 --> 00:52:49.050
It's twofold.

00:52:49.050 --> 00:52:51.390
It's because money has
come in from pension

00:52:51.390 --> 00:52:53.370
funds for the senior debt.

00:52:53.370 --> 00:52:57.900
Money has come in from the hedge
funds for that junior debt.

00:52:57.900 --> 00:53:01.080
And together, they brought
much, much more money

00:53:01.080 --> 00:53:04.840
into this business
than ever before.

00:53:04.840 --> 00:53:07.680
And the question is, how
do you take that money

00:53:07.680 --> 00:53:09.600
and push it out to people.

00:53:09.600 --> 00:53:13.710
Well, it turns out that because
housing markets are going up,

00:53:13.710 --> 00:53:16.210
that was a perfect
way to get these

00:53:16.210 --> 00:53:18.600
this money out to investors.

00:53:18.600 --> 00:53:19.760
Yes?

00:53:19.760 --> 00:53:22.510
STUDENT: This model is based on
the probability of the Moody's.

00:53:22.510 --> 00:53:23.680
I have a question.

00:53:23.680 --> 00:53:26.070
Is there any way investors
can estimate this probability

00:53:26.070 --> 00:53:28.833
by themselves instead
of relying on Standard

00:53:28.833 --> 00:53:30.390
and Poor's or Moody's?

00:53:30.390 --> 00:53:32.310
ANDREW LO: It's very
difficult for investors

00:53:32.310 --> 00:53:34.170
to estimate the
probabilities themselves,

00:53:34.170 --> 00:53:36.840
because they don't have
access to the same data

00:53:36.840 --> 00:53:40.024
that Moody's and
S&P and Fitch do.

00:53:40.024 --> 00:53:41.940
Typically when you
estimate the probabilities,

00:53:41.940 --> 00:53:44.520
you need data in terms of
the underlying portfolio

00:53:44.520 --> 00:53:45.780
and the riskiness.

00:53:45.780 --> 00:53:48.780
As a typical investor, certainly
as a pension fund investor,

00:53:48.780 --> 00:53:50.430
you would not be given access.

00:53:50.430 --> 00:53:52.440
And even if you
were given access,

00:53:52.440 --> 00:53:55.756
you don't have the staff that
can actually analyze this.

00:53:55.756 --> 00:53:57.630
STUDENT: So if Moody's
or Standard and Poor's

00:53:57.630 --> 00:54:00.880
made a mistake, then every
pension fund or other investors

00:54:00.880 --> 00:54:02.726
will made the same mistake.

00:54:02.726 --> 00:54:04.350
ANDREW LO: The mistakes
can carry over.

00:54:04.350 --> 00:54:04.891
That's right.

00:54:04.891 --> 00:54:07.500
There is no way for
pension funds, endowments

00:54:07.500 --> 00:54:10.170
and foundations, or
retail investors,

00:54:10.170 --> 00:54:12.510
to do their own kind
of due diligence.

00:54:12.510 --> 00:54:15.840
They're relying on those
managers of the pension funds

00:54:15.840 --> 00:54:16.990
to do that.

00:54:16.990 --> 00:54:20.360
And by the way, it wasn't just
pension funds that did this.

00:54:20.360 --> 00:54:23.340
There was some mutual
funds that did this too.

00:54:23.340 --> 00:54:26.570
And not only mutual funds,
but there were also some money

00:54:26.570 --> 00:54:28.800
market funds that did this.

00:54:28.800 --> 00:54:31.910
Now, money market funds you
say, why would money market

00:54:31.910 --> 00:54:33.950
funds get invested in this?

00:54:33.950 --> 00:54:35.660
Well remember,
money market funds

00:54:35.660 --> 00:54:39.650
are supposed to be putting money
into short term, fixed income

00:54:39.650 --> 00:54:41.210
instruments.

00:54:41.210 --> 00:54:43.940
Well, these could be
short term, and these

00:54:43.940 --> 00:54:45.350
are fixed income instruments.

00:54:45.350 --> 00:54:47.370
And if you add some
insurance on top of that,

00:54:47.370 --> 00:54:50.180
they're even safer,
on paper anyway,

00:54:50.180 --> 00:54:53.270
than many of the other
traditional instruments.

00:54:53.270 --> 00:54:57.560
So you can see now how a
wonderful idea, and this really

00:54:57.560 --> 00:54:59.540
is wonderful because
it dramatically

00:54:59.540 --> 00:55:03.690
increased the risk bearing
capacity of the economy.

00:55:03.690 --> 00:55:06.920
And by the way, it made a
lot of people better off.

00:55:06.920 --> 00:55:10.010
So right now, we're in the
midst of a financial crisis

00:55:10.010 --> 00:55:13.130
and we're focusing
on the negatives.

