ECON 252

Financial Markets (2011)

Lecture 1 - Introduction and What this Course Will Do for You and Your
Purposes [January 10, 2011]
Chapter 1. Introduction to the Course [00:00:00]
Professor Robert Shiller: OK. Welcome to Economics 252. This is Financial Markets, and I'm Robert
Shiller. This is a course for undergraduates. It doesn't presume any prerequisites except the basic Intro Econ
[Introductory Economics] prerequisite. It's about--well, the title of the course is Financial Markets. By
putting "markets" in the title of the course, I'm trying to indicate that it's down to earth, it's about the real
world, and, well, to me it connotes that this is about what we do with our lives. It's about our society. So,
you might imagine it's a course about trading since it says "markets," but it's more general than that.
Finance, I believe, is, as it says in the course description, a pillar of civilized society. It's the structure
through which we do things, at least on a large scale of things. It's about allocating resources through space
and time, our limited resources that we have in our world. It's about incentivizing people to do productive
things. It's about sponsoring ventures that bring together a lot of people and making sure that people are
fairly treated, that they contribute constructively and that they get a return for doing that. And it's about
managing risks, that anything that we do in life is uncertain. Anything big or important that we do is
uncertain. And to me that's what financial markets is about.
To me, this is a course that will have a philosophical underpinning, but at the same time will be very
focused on details. I'm fascinated by the details about how things work. It can be boring, and I hope I'm not
boring in this course, but it's in the details that things happen. So, I want to talk about particular institutions,
and I'm interpreting finance broadly in this course. I want to talk about banking, insurance --sometimes
people don't include insurance as part of finance, but I don't see why not, so we'll include it. It's about
securities, about futures markets, about derivatives markets, and it's going to be about financial crises. And
it's also about the future. I like to try to think about the future, although it's hard to do so. Where are we
going?
This course will have a U.S. bias since we live in the United States. I know the U.S. better than any other
country, but at the same time, I recognize that many of you, or even most of you, will work outside the
U.S., and so it's important that we have a world perspective, which is something I will try my utmost to
incorporate in this course.
The world perspective also particularly matters since we have other viewers for this course besides those
people in this room. This course is one of a couple dozen courses that Yale University is offering free to the
world as part of Open Yale. And that means there's a cameraman back there if you've noticed. That's Dan
Cody filming the course. And it will be eventually posted on the Internet and it will be available through
Open Yale, and then by proliferation, you'll find it on many other websites as well. This is the second time
this course has been filmed for Open Yale. The first time was in 2008, three years ago. And I'm very
pleased to report that I have a lot of people in every imaginable country who have watched these lectures.
And I get emails from them, so I know that they're out there.
But I thought that this course needs updating, probably more than any course on Open Yale. You know, a
course in physics only has to be updated for the last three years of research in physics, and it's probably not
a big thing for an undergraduate course. But finance really has to be updated, I think, because it's going
through such turmoil and change right now. We've had the worst financial crisis since the Great
Depression, and it's been a worldwide crisis. And governments around the world are working on changing
our financial institutions. We have organizations of governments, notably the G20, which is very involved
in finance. It's one of the top items on their agenda for international cooperation; it's changing our financial
markets. So, I think that that's another reason why I want to try to keep as international a focus as I'm good
at doing in this course.
But I hope that those of you who are in this room are not disturbed by the camera and feel you can ask
questions. You don't have to be on camera. I think I'm just being filmed. So, that's where we are.
Chapter 2. Broader Context of the Course [00:06:12]
Now, I wanted to put this in a little bit broader context. The other major finance course that we have here at
Yale is Economics 251 and it's taught by Professor John Geanakoplos, who is a mathematical economist
and also a practitioner. He's research director for Ellington Capital. So, he's somewhat like me in that he's
interested both in theory and practice. But his course is definitely more theoretical and mathematical than
mine. His is entitled "Financial Theory." And I can read some of the topics that--and his course also will
appear on Open Yale shortly. You can take the whole course. But I don't know--it's not up at this moment.
It will be up in a matter of months.
So, I encourage you, if you want to, to take Open Yale Econ 251. But the things that he talks about in that
course, if you read the topics in this course you'll see that they're more mathematical and technical than
mine. He talks about ''Utilities, Endowments and How It Leads to Equilibrium,'' ''Assets and Time,'' ''The
Mathematical Theory of Bond Pricing,'' ''Dynamic Present Value,'' ''Social Security and the Overlapping
Generations Model,'' ''Uncertainty and Hedging.'' I'm quoting his titles. ''State Pricing.'' That's kind of an
abstract theory. We talk about the price of a state of nature. I won't explain that. He talks in some length
about the ''Theory of Risk'' and the ''Capital Asset Pricing Model,'' and about the ''Leverage Cycle,'' which
is relevant to our crises.
So, I recommend you take Econ 251, but I don't expect you to take it. This course is self-contained. And
I'm going to keep mathematics to the minimum in these lectures. But the idea here is that we can't avoid it
completely. I personally am mathematically inclined, too, but I'm understanding that we have divided our
subject matter. So, John Geanakoplos is doing the math and the theory, and I'm doing the real world. It's
not a complete division like that, but it's something like that. So, I'm going to stay to that. I'm going to talk
more about institutions and history than about mathematics.
Since I know that most of you or many of you will not take Economics 251, what we are doing is, I'll give a
little indication of the mathematical principles, more intuitive, and we have review sessions with our
teaching assistants. We plan to have six of those. And those will be on a Friday in this room. And they
won't be on Open Yale. Those will cover the theory, and it will be like a short form of Geanakoplos' course.
And then we'll have problem sets. And there will be six problems sets, one for each of those sessions. So,
there will be some math in this course.
I wanted to talk about the purpose of this course, to clarify it. One thing is, what do I imagine you're going
to do with this course? Well, first of all, I pride myself that I think I teach--if I might boast for a minute--I
think I teach one of the most useful courses in Yale College. At least that's the way I think about it. Because
this course really prepares you to do things in the world. By the way, I've been teaching this course now for
25 years. I first taught it in the fall of 1985. Now I don't know if that's depressing or not. To me, it's great. I
like to be able to keep moving ahead. I wonder what my 1985 course looked like? Unfortunately, they
didn't do Open Yale and I can't go back and look at it. But I think I've gotten more philosophical and maybe
more real world oriented as time has gone by. But the excitement I have is when I go--I give a lot of public
talks, and it's often on Wall Street. And when I do one on Wall Street, I like to ask people for a show of
hands. How many of you were in my Economics 252 class? And I typically get one or two at least who
raise their hand. So, that's a source of pride to me, that I was involved in the beginning of their careers. And
I hope I instilled some kind of moral sense to what they do.
But I should say I don't think that most of you will go into finance, because I think that most of you have
other purposes. What does it mean to go into finance? Well, it sounds like that means you would be listed
as someone who is very focused on finance. But I think everyone should know finance. This should be a
required course, actually, at Yale College, because finance is so fundamental to what we do and the
structure of our lives that I don't see how you can avoid doing finance if you want to do something big and
important.
Maybe you don't want to do that either, so you might want to become a hermit and then you don't need
finance. But to me, I like to think that many of you have a sense of purpose in life. I should say--that
sounded funny, didn't it? But what I'm saying is your purpose is not to make money. And this is one thing
about finance that bothers me, is that people think that it's a field for money-grubbing people who just want
to go out and make money. And I don't think so. I think it's a technology for doing things, and you don't
want to be mystified by it. When someone talks some financial jargon, you don't want to say, I don't have a
clue what that's about, because what that's about is how we make things happen. And so, I hope that you
have other purposes in life besides finance, even those of you who go into finance.
But the question is whether this is a vocational course. Here at Yale College there has been a long tradition
that we are not a vocational school--I suppose you know that--that Yale is a liberal arts [college]-- we teach
you the arts and sciences. I actually went to look at the charter and the act of the Connecticut government in
1701 that founded this university. This university was initially mostly a training ground for the ministry.
But I actually read in the Acts of the Governor and Company of the Colony of Connecticut: "Yale College
is founded for the educating and instructing of youth in good literature, arts, and sciences." I think that is
the motive here for this university. And so, I think it is in some level vocational, but it's not vulgar
vocational. I want you to think about what we're doing and how it fits into what you do for your life.
So, I think of finance as a kind of engineering in a way. But it's an engineering that works not with what we
call a technical apparatus, but with people. And so, if we want to understand how to do these things, we
have to get some technical apparatus under our belt. And that's what I'm going to try to do in this course.
