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ANDREW LO: Last
time when we met,
we saw that the yield
curve was somewhere--
the short end was somewhere at
the 30 to 40 basis point level.
And let's see where it is today.
The yield on a three
month treasury bill,
according to this, is at
71 to 72 basis points.
So that's pretty good.
That's better than
it was last week.
There was a point, actually,
earlier this morning,
that the yield curve was--
the short end was
slightly above 1%.
But it's now come back down,
because of additional trading
and demand for these securities.
But that suggests that at least
the panic is not as severe
as it was last week.
Things are getting a bit better.
And not surprisingly, the reason
they're getting a bit better,
is because there's
more certainty now
that something was
going to happen.
When we met last, it seemed
as if there was a possibility
that this wasn't going
to happen at all,
that there was going to be some
breakdown between Democrats
and Republicans, and that
there was an impasse.
Fortunately, that got
resolved over the weekend.
At least it seems to be.
It's going to be voted
on as we speak actually.
So hopefully, we'll
find out by the end
of class or end of today
whether or not it happens.
If it doesn't
happen, what do you
think is going to happen
to the three month?
Yeah, so you could actually
look at this as a thermometer.
Check the temperature
of our economy.
It's pretty amazing, isn't it?
It tells you that financial
markets are very dynamic,
and that you actually can
learn a lot from market prices.
Again, are market
prices correct?
No, there's no such
thing as correct.
I want you to get away from
that notion of correct.
There is a market
price that reflects
the aggregate sentiment of the
economy and the participants
on a given day, at a
given point in time,
with a certain set
of market conditions.
And then you have to
decide whether or not
that set of prices is something
that you would like to use
in your own calculations.
So right now, these
are the prices
that reflect what's
going on in the economy.
By the way, at the
long end, last time
we saw that two weeks ago, the
long end of the yield curve
was pretty high, because
of concerns that there
was going to be inflation.
And then last week, we
saw that it went down.
What is it now?
Well, if you take a look at the
30 year, the yield is at 422.
That's slightly
lower, not by much,
but it's slightly lower
than what we saw last time.
And certainly lower than
what it was two weeks ago.
So the concerns about inflation,
while they're still there,
at least from the
data here it looks
like they're a little bit less.
So are people right today
and were wrong last week?
Who knows.
The point is that this reflects
what the current market
sentiment is.
And so at every point in time,
when you look at market prices,
what you're getting is a
window on current expectations
and current information, and you
have to make the best of that.
Any other questions?
Yup?
STUDENT: I just have
sort of two questions.
One is that, when the three
months treasuries are so high,
we said it was just a
couple basis points,
why wouldn't you
just short those?
Because don't you
have a [INAUDIBLE],,
they can't go above 0.
So you have a couple
basis points downside,
and [INAUDIBLE]
basis points upside.
ANDREW LO: That's right.
You could have shorted them.
Andy, do you want to answer?
ANDY: I'm not sure I agree
that you can short them.
ANDREW LO: OK, why not?
ANDY: Because going
short that means
that you want to
borrow money at 3 basis
points for three months, but
you're not the US Government.
And no on will allow
you to do that.
ANDREW LO: Well, it would be
hard to borrow the securities
and then sell them, right?
And unfortunately, you can't
manufacture the pieces of paper
the way the US Government can.
It's kind of hard
to do the printing
press in just the same way.
In fact, I think it
may even be illegal.
But you're right that if--
it's such a low
level, what you would
like to be able to
do is you'd like
to be able to issue that stuff.
And by the way,
the US Government
did take the opportunity to
issue some paper last week
to take advantage of this.
Because it's a great
way to do it, right?
You borrow money at
virtually zero interest
rate because you are
the US Government,
and all you need
to do is print up
these wonderful certificates.
But I think the issue
is exactly right.
If you wanted to
short it, you've
got to be able to borrow it from
somebody else and then short,
and they have to let
you borrow it from them
at appropriate premium.
So there's a risk
and a price for that.
But if you could do it, it
was a pretty good trade.
On the other hand, think
about what you're saying.
What you're saying
is that you would
like to be able to allow
people who want liquidity
to have liquidity.
You would like to provide them
with that kind of a liquidity.
If everybody is panicking
and wanting liquidity,
then that might be
a very good strategy
because when markets
calm down, eventually,
you will do quite well.
In effect, that's
what the US Government
is hoping to do with
this so-called bailout
package, which is
what I mentioned
last week that bailout is
probably not the right term.
It's a rescue
package undoubtedly.
But whether or not it's
a bailout or a very
savvy investment depends
simply on the price--
on the price that
you can get it at,
and the price that you
ultimately sell it for.
So that remains to be seen.
Other questions?
Yep?
STUDENT: I don't know the
details of the [INAUDIBLE],,
but I'm wondering,
this crises is
based on the whole economy is
leveraged on some assets that
are not really working
or are worth less
than they were supposed to.
And I wonder, at the
end, would the people
that have credit, but
bad credit, suffer?
Will they save
their homes or not?
I don't see--
because the only way
I see for this to be corrected
is to go to [INAUDIBLE]..
There's a lot of people
leveraged that cannot pay
so how will this get to--
Am I explaining myself?
ANDREW LO: I think so.
I think so.
I think you're expressing
the same kind of concern
and confusion that the
American public has expressed
at the bailout package.
Because it doesn't
seem like the bailout
is really applying to the
ultimate root cause of this,
which is the home owners.
The politicians would say
that you're bailing out
Wall Street when
you should really
be bailing out Main Street.
Let me hold off on answering
that, because it turns out that
this Thursday, October
2nd, from 5:30 to 7:00,
the Sloan School
will be organizing
a panel discussion
of the bailout,
as well as the root causes
of some of these issues.
So rather than take up
any more class time,
let me defer that question
to that Thursday panel,
and then I'd be happy to
talk about it afterwards.
But I'd rather make
sure that we stay
on track with our
curriculum and just use
this as an illustration.
But let me give you the
short answer to the question.
The short answer
is that the idea
is that you have to deal with
the current crisis right now.
So it's sort of like having a
patient come into the emergency
room and they're bleeding
out, and it turns out
that the reason they're bleeding
out is they've abused drugs
and they've done all
sorts of bad things
to their diet and health.
Now, at that time,
you probably don't
want to give a lecture
on good nutrition
and the dangers of
recreational pharmaceuticals.
You've got to stop the bleeding.
And then, over the course of
the next few weeks and months,
you try to rehabilitate
the patient.
So what the package is
meant to do, first of all,
is to stop the bleeding.
And then, over time, we're
going to have to address exactly
the issues that you raised.
And that's part of what the
proposal was trying to do.
That's why it took them
time to put it together.
It's easy to figure out
how to stop the bleeding.
Money will stop the bleeding.
But the problem is that
throwing money, good money,
at bad assets is not necessarily
the long run solution.