00:55:13.130 --> 00:55:17.060
But let's not be
too quick to forget

00:55:17.060 --> 00:55:21.800
that these kinds of
securitization processes

00:55:21.800 --> 00:55:25.040
brought in huge amounts of
money that ultimately went

00:55:25.040 --> 00:55:28.641
to homeowners to be able to
buy homes that they otherwise

00:55:28.641 --> 00:55:30.890
couldn't have afforded, and
maybe you would argue they

00:55:30.890 --> 00:55:33.540
shouldn't have afforded,
but there are still many,

00:55:33.540 --> 00:55:36.290
many homeowners out there
that have subprime loans that

00:55:36.290 --> 00:55:37.992
are paying their
mortgage payments,

00:55:37.992 --> 00:55:39.950
that are perfectly happy
living in their atoms,

00:55:39.950 --> 00:55:42.740
and otherwise couldn't have
afforded it without it.

00:55:42.740 --> 00:55:44.540
And Moreover, there
are a whole host

00:55:44.540 --> 00:55:49.250
of individuals that made tons of
money because of the real state

00:55:49.250 --> 00:55:51.560
boom and because they
were able to leverage

00:55:51.560 --> 00:55:53.720
using these kinds of funds.

00:55:53.720 --> 00:55:57.930
STUDENT: In this example, the
ones who [INAUDIBLE] are us.

00:55:57.930 --> 00:55:59.169
Is that like Lehman Bothers?

00:55:59.169 --> 00:56:00.210
Are those the companies--

00:56:00.210 --> 00:56:01.210
ANDREW LO: That's right.

00:56:01.210 --> 00:56:03.560
So an example would be some
of the investment banks,

00:56:03.560 --> 00:56:05.837
as well as some of
the commercial banks.

00:56:05.837 --> 00:56:07.670
Now, in a minute, I'm
going to tell you what

00:56:07.670 --> 00:56:08.836
went wrong with all of this.

00:56:08.836 --> 00:56:10.190
So far, the story is great.

00:56:10.190 --> 00:56:14.270
This is really an innovation
in financial engineering,

00:56:14.270 --> 00:56:18.260
because by securitization,
by repackaging,

00:56:18.260 --> 00:56:19.790
we've done nothing dishonest.

00:56:19.790 --> 00:56:22.410
We've told people
exactly what we're doing.

00:56:22.410 --> 00:56:24.110
We've given them transparency.

00:56:24.110 --> 00:56:27.110
And we've given the safer
asset to the community

00:56:27.110 --> 00:56:28.680
that wants safer assets.

00:56:28.680 --> 00:56:30.687
And we've given the
very exciting assets

00:56:30.687 --> 00:56:32.270
to those who want
the exciting assets.

00:56:34.800 --> 00:56:37.325
Now, where does this go wrong?

00:56:37.325 --> 00:56:38.450
Question before we do that.

00:56:38.450 --> 00:56:40.450
STUDENT: The assumption
that you made in this is

00:56:40.450 --> 00:56:43.306
that they are not correlated?

00:56:43.306 --> 00:56:47.815
Isn't there more likeliness of
correlation between the two?

00:56:47.815 --> 00:56:49.190
ANDREW LO: So that
there's always

00:56:49.190 --> 00:56:53.690
somebody that's ready to spoil
the party for the rest of us.

00:56:53.690 --> 00:56:55.550
You're absolutely right.

00:56:55.550 --> 00:56:59.340
That's where the story
gets interesting.

00:56:59.340 --> 00:57:04.760
I've assumed that these
two bonds are uncorrelated.

00:57:04.760 --> 00:57:07.330
What if that
assumption is wrong?

00:57:07.330 --> 00:57:13.260
In fact, what happens if not
only are they uncorrelated,

00:57:13.260 --> 00:57:18.930
but what happens if the bonds
are perfectly correlated?

00:57:18.930 --> 00:57:19.950
Let's work that out.

00:57:19.950 --> 00:57:23.420
That's a numerical example
that's not hard to do.

00:57:23.420 --> 00:57:25.580
If the bonds are
perfectly correlated,

00:57:25.580 --> 00:57:27.680
that means they default
at the same time

00:57:27.680 --> 00:57:30.680
and they pay off at the
same time, then instead

00:57:30.680 --> 00:57:34.580
of three outcomes, we
only have two outcomes.

00:57:34.580 --> 00:57:38.420
Either we get paid
$2,000 in the portfolio,

00:57:38.420 --> 00:57:40.670
or we get paid nothing
in the portfolio.

00:57:43.410 --> 00:57:48.030
Now, what happens to the
senior and junior tranches?

00:57:48.030 --> 00:57:53.370
Well, now, the senior
tranche, the tranche

00:57:53.370 --> 00:57:56.760
that was AAA, the tranche
that had less than 1%

00:57:56.760 --> 00:57:58.650
probability of
default, the tranche

00:57:58.650 --> 00:58:02.400
that was supposed to be so
safe that all sorts of very

00:58:02.400 --> 00:58:06.950
conservative institutions
could take it on, that tranche

00:58:06.950 --> 00:58:11.690
has now increased in
riskiness by a factor of 10.