The textbook that I chose for this course is by Frank Fabozzi, who is a professor at the Yale School of
Management--well, with two co-authors. We have Franco Modigliani, for whom I have some personal
affection, because he was my dissertation adviser at MIT, and who unfortunately died in 2003, and Frank
Jones of Guardian Life Insurance Company. I've also written joint papers with, well, two of the three
authors. I've written joint papers with Fabozzi and with Modigliani--research papers. But they're similar to
me in many ways. They're interested in the details. I hope you get interested in the details.
I find this textbook fascinating for me. Well, I first read this book when I first started assigning it. I was
going on vacation with my friend Jeremy Siegel and our families, who's a professor at the Wharton School,
and I brought this book as my poolside reading. And I was sitting there with this book. Other people were
reading novels and fun things. I don't know what they thought of me reading this textbook by the pool, but I
thought this is great because I thought I knew most of what's in here, but there's a lot of things that I still
didn't know and it was answering all kinds of questions. Things you always wanted to know about real
estate securities, OK, but you never found out. Well it's all answered here. So, I hope you can take that
spirit in reading the textbook. That's the only book you have to purchase for this course. And it's the main
work that you have.
So, I'm going to ask you about the details on exams. The kinds of municipal securities we have and how the
rating agencies rate them, that's part of this course. I believe the details matter. And so I'm not going to just
ask you broad generalities on the exam. I can ask you the details. It's a little bit like teaching a language,
right? Learning a language is really important, and you've got to learn all the words, right? There's
thousands of them. It's like that. You're going to be learning the words of finance.
So, I have another book also, which is actually not done yet, but you can access it through Classes*v2, and
later it will come out as a published book. But I'm working on a book called--well, I don't know what it will
be called finally. When you're writing a book, one thing you learn as an author is you can never be sure
what the title of the book will be. Because if somebody else uses the same title and you're done, somebody
else gets to it first, you've got to change your title.
But at this moment the title of my book is "Finance and the Good Society." I'm not sure when it will be out.
I was hoping next year, but now I'm thinking it might take longer than that. So, you have something that's
imperfect. I hope youll excuse me when you look at the chapters of this book. You don't have quite all the
chapters either. But I just thought it was a good thing to put it in process for you to--maybe if you have
ideas you can tell me and the book will change with your input. To me it's a good way to write a book, is to
be writing a book and teaching a class at the same time on the same topic. It's more social. You know, you
just sit in your office and write and you end up feeling sterile. So, this makes it more alive to me to do that
at the same time.
But I'll tell you what my book is about. The title that I now have, "Finance and the Good Society," may
sound to some people like an oxymoron because they're kind of incompatible. People are angry about
finance these days. We've had--and this is going to be an important part of this course--we've had the worst
financial crisis since the Great Depression of the 1930s. And it's been a worldwide financial crisis and it
isn't over yet, or it's not clear that it's over yet. And people are angry. People are angry about finance,
people who seem to be getting rich often it seems at the expense of others. Or they seem to be lobbying
their governments to give them breaks and bailouts, and they walk home with billions of dollars.
Something seems immoral and wrong. Well, I'm sure some immoral things are happening, but I don't think
that finance, as a whole, is wrong. And I think of it as a noble profession. So I wanted to try to put it in
perspective. And it's especially important when talking to young people like yourselves because you're
launching out on a career, and I want that to be a moral and purposeful career. And I want to put finance in
the perspective.
So, the theme that I want to develop in my book is that part--you know, we live in a capitalist world now
and this world is increasingly built on finance. Some people call it we're living in the era of financial
capitalism. We have these big multinational institutions that are owned by huge numbers, maybe millions,
of shareholders dispersed all over the world. And what makes the whole thing work and click? It's the
financial arrangements. The world is discovering the importance of finance.
When I go to a foreign country and give a talk, I find that people--it doesn't matter what country--they're
generally very interested in finance, because they think that our modern financial techniques are part of
what's making so many places in the world grow at rapid rates now. We're living in a time in history when
[the] developing world is exploding with growth, and these countries that are doing that are countries that
are adopting modern finance. So, I want this to go right, and I want this to be developing a good society. By
good society, I mean a just and fair society that allows people to develop their talents and expertise.
Chapter 3. Finance as an Occupation [00:22:41]
So, another thought I had was that the field of finance-- let me give you another slide. I said I view this
course as one of the most important courses in Yale College, at least from a standpoint of your lives and
careers. I wanted to compare finance jobs with jobs. And I don't mean to put down other departments, but
at least vocationally, let's put this in perspective. I wanted to compare jobs in finance with jobs in other
fields. So, this is a chart that I constructed using data from the Bureau of Labor Statistics. And what it has
is the number of people in various occupations in 2008 and their projections for the same in 2018. So, the
red bar is for 2018, and we'll emphasize that because you'll be just getting into your careers when that
comes.
So, it says, if you look at financial analysts in the United States there's almost 300,000. Financial managers,
it's over half a million. Personal financial advisers, a quarter of a million, all right? These are people who
specialize entirely in one form of finance or another. But compare that with economists. Look at that. What
is that? About 20,000? I think they're excluding professors. But, you know, just economists out there--not
very many. How about astronomers? OK. I can't even read that. I love astronomy by the way, but I think I
made the right choice when I decided--well, I shouldn't say that, you never know. We all have to do
something different. And you could become an astronomer, but there aren't many jobs in astronomy.
Sociologists, political scientists, just not many compared to--this is just enormously bigger. Or
mathematicians.
I also put one oddball field on here: massage therapists, OK? The number of massage therapist jobs
outnumbers any of those other fields by, what is it, 100:1. So this is the kind of disappointment that people
face. You go to the college or university--this is very much on my mind--you go to the university and you
develop special skills, and you leave and then you end up driving a taxi. That doesn't mean that I want to
become vocational. I mean, I don't want to just train you for a job, but I want to be relevant. And it seems to
me that I can be relevant in talking about finance. And so that's the basic core that I wanted to get.
I mentioned before that people think that finance is the field for people who want to get rich, who want to
make a lot of money. Well, I think that's right, actually.
[LAUGHTER]
I don't advise you to take that as your--but I wanted to talk about that a little bit. So, one thing that you'll
note, Forbes Magazine has an annual list of the 400 richest people in America. So, I looked at that list. Who
do you think they are? Most of you probably have not read this list. You might think that, well, who makes
a lot of money? Well, it's athletes. Football players, right? Baseball players. And who else? Oh, movie
stars, right? They make a lot of money. So how many do you think of those are on the Forbes 400 of the
richest people in America?
Well, as I read the list I didn't see a single movie star or a single athlete. There is--it depends on how you
define it. Oprah Winfrey is on the list. OK? You've heard of her. She's in the entertainment business. But
you know, she's also a finance person. She runs big businesses. She's into making things happen. And I can
assure you that she knows finance, at least some basic finance. You see, finance gets you to build
organizations. That's how it's done. And it means raising capital to make things happen on a big scale. You
know, no athlete is as powerful as one of these random guys on the Forbes 400 list.
It's interesting. I looked down the list and I didn't spot a single Nobel Prize winner. Maybe I missed one. I
looked for best selling authors. I found one: Bill Gates, who wrote a book called The Road Ahead. But
there are not many best selling authors either. What do they have in common? Now about a third of them
just inherited it from their parents, but most of them did it themselves. They just made huge sums of
money. And what do they do? Well, they're typically in some boring line of business. They make
something, but they're doing it on a vast scale. And so that means they're making deals, they're putting
things together, they're buying companies, they're absorbing other companies into theirs. There's something
powerful about an ability to do that. And I think that it's good for you to understand and appreciate that.
By the way, Forbes has another list called the Forbes Celebrity 100. And to be on that list, you have to be a
celebrity. It's a completely different list. Oprah is on both lists, but she's practically the only one. Steven
Spielberg is on both lists, I think. He makes movies, but he has a whole company called DreamWorks, and
he finances all kinds of movies, so he's a businessperson as well. So I don't think of finance as a
mathematical--I mean it is mathematical, it has a core element of that. But to me, it's about making things
happen and about putting together deals and getting people incentivized to do something, and getting
capital, getting resources in a massive scale so that something can happen. And so that's what this course is
about. Oh, Jerry Seinfeld is listed by Forbes as a possibility--he's about the only one--to make the list of the
Forbes 400. But he isn't there yet.
I don't mean to diminish these celebrity people, but there's something else that goes on in finance, and it's
quiet. It's behind the--actually, most of the Forbes 400 you've never heard of. They're kind of behind the
scenes doing things that are big and important, but they don't get on the news so much. It's one of the
ironies of life. You might aspire to do this, to get on the Forbes 400. You can do it and still nobody knows
who you are or cares. So that's just as well, I think, for many people.