You have to figure out what
the ultimate causes are dealing
with foreclosures, dealing
with all of these very
complex securities, figuring
out how to value them,
coming up with proper
insurance agreements
to be able to create stability
across the entire market.
And that's what the various
aspects of the bailout package
are designed to do.
So we'll talk about
it on Thursday,
and I would encourage
all of you who
are interested to
come to that session.
We've got a number of economists
and accounting faculty
and other folks who are
going to be there to present.
You'll get a notice about that
probably later this afternoon.
STUDENT: One more thing.
On the Wachovia deal, what's
going to happen with the bank?
Is it going to
continue the same?
ANDREW LO: Well, obviously
that's a work in progress.
It looks like most of
the units of Wachovia
will be sold off to
Citigroup, but there
are a few units of Wachovia,
including AG Edwards, which
is a broker dealer,
and Evergreen, which
is another broker dealer,
that will remain separate
and will be freestanding.
So that will not be
acquired by Citigroup.
But apart from that, all
the other units of Wachovia
will be taken on by
Citigroup, and that there
will be a backstop provided
by the FDIC in case
the losses exceed
more than $40 billion.
So Citigroup will
be able to take that
onto its balance sheets.
And in exchange
for taking on all
of these bad debts
and other problems,
Citigroup gets the
retail access to all
of the various
different channels
that Wachovia has set up.
So now, Citigroup
has the ability
to compete head-to-head with
Merrill Lynch having been
acquired by Bank of America.
Whereas before, they wouldn't
have been able to do that.
So you see, this is what
I was saying last time,
that with every kind of crisis,
with every kind of dislocation,
there are opportunities
that are created.
And so when you have
one door closing,
three other doors
open for opportunities
that can be taken advantage of.
And by the way, let we
mention, this is also
true for your careers.
You might be discouraged
about financial services.
I would argue just the opposite.
Right now, all of you are
at an excellent position
as first year students,
because first of all, you're
here in school waiting out
the passage of the storm.
And when the storm
passes, believe me,
there are going to be
tons of opportunities.
In fact, typically the
largest growth period for jobs
is not at business cycle
peaks, but its exactly
after these kinds of
troughs that occur.
So within the next
6 to 12 months,
there's going to be tons
of career opportunities.
In fact, for those
of you who are
interested in going to
the New York Banking Day,
and you really should if
you're interested in a career
in finance.
My guess is if you visit
Goldman Sachs, Morgan Stanley,
as difficult as a
set of circumstances
they're in right now, my
guess is every single one
of these firms will be hiring.
And the reason they're
going to be hiring
is because they want to take
advantage of the opportunity
to cut costs and to
hire younger, more
energetic employees to
be able to really beef up
their future generations
of human capital.
So they're going to be
making an investment in that.
So I think that's a good example
of how it's true that you're
going to have consolidation.
So now, after
this, there's going
to be three major money center
banks, JP Morgan Chase, Bank
of America, and Citigroup,
which is astonishing
because just a few months ago
there were quite a few others.
So the landscape has changed.
But the competitive
landscape changing
means that opportunities
get created along the way.
STUDENT: I was just wondering
from your point of view.
Why is it better to have the
banking industry consolidated
into three buckets?
In that, wouldn't
it have been better
to let Wachovia fail and
let the regional [INAUDIBLE]
pick up the slack instead of
now having literally JP, B of A,
and CitiGroup dominate
the entire landscape
and be in a position to
monopolize [INAUDIBLE]
going forward.
ANDREW LO: Well, so that's
an interesting thought,
letting Wachovia fail.
Obviously, you're not
a Wachovia customer.
I think that what's
happening right now
is that there's a great
deal of sensitivity,
not only on the part of
Wall Street, but regulators,
to stem the tide of
mass financial panic.
We talked a bit
about that last time.
The reason that regulators
and the government
sprang into action was not
because Lehman went under,
or AIG went under, or
any of these other large
organizations.
The reason that finally got
them over the edge of moving
to do something substantial
is because the reserve
fund, a retail money market
fund, broke the buck.
And if that happens on a regular
basis beyond the reserve fund,
you will have a very, very
significant financial market
dislocation.
It turns out that Wachovia is
part of that retail network.
And if you let
Wachovia fail, you
risk igniting further problems
in that retail sector.
Citigroup is perfectly
happy to take them over
and are able to
given their balance
sheet-- are able to manage
that without any problem.
So that seemed like
an ideal solution
from everybody's perspective.
Because if you allow
Wachovia to fail, remember,
the FDIC is on the hook to pay
all the depositors their FDIC
deposit insurance up to
$100,000 per name, per account.
That could be a very substantial
number by letting the bank fail
and by having all of its
value completely lost.
This way, they actually
preserve a fair amount of value,
because as an ongoing
concern, Wachovia has
quite a lot of good business.
So it actually is the
cost minimizing solution,
but at the same time
it also preserves
the current fragile integrity
of financial markets at least
until the bailout fund is set.
My guess is that in about three
or four weeks, if we have banks
that end up not being able
to make their commitments,
they are going to
be allowed to fail.
Because at that
point, those failures
won't jeopardize the
entire financial system,
they'll be dealt with by
this bailout organization.
So I think that
that's the logic.
Yeah, last question,
let's move on.
STUDENT: Is that
the same thought
process as freezing Washington
Mutual's failure [INAUDIBLE]..
ANDREW LO: Well, that's right.
But the difference there is
that Washington Mutual has
much bigger exposure to
these subprime loans,
and so I think in that
case, there really
wasn't much of a choice.
And very much so transferring
the business units
that are able to be moved
over JP Morgan Chase
would make a fair bit of sense.
So there's a lot of
consolidation going on
in this industry, but
once again, consolidation,
while it seems like
it's a big upheaval,
and it is for the people that
are at these organizations,
it's very disruptive,
the fact is
that these kind
of disruptions are
part and parcel of how
businesses grow and develop
and morph over time.
In fact, if you went
back to the 1960s,
and you looked at a Wall
Street Journal on microfiche--
I happened to do
that just because I
was looking for a particular
citation at one point--
if you look at the
advertisements in the 1960s
or even 15 years ago, you
look at the advertisements
in the Wall Street
Journal in those days,
there are names of financial
institutions that you've never
heard of, that were really
big institutions back then.
So it's rare that we
have institutions that
survive for 50, 75, 100 years.
It's part and parcel of
how businesses develop.
And the key is to focus on the
process by which businesses
change.
So when we start talking
about equity evaluation,
we're going to see that by
looking at income statements
and balance sheets together,
we can see not only what's
a good business and
what a bad business,
we can also see how
businesses evolve over time.
And it's that
evolution that we hope
to try to bring across
to you in this course.
I want to show you how it
is that you can understand
the dynamics of changes
in business conditions,
because that really is, I think,
the key to a lot of what you
can use in your own careers.