00:58:11.690 --> 00:58:16.790
The probability of default
has gone from 1% to 10%.

00:58:16.790 --> 00:58:19.760
And the junior
tranche, the tranche

00:58:19.760 --> 00:58:21.980
that was supposed
to be toxic waste,

00:58:21.980 --> 00:58:25.670
and that had a 90%
default rate, now it

00:58:25.670 --> 00:58:28.790
looks incredibly good,
because it's gone up

00:58:28.790 --> 00:58:30.170
in terms of its quality.

00:58:30.170 --> 00:58:33.620
It's gone down in terms
of its default probability

00:58:33.620 --> 00:58:37.200
from 19% to 10%.

00:58:37.200 --> 00:58:39.290
So if you look at
the pricing, now

00:58:39.290 --> 00:58:42.920
the pricing of these two
things, of course, is $900.

00:58:42.920 --> 00:58:45.500
If they're perfectly
correlated, then securitization

00:58:45.500 --> 00:58:46.910
does nothing.

00:58:46.910 --> 00:58:49.640
All you've done is to
take two pieces of paper

00:58:49.640 --> 00:58:54.090
and slice them up into two
identical pieces of paper.

00:58:54.090 --> 00:58:56.560
That's what happens if
they're perfectly correlated.

00:58:56.560 --> 00:59:02.560
So now, why would they
become perfectly correlated?

00:59:02.560 --> 00:59:06.160
Well, this has to do with what
happened in the housing market.

00:59:06.160 --> 00:59:08.080
When the housing
market turned down,

00:59:08.080 --> 00:59:13.120
as it did shortly
after June of 2006,

00:59:13.120 --> 00:59:18.500
that created a huge dislocation
in these credit markets,

00:59:18.500 --> 00:59:21.350
because what was
uncorrelated all of a sudden

00:59:21.350 --> 00:59:22.670
became highly correlated.

00:59:22.670 --> 00:59:24.760
It's as if an
insurance company that

00:59:24.760 --> 00:59:29.320
was insuring property and
casualty across the country,

00:59:29.320 --> 00:59:32.200
all of a sudden experienced
earthquakes in every one

00:59:32.200 --> 00:59:35.050
of the 50 states all at once.

00:59:35.050 --> 00:59:38.140
An insurance company
cannot withstand that kind

00:59:38.140 --> 00:59:41.590
of an event, unless of
course it's prepared for it.

00:59:41.590 --> 00:59:44.860
And earthquake
insurers prepare for it

00:59:44.860 --> 00:59:50.800
by insuring not just earthquakes
but hurricanes, fires,

00:59:50.800 --> 00:59:53.140
and other natural
disasters, which

00:59:53.140 --> 00:59:59.040
rarely come all at the same
time and all in the same place.

00:59:59.040 --> 01:00:00.780
We weren't prepared for this.

01:00:00.780 --> 01:00:03.300
The people that sold these
securities, that held them,

01:00:03.300 --> 01:00:04.380
weren't prepared.

01:00:04.380 --> 01:00:07.890
In fact, I skipped over a
quote at the very beginning

01:00:07.890 --> 01:00:09.060
of this section.

01:00:09.060 --> 01:00:14.940
This is a quote that appeared
in The Economist magazine,

01:00:14.940 --> 01:00:17.310
anonymously, and it
was the Chief Risk

01:00:17.310 --> 01:00:21.270
Officer of a major
financial institution.

01:00:21.270 --> 01:00:29.390
And the risk manager wrote in
the first part of the article,

01:00:29.390 --> 01:00:31.820
"Like most banks,
we owned a portfolio

01:00:31.820 --> 01:00:33.710
of different tranches
of collateralized debt

01:00:33.710 --> 01:00:38.390
obligations" that's what the
securitized set of obligations

01:00:38.390 --> 01:00:41.620
are called, "which are packages
of asset-backed securities.

01:00:41.620 --> 01:00:43.190
Our business and
risk strategy was

01:00:43.190 --> 01:00:46.020
to buy pools of
assets, mainly bonds,

01:00:46.020 --> 01:00:49.730
warehouse them on our own
balance sheet" meaning put them

01:00:49.730 --> 01:00:54.440
in a portfolio in our company,
"and structure them into CDOs

01:00:54.440 --> 01:00:56.690
and finally distribute
them to end investors."

01:00:56.690 --> 01:00:59.780
Issue the pieces of paper
to the different investors.

01:00:59.780 --> 01:01:03.260
"We were most eager to sell the
non-investment grade tranches,"

01:01:03.260 --> 01:01:06.290
the toxic waste, "and
our risk approvals

01:01:06.290 --> 01:01:09.140
were conditional on
reducing these to zero."

01:01:09.140 --> 01:01:11.600
So they were very,
very careful to get rid

01:01:11.600 --> 01:01:14.010
of all that toxic waste.