Chapter 4. Using Wealth for a Purpose [00:30:40]
So then the question is: Suppose you get on the Forbes 400, what are you going to do with it? In other
words, to get on the Forbes 400 you have to have made at least a billion dollars. So that means, you have in
your own portfolio a thousand million dollars. That's the minimum to make the list. So what are you going
to do with a thousand million? Any ideas, what would you do with it? You could buy cars, right? How
many sports cars could you buy for that? What could you do? You could buy 20 houses. But that doesn't
begin--you could buy 20 houses and so what? You know, you still have 900 million leftover. So what are
you going to do with all that money? And that's a question.
Now, some people who do that, who make all this money, try to see if they can maximize their appearance
of wealth. They try to show to the world how rich they are. So, you just build the biggest mansion and you
do something really spectacular. But when you got a billion dollars, there isn't a house in the country you
could buy for a billion dollars. You can only stay in one at a time, right? So, what are you going to do? But
there are people who do that, and I think that there's a history of disgust for those people, a long history.
We don't like people who do that. It's almost like it's a big mistake. Why would you do that when people
don't like people who show off their wealth? There's evidence that people feel that way in many different
countries and cultures, because lots of countries in history have what are called sumptuary laws. It goes
back at least to 700 BC in Ancient Greece with the Locrian code. These are laws prohibiting people from
conspicuous consumption. And they've been in so many different countries that I think it's evidence that
something is amiss with making wealth as the objective of your life.
So, one of the themes in the beginning of our reading list is--I think there's a movement afoot today around
the world of thinking about this problem, that you can get so big and powerful if you build a business and
you use the financial techniques that are successful for other people, but it's meaningless unless you give it
away. And so, what else can you do with all this wealth but plan to give it away.
So, one thing I have on the reading list right at the beginning is a chapter from a book--well, the title of the
book is The Gospel of Wealth and Other Essays and it was written by Andrew Carnegie. Actually, he wrote
a short article in a magazine called "Wealth" in 1889. And in the final paragraph he used the term "gospel
of wealth" and it was picked up all over the world as just outrageous. And so it became named The Gospel
of Wealth. So, later in the early 20th century he came out with a book entitled The Gospel of Wealth. And
that's what I have assigned. You can click on it on the reading list. And Andrew Carnegie was one of these-
-they didn't have Forbes 400, but he was one of the richest men in America through his Carnegie Steel
Company, very much steeped in finance.
But he decided when he wrote his essay, The Gospel of Wealth, in 1889 that once a person reaches middle
age, like 50 or 55, and has made a lot of money, they really have to go into philanthropy. There's a moral
imperative. So the theme of The Gospel of Wealth was some people are just better at what he called affairs
than other people. That means business. Some people have a sense of how to make things happen. These
people have a moral obligation to make this work for the benefit of humankind. And that means, while
they're still young, they have to take their fortune and give it all away before they die. Because if they don't
give it all away, it's nonsense. If you make a billion dollars and you leave it to your children, chances are
they're not like you. They're not going to be interested in working hard and making things happen. They're
just going to squander it. And so that's what the moral obligation is. You have to stop at age, let's say 55--
OK, you still got time left--and then use your same talents.
So, it was almost a theory of capitalism--it is a theory of capitalism. It is a theory that some people are just
more practical and hardworking and business-oriented, and these people can find things to do that benefit
mankind, and they should do it. So, there's a natural selection. This is Carnegie. I'm not endorsing this
entirely. I think there's an element of truth to The Gospel of Wealth, but it's not exactly true. But the
element of truth is right, that people like Carnegie who was a very gifted person--you know what he did?
He set up the Carnegie Institute of Technology, now called Carnegie Mellon University. He set up the
Carnegie Endowment for World Peace, Carnegie Hall in New York. He probably gave something to Yale,
too. Anyone know? Is there a Carnegie? He gave to like every imaginable university. I know at Princeton
they have a Lake Carnegie. He was visiting Princeton and someone pointed out this kind of swampy land
and said we'd like to really create a lake. So he said, fine. He gave them money to create Lake Carnegie.
And he also gave the money for the prize for the first true competition on Lake Carnegie. So, he just had all
kinds of gifts he gave it away.
I also have--it's interesting, I found this on the web. Thomas Edison, the inventor, was so impressed with
Carnegie's The Gospel of Wealth that Edison was developing the sound movie, I think it was 1914, but he
didn't perfect it. But he said the first sound movie should involve geniuses of our time. So, he made a sound
movie of Carnegie reading from his The Gospel of Wealth. Unfortunately, the visual side of it somehow
got lost. Maybe it didn't work. We only have the soundtrack from the movie. So, you can listen to Carnegie
reading from this book in 1914, and it's the only recording of Carnegie's voice that survived.
Since then, Bill Gates and Warren Buffett and others of the Forbes 400 have done a campaign to get
billionaires around the world to commit to give most of their wealth away, while they're still alive. And I'm
trying to get one of these people to speak to our class, but I haven't yet arranged that.
I also have on the website a review from 1890 of Carnegie's original essay from a California newspaper,
and they were so negative about it. They said, Carnegie thinks that making wealth and giving it away is a
noble cause. That cannot possibly be right. These people who make money are not the most enlightened
and smart people in our world. I think that the truth lies somewhere in between. But we do have a society
now where people--we have an increasing concentration of wealth at the top, and I don't know what we're
going to do about this. This is a trend that may continue.
And so, this is the thing I want to think about in this course. I don't think finance necessarily does this. It
may be a bubble, that there is currently a bubble in financial careers and that you are going to be
disappointed because 20 or 30 years from now if you go into a finance-related field, you'll find that it's not
as lucrative as you hoped. That kind of happens, right? When a field becomes known for having a lot of
successful people, then more young people go into it and they swamp the field. On the other hand, I think
that it will always be true that just because of the power of the technology the top wealthiest people in the
world will be finance-related. And I think that they will have a moral obligation to give their wealth away
in a productive way.
Chapter 5. Outside Speakers and Teaching Assistants [00:40:30]
So, I have several outside speakers, and I tried to bring in people that are connected to the world in a
positive way. I'm trying to bring in inspirations for you as outside speakers. And they're people who are in
finance but who are not selfish. They may be rich but they are good people.
So, the first person that I'm going to bring in, as I've done in previous years, is David Swensen, who is
Chief Investment Officer for Yale University. Swensen also teaches a course, Economics 450, with Dean
Takahashi, which you might want to take. But I have him here just for one lecture. And what Swensen has
done is turn the Yale endowment into a huge number. He came to Yale in 1985, and at that time, Yale had
less than $1 billion in its endowment.
Swensen is the most successful university endowment manager of the United States. He turned less than $1
billion into $22.9 in 2008. The financial crisis hit and the endowment fell, but as of June of 2010, it was
still 16.7 billion. So, he has done so much to make Yale a success. But it matters. That's a lot of money.
And it's all for a good cause. Now I say, I believe Swensen is a good person. I think he turned down
opportunities to make much more on Wall Street, because he is known--and he's continually turning them
down--as an investment genius. He can command huge salaries and bonuses if he wanted to, but he stays
here with Yale. I don't think that people in finance are money-grubbers, and this is an example of someone
who's not.
The second speaker I have is Maurice "Hank" Greenberg, who founded AIG. It started out in 1962. In
1962, he was put in charge of North American operations of the American International Group, an
insurance company, which was then failing. The head of the company, C.V. Starr, put him in this to try to
turn the company around. He turned it, over many years as CEO of AIG, into the biggest insurance
company in the world, and he ran it until 2005.
The company--have you heard of this, AIG? You must have heard of this. In the recent financial crisis it
has encountered some problems. And, in fact, it was the biggest bailout of all. It was bailed out by the U.S.
government. And there's a scandal about that because the bailout was so huge. It was in the hundreds of
billions. Record-setting bailout. And some people are angry with Greenberg. But I think that's completely
unfair, because it all happened after he left AIG. And the problems were in a particular unit within AIG that
he was not really responsible for.
But Greenberg is a person who has, I think, a moral purpose that I want to illustrate for you. He's been
criticized. Anyone who does business on that scale is going to be criticized for being too tough or too
aggressive at times. But he's a very involved person. He's the Vice Chairman for the Council on Foreign
Relations, which is a think tank that thinks about the United States and its place in the world. It's a very
important think tank. He's also a major philanthropist and he's given to Yale. Notably, he gave the
Greenberg Center, which is right next to the Center for Globalization. A beautiful new building. So he has
agreed to come. I'm very pleased to have him.