I know there are more questions.
But let me hold off on those
and start on the lecture today
and then we can cover those a
little bit later on after we've
made some progress.
So this is a continuation
of last lecture
where we were talking about
convexity and duration
as two measures of the
riskiness of a bond portfolio.
And I concluded last lecture
by talking about the fact
that if you think about
a bond as a function
of the underlying yield, then
you can use an approximation
result that says that the bond
price, as a function of yield,
is approximately
going to be given
by a linear function
of its duration
and a quadratic function
of its convexity.
So we have an
approximation that says
that the price of
the bond at a yield y
prime, is going to be equal
to the price of the bond
at a yield y multiplied by this
linear quadratic expression.
And really, the
purpose of this is just
to give you a way of
thinking about how
changes in the fluctuations
of a bond portfolio,
as well as the curvature
of that bond portfolio,
will affect its value and
therefore its riskiness.
These are just two measures
that will allow you to capture
the risk of a bond portfolio.
So I have a numerical
example here
that you can take a
look at and work out,
and you can see how good
that approximation is.
This is an approximate result
that the price at a yield of 8%
is going to be given as
a function of the price
of the bond and a
yield of 6% multiplied
by this linear
quadratic expression.
And the actual result
of the bond price,
now that we have high speed
digital computers that
can calculate all of this
at a moment's notice,
you can see the difference.
It differs basically
by about a penny.
A penny it's not a big deal.
But when you're dealing with
billions of dollars actually,
a penny is a pretty
significant amount.
So what you want to
do is to make sure
that you use the right
formula to calculate it.
I wouldn't argue that you should
use convexity and duration
to do any kind of
bond pricing analysis,
but for a quick and dirty
method for getting intuition
about how risky a bond portfolio
is, the two questions you ought
to ask somebody is,
what's the duration
and what's the convexity.
And what those two numbers, you
can develop a kind of intuition
for how the bond
price is going to move
in response to underlying
changes in the yield curve.
And right now, we
see that the yields
are changing pretty rapidly.
The Treasury yield curve,
at least at the short end,
is bouncing around
depending on what happens
every day in Washington.
And so if you have that sense
of short term yields changing,
by looking at
convexity and duration
you can get a sense of how
sensitive your portfolio might
be to those kinds of exposures.
The last topic I'm going to
take on is now corporate bonds.
Up until this point, the
only thing that we focused on
has been default free
securities, namely
government securities,
because governments can always
print money and
therefore they can always
make good on the claim that
they will pay you a face
value of $1,000 in 27 years.
There's no risk that they can't
run those printing presses.
What I want to turn
to now is risky debt,
and in particular
I want to point out
that risky debt is fundamentally
different in the sense
that there is a chance that
you don't get paid back.
So one of the most
significant concerns
of pricing corporate
bonds is default risk.
And the market has
created its own mechanism
for trying to get a sense of
what the default risk really
is.
Namely, credit ratings.
These are ratings put out
by a variety of services.
The services that
are most popular
are Moody's, S&P, and Fitch.
And these services do
analyzes on various companies,
and then they issue reports,
and ultimately ratings,
on those companies.
They'll say this company
is rated AAA, AAA being
the highest category.
And I've listed the
different ratings categories
for the three
different agencies here
so you can get a sense
of how they compare.
Typically, these
ratings are grouped
into two categories, investment
grade and non-investment grade.
And really, the
difference is just
the nature of the default
risk or the speculativeness
of the default probability.
Bonds that are below
investment grade
have a higher default rate,
and bonds that are supposedly
investment grade
are ones that are
appropriate for prudent and
conservative investments.
STUDENT: Do you mind
maximizing the slide?
It's a little hard
to read back here.
ANDREW LO: Oh, sorry about that.
Thank you.
Yeah, that's better.
So investment grade for Moody's
is AAA, high quality is AA,
upper medium quality is A,
and then medium grade is BAA,
and then anything
below BAA is considered
non-investment grade.
Now, the one thing you have to
keep in mind about fixed income
securities is that
apart from some
of the more esoteric strategies
that we talked about last time
like fixed income arbitrage,
this idea of taking
a bunch of bonds and figuring
out which ones are mispriced
and trading them, apart
from those strategies,
most people invest in
bonds not because they
want exciting returns.
If you want exciting
returns, you put your money
in the stock market or real
state or private equity
or other kinds of
exciting ventures.
Bonds are supposed to be boring.
You put your money in, and five
years later you get your money
out with a little extra.
That's what bonds
are supposed to do.
And it wasn't until the 1970s,
when the era of junk bonds
came on the scene, 70s and 80s,
with Michael Milken and Drexel,
Burnham, Lambert,
that you really
had a very different face
of fixed income markets.
By and large, fixed income
markets dwarf equity markets.
But the reason that
they're so large
is because most people use
them as a kind of a safe haven.
And as you get
riskier and riskier,
it starts to look less like
bonds and more like equity.
In fact, if you think about
the bankruptcy process,
if you've got a risky corporate
bond, you're the bond holder,
and the company
declares bankruptcy,
they can't pay your interest
payments that are due to you,
when they declare
bankruptcy, then
at least from a
theoretical perspective,
you the bondholder now
become equity holders.
You own the assets.
Because they can't
pay you, so they're
obligated to give you
control of their company.
So as bonds become
more risky, they
start to look more and more
not like debt, but like equity.
That is, the returns
are random and you don't
know what you're going to get.
It's sort of a
surprise every day.
It's the gift that
keeps on giving.
But for the most part, investors
that are invested in bonds
aren't looking for that.
We're looking for safe returns.
And they're looking
for the highest
yield that is a safe return.
So investment grade
is the category
that typically pension
funds, endowments,
and other relatively
conservative institutions
look to.
Within that category,
they would like
to get as much
yield as possible.
So which of these
different grades
do you think offers
the highest yield?
Why is that?
Yes, you're right.
Why is that?
What's the logic for that?
STUDENT: [INAUDIBLE]
Exactly.
Given that it's lower
rated, that means
it's got a higher
probability of default,
you've got to pay investors a
little bit of extra for them
to bear that risk.
Simple as that.
So the reason that there are
multiple categories, even
in investment
grade, is that there
are different levels
of risk aversion
that investors want to take on.
Some investors are
highly risk averse,
and for the very, very
risk averse investors,
they're going to take on AAA.
And for those that are a
little bit more adventurous,
they'll take on lower grade.
And for those hedge funds, who
are looking for lots of risk
and lots of return,
they're the ones
that are dealing in the
non-investment grade issues.
Those are the ones where you
have relatively large returns,
15% or 20% returns,
you didn't think
you can get a return of
15% to 20% for bonds,
but you can if
there is a 5% or 10%
chance that you
won't get anything.
So when you do get
paid, you get paid well,
but you don't always get paid.
So that's the
categories that are
developed by the various
different ratings institutions.