01:01:14.010 --> 01:01:19.120
"We will allow positions
however of the top rated AAA

01:01:19.120 --> 01:01:22.800
and super-M senior
(even better than AAA)

01:01:22.800 --> 01:01:27.000
tranches to be held on
our own balance-sheets

01:01:27.000 --> 01:01:30.270
as the default was deemed
to be well protected

01:01:30.270 --> 01:01:32.790
by all the lower
tranches, which would have

01:01:32.790 --> 01:01:34.845
to absorb any prior losses."

01:01:37.940 --> 01:01:40.760
"in May of 2005 we
held AAA tranches,

01:01:40.760 --> 01:01:45.650
expecting them to rise in value,
and sold non-investment grade

01:01:45.650 --> 01:01:48.290
tranches, expecting
them to go down."

01:01:48.290 --> 01:01:52.760
They were long the
seniors, short the juniors.

01:01:52.760 --> 01:01:54.457
That's a strategy.

01:01:54.457 --> 01:01:56.040
"From a risk-management
point of view,

01:01:56.040 --> 01:01:59.570
this was perfect: have a long
position in the low risk asset,

01:01:59.570 --> 01:02:03.150
and have a short one in
the higher-risk asset.

01:02:03.150 --> 01:02:06.540
But the reverse happened
of what we had expected:

01:02:06.540 --> 01:02:10.470
AAA tranches went down in
price and non-investment grade

01:02:10.470 --> 01:02:13.950
tranches went up,
resulting in losses as we

01:02:13.950 --> 01:02:17.880
mark the positions to market."

01:02:17.880 --> 01:02:21.570
And then the risk manager,
this Chief Risk Officer

01:02:21.570 --> 01:02:24.760
of a major financial
institution,

01:02:24.760 --> 01:02:26.050
said the following.

01:02:26.050 --> 01:02:28.900
"This was entirely
counter-intuitive.

01:02:28.900 --> 01:02:30.880
Explanations of why
this had happened

01:02:30.880 --> 01:02:34.180
were confusing and focused on
complicated cross-correlations

01:02:34.180 --> 01:02:35.032
between tranches.

01:02:35.032 --> 01:02:36.490
In essence it turned
out that there

01:02:36.490 --> 01:02:38.916
had been a short squeeze in
non-investment grade tranches,

01:02:38.916 --> 01:02:40.540
driving up prices
and generally selling

01:02:40.540 --> 01:02:42.748
of all the more senior
[INAUDIBLE] even the very best

01:02:42.748 --> 01:02:44.430
ones."

01:02:44.430 --> 01:02:46.770
He still doesn't get it.

01:02:46.770 --> 01:02:48.690
The numerical example
that I just showed you

01:02:48.690 --> 01:02:50.790
explains what happened.

01:02:50.790 --> 01:02:52.290
What happened is
the correlations,

01:02:52.290 --> 01:02:55.650
that were assumed to be zero,
turned out not to be zero.

01:02:55.650 --> 01:02:59.580
And when things change, when
the correlations change,

01:02:59.580 --> 01:03:00.690
that changes the risk.

01:03:00.690 --> 01:03:03.060
And when you change the risk,
it changes the valuation

01:03:03.060 --> 01:03:04.650
because the markets
are not stupid.

01:03:04.650 --> 01:03:07.290
People realize, wow, I assumed
they were uncorrelated,

01:03:07.290 --> 01:03:09.150
but now these things
are very correlated.

01:03:09.150 --> 01:03:11.790
I better recalculate my model
and see what it tells me.

01:03:11.790 --> 01:03:14.700
And it tells me that AAA
is not AAA any longer.

01:03:14.700 --> 01:03:18.300
And it tells me that the
BA is actually now BAA.

01:03:18.300 --> 01:03:22.230
So what he experienced is
what every major financial

01:03:22.230 --> 01:03:23.790
institution dealing
with this stuff

01:03:23.790 --> 01:03:26.310
experienced over the
last couple of years.

01:03:26.310 --> 01:03:29.100
It's that kind of
a double whammy,

01:03:29.100 --> 01:03:32.850
because of the
default rates changing

01:03:32.850 --> 01:03:37.020
in a way that was never expected
given the historical behavior

01:03:37.020 --> 01:03:38.860
of the US housing market.

01:03:38.860 --> 01:03:39.450
Yeah, Beta.

01:03:39.450 --> 01:03:43.670
STUDENT: [INAUDIBLE]

01:03:51.434 --> 01:03:53.350
ANDREW LO: It was typically
through the banks.

01:03:53.350 --> 01:03:56.590
So the banks actually arrange
with the insurance companies

01:03:56.590 --> 01:03:58.390
to insure those assets.

01:03:58.390 --> 01:04:01.030
And then they would sell
it to the end investor.