The third outside speaker that I have now is Laura Cha, although she won't be here in person. We're going
to have her image up on the screen because she is in Hong Kong. And she is a non-official member of the
Executive Council of Hong Kong. She's a member of the government of the People's Republic of China at
the vice-ministerial rank. She's the first non-Chinese delegate to the National People's Congress
representing Hong Kong, and has been vice chair of the China Securities Regulatory Commission. So she is
very involved in finance. She's also been affiliated with Yale and helped some of our initiatives. She'll have
to get up very late at night, I think, to be on for 9:00 in the morning for us from Hong Kong. I might get
one or two other speakers, but that's where it stands right now.
So, I wanted also to tell you about our teaching assistants. We have four teaching assistants now. We might
get another, but at this point. The first is Oliver Bunn who is from Germany, University of Bonn, and is a
PhD student in economics. He's also our head TA who coordinates the whole operation.
And then we have--the second one is Elan Fuld from the United States. And he's doing an interesting study
of the pizza delivery industry. It sounds funny, but it's an interesting application of economic theory to very
much the real world.
Bige Kahraman is from Bilkent University in Turkey, and she's interested in Behavioral Finance. That
means--I should have said this. It's also an interest of this course. I've skipped by it in my notes. Behavioral
Finance is the application of psychology, sociology, and other social sciences to finance. I don't know how
I omitted mentioning that. It's about people in finance--well, I didn't really completely omit mentioning it.
You've got the sense that I'm interested in people. But there's been a revolution in finance over the last 20
years. Twenty years ago, finance was thought of in academia as an essentially mathematical discipline, that
and nothing more. Well, maybe I'm exaggerating a little bit. But what's happened since then is people think
of finance as involving psychology. We have to bring people with knowledge of human beings in.
And so, her dissertation topic, a major theme of it, is how mutual funds operate. Mutual funds are
companies that offer investment vehicles to the general public, and she finds that the mutual fund
companies have complicated fee schedules and they offer different choices to people. And what sense does
this make? Why are there all these different choices? You look at the fee schedules and you think--it's just
like your cell phone plan, right? It's got different choices and you don't know which one I should take. Why
are they doing all this? Well, she tries to analyze what's going on and she finds that sometimes it seems like
clients are steered toward a fee schedule that's really not in their interest and that the mutual fund managers
are doing some things that maybe we don't want them to do. Maybe it's not ideal. They're pushed by
competitive pressures into offering products that are a little bit manipulative of people.
And her dissertation also brings up another theme, which I thought I perhaps should have emphasized, that
all is not well in the financial world. Lots of bad things happen. Or not necessarily awful things, but, you
know, not socially conscious things. And that's why we need regulators. That's another reason why I
brought in Laura Cha, by the way. She's a regulator. I wanted to have a voice from that side, because I
personally admire regulators and think that they have a very important function in our society. So, her work
fits more into that regulatory side of finance.
And then, finally, our fourth teaching assistant is Bin Li from Beijing, although he went to college at
University College London. And he has broad interests including Leveraged Asset Pricing and also
Behavioral Finance. So, those are the teaching assistants.
Chapter 6. Outline of the Lectures [00:50:26]
So, let me just give a brief outline of the course. There are 20 lectures that I'm giving in this course. This is
the first. Let me just go through what's the content of these lectures.
So, Lecture 2, that would be on Wednesday of this week, I want to talk about the core concept of risk and
also about financial crises. The one reason why I wanted to update this course with Open Yale this year is
because I wanted to talk about the financial crisis that we've been through, though I thought this lecture
would start with something about the theory of probability, but I'm not going to get into that very much.
That will be more for a TA section that will come in later.
But even so, this is not a probability course. I just want to kind of remind you of the concepts of
probability. And there's a concept of independent risks. If risks are independent you can diversify away
them, and you can put together a portfolio that minimizes the risks. The law of large numbers says if you
have a lot of independent risks, they'll average out if you have a large number of these different risks in
your portfolio and there's no risk left. That's if they're independent. But in fact, risks are not as independent
as you think, and that's one reason why we had a financial crisis. And so a lot of people were making plans
based on portfolio theory in finance, but the plans assumed that there won't be a crisis, that maybe one of
our investments will go bad, but they can't all go bad or a large number of them can't go bad. So, that was a
failure of the independence assumption in finance.
That failure created the financial crisis that we've been through. It was a near miss onto another Great
Depression. The financial crisis that began in 1929--I'll talk about that briefly in that lecture--started with
the stock market crash of 1929 and the economy spiraled down until 1933. It just kept getting worse and
worse. More and more bankruptcies, more and more layoffs. So, by 1933, 25% of the U.S. population was
unemployed. And it wasn't just the U.S., it was all over the world. It was a horrible crisis. And we didn't get
over that crisis until World War II. It's like we couldn't get out of it. The crisis got so bad that nobody in the
world could figure out what to do. And I think that part of the reason we had World War II was because of
the anxieties and animosities caused by this massive unemployment. But we got out of it because World
War II created a huge stimulus program. I mean, they drafted all the unemployed and made them fight.
What an awful outcome, but that's what happened. It's terrible.
And so this time we saw the beginnings of a similar crisis. We saw crashes in the stock market and the real
estate market, we saw bankruptcies appearing, we saw runs on banks. And this time the Government
decided on a controversial bailout package. And so, Ben Bernanke and Mervyn King and other central
bankers and government policymakers around the world had the idea that we can't let it happen the same
way this time. So, there was massive bailouts, controversial bailouts, because they seemed to be unfair to
many people. So, it's a huge and interesting story.
I've written three books, by the way, about this crisis. Well, two of them with co-authors. So, it's something
that fascinates me. But I don't want to dwell on it too much in this course, because I'm hopeful that it will
heal itself and we can put it behind us.
And the financial crisis doesn't call into question the basic principles of finance. Not in my mind. The
vulnerability to a crash that we see in financial markets is like the same thing as the vulnerability to crash
of airplanes. Airplanes crash from time to time. You must know that when you get on one. But that doesn't
mean we shouldn't have airplanes. And I think the financial system is advancing in the world with such
speed and such impressiveness that this crisis is just a blip on the screen of that, and not something I think
we should worry too much about.
The third lecture is about technology and invention in finance. Finance is a technology just like engineering
or mechanical engineering. It has principles, it has techniques, and it involves inventing of details. That is,
financial institutions are complicated. They're complicated in the same way automobiles or airplanes or
nuclear power reactors are. You can see this complexity if you read some of the documents that are
associated with the modern corporation. There's a lot there. And the way the cash flows are divided up
among different people, involving options and derivatives and other complicated financial instruments, are
part of the technology. And this technology is advancing, and it will advance a lot over the time of your
career.
I don't have an ability to predict the future with any accuracy, but I want to try to think about what we can
say about the future. I wrote a book in 2003 called The New Financial Order, and it was my take on the
future. But the problem is nobody really knows the future very well. You kind of have to just invent it or
dream about what it might be like. That's what I did. I kind of thought about principles of financial theory
and where they might go with the advance of information technology and the globalization of the world.
So, I have just a chapter from that for that section of the course.
Then, Lecture 4 is about portfolio diversification, how risks are spread. And we'll talk briefly about the
Capital Asset Pricing Model. Now again, the Capital Asset Pricing Model is a mathematical theory of
diversification. A very important theory, and it's something that John Geanakoplos will cover with more
rigor in Econ 251 that I already mentioned. But for me, I will talk briefly about the capital asset pricing
model, and one of our teaching assistants will give a section on it. But I want to also think about, since this
is a course about the real world, I want to think about financial institutions, and so many of our institutions
are offering diversification one way or another. And so, again, I wanted to talk about the real world
component of this.
The fifth lecture is about insurance. And the insurance industry developed over the centuries. It goes,
actually, all the way back to Ancient Rome, but only minimally. People didn't have the concepts until the
1600s when probability theory was invented. There was an intuitive concept that, sure, I could start an
insurance company, I could put together a lot of insurance policies and charge for them, and probably I
won't--you just have intuitive sense about law of large number or independence of risks. Probably, I'll be
OK and I can make good on the policies I wrote. But it was never clear until probability theory was
developed. Since then, it's been growing and it's becoming a bigger and bigger part of our lives. And I think
that insurance is actually a lifesaver.
I'll give you one example. You note that in the earthquake in Haiti--what was that, about a year ago? There
was a tremendous loss of life, but the earthquake in San Francisco decades earlier was of the same
magnitude and had very little loss of life. Also, the loss suffered by people in terms of destruction of their
homes and their office buildings was vastly higher in Haiti. Well, it turns out that Haiti, a less developed
country, didn't have much of the modern insurance industry, so that people were uninsured against risk of
collapse of their structure and you didn't have insurance industries going in and policing building codes. If
the insurance company is liable to the risk then they go in and say, we won't insure you unless you fix this.
Since it didn't happen, so many people died.