And once you get a rating,
that allows you to approach
investors and say,
OK, this is what
I'm looking to get
for my corporate bond,
and what I'm hoping to get is
commensurate with the risks
that we're bearing.
Here's a little history of the
yields on Moody's BAA bonds
minus the US 10
year treasury yield.
So this spread tells
you what the difference
is between a very
safe asset and a BAA
asset, which in this
category, is just
above non-investment grade.
So it's the lowest grade
that you can get and still
be passing.
This is sort of like
the 65 or something
of junior high school
and high school.
So that spread between
BAA and US treasuries
is an indication of the risk
premium implicit in the default
potential of a BAA bond.
And look at how it's changed.
In the 1930s, this spread was
about 7 and 1/2 percentage
points.
That's a big spread
by today's standards.
Now of course, by
today's standards,
literally today,
things are different,
and we may be getting
up there soon.
But let's take a
look at where we
were at least where the data
ended, which is back in 2005.
At the end of this
dataset, the credit spread
was maybe 1 and 1/2 to 2%.
That's at a near historic low.
Now, you can see that there
are a little bit of a blip
every once in a while.
December.
1987, this is after the stock
market crash of October 87.
You see a big blip going up.
And September of 1998
after LTCM, that goes up.
And then of course credit
spreads widen over here.
September 11 happened,
2001, over here.
And so credit spreads got
as high as something like 3-
3 1/2% percent, and now,
prior to what's happened over
the last several weeks, credit
spreads were at a close to all
time low.
What does it mean when credit
spreads are really low?
What does that tell you?
What does it say?
Yeah.
STUDENT: [INAUDIBLE]
ANDREW LO: Right.
That's one interpretation,
that the market
is perceiving the default
risk as not as significant
as it used to be.
Another way of
interpreting that is
that the investment
population is
less concerned about the default
risk than back in the 1930s.
Not surprisingly.
Something did
happen in the 1930s
that was kind of significant.
What was that?
The crash of 29, and
then the depression
that led from that crash.
So that tells you that at
least at the end of 2005,
beginning in 2006, people were
less risk averse, at least
on paper what this shows.
What else does it tell you
about the probability of credit?
STUDENT: [INAUDIBLE]
ANDREW LO: Exactly.
Lots of money.
Another way of interpreting this
is that there's lots of money
out there.
Lots of money willing
to be lent out
to all sorts of risky
ventures without much
in the way of expectation
that they should get
paid a much larger premium.
So those two interpretations
are likely to be both true.
That is, the
population of investors
did seem less risk averse, and
there is empirical evidence
to support that.
But on top of that,
it also suggests
that there's tons of
money out there being lent
to various different
projects, and because there's
so much money, there's such an
increase in supply of funds,
the extra premium that is
commanded by those funds
could not be that great, simply
because of the competition
to supply funds to these
various risky ventures.
So if you wanted
to do a startup,
the time to have
done it was in 2006,
because you would have gotten
great deals since there
was so much capital out there.
Now that's changed.
But part of the
reason it's changed,
part of the reason that we're
in the current financial
difficulties that we're
in, is because there
was too much money
chasing too few genuinely
good opportunities.
And so we're seeing
now the after effects
of some of those
poorer investments
in those opportunities.
So this kind of
credit spread picture
can give you a sense of
the dynamics of money flows
within the economy,
and definitely
worth keeping track of.
Now, there are a number of
things that are in that spread,
in that premium.
Obviously, there's an
expected default loss,
but there's also tax effects.
There's also some other kind
of systematic risk premium
that has to do with
aggregate risk exposure.
And a variety of
other academic studies
have been done to
decompose that spread
into different components.
Graphically, you can see
that if you look at--
if you take a look at the
composition of that premium,
you can show that part of it
is due to default, part of it
is due to the riskiness of
the particular investment,
and then the other part is
simply the default free.
That's the part that we've
studied up until today.
So the other two parts, the
other extra risk premium,
is really decomposed into a
default risk premium, but also
a market risk premium.
That is, just general riskiness
and price fluctuation.
People don't like
that kind of risk,
and they're going to
have to be compensated
for that risk
irrespective of default.
Just the fact that
prices move around
will require you to reward
investors for holding
these kind of instruments.
And in the slides, I give you
some citations for studies
on how you might go
about decomposing
those kind of risk premiums.
So you can take a look
at that on your own.
But the last topic
that I want to turn to,
in just a few minutes
today, before we
move on to the pricing
of equity securities.
The last topic I want to
turn to is directly related
to the problem of
subprime mortgages.
I promised you that I
would touch upon this.
I'm not going to go through
it in detail, because this
is the kind of material
that we will go through
in other sessions on the
current financial crisis.
But I want to at least
tell you about one
aspect of bond markets
that's been really important
over the last 10 years.
And that is, securitization.
Now, when you want to
issue a risky bond,
as a corporation or
even as an individual,
you have to deal with a
counterparty, a bank typically.
Banks were the traditional
means of borrowing and lending
for most of the 20th century,
and up until the last 10 years.
But about 10 years ago, an
innovation was really created.
Actually, it wasn't
created 10 years ago
but it really took
off 10 years ago,
where instead of borrowing
from financial institutions
like banks, you were able
to tap into the borrowing
power of financial markets.
This is what's often
called disintermediation.
Banks are considered
intermediaries.
They serve as a conduit between
us, the retail investor,
and financial markets or
other counter-parties.
They stand in the middle.
They take money from
us, put it in deposits,
they take those deposits,
lend it out to corporations,
and they take money
from corporations,
and bring it into their
bank, and lend it to us
in the form of mortgage
payments-- mortgages,
so that we can buy our house.
About 10 years
ago, intermediation
started to unwind because of
innovations in securitization.
The idea being that we are going
to instead of dealing directly
with banks, tap into the
power of financial markets
in borrowing and lending.
And so I want to give you an
example of how that works.
Something that I went
over in the Pro Seminar.
But for those of you
who didn't attend,
I want to show it to you because
it's such an important idea.
And this is an idea
that is best done
through a very simple
numerical example.
So in about 10 or
15 minutes, I'm
going to illustrate
to all of you
the nature of problems in
the subprime mortgage market.
That's all it'll take.
To get to the bottom
of it could take years.
But at least to understand
what's going on,
I'm going to do this
very simple example.
Suppose that I have a bond,
which is a risky bond.
It's an IOU that pays $1,000
if it pays off at all.
So the face value of
this bond is $1,000.
But this is a risky
bond in the sense
that it pays off $1,000
with a certain probability,
and it pays off nothing
with another probability,
let's say 90 10.
So the simple expected
value of this is $900.
And so you might think
that that should be
a proxy for the market price.
And in fact, that would be
a pretty good approximation.
Now, right there is
an interesting insight
into the pricing of risky bonds.