01:04:01.030 --> 01:04:03.910
The end investor wasn't
the one engaging in these.

01:04:03.910 --> 01:04:06.880
Although, under
certain circumstances,

01:04:06.880 --> 01:04:08.830
certain pension
funds were so risk

01:04:08.830 --> 01:04:11.170
averse that they
ultimately ended up

01:04:11.170 --> 01:04:14.770
buying extra insurance in the
form of credit default swaps

01:04:14.770 --> 01:04:17.800
on these kinds of contracts
with other counter-parties.

01:04:17.800 --> 01:04:21.100
So in many cases, some of
the insurance companies

01:04:21.100 --> 01:04:24.070
actually did have relationships
with the end investors,

01:04:24.070 --> 01:04:27.090
as well as with the
investment banks.

01:04:27.090 --> 01:04:27.730
Yeah, Maria.

01:04:27.730 --> 01:04:32.522
STUDENT: [INAUDIBLE]

01:04:45.749 --> 01:04:46.540
ANDREW LO: They do.

01:04:46.540 --> 01:04:47.950
They do downgrade these.

01:04:47.950 --> 01:04:48.980
Absolutely.

01:04:48.980 --> 01:04:52.450
And in fact, not only do
they downgrade the bonds,

01:04:52.450 --> 01:04:55.090
but they also downgrade the
equity of the companies that

01:04:55.090 --> 01:04:56.530
are issuing the bonds.

01:04:56.530 --> 01:05:01.120
So for example,
AIG was downgraded

01:05:01.120 --> 01:05:03.910
because there was
concern of whether or not

01:05:03.910 --> 01:05:05.512
it could meet its obligations.

01:05:05.512 --> 01:05:06.970
And because of that
downgrade, that

01:05:06.970 --> 01:05:09.490
triggered a bunch of
other transactions.

01:05:09.490 --> 01:05:11.870
STUDENT: And the other question
is, are they independent,

01:05:11.870 --> 01:05:16.154
and are they really
objective when they are--

01:05:19.010 --> 01:05:21.630
ANDREW LO: Well, so those
are two separate questions.

01:05:21.630 --> 01:05:25.180
Are they independent
and are they objective?

01:05:25.180 --> 01:05:27.840
Yes, they are independent,
strictly speaking, in the sense

01:05:27.840 --> 01:05:31.560
that S&P and Moody's
and Fitch are not

01:05:31.560 --> 01:05:36.390
owned by any of the companies
that are being rated,

01:05:36.390 --> 01:05:37.650
number one.

01:05:37.650 --> 01:05:39.180
Are they objective?

01:05:39.180 --> 01:05:41.730
That's a different
question because remember

01:05:41.730 --> 01:05:45.090
that S&P, Moody's and
Fitch are businesses,

01:05:45.090 --> 01:05:47.430
and businesses generally
try to make money.

01:05:47.430 --> 01:05:50.310
And in order to make money,
you have to get revenues.

01:05:50.310 --> 01:05:52.260
And in order to
get revenues, you

01:05:52.260 --> 01:05:54.090
have to have lots of customers.

01:05:54.090 --> 01:05:57.630
And so the question
is, did they ultimately

01:05:57.630 --> 01:05:59.929
end up giving ratings
out too easily

01:05:59.929 --> 01:06:01.470
that they shouldn't
have because they

01:06:01.470 --> 01:06:02.910
wanted to get more business?

01:06:02.910 --> 01:06:04.660
I don't know the answer
to that, but there

01:06:04.660 --> 01:06:07.380
is going to be a lot of
people, particularly lawyers,

01:06:07.380 --> 01:06:09.690
asking those questions
in the coming months.

01:06:09.690 --> 01:06:12.390
So the rating agencies
have definitely

01:06:12.390 --> 01:06:15.879
been under fire by a number
of different organizations.

01:06:15.879 --> 01:06:17.670
I don't know where
that's going to come out

01:06:17.670 --> 01:06:20.520
and I don't know the details
of how they actually conducted

01:06:20.520 --> 01:06:22.990
the ratings, but there
is definitely an issue

01:06:22.990 --> 01:06:28.590
because what is AAA should
not default more than 1% or 2%

01:06:28.590 --> 01:06:32.370
over the life of
the particular loan.

01:06:32.370 --> 01:06:33.930
And clearly, with
these securities,

01:06:33.930 --> 01:06:35.596
they've defaulted at
a much higher rate.

01:06:35.596 --> 01:06:40.990
STUDENT: [INAUDIBLE]

01:06:40.990 --> 01:06:41.679
ANDREW LO: Yes.

01:06:41.679 --> 01:06:42.220
That's right.

01:06:42.220 --> 01:06:43.720
They only relied
on three companies.

01:06:43.720 --> 01:06:45.100
And actually, it's
very difficult

01:06:45.100 --> 01:06:47.890
to start a rating
agency now, because

01:06:47.890 --> 01:06:50.470
the regulatory
authorities require

01:06:50.470 --> 01:06:52.720
certain kinds of
standards to be met

01:06:52.720 --> 01:06:57.190
that are virtually impossible
for a startup to be able to do.