I think that Haiti will come along. There is already a Caribbean insurance initiative that was starting. We
want to see the developing world get these institutions. I want to try to give a sense of the reality of that,
that we tend to think of Haiti as an opportunity for our charity, and a lot of us gave money to help these
people. But, you know, charity doesn't work on a big enough scale. Going around to people on the street
and asking them to give money to help the Haitian earthquake victims, it doesn't amount to a lot. What
really becomes big and important is the insurance industry, which is doing the same thing as a business
model. And that's the real world and it matters enormously.
The sixth lecture is about efficient markets. This is about a theory that developed in the 1960s, that
financial markets are wonderfully perfect. I'm saying I'm a little bit skeptical of this theory, although I think
it has an element of truth. Efficient Markets Theory is the idea that you really can't make money by trading
in financial markets because the markets are so competitive that the price is always pushed to an optimal
level that incorporates all information that anyone could ever have about the security. And the theory has
been that it's hopeless to try to invest and beat the market. Well, I think there's an element of truth to that
but it's not quite true, and people like David Swensen are counterexamples, that it is possible for
professional money managers to beat the market. And that's something I want to think about and talk about
in that lecture.
Lecture 7 is about debt markets. We have a lot of money that's lent. The Federal Reserve manages these
markets. It tries to coordinate the markets through open market operations and through what now is called
Quantitative Easing. But the markets are huge and international. They involve errors that people make. A
lot of people get overly indebted and make mistakes over their lives. But they also offer opportunities, that
debt markets are fundamental to the things we want to do in our lives. For example, when you are a little bit
older, many of you will want to buy a house, right? But you won't be in that point in the life cycle when
you have the money to buy a house, most of you, so you'll be borrowing. It's elementary. You take out a
mortgage. That seems obvious. But still today in many countries of the world, the mortgage market is not
very developed, and you can't do that. So, there's a good side to borrowing as well as a bad side. I want to
put it in perspective. We've got our review session. We'll talk a little bit, somewhat, with one of our
teaching assistants about the mathematics of debt.
Lecture 8 will be about the stock market. Again, I think of the stock market not as something that we're
going to beat. I think it's something that is an invention to motivate people to get people working together.
So, the basic idea of a stock investment: You and your friends want to set up a company, OK? How do you
do that? Well, the company needs money to start. So, somebody's got to contribute capital. Well, some of
you have more money to contribute than others, so you should have a bigger share in the company. Some
of you have no money at all to contribute, but you're going to contribute your time and energy. So, you
want to give a share in the company to these other people as well in order to incentivize them.
So, you devise a whole scheme to set up a company that involves the creation of stock. And then you start
trading the stock and then it gets all the more interesting. And then there are options on these stock
certificates. But it's all for a purpose. The purpose is to make some enterprise happen. And it really is
important that we have these institutions, and if you don't have them, your little group trying to do
something is going to fall apart. Someone's going to get angry and leave. It's just not going to work. And so
I think of the stock market as doing these functions. Now I know Karl Marx said he thought it was a big
casino, but we're not communists here. This is about modern finance.
Lecture 9 is about real estate--another fascination for me. I've been working for years about real estate.
And, in fact, with my colleague Karl Case, we have our own home price indices called the Standard and
Poor Case-Shiller Home Price Indices. We'll talk about those. But it's really important for this crisis that
we've just seen, because the financial crisis was caused substantially by a bubble in home prices, I believe,
a psychologically induced excitement or euphoria about home prices in the United States and in other
countries that collapsed around 2006. These bubbles are restarting in other parts of the world more recently.
And the real estate market is getting very speculative and psychological, I believe. And the outlook right
now for the economy hinges on how these markets behave. So, that will be, I think, an important lecture for
this course.
Lecture 10 is about Behavioral Finance. It's about psychology in finance. I talked about that. It's another
long-standing interest of mine to try to incorporate psychology into our theory.
So, lecture 12 is about banking, multiple expansion of credit, the money multiplier, and bank regulation,
which is something that is a fascinating topic because we almost lost our banking system. We had to bail
them out massively. We have international accords now. Notably, a new one just came out called Basel III
from Basel, which is the city in Switzerland, and it was endorsed by the G-20 countries at their Korean
meeting in Seoul. So, we're seeing a change in bank regulation that will, we hope, prevent another crisis
like the one we just went through.
Lecture 13 is about forwards and futures markets. Forward markets are markets for contracts that deliver in
the future. Over-the-counter contracts, they're called, that are done one-on-one between parties with the
help of an investment bank. Or futures contracts, which are traded on organized futures exchanges, like the
Chicago Mercantile Exchange. I have some involvement with this because we worked with the Chicago
Mercantile Exchange to create a futures market for single-family homes using the S&P Case-Shiller Index.
So, I'm involved in this. And we have that market functioning at a rather low level, but it is functioning and
it seems to be growing lately. I'm hopeful for that market.
Lecture 14 is about options markets. These are most typically stock options, which are contracts that allow
you to purchase a share of a stock or to sell a share at a pre-specified price. These are traded on options
exchanges. They have a price that goes up and down. This is an example of a derivative contract that injects
a lot of complexity into financial theory.
Lecture 15 is about monetary policy. It's about the central banks of the world. For example, our central
bank, called the Federal Reserve in the United States. And it's about what they do and how they help
prevent crises like the one we've just seen. They did help prevent it. I think they staved off disaster.
Lecture 16 is about investment banking. I know this is of great interest because we place a lot of students in
good jobs in investment banking. Companies like Goldman Sachs, the most talked about one. Investment
bankers help companies raise capital, issue securities, retire securities. And we're going to talk about how
they're regulated. And I didn't mention Dodd-Frank, by the way, but we have a new bill that just passed in
July in the United States that changes the regulatory structure for investment banks and a whole array of
financial institutions. And I want to talk about that.
The European Parliament has created a number of new laws and organizations that somewhat resemble
Dodd-Frank. And other countries have also done financial regulation reform that affects investment
banking and other aspects of finance. It's extremely complicated. I don't want to give you too many details
but I want to give you some sense of the revolution that we're seeing.
Lecture 17 is about professional money managers like David Swensen, people who manage portfolios. You
don't have to be a billionaire to manage a billion-dollar portfolio. In fact, some of you may be doing it
sooner than you realize if you get the right kind of job. Managing a portfolio means managing the risks,
putting them in the right places. You think of institutional investors, big money managers, as just trying to
make money. But when you get into that field you realize that you have power as an institutional investor.
When you own a big share of some company, you can go to the board meeting and talk to these people, or
the stockholders' meeting, and you will get heard if you own 10% of the shares of a company. Then you
suddenly realize that you are a steward of the public interest. And I think institutional investors are
recognizing that more and more.
Lecture 18 is about exchanges, brokers, dealers, clearinghouses, like the New York Stock Exchange or the
London Stock Exchange. They are proliferating around the world. Whereas there were just a few 30 years
ago, now almost every country has a stock exchange and a complicated list of exchanges. They're
increasingly electronic; they have interesting new features, like microsecond trading that's going on,
computers trading with other computers. We'll talk about where this is going.
Lecture 19 is about public and nonprofit finance. So, I think this is very important. Nonprofit finance would
include organizations like Yale University, or churches and charities and other things like that. But I'm also
including in this lecture public finance. And that means governments financing projects. So, for example,
you take it for granted that our city here of New Haven has roads, it has schools, it has sewers, it has water.
All this kind of comes without you even asking. But all of these things had to be financed. And the City of
New Haven, like other cities, is issuing debt and it's a complicated business. I want to get you into some of
the details because it matters, because this is how you make things happen. You can go to your city
government and you can propose that they issue revenue bonds to start some new product. You would
know--that's what I want you to do, is to know how these things are done so that it's not just imagination,
you can make it happen. And also nonprofits. I want you to understand that you can set up your own
nonprofits, and there's a lot of advantages to doing that. That's an organization that has a financial structure
but no shareholders. Nobody takes home the money. It all goes to some cause.
And, finally, my last lecture, Lecture 20, I'm calling it ''Finding your Purpose in Finance.'' I just want to
come back in the last lecture to the idea that this is a course not about making money. I don't want you to
give a billion dollars to your children and grandchildren, which they will then squander in conspicuous
consumption. The idea is a moral purpose. And that's one thing I wanted to try to convey, partly with
outside speakers, maybe with other examples that I can give, that I think that many people who are wealthy
and who have succeeded in finance really don't care about spending the money on themselves. They really
do have a purpose. And even if that's not true of many of them.
There's an interesting book by Robert Frank, I don't have it on the reading list, called Richistan, who talks
about what wealthy people are like these days. And if you read his book sometimes they are disgustingly
rich and spending the money on silly things. But there is an idea among many of them that they are going
to do their good things for the world. I think many of you will do these things; I want to think about the
purpose that you'll find in finance.