Because if we have a security
that has $1,000 face value,
but it's got a
probability of default,
and you compute the
current value as $900,
then that gives you an
implicit yield for the bond.
What yield is it?
It's whatever number, one
point something multiply by 900
gives you $1,000.
So the very fact
that it defaults, now
allows us to compute a
yield without reference
to the time value of money.
The time value of money
can add an additional piece
into this calculation.
I decide to ignore it
just for simplicity.
But suppose the
interest rate was 5%,
the risk free interest rate
was 5%, then what I might do
is to say, OK, $900 is what I
expect to get out of the bond.
I'm going to take that
$900 and discount it back
a year by 1.05, and
that will give me
a number such that
when I compute
the yield on that number
relative to $1,000,
it will have the total
yield of this bond.
5% of which is the risk free
part, and the other part
is the default part.
But I want to keep
the example simple.
So let's just assume that the
risk free rate of interest
is zero 0.
So I've got my bond that
pays off $1,000 next period
with probability 90%.
So the expected value is 0.9
times 1,000 plus 0.10 times
nothing.
$900 for this bond.
Now let's suppose that I have
not just one of these bonds,
but I have two of them.
And they're absolutely
identical in every respect.
They're just two
of the same bonds.
For each of the bonds, you
might think that it's not
that easy to find a buyer.
And you're right, because a 10%
default rate is pretty risky.
In a minute, I'll
show you how risky
when we look at the default
rates, historical default
rates, of bonds with various
different credit ratings.
But right now,
with a 10% rating,
this bond would be
rated below BAA.
It would be below
investment grade.
So you're not going to get a lot
of people that want to buy one.
In fact, we can auction
it off in this class
right now to figure
out what the price is.
My guess is that
I may not even get
$900 for that in this class,
given your current mood
and liquidity issues.
But I'm going to show
you some magic that
will make this incredibly
interesting to a large number
of investors,
including all of you.
I'm going to take
these two bonds
and put them together
in a portfolio.
Now, what exactly
does that mean?
So far I've said nothing.
I've drawn a circle
around the bonds.
By portfolio, I
mean that I'm going
to create an entity, a
corporation, whose sole purpose
it is to buy these two bonds.
And therefore, the
fortunes of the corporation
are tied not to the performance
of any one or two bonds,
but to the performance of the
collective portfolio of bonds.
So that's what I mean when
I say, form a portfolio.
I mean, consider a
single entity that
will hold both of these bonds.
And let's assume, for
the sake of argument,
that the default of these
two bonds is uncorrelated.
In fact, I'm going
to assume that these
are two separate coin flips,
and they're different coins,
they have the same probability
of coming up heads 90%,
10% tails, but they're
different coins.
They have nothing to
do with each other.
So they're independent.
Whether or not one
bond fails has nothing
to do with the other bond.
When I put this
into a portfolio,
how does the portfolio
behave looking at it
as a single entity?
There are three
possible outcomes.
Actually, there are four,
but only three of them
are really distinct.
Both bonds will pay off,
or both bonds will default,
or one bond pays off
and the other defaults.
Those are the only three
outcomes that are possible.
And the payoffs
and probabilities,
assuming that they are separate
and independent coin tosses,
is given in that table.
$2000 if they both pay off.
And the probability of
that is 81%, 0.9 times 0.9.
And I'm multiplying, because I'm
assuming they're independent.
The probability that they both
don't pay off, in which case
my portfolio is worth
nothing, is 1%, 10% times 10%.
And then whatever's left
over is in the middle.
That is, there's a
chance that one of them
pays off but the other
one doesn't, and then
the portfolio is worth
$1,000, and there's
an 18% chance of that.
So here's the stroke of genius.
The stroke of genius
is to say, I've
got these two securities
that are not particularly
popular on their own.
What I'm going to do is to
stick them in a portfolio,
and then I'm going to issue
two new pieces of paper,
each with $1,000 face value.
So they're just like
the old pieces of paper,
but there's one difference.
They have different priority.
Meaning there is a
senior piece of paper
and there is a junior
piece of paper.
The senior piece of
paper gets paid first,
and the junior paper only
gets paid if and when
the senior paper gets paid.
So I'm going to issue
two pieces of paper.
The blue is the senior
and the red is the junior.
The senior paper I'm going
to call the senior tranche.
Tranche, I believe is the
French word for trench,
which seems much more
appropriate today than it
did before.
We're digging our
own trenches here.
The senior paper
is going to have
first dibs on that portfolio.
And the junior
paper will only get
paid after the senior
paper gets paid.
And so let's see what
happens with that.
Remember, they're both
$1,000 face values.
So on paper, I've
done nothing in terms
of creating or destroying the
total claims on the asset pool.
The portfolio has claims
at $2000 of face value,
and my new securities has
claims on $2000 at face value.
But all I've done is to change
the order, the priority,
of the payout.
Here's the table.
I have three values for my
portfolio, $2000, $1,000,
and nothing.
Now let's see what happens
to each of those two
claims, the senior claim
and the junior claim,
of my new securities
that I've issued
The senior claim
gets paid $1,000
if both bonds in my
portfolio pay off.
But the senior claim
also gets paid $1,000
if only one of those
bonds pays off.
So two out of the
three outcomes are
good news for the senior debt.
And in the third case, where
both of them don't pay off,
then the senior
paper is out of luck.
Now, the junior paper
is exactly the reverse.
The junior paper only will get
paid if both bonds pay off,
because in that case,
the senior guy gets paid
and then there's money
left for the junior guy.
In the latter two cases,
if only one bond fails
or both bonds fail, then the
junior claim gets paid nothing.
So what I've done is to
take two identical bonds,
and I've created two
non-identical claims,
such that one is a lot
safer than the other.
How much safer?
Well, the bond that is senior
has a 1% chance of default, 1%,
because both bonds have to fail
before the senior guy doesn't
get paid.
1%, what was it before?
It was 10% for both bonds.
But because I stuck
it in a portfolio,
and I changed the
priority of payouts,
the senior claim now
looks a lot safer.
But that's not a free lunch,
because the junior claim
is a heck of a lot riskier.
The junior claim now loses
money 19% of the time.
It used to be the case
that one of these bonds
had a 10% default rate,
but the junior claim
has a 19% default rate, 18%
plus 1% from those two outcomes.
As long as investors
know the structure,
nobody's getting a good
deal or a bad deal.
There's no cheating going on.
We explain this to
investors, so you all
see these probabilities.
And now, let's calculate
what the expected
values are for the payouts.
The expected values--
before I do that,
let me comment on default rates.
So a 1% default rate
seems like a small number.
And a 19% default rate
seems like a large number.
Well, let's take a look at
the empirical evidence given
debt ratings.
These are historical
default rates
for bonds from 1920 to 1999.
So I've got almost an
80 year record of bonds
that have been issued
by corporations
and that have been stamped by
Moody's with their ratings.