01:06:57.190 --> 01:07:00.490
So you're right, that
investors relied on this,

01:07:00.490 --> 01:07:04.810
and they ultimately
were badly misled.

01:07:04.810 --> 01:07:08.110
But the argument that S&P,
Moody's and Fitch would make

01:07:08.110 --> 01:07:10.300
is that, we were doing
the best we could,

01:07:10.300 --> 01:07:15.190
we looked at historical
default rates of mortgages,

01:07:15.190 --> 01:07:17.920
and we made very
conservative assumptions.

01:07:17.920 --> 01:07:21.700
In fact, if you assume that
they were zero correlation,

01:07:21.700 --> 01:07:24.910
but instead you tried
to be conservative

01:07:24.910 --> 01:07:28.230
and you said OK, the
correlation maybe is not zero,

01:07:28.230 --> 01:07:31.480
but let's make it,
oh I don't know, 25%.

01:07:31.480 --> 01:07:34.300
Even though historically,
the correlation

01:07:34.300 --> 01:07:36.760
is maybe much, much
less than that.

01:07:36.760 --> 01:07:40.960
If you just used an artificial
number like 25% or 30%,

01:07:40.960 --> 01:07:43.360
you would still not have
had the kind of dislocation

01:07:43.360 --> 01:07:45.130
that we saw over the
last couple of years,

01:07:45.130 --> 01:07:47.780
because the correlation
actually has gone much,

01:07:47.780 --> 01:07:49.450
much higher than
that, particularly

01:07:49.450 --> 01:07:51.790
for the subprime
mortgages, as you know,

01:07:51.790 --> 01:07:53.740
because the housing
market's turned down.

01:07:53.740 --> 01:07:56.350
And a lot of this was
triggered by this decline

01:07:56.350 --> 01:08:00.660
in housing, which has been
a very, very sharp decline.

01:08:00.660 --> 01:08:03.670
And over the last 30
years, the housing market

01:08:03.670 --> 01:08:06.460
in the United States has really
never gone down by more than 1%

01:08:06.460 --> 01:08:08.390
or 2% in a year.

01:08:08.390 --> 01:08:12.980
Never mind going down 10%
over the last 12 months.

01:08:12.980 --> 01:08:16.479
That's a really big
shock to the system.

01:08:16.479 --> 01:08:17.538
Yeah?

01:08:17.538 --> 01:08:21.600
STUDENT: [INAUDIBLE]

01:08:46.520 --> 01:08:49.189
ANDREW LO: Well, in fact they
have done that in the sense

01:08:49.189 --> 01:08:52.189
that they've actually chopped
up these kinds of security

01:08:52.189 --> 01:08:54.260
into five different tranches.

01:08:54.260 --> 01:08:57.060
And they've done it,
they've spread it out very,

01:08:57.060 --> 01:08:57.950
very broadly.

01:08:57.950 --> 01:08:59.720
That's how the US
housing market was

01:08:59.720 --> 01:09:02.870
able to grow as quickly as it
has over the last 10 years.

01:09:02.870 --> 01:09:05.600
It's because they brought
in huge amounts of money,

01:09:05.600 --> 01:09:09.710
unprecedented amounts of
money, through this mechanism.

01:09:09.710 --> 01:09:12.229
And all of the
investors invested

01:09:12.229 --> 01:09:14.180
based upon these
ratings, as well as

01:09:14.180 --> 01:09:17.899
their sense of how secure
these markets were.

01:09:17.899 --> 01:09:21.050
And in each case, there is
going to be dislocation,

01:09:21.050 --> 01:09:23.180
other than perhaps
in the middle tranche

01:09:23.180 --> 01:09:25.490
where it hits exactly
right and you don't

01:09:25.490 --> 01:09:27.452
get any kind of dislocation.

01:09:27.452 --> 01:09:28.910
But that's not the
biggest tranche.

01:09:28.910 --> 01:09:31.700
The biggest tranche was by
far the most senior one,

01:09:31.700 --> 01:09:34.790
because that's the one that has
the largest amounts of money

01:09:34.790 --> 01:09:36.838
waiting to be invested.

01:09:36.838 --> 01:09:41.083
STUDENT: [INAUDIBLE]

01:09:58.050 --> 01:09:59.800
ANDREW LO: Oh yes, absolutely.

01:09:59.800 --> 01:10:00.540
Yes, absolutely.

01:10:00.540 --> 01:10:04.560
Hedge fund managers have
profited greatly from this,

01:10:04.560 --> 01:10:07.500
because they bought the toxic
waste that nobody else wanted

01:10:07.500 --> 01:10:10.440
and then the value has
gone up dramatically

01:10:10.440 --> 01:10:13.200
because of these kind of
increases in default rates.