So, that's just the closing thought. I'll see you again on Wednesday. But the closing thought is that this is
about making your purposes happen. OK.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 2 - Risk and Financial Crises [January 14, 2011]
Chapter 1. Financial Crisis of 2007-2008 and Its Connection to Probability Theory [00:00:00]
Professor Robert Shiller:So, what I want to do this time is talk about probability. I don't think many of
you have taken a course in probability theory. I don't take that as a prerequisite for this course, but I think
that actually Probability theory is fundamental to the way we think about finance. So, I wanted to talk about
that a little bit today. And I'm going to put it in a concrete context, namely, the crisis that the world has
been through since 2007, and which we're still in at this point. It's a financial crisis that's bigger than any
since the Great Depression of the 1930's. There's many different ways of thinking about a crisis like this.
And I wanted to focus on one way that people think about it in terms of probability models. So, that's not
the only way, it's not necessarily my favorite way of thinking about it. That's, I think, a good way of
introducing our discussion of probability as it relates to finance. Excuse my cold. I am managing to talk. I
didn't bring any water. I hope I make it through this lecture. It's a little bit iffy.
So, let's just think about the crisis. Most people, when they talk about financial crises, they talk in terms of
narrative, of a historical narrative. So, I'll give you a quick and easy historical narrative about the crisis.
The crisis began with bubbles in the stock market, and the housing market, and also in the commodities
market. Bubbles are--I will talk about these later, but bubbles are events, in which people get very excited
about something, and they drive the prices up really high, and it's got to break eventually. And there was a
pre-break around 2000 when the stock market collapsed around the world. All over the world, the stock
markets collapsed in 2000. But then they came back again after 2003 and they were on another boom, like a
roller coaster ride. And then they collapsed again. That's the narrative story.
And then, both the housing market [and the] stock market collapsed. And then, what happened is, we see a
bunch of institutional collapses. So, we see, in 2007, failures in companies that had invested in home
mortgages. And we see a run on a bank in the United Kingdom, Northern Rock. It was arrested, but it
looked like 1930's all over again with the bank failure. We saw bank failures in the United States. And
then, we saw international cooperation to prevent this from spreading like a disease. And then, we had
governments all over the world bailing out their banks and other companies. So, a disaster was averted, and
then we had a nice rebound. That's the narrative story, OK. And it makes it sound--and I'm going to come
back to it, because I like the narrative story of the collapse.
But I want to today focus on something that's more in keeping with probability, with the way financial
theorists think about it. And what financial theorists will think about is that actually it's not just those few
big events. The crisis we got into was the accumulation of a lot of little events. And sometimes they
accumulate according to the laws of probability into big events. And you are just telling stories around
these accumulation of shocks that affected the economy. And the stories are not, by some accounts, not that
helpful. We want to understand the underlying probabilities. And so that's--thank you, a good assistant. He
knows what I need. I just announced what I need, he got it. A bottle of water. Tomorrow I may have
absolutely no voice. You're lucky.
I'm going to talk today about probability, and variance, and covariance, and regression, and idiosyncratic
risk, and systematic risk. Things like that which are core concepts in finance. But I'm also going to, in the
context of the crisis, emphasize in this lecture, breakdowns of some of the most popular assumptions that
underlie financial theory. And I'm thinking particularly of two breakdowns. And we'll emphasize these as
other interpretations of the crisis. One is the failure of independence. I'll come back and redefine that. And
another one is a tendency for outliers or fat-tailed distributions. So, I'll have to explain what all that means.
Chapter 2. Introduction to Probability Theory [00:05:51]
But basically, let me just try to elaborate on--probability theory is a conceptual framework that
mathematicians invented. And it's become a very important way of thinking, but it doesn't go back that far
in time. The word probability in its present meaning wasn't even coined until the 1600's. So, you if you talk
to someone before the year 1600, and say, this has a probability of 0.5, they would have no idea what
you're talking about. So, it's a major advance in human understanding to think in terms of probabilities.
Now we do. And now it's routine, but it wasn't routine at all. And part of what I'm thinking about is, what
probability theorists do, or in particular finance theorists like to do, is they think that the world is, well, let
me just say, it's kind of a realization that the world is very complex, and that the outcomes that we see are
the results of millions of little things. And the stories we tell are just stories.
So, how do we deal with the complexity of the world? Well, we do it by dealing with all of these little
incremental shocks that affect our lives in a mathematical way. And we think of them as millions of shocks.
How do they accumulate? We have mathematical laws of how they accumulate. And once we understand
those laws, we can we can build mathematical models of the outcomes. And then we can ask whether we
should be surprised by the financial events that we've seen. It's a little bit like science, real hard science.
So, for example, weather forecasters. They build models that--you know, you see these weather forecasts.
They have computer models that are built on the theory of fluid dynamics. And there is a theory of all those
little atoms moving around in the air. And there's too many atoms to count, but there's some laws about
their cumulative movement that we understand. And it actually allows us to forecast the weather. And so,
people who are steeped in this tradition in finance think that what we're doing when we're doing financial
forecast is very much like what we do when we do weather forecasts. We have a statistical model, we see
all of the shocks coming in, and of course there will be hurricanes. And we can only forecast them--you
know there's a limit to how far out we can forecast them. So, all hurricanes are a surprise two weeks before
they happen. Weather forecasters can't do that. Same thing with financial crises. This would be the model.
We understand the probability laws, there's only a certain time horizon before which we can forecast the
financial crisis.
That isn't exactly my view of the situation. I'm presenting a view this time which is very mathematical and
probability theory oriented. So, let me get into some of the details. And again, these are going to be re-
covered in the review session that Elan Fuld, one of our teaching assistants, will do. I have just slides with
some graphs and equations. But, that's not Elan Fuld.
Chapter 3. Financial Return and Basic Statistical Concepts [00:09:58]
I want to start out with just the concept of return. Which is, in finance, the basic, the most basic concept
that --
[SIDE CONVERSATION]
Professor Robert Shiller:When you invest in something, you have to do it for a time interval. And I'm
writing the return as one time period. T is time. And so, it could be [a] year, or it could be months, or it
could be [a] day. We're going to number these months, let's say it's monthly return, we're going to number
these months, so that the first month is number one, second month is number two.
And so, return at time t, if t is equal to 3, that would be the return at month three. And we'll do price at the
beginning of the month. And so, what is your return to investing in something? It's the increase in the price.
That's p
t+1
p
t
. I'm spelling it out here. Price--I spelled it out in the numerator, I guess I didn't do it in the
denominator. It's price at time t+1 minus the price at time t, which is called the capital gain, plus the
dividend, which is a check you receive, if you do, from the company that you're investing in. That's the
return.
We have something else called gross return. Which is just 1 plus the return. Returns can be positive or
negative. They can never be more than--never be less than minus 100%. In a limited liability economy that
we live in, the law says that you cannot lose more than the money you put in, and that's going to be our
assumption. So, return is between minus 100% and plus infinity. And gross return is always positive. It's
between zero and infinity.
Now what we're going to do--this is the primary thing that we want to study, because we are interested in
investing and in making a return. So, we want to do some evaluations of the success of an investment. So, I
want to now talk about some basic statistical concepts that we can apply to returns and to other random
variables as well. These on this slide are mostly concepts that you've already heard. This is expected value.
This is the mathematical expectation of a random variable x, which could be the return, or the gross return,
or something else, but we're going to substitute something else.
We're going to substitute in what they are. So, the expectation of x, or the mean of x, !
x
is another term for
it, is the weighted sum of all possible values of x weighted by their probabilities. And the probabilities have
to sum to 1. They're positive numbers, or zero or positive numbers, reflecting the likelihood of that random
variable occurring, that value of the random variable occurring.
So, I have here--there's an infinite number of possible values for x, and we have a probability for each one,
and the expectation of x is that weighted sum of those, weighted by probabilities, of those possible values.
This is for a discrete random variable that takes on only a finite, only a countable number of values. If it's a
continuous random variable, if x is continuous, then the expectation of x is an integral of the probability
density of x, times x dx. I'm just writing that down for you now for completeness. But I'm not going to
explain or elaborate that.
These two formulas here are measures of the central tendency of x, OK. It's essentially the average of x in
the probability metric that we have up here. But this formula is something we use to estimate the expected
value of x. This is called the mean or average, which you've learned long ago. If you have n observations
on a random variable x, you can take the sum of the x observations, summation [over] i equals 1 to n, and
then divide that by n. That's called the average. So, what I want to say is that this is the average, or the
mean, or sample mean when you have a sample of n observations, which is an estimate of the expected
value of x.