And the different
bars correspond
to how long the bonds have been
issued and are outstanding.
Because obviously, the
longer the bond is out there,
the more likely it is
that it will default.
So you have to separate them
by the years out in the market.
If you take a look at a
five year period, that's
the bars all the way
to the extreme left
of each rating category, you see
that for a five year periods,
the default rate
of AAA securities
is well, well below 1%.
It's measured in basis
points, that probability.
If you wait 20
years for AAA bonds,
the default rate goes
up to maybe 2% or 3%.
So that means that when
AAA bonds are issued
and you wait for 20 years
to see what happens to them,
it's a very, very small group
that ends up defaulting,
if they have a AAA rating.
On average, AAA bonds default
maybe 1% of the time or less.
On the other hand,
if you take a look
at below investment
grade-- so BAA
is just at the borderline
of investment grade.
And if you take a look
at the default rates
here, lots higher.
But by lots higher, we're
talking about 5% to 10%,
5% to 10%.
So based upon these
categorizations,
we can now rate our own bonds,
what I just decided to issue
with these securities, right?
The senior tranche is
rated AAA, and what would
you rate the junior tranche?
BA maybe.
BAA at the best, but
probably more like BA.
So the senior tranche
looks pretty good,
and the junior tranche
looks pretty bad,
but you know what their
ratings are, and therefore,
go ahead and price
them accordingly.
So let's do that.
If you price them
accordingly, what happens
is that the senior tranche
gets priced at $990,
and the junior tranche gets
priced at 810, 990 and 810.
Now, this is very different
from what the price was before.
The price for both
bonds was 900, right?
The expected value
of the payout.
And the expected value
of each bond is 900.
When you add them
up, you get 1,800.
Here, when you add up these
two bonds, you also get 1,800.
So I have neither created
nor destroyed value.
All I've done is to
reallocate that value.
I've given the senior
bondholders lower default risk
and therefore higher likelihood
of getting their money back,
therefore a lower
yield is necessary
in order to sell that bond.
On the other hand,
that extra benefit
that we've given to
the senior claimants
comes from the junior
claimants, and therefore, they
get a lower price,
or they have to be
given a higher yield, to entice
them to bear that kind of risk.
Now, why is this such
a stroke of genius?
It's because what we've done is
take two identical securities
that nobody was
particularly excited about,
and we've created, by this
securitization process,
we've created two other
securities that actually
a number of communities
are very excited about.
For example, the pension
funds, endowments, foundations,
all of the very
conservative investors
that want a very
boring bond portfolio.
No excitement, no headline risk.
They just want their money
back with a reasonable rate
of return.
They've got it with
the senior tranche.
And by the way, if they're even
nervous about this very, very
safe structure, let's insure it.
Let's get a large,
stable insurance company,
oh I don't know, maybe
AIG, and let's get
them to insure that these won't
default. Because if they do,
AIG will pay an extra
premium on top of that.
So then they're called
super senior securities,
super senior tranche securities,
because they've got guarantees
on top of the
securitization features.
Pension funds love this.
They bought this in
large, large quantities.
Now, what about the
so-called toxic waste
that the junior tranche?
Well, we know it's toxic waste.
We've priced it as if
it were toxic waste.
And so those investors that are
looking for 15% or 20% returns,
that are not looking
for boring, safe assets,
they will go for
the junior tranche.
Namely, the hedge funds.
And as many of you
know, hedge funds
have grown by leaps and bounds.
Over just the last
10 years, they've
increased their assets
under management
by a factor of 10 to 20.
And that money is
looking for a home.
And boring, safe
investments that
earn 6%, 7%, 8%, that's
not for hedge funds.
They are looking
for 15, 20, 30 40%,
and they get that with
that junior tranche.
That's why the market, over the
last 10 years, has exploded.
It's twofold.
It's because money has
come in from pension
funds for the senior debt.
Money has come in from the hedge
funds for that junior debt.
And together, they brought
much, much more money
into this business
than ever before.
And the question is, how
do you take that money
and push it out to people.
Well, it turns out that because
housing markets are going up,
that was a perfect
way to get these
this money out to investors.
Yes?
STUDENT: This model is based on
the probability of the Moody's.
I have a question.
Is there any way investors
can estimate this probability
by themselves instead
of relying on Standard
and Poor's or Moody's?
ANDREW LO: It's very
difficult for investors
to estimate the
probabilities themselves,
because they don't have
access to the same data
that Moody's and
S&P and Fitch do.
Typically when you
estimate the probabilities,
you need data in terms of
the underlying portfolio
and the riskiness.
As a typical investor, certainly
as a pension fund investor,
you would not be given access.
And even if you
were given access,
you don't have the staff that
can actually analyze this.
STUDENT: So if Moody's
or Standard and Poor's
made a mistake, then every
pension fund or other investors
will made the same mistake.
ANDREW LO: The mistakes
can carry over.
That's right.
There is no way for
pension funds, endowments
and foundations, or
retail investors,
to do their own kind
of due diligence.
They're relying on those
managers of the pension funds
to do that.
And by the way, it wasn't just
pension funds that did this.
There was some mutual
funds that did this too.
And not only mutual funds,
but there were also some money
market funds that did this.
Now, money market funds you
say, why would money market
funds get invested in this?
Well remember,
money market funds
are supposed to be putting money
into short term, fixed income
instruments.
Well, these could be
short term, and these
are fixed income instruments.
And if you add some
insurance on top of that,
they're even safer,
on paper anyway,
than many of the other
traditional instruments.
So you can see now how a
wonderful idea, and this really
is wonderful because
it dramatically
increased the risk bearing
capacity of the economy.
And by the way, it made a
lot of people better off.
So right now, we're in the
midst of a financial crisis
and we're focusing
on the negatives.
But let's not be
too quick to forget
that these kinds of
securitization processes
brought in huge amounts of
money that ultimately went
to homeowners to be able to
buy homes that they otherwise
couldn't have afforded, and
maybe you would argue they
shouldn't have afforded,
but there are still many,
many homeowners out there
that have subprime loans that
are paying their
mortgage payments,
that are perfectly happy
living in their atoms,
and otherwise couldn't have
afforded it without it.
And Moreover, there
are a whole host
of individuals that made tons of
money because of the real state
boom and because they
were able to leverage
using these kinds of funds.
STUDENT: In this example, the
ones who [INAUDIBLE] are us.
Is that like Lehman Bothers?
Are those the companies--
ANDREW LO: That's right.
So an example would be some
of the investment banks,
as well as some of
the commercial banks.
Now, in a minute, I'm
going to tell you what
went wrong with all of this.
So far, the story is great.
This is really an innovation
in financial engineering,
because by securitization,
by repackaging,
we've done nothing dishonest.
We've told people
exactly what we're doing.
We've given them transparency.
And we've given the safer
asset to the community
that wants safer assets.