01:10:13.200 --> 01:10:17.160
Because they were priced to be
much worse than they ultimately

01:10:17.160 --> 01:10:19.500
ended up being.

01:10:19.500 --> 01:10:23.640
So it's absolutely the
case that the money has not

01:10:23.640 --> 01:10:25.560
disappeared into thin air.

01:10:25.560 --> 01:10:28.240
It's gone from the
senior to the junior.

01:10:28.240 --> 01:10:31.990
It's a wealth transfer in a way.

01:10:31.990 --> 01:10:33.720
Sorry, Ken.

01:10:33.720 --> 01:10:39.125
STUDENT: Just a comment
on why Moody's maybe rated

01:10:39.125 --> 01:10:40.375
these things the way they did.

01:10:40.375 --> 01:10:42.538
At least in my experience,
what would happen

01:10:42.538 --> 01:10:46.655
was the structuring
teams would meet

01:10:46.655 --> 01:10:52.030
with people who were going
to rate these securities

01:10:52.030 --> 01:10:54.420
and explain to them,
hey, this is what we did,

01:10:54.420 --> 01:10:58.000
this is why it makes sense,
and essentially convince them.

01:10:58.000 --> 01:11:09.950
True earlier why the

01:11:09.950 --> 01:11:10.770
ANDREW LO: Oh sure.

01:11:10.770 --> 01:11:12.260
There's a lot of
research that goes on.

01:11:12.260 --> 01:11:14.480
In other words, Moody's,
S&P and Fitch doesn't just

01:11:14.480 --> 01:11:17.260
decide based upon how they
feel that day whether is

01:11:17.260 --> 01:11:18.434
should get AAA or not.

01:11:18.434 --> 01:11:19.850
They do a fair
amount of research,

01:11:19.850 --> 01:11:21.892
and they go through the
details of the portfolio,

01:11:21.892 --> 01:11:23.600
they look at the
seniority of the claims,

01:11:23.600 --> 01:11:25.160
they look at the
legal documents,

01:11:25.160 --> 01:11:26.720
they look at the
historical record,

01:11:26.720 --> 01:11:29.900
they go back and go
back 30, 40, 50 years

01:11:29.900 --> 01:11:31.440
and take a look at the data.

01:11:31.440 --> 01:11:33.110
So that's why I
said, they actually

01:11:33.110 --> 01:11:37.100
have a case for making
the ratings as they did.

01:11:37.100 --> 01:11:39.274
How they could have
gone so far wrong

01:11:39.274 --> 01:11:40.940
is a question that
we're going to debate

01:11:40.940 --> 01:11:42.122
for the next several years.

01:11:42.122 --> 01:11:43.580
And ultimately, I
think we're going

01:11:43.580 --> 01:11:46.890
to learn that we need to make
our models more sophisticated.

01:11:46.890 --> 01:11:49.430
We need to have parameters
that are time varying.

01:11:49.430 --> 01:11:51.050
We need to have a
different approach

01:11:51.050 --> 01:11:53.150
to how we do
quantitative analysis

01:11:53.150 --> 01:11:54.830
for these kinds of markets.

01:11:54.830 --> 01:11:57.157
But that is an open
question that I

01:11:57.157 --> 01:11:59.240
think will have to be
examined in much more depth.

01:11:59.240 --> 01:12:03.460
STUDENT: [INAUDIBLE]

01:12:28.750 --> 01:12:31.390
ANDREW LO: Oh, in the current
situation can somebody make

01:12:31.390 --> 01:12:32.350
money?

01:12:32.350 --> 01:12:33.220
Absolutely.

01:12:33.220 --> 01:12:33.730
Absolutely.

01:12:33.730 --> 01:12:37.330
This is why I was saying at
the very start of this crisis

01:12:37.330 --> 01:12:41.800
that times of crisis are
also times of opportunity.

01:12:41.800 --> 01:12:45.190
You can absolutely make money,
because these securities now

01:12:45.190 --> 01:12:47.140
are priced all over the place.

01:12:47.140 --> 01:12:49.570
Some way to high,
some way to low.

01:12:49.570 --> 01:12:51.730
And if you understand
these models

01:12:51.730 --> 01:12:55.890
better than the next
person, you will make money.

01:12:55.890 --> 01:12:59.250
One of the largest payouts
that has occurred in hedge fund

01:12:59.250 --> 01:13:02.640
history occurred last year
to a hedge fund manager

01:13:02.640 --> 01:13:05.331
in New York named John Paulson.

01:13:05.331 --> 01:13:07.830
I think he was paid-- it's in
the Wall Street Journal so you

01:13:07.830 --> 01:13:08.496
can look it up--

01:13:08.496 --> 01:13:12.450
I think he was paid something
like $3 or $4 billion.

01:13:12.450 --> 01:13:14.790
Was it $4 billion?

01:13:14.790 --> 01:13:17.670
That was his take
home pay last year.