So, for example, if we're evaluating an investor who has invested money, you could get n observations, say
annual returns, and you can take an average of them. And that's the first and most obvious metric
representing the success of the investments if x is the return, OK. People are always wanting to know,
they're looking at someone who invests money, is this person a success or not? Well this is the first and
most obvious measure. Let's see what that person did on average. You were investing for, let's say n equals
10, ten years, let's take the returns you made each year, add them up and divide by 10. And that gives us an
average.
I put this formula down as an alternative, because it's another--this is called the geometric mean. This is the
arithmetic mean. This is the geometric mean and you're probably not so familiar with that, because it's a
different concept. The geometric mean, instead of adding your n observations, you multiply them together.
You form a product of them. And then, instead of dividing by n, you take the nth root of the product. And
so, that's a formula that's used to estimate the average return of a portfolio of investments, where we use
gross return for x, not just the simple return. This geometric mean makes sense only when all the x's are
non-negative. If you put in a negative value, you might get a negative product, and then, if you took the nth
root of that, it could be an imaginary number, so let's forget that. We're not going to apply this formula if
there are any negative numbers. But it's often used, and I recommend its use, in evaluating investments.
Because if you use gross return, it gives a better measure of the outcome of the investments.
So, think of it this way. Suppose you invested money with some investment manager, and the guy said, I've
done a wonderful job investing your money. I made 50% one year, I made 30% another year, oh, and by
the way, I had one bad year with minus 100%, OK. So, what do you think of this investor? Well, you think
about it, if he made 50% one year, and then 30% another year, and then he lost everything. That dominates
everything, right? If you have a minus 100% simple return, your gross return is 0, OK?
So, if I plug in, if I put in a 0 here to any of the x's, right, this product will be 0. Anything times 0 is 0. And
I take the nth root of zero, and what's that? It's 0. So, if there's ever a year in which the return is minus
100%, then the geometric mean is 0. That's a good discipline. This obviously doesn't make sense as a way
to evaluate investment success. Are you with me on this? Because you care a lot, if the guy wipes you out.
Whatever else is done after that doesn't matter. So, that's why we want to use the geometric return.
These are all measures of central tendency. That is, what is the central result? Sometimes the investor had a
good year, sometimes the investor had a bad year, but what was the typical or central value? So, these are a
couple of measures of them. But we care more than just about central tendency when evaluating risk. We
have to do other things as well.
And so, you want to talk about--and this is very fundamental to finance. We have to talk about risk. What
could be more fundamental than risk for finance? So, what we have here now is a measure of variability.
And the upper equation here is something called variance. And it's equal to the weighted average of the x
random variables [correction: realizations of the x random variables] squared deviation from the mean,
weighted by probabilities. OK? All it is, is the expectation of the square of the deviation from the mean.
The mean is the center value, and the deviations from the mean are--whether they're positive or negative, if
you square them they become positive numbers. And so, that's called variance. So, for example, if x tends
to be--if the return tends to be plus or minus 1% from the mean return. . . say the mean return for an
investor is 8% a year, and it's plus or minus 1%, then you would see a lot of 1's when you squared the
deviation from the mean. And the variance would probably be 1. And the standard deviation, which is--the
standard deviation is the square root of the variance. And it would also be 1. OK.
This is a very simple concept. It's just the average squared deviation from the mean. The estimate of the
variance, or the sample variance, is given by this equation. And it's s squared of x. It's just the sample
mean. Take deviations of the variable from its sample mean. You have n observations, say someone has
invested money for ten years, you take the average return for the ten years and that's x bar, and then you
take all 10 deviations from the mean and square them, and then divide by n. Some people divide by n-1, but
I'm just trying to be very basic and simple here, so I'm not going to get into these ideas.
The next thing is covariance. We're getting through these concepts. They're very basic concepts.
Covariance is a measure of how two different random variables move together. So, I have two different
random variables, x and y. So, x is the return on, let's say, the IBM Corporation, and y is the return on
General Motors Corporation. And I want to know, when IBM goes up, does General Motors go up or not?
So, a measure of the co-movement of the two would be to take the deviation of x from its mean times the
deviation of y from it's mean, and take the average product of those. And that's called covariance.
It's a positive number if, when x is high relative to it's mean, y is high relative to its mean also. And it's a
negative number if they tend to go in opposite directions. If GM tends to do well when IBM does poorly,
then we have a negative covariance. Because, if one is above its mean, and the other is below its mean, the
product is going to be a negative number. If we get a lot of negative products like that, it means that they
tend to move opposite each other. And if they are unrelated to each other, then the covariance tends to be 0.
And this is the core concept that I was talking about. Some idea of unrelatedness underlies a lot of our
thinking in risk. So, if x and y are independent, theyre generated [independently]-- suppose IBM's business
has just nothing at all to do with GM's businesses, they're so different. Then I'd say the covariance is
probably 0. And then we can use that as a principle, which will underlie our later analysis.
Correlation is a scaled covariance. And it's a measure of how much two variables move together. But it's
scaled, so that it varies only over the range of minus 1 to plus 1. So, the correlation between two random
variables is their covariance divided by the product of their standard deviations. And you can show that that
always ranges between minus 1 and plus 1. So, if two variables have a +1 correlation, that means they
move exactly together. When one moves up 5%, the other one moves up 5% exactly. If they have a
correlation of -1, it means the move exactly opposite each other. These things don't happen very often in
finance, but in theory that's what happens. If they have a zero correlation, that means there's no tendency
for them to move together at all. If two variables are independent, then their correlation should be zero.
OK, the variance of the sum of two random variables is the variance of the first random variable, plus the
variance of the second random variable, plus twice the covariance of the random variables. So, if the two
random variables are independent of each other, then their covariance is zero, and then the variance of the
sum is the sum of the variances. But that is not necessary. That's true if the random variables are
independent, but we're going to see that breakdown of independence is the story of this lecture right now.
We want to think about independence as mattering a lot. And it's a model, or a core idea, but when do we
know that things are independent?
Chapter 4. Independence and Failure of Independence as a Cause for Financial Crises [00:26:29]
OK, this is a plot. I was telling you earlier about the--let me see, OK, let me just hold off on that a minute.
Well, I'll tell you what that was. That was a plot of the stock market from 2000 to 2010 in the U.S. And I'm
going to come back to that. These are the crises I was telling you about. This is the decline in the stock
market from 2000 to 2002 or 2003 and this is the more recent decline from 2007 to 2009. Those are the
cumulative effects of a lot of little shocks that didn't happen all at once. It happened over years. And we
want to think about the probability of those shocks occurring. And that's where I am going.
But what I want to talk about is the core concept of independence leading to some basic principles of risk
management. The crisis that we've seen here in the stock market is the accumulation of--you see all these
ups and downs in the stock market, and then all these ups and downs on the way up. There were relatively
more downs in the period from 2000 and 2002 and there were relatively more ups from the period 2003 to
2006. But how do we understand the cumulative effect of it, which is what matters? So, we have to have
some kind of Probability Model. The question immediately is, are these shocks that affected the stock
market, are they independent, or are they somehow related to each other? And that is a core question that
made it so difficult for us to understand how to deal with the potential of such a crisis, and why so many
people got in trouble dealing with this crisis.
So, we had a big financial crisis in the United States in 1987, when there was a stock market crash that was
bigger than any before in one day. We'll be talking about that. But after the 1987 crash, companies started
to compute a measure of the risk to their company, which is called Value at Risk. I'll write it up like that. I
capitalized the first and the last letter, so you'll know that I'm not--this is not the same thing as variance.
This is Value at Risk. And what companies would do after 1987 to try to measure the risk of their activities
is to compute a number something like this. They would say, there's a 5% probability that we will lose $10
million in a year. That's the kind of bottom line that Value at Risk calculations would make.
And so, you need a Probability Model to make these calculations. And so, you need probability theory in
order to do that. Many companies had calculated Value at Risk numbers like this, and told their investors,
we can't do too badly because there's no way that we could lose--the probability is only 5% that we could
lose $10 million. And they'd have other numbers like this. But they were implicitly making assumptions
about independence, or at least relative independence. And that's the concept I'm trying to emphasize here.
It's a core concept in finance. And it's not one that is easy to be precise about.
We have an intuitive idea that, you know--we see the ups and downs on the stock market, and we notice
them, and they all average out to something not too bad. The problem that brought us this crisis is that the
Value at Risk calculations were too optimistic. Companies all over the world were estimating very small
numbers here, relative to what actually happened. And that's a problem.