And we've given the
very exciting assets
to those who want
the exciting assets.
Now, where does this go wrong?
Question before we do that.
STUDENT: The assumption
that you made in this is
that they are not correlated?
Isn't there more likeliness of
correlation between the two?
ANDREW LO: So that
there's always
somebody that's ready to spoil
the party for the rest of us.
You're absolutely right.
That's where the story
gets interesting.
I've assumed that these
two bonds are uncorrelated.
What if that
assumption is wrong?
In fact, what happens if not
only are they uncorrelated,
but what happens if the bonds
are perfectly correlated?
Let's work that out.
That's a numerical example
that's not hard to do.
If the bonds are
perfectly correlated,
that means they default
at the same time
and they pay off at the
same time, then instead
of three outcomes, we
only have two outcomes.
Either we get paid
$2,000 in the portfolio,
or we get paid nothing
in the portfolio.
Now, what happens to the
senior and junior tranches?
Well, now, the senior
tranche, the tranche
that was AAA, the tranche
that had less than 1%
probability of
default, the tranche
that was supposed to be so
safe that all sorts of very
conservative institutions
could take it on, that tranche
has now increased in
riskiness by a factor of 10.
The probability of default
has gone from 1% to 10%.
And the junior
tranche, the tranche
that was supposed
to be toxic waste,
and that had a 90%
default rate, now it
looks incredibly good,
because it's gone up
in terms of its quality.
It's gone down in terms
of its default probability
from 19% to 10%.
So if you look at
the pricing, now
the pricing of these two
things, of course, is $900.
If they're perfectly
correlated, then securitization
does nothing.
All you've done is to
take two pieces of paper
and slice them up into two
identical pieces of paper.
That's what happens if
they're perfectly correlated.
So now, why would they
become perfectly correlated?
Well, this has to do with what
happened in the housing market.
When the housing
market turned down,
as it did shortly
after June of 2006,
that created a huge dislocation
in these credit markets,
because what was
uncorrelated all of a sudden
became highly correlated.
It's as if an
insurance company that
was insuring property and
casualty across the country,
all of a sudden experienced
earthquakes in every one
of the 50 states all at once.
An insurance company
cannot withstand that kind
of an event, unless of
course it's prepared for it.
And earthquake
insurers prepare for it
by insuring not just earthquakes
but hurricanes, fires,
and other natural
disasters, which
rarely come all at the same
time and all in the same place.
We weren't prepared for this.
The people that sold these
securities, that held them,
weren't prepared.
In fact, I skipped over a
quote at the very beginning
of this section.
This is a quote that appeared
in The Economist magazine,
anonymously, and it
was the Chief Risk
Officer of a major
financial institution.
And the risk manager wrote in
the first part of the article,
"Like most banks,
we owned a portfolio
of different tranches
of collateralized debt
obligations" that's what the
securitized set of obligations
are called, "which are packages
of asset-backed securities.
Our business and
risk strategy was
to buy pools of
assets, mainly bonds,
warehouse them on our own
balance sheet" meaning put them
in a portfolio in our company,
"and structure them into CDOs
and finally distribute
them to end investors."
Issue the pieces of paper
to the different investors.
"We were most eager to sell the
non-investment grade tranches,"
the toxic waste, "and
our risk approvals
were conditional on
reducing these to zero."
So they were very,
very careful to get rid
of all that toxic waste.
"We will allow positions
however of the top rated AAA
and super-M senior
(even better than AAA)
tranches to be held on
our own balance-sheets
as the default was deemed
to be well protected
by all the lower
tranches, which would have
to absorb any prior losses."
"in May of 2005 we
held AAA tranches,
expecting them to rise in value,
and sold non-investment grade
tranches, expecting
them to go down."
They were long the
seniors, short the juniors.
That's a strategy.
"From a risk-management
point of view,
this was perfect: have a long
position in the low risk asset,
and have a short one in
the higher-risk asset.
But the reverse happened
of what we had expected:
AAA tranches went down in
price and non-investment grade
tranches went up,
resulting in losses as we
mark the positions to market."
And then the risk manager,
this Chief Risk Officer
of a major financial
institution,
said the following.
"This was entirely
counter-intuitive.
Explanations of why
this had happened
were confusing and focused on
complicated cross-correlations
between tranches.
In essence it turned
out that there
had been a short squeeze in
non-investment grade tranches,
driving up prices
and generally selling
of all the more senior
[INAUDIBLE] even the very best
ones."
He still doesn't get it.
The numerical example
that I just showed you
explains what happened.
What happened is
the correlations,
that were assumed to be zero,
turned out not to be zero.
And when things change, when
the correlations change,
that changes the risk.
And when you change the risk,
it changes the valuation
because the markets
are not stupid.
People realize, wow, I assumed
they were uncorrelated,
but now these things
are very correlated.
I better recalculate my model
and see what it tells me.
And it tells me that AAA
is not AAA any longer.
And it tells me that the
BA is actually now BAA.
So what he experienced is
what every major financial
institution dealing
with this stuff
experienced over the
last couple of years.
It's that kind of
a double whammy,
because of the
default rates changing
in a way that was never expected
given the historical behavior
of the US housing market.
Yeah, Beta.
STUDENT: [INAUDIBLE]
ANDREW LO: It was typically
through the banks.
So the banks actually arrange
with the insurance companies
to insure those assets.
And then they would sell
it to the end investor.
The end investor wasn't
the one engaging in these.
Although, under
certain circumstances,
certain pension
funds were so risk
averse that they
ultimately ended up
buying extra insurance in the
form of credit default swaps
on these kinds of contracts
with other counter-parties.
So in many cases, some of
the insurance companies
actually did have relationships
with the end investors,
as well as with the
investment banks.
Yeah, Maria.
STUDENT: [INAUDIBLE]
ANDREW LO: They do.
They do downgrade these.
Absolutely.
And in fact, not only do
they downgrade the bonds,
but they also downgrade the
equity of the companies that
are issuing the bonds.
So for example,
AIG was downgraded
because there was
concern of whether or not
it could meet its obligations.
And because of that
downgrade, that
triggered a bunch of
other transactions.
STUDENT: And the other question
is, are they independent,
and are they really
objective when they are--
ANDREW LO: Well, so those
are two separate questions.
Are they independent
and are they objective?
Yes, they are independent,
strictly speaking, in the sense
that S&P and Moody's
and Fitch are not
owned by any of the companies
that are being rated,
number one.
Are they objective?
That's a different
question because remember
that S&P, Moody's and
Fitch are businesses,
and businesses generally
try to make money.
And in order to make money,
you have to get revenues.
And in order to
get revenues, you
have to have lots of customers.
And so the question
is, did they ultimately
end up giving ratings
out too easily
that they shouldn't
have because they
wanted to get more business?