01:13:17.670 --> 01:13:19.200
That was on his W-2.

01:13:19.200 --> 01:13:22.680
That was not wealth,
that was income.

01:13:22.680 --> 01:13:26.040
And he did it by betting
on certain movements

01:13:26.040 --> 01:13:29.700
in these markets, including
these kinds of securities.

01:13:29.700 --> 01:13:31.706
So there's a lot of
money to be made.

01:13:31.706 --> 01:13:33.330
There's a lot of
opportunity out there.

01:13:33.330 --> 01:13:36.140
But it requires an edge.

01:13:36.140 --> 01:13:38.300
So you really have to
spend some time trying

01:13:38.300 --> 01:13:39.650
to understand these securities.

01:13:39.650 --> 01:13:43.250
And what we've done today, this
relatively simple analysis,

01:13:43.250 --> 01:13:47.330
is an analysis that apparently
eluded this Chief Risk Officer.

01:13:47.330 --> 01:13:51.620
Because they're focusing at
a very, very detailed level

01:13:51.620 --> 01:13:53.510
on models that are
probably not as

01:13:53.510 --> 01:13:56.190
relevant for the
macroscopic picture.

01:13:56.190 --> 01:13:56.690
Yeah?

01:13:58.825 --> 01:14:00.450
STUDENT: If no one
is able to determine

01:14:00.450 --> 01:14:01.020
the right price
for these things,

01:14:01.020 --> 01:14:01.972
how is the government going
to use the $700 billion

01:14:01.972 --> 01:14:03.400
to buy these things?

01:14:05.892 --> 01:14:07.600
ANDREW LO: Well, that's
a great question.

01:14:07.600 --> 01:14:09.808
That's one of the reasons
why there's so much debate.

01:14:09.808 --> 01:14:13.140
It's because the view is that
if the very best minds on Wall

01:14:13.140 --> 01:14:14.700
Street couldn't get
this right, what

01:14:14.700 --> 01:14:17.760
makes us think that the
Treasury can get it right,

01:14:17.760 --> 01:14:19.630
which is a little scary.

01:14:19.630 --> 01:14:21.000
I agree.

01:14:21.000 --> 01:14:22.470
There are a couple
of things that

01:14:22.470 --> 01:14:24.000
are being done to address that.

01:14:24.000 --> 01:14:25.860
One is that as part
of the proposal,

01:14:25.860 --> 01:14:28.560
they plan to set up an
advisory board of people that

01:14:28.560 --> 01:14:31.560
are in the industry, seasoned
veterans that are engaged

01:14:31.560 --> 01:14:33.600
in these transactions,
to help the government

01:14:33.600 --> 01:14:34.440
price these things.

01:14:34.440 --> 01:14:35.280
That's one.

01:14:35.280 --> 01:14:37.650
The second approach
is that they plan

01:14:37.650 --> 01:14:44.010
to engage in equity ownership
as a possible outcome for this.

01:14:44.010 --> 01:14:46.260
So in other words,
it's a bailout

01:14:46.260 --> 01:14:51.380
if you buy for $100
what is really worth 60.

01:14:51.380 --> 01:14:53.810
But it's not nearly
as much of a bailout

01:14:53.810 --> 01:14:56.870
if you buy for 50 what's 60.

01:14:56.870 --> 01:14:59.870
And it could actually be
quite profitable if not only

01:14:59.870 --> 01:15:02.870
do buy for 50 what's
worth 60, but you also

01:15:02.870 --> 01:15:06.230
get to own 80% of the
company in the process, which

01:15:06.230 --> 01:15:09.570
is kind of like the deal
that AIG has struck,

01:15:09.570 --> 01:15:12.770
and not that different from
some of the discussions

01:15:12.770 --> 01:15:16.760
that Warren Buffett has
had with Goldman Sachs.

01:15:16.760 --> 01:15:19.370
So the idea behind
the current proposal

01:15:19.370 --> 01:15:21.920
is that there will be
additional protections

01:15:21.920 --> 01:15:23.480
to allow the
government to benefit

01:15:23.480 --> 01:15:25.490
from the upside of
these securities,

01:15:25.490 --> 01:15:28.012
and to be able to get the
expertise needed to price them.

01:15:28.012 --> 01:15:30.470
And there are other protections
that would require industry

01:15:30.470 --> 01:15:33.980
to pay up for additional
insurance on these portfolios,

01:15:33.980 --> 01:15:36.140
and ultimately to
allow legislation

01:15:36.140 --> 01:15:39.650
to recoup some of the losses,
if at the end of 5 or 10 years

01:15:39.650 --> 01:15:41.420
the government ends
up losing money

01:15:41.420 --> 01:15:44.300
on these kind of transactions.

01:15:44.300 --> 01:15:46.860
Let me stop here, and
we'll see you on Wednesday.

01:15:46.860 --> 01:15:50.170
We'll talk about common stock.