I don't know the answer
to that, but there
is going to be a lot of
people, particularly lawyers,
asking those questions
in the coming months.
So the rating agencies
have definitely
been under fire by a number
of different organizations.
I don't know where
that's going to come out
and I don't know the details
of how they actually conducted
the ratings, but there
is definitely an issue
because what is AAA should
not default more than 1% or 2%
over the life of
the particular loan.
And clearly, with
these securities,
they've defaulted at
a much higher rate.
STUDENT: [INAUDIBLE]
ANDREW LO: Yes.
That's right.
They only relied
on three companies.
And actually, it's
very difficult
to start a rating
agency now, because
the regulatory
authorities require
certain kinds of
standards to be met
that are virtually impossible
for a startup to be able to do.
So you're right, that
investors relied on this,
and they ultimately
were badly misled.
But the argument that S&P,
Moody's and Fitch would make
is that, we were doing
the best we could,
we looked at historical
default rates of mortgages,
and we made very
conservative assumptions.
In fact, if you assume that
they were zero correlation,
but instead you tried
to be conservative
and you said OK, the
correlation maybe is not zero,
but let's make it,
oh I don't know, 25%.
Even though historically,
the correlation
is maybe much, much
less than that.
If you just used an artificial
number like 25% or 30%,
you would still not have
had the kind of dislocation
that we saw over the
last couple of years,
because the correlation
actually has gone much,
much higher than
that, particularly
for the subprime
mortgages, as you know,
because the housing
market's turned down.
And a lot of this was
triggered by this decline
in housing, which has been
a very, very sharp decline.
And over the last 30
years, the housing market
in the United States has really
never gone down by more than 1%
or 2% in a year.
Never mind going down 10%
over the last 12 months.
That's a really big
shock to the system.
Yeah?
STUDENT: [INAUDIBLE]
ANDREW LO: Well, in fact they
have done that in the sense
that they've actually chopped
up these kinds of security
into five different tranches.
And they've done it,
they've spread it out very,
very broadly.
That's how the US
housing market was
able to grow as quickly as it
has over the last 10 years.
It's because they brought
in huge amounts of money,
unprecedented amounts of
money, through this mechanism.
And all of the
investors invested
based upon these
ratings, as well as
their sense of how secure
these markets were.
And in each case, there is
going to be dislocation,
other than perhaps
in the middle tranche
where it hits exactly
right and you don't
get any kind of dislocation.
But that's not the
biggest tranche.
The biggest tranche was by
far the most senior one,
because that's the one that has
the largest amounts of money
waiting to be invested.
STUDENT: [INAUDIBLE]
ANDREW LO: Oh yes, absolutely.
Yes, absolutely.
Hedge fund managers have
profited greatly from this,
because they bought the toxic
waste that nobody else wanted
and then the value has
gone up dramatically
because of these kind of
increases in default rates.
Because they were priced to be
much worse than they ultimately
ended up being.
So it's absolutely the
case that the money has not
disappeared into thin air.
It's gone from the
senior to the junior.
It's a wealth transfer in a way.
Sorry, Ken.
STUDENT: Just a comment
on why Moody's maybe rated
these things the way they did.
At least in my experience,
what would happen
was the structuring
teams would meet
with people who were going
to rate these securities
and explain to them,
hey, this is what we did,
this is why it makes sense,
and essentially convince them.
True earlier why the
ANDREW LO: Oh sure.
There's a lot of
research that goes on.
In other words, Moody's,
S&P and Fitch doesn't just
decide based upon how they
feel that day whether is
should get AAA or not.
They do a fair
amount of research,
and they go through the
details of the portfolio,
they look at the
seniority of the claims,
they look at the
legal documents,
they look at the
historical record,
they go back and go
back 30, 40, 50 years
and take a look at the data.
So that's why I
said, they actually
have a case for making
the ratings as they did.
How they could have
gone so far wrong
is a question that
we're going to debate
for the next several years.
And ultimately, I
think we're going
to learn that we need to make
our models more sophisticated.
We need to have parameters
that are time varying.
We need to have a
different approach
to how we do
quantitative analysis
for these kinds of markets.
But that is an open
question that I
think will have to be
examined in much more depth.
STUDENT: [INAUDIBLE]
ANDREW LO: Oh, in the current
situation can somebody make
money?
Absolutely.
Absolutely.
This is why I was saying at
the very start of this crisis
that times of crisis are
also times of opportunity.
You can absolutely make money,
because these securities now
are priced all over the place.
Some way to high,
some way to low.
And if you understand
these models
better than the next
person, you will make money.
One of the largest payouts
that has occurred in hedge fund
history occurred last year
to a hedge fund manager
in New York named John Paulson.
I think he was paid-- it's in
the Wall Street Journal so you
can look it up--
I think he was paid something
like $3 or $4 billion.
Was it $4 billion?
That was his take
home pay last year.
That was on his W-2.
That was not wealth,
that was income.
And he did it by betting
on certain movements
in these markets, including
these kinds of securities.
So there's a lot of
money to be made.
There's a lot of
opportunity out there.
But it requires an edge.
So you really have to
spend some time trying
to understand these securities.
And what we've done today, this
relatively simple analysis,
is an analysis that apparently
eluded this Chief Risk Officer.
Because they're focusing at
a very, very detailed level
on models that are
probably not as
relevant for the
macroscopic picture.
Yeah?
STUDENT: If no one
is able to determine
the right price
for these things,
how is the government going
to use the $700 billion
to buy these things?
ANDREW LO: Well, that's
a great question.
That's one of the reasons
why there's so much debate.
It's because the view is that
if the very best minds on Wall
Street couldn't get
this right, what
makes us think that the
Treasury can get it right,
which is a little scary.
I agree.
There are a couple
of things that
are being done to address that.
One is that as part
of the proposal,
they plan to set up an
advisory board of people that
are in the industry, seasoned
veterans that are engaged
in these transactions,
to help the government
price these things.
That's one.
The second approach
is that they plan
to engage in equity ownership
as a possible outcome for this.
So in other words,
it's a bailout
if you buy for $100
what is really worth 60.
But it's not nearly
as much of a bailout
if you buy for 50 what's 60.
And it could actually be
quite profitable if not only
do buy for 50 what's
worth 60, but you also
get to own 80% of the
company in the process, which
is kind of like the deal
that AIG has struck,
and not that different from
some of the discussions
that Warren Buffett has
had with Goldman Sachs.
So the idea behind
the current proposal
is that there will be
additional protections
to allow the
government to benefit
from the upside of
these securities,
and to be able to get the
expertise needed to price them.
And there are other protections
that would require industry
to pay up for additional
insurance on these portfolios,
and ultimately to
allow legislation
to recoup some of the losses,
if at the end of 5 or 10 years
the government ends
up losing money
on these kind of transactions.
Let me stop here, and
we'll see you on Wednesday.
We'll talk about common stock.