I wanted to emphasize core concepts here. Intuitive concepts that you probably already have. One of these
concepts is something we'll call the law of large numbers. And the law of large numbers says that, there's
many different ways of formulating it, but putting it in its simplest form, that if I have a lot of independent
shocks, and average them out, on average there's not going to be much uncertainty. If I flip a coin once,
let's say I'm making a bet, plus or minus. If it comes up heads, I win a dollar; if it comes up tails, I lose a
dollar. Well, I have a risk. I mean, I have a standard deviation of $1 in my outcome for that. But if I do it
100 times and average the result, there's not going to be much risk at all.
And that's the law of large numbers. It says that the variance of the average of n random variables that are
all independent and identically distributed goes to 0 as the number of elements in the average goes to
infinity. And so, that's a fundamental concept that underlies both finance and insurance. The idea that
tossing a coin or throwing a die in a small number of--it has uncertainty in a small number of observations,
but the uncertainty vanishes in a large number of observations, goes back to the ancient world. Aristotle
made this observation, but he didn't have probability theory and he couldn't carry it further.
The fundamental concept of insurance relies on this intuitive idea. And the idea was intuitive enough that
insurance was known and practiced in ancient times. But the insurance concept depends on independence.
And so, independence is something that apparently breaks down at times like these. Like these big down
crises that we've seen in the stock market, in the two episodes in the beginning of the 20th century.
So, the law of large numbers has to do with the idea that if I have a large number of random variables, what
is the variance of--the variance of x
1
+ x
2
+ x
3
+ + x
n
? If they're all independent, then all of the
covariances are 0. So, it equals the variance of x
1
, plus the variance of x
2
, , plus the variance of x
n
.
There's n terms, I'm not showing them all. OK? So, if they all have the same variance, then the variance of
the sum of n of them is n times their variance, OK. And that means the standard deviation, which is the
square root of the variance, is equal to the square root of n times the standard deviation of one of them. The
mean is divided by n. So, that means that the standard deviation of the mean is equal to the standard
deviation of one of the x's divided by the square root of n. So, as n goes large, you can see that the standard
deviation of the mean goes to 0. And that's the law of large numbers. OK.
But the problem is, so you know, you can look at a financial firm, and they have returns for a number of
years, and those returns can be cumulated to give some sense of their total outcome. But does the total
outcome really behave properly? Does it become certain over a longer interval of time? Well, apparently
not, because of the possibility that the observations are not independent.
So, we want to move from analysis of variance to something that's more--I told you that VaR came in 1987
or thereabouts, after the stock market crash of '87. There's a new idea coming up now, after this recent
crisis, and it's called CoVaR. And this is a concept emphasized by Professor Brunnermeier at Princeton and
some of his colleagues, that we have to change analysis of variance to recognize, I'm sorry, we have to
change Value at Risk to recognize that portfolios can sometimes co-vary more than we thought. That there
might be episodes when everything goes wrong at the same time. So, suddenly the covariance goes up. So,
CoVaR is an alternative to Value at Risk that does different kinds of calculations. In the present
environment, I think, we recognize the need for that.
Chapter 5. Regression Analysis, Systematic vs. Idiosyncratic Risk [00:38:58]
So, this is the aggregate stock market, and let me go to another plot which shows both the same aggregate
stock market, that's this blue line down here, and one stock. The one stock I have shown is Apple, the
computer company. And this is from the year 2000--this is just the first decade of the twentieth century.
Can you see this? Is my podium in the way for some of you? You might be surprised to say, wait a minute,
did I hear you right? Is this blue line the same line that we just saw? But you know if Ill go back, it is the
same line. It's just that I rescaled it. There it is, it's a blue line.
This looks scary, doesn't it? The stock market lost something like almost half of its value. It dropped 40%
between 2000 and 2002. Wow. Then it went all the way back up, and then it dropped almost 50%. These
are scary numbers, right? But when I put Apple on the same plot, the computer had to, because Apple did
such amazing things, it had to compress. And that's the same curve that you were just looking at. It's just
compressed, so that I can plot it together. I put both of them at 100 in the year 2000. So, what I'm saying
here is that somehow Apple did rather differently than the--this is the S&P 500. It's a measure of the whole
stock market. Apple computer is the one of the breakout cases of dramatic success in investing. It went up
25 times.
This incidentally is the adjusted price for Apple, because in 2005 Apple did a 2-for-1 split. You know what
that means? By tradition in the United States, stocks should be worth about $30 per share. And there's no
reason why they should be $30 per share. But a lot of companies, when the price hits $60 or something like
that, they say, well let's just split all the shares in two. So, that they're back to $30. Apple went up more
than double, but they only did one split in this period. So, we've corrected for that. Otherwise, you'd see a
big apparent drop in their stock price on the day of the split. Are you with me on this split thing? It really
doesn't matter, it's just a units thing. But you can see that an investment in Apple went up 25 times, whereas
an investment in the S&P 500 went up only--well, it didn't go up, actually, it's down.
So now, this is a plot showing the monthly returns on Apple. It's only the capital gain returns; I didn't
include dividends. But it is essentially the return on these two, on the S&P 500 and on Apple. Now, this is
the same data you were just looking at, but it looks really different now, doesn't it? It looks really different.
They're unrecognizable as the same thing. You can't tell from this plot that Apple went up 25-fold. That
matters a lot to an investor. Maybe you can, if you've got very good eyes. There's more up ones than there
are down ones, more up months than down months. There's a huge number of--enormous variability in the
months.
But I like to look at a picture like this, because it conveys to me the incredible complexity of the story.
What was driving Apple up and down so many times? Really a pretty simple picture. Buy Apple and your
money will go up 25-fold. Incidentally, if you were a precocious teenager, and you told your parents ten
years ago, OK, where you into this then? But just imagine, you say, mom, let's take out a $400,000
mortgage on the house and put it all in Apple stock, OK. Your parents would thank you today if you told
them to do that. Your parents could do that. They have probably paid off their mortgages, right; they could
go get a second mortgage. Easily come up with $400,000. Most of your houses would be worth that. So,
what would it be worth today? $10 million. Your father, your mother would be saying, you know, I've been
working all ten years, and your little advice just got me $10 million. It's more than I made, much more than
I made in all those years.
So, these kinds of stories attract attention. But you know, it wasn't an even ride. That story seems too good
to be true, doesn't it? I mean 25-fold? The reason why it's not so obvious is that the ride, as you're
observing this happen, every month it goes opposite. It just goes [in] big swings. You make 30% in one
month; you lose 30% in another month. It's a scary ride. And you can't see it happening unless you look at
your portfolio and see what--you can't tell. It's just so much randomness from one month to the other.
Incidentally, I was a dinner speaker last night for a Yale alumni dinner in New York City. And I rode in
with Peter Salovey who's Provost at Yale. And on the ride back he reminded me of a story that I think I've
heard, but it took me a while to remember this. But I'll tell you that it's an important Yale story. And that is
that in 1979, the Yale class of 1954 had a 25th reunion, OK. This is history. Do you know this story? Do
you know where I'm heading? So, somebody said, you know, we're here at this reunion, there's a lot of us
here, let's all, as an experiment, chip in some money and ask an investor to take a risky portfolio investment
for Yale and let's give it to Yale on our 50th anniversary, all right? Sounds like fun.
So, they got a portfolio manager, his name was Joe McNay, and they said--they put together--it was
$375,000. It's like one house, you know, for all the whole class of 1954, no big deal. So, they gave Joe
McNay a $375,000 start. And they said, just have fun with this. You know, we're not conservative. If you
lose the whole thing, go ahead. But just go for maximum return on this.
So, Joe McNey decided to invest in Home Depot, Walmart, and Internet stocks, OK? And on their 50th
reunion, that was 2004, they presented Yale University with $90 million dollars. That's an amazing story.
But I'm sure it was the same sort of thing, same kind of roller coaster ride the whole time. And now, we're
trying to decide, is Joe McNey a genius? What do you think, is he a genius? I think, maybe he is. But the
other side of it is, I just told you what to do in just a few words. It's Walmart Home Depot, and Internet
stocks. And the other thing is, he started liquidating in 2000, right the peak of the market. So, it must be
partly luck.
The thing is, how did he know that Walmart was a good investment in 1954 [correction: 1979]? I don't
know. It's sort of--he took the risks. Maybe that's why--I'm just digressing a little bit to think about the way
things go in history. But it seems that--I talked about the Forbes 400 people, and I mentioned last lecture
about Andrew Carnegie's The Gospel of Wealth, and he says that some people are just very talented and
they make it really big, and we should let them, then, give their money away, and it's kind of the American
idea that we let talented people prove themselves in the real marketplace and then they end up becoming
philanthropists and guiding our society. But maybe they're just lucky. No one could have known that
Walmart was going to be such a success.
And I think that history is like that. The people you read about in history, these great men and women of
history, are often just phenomenal risk takers like Joe McNey. And for every one of them that you read
about, there's 1,000 of them that got squashed. I was reading the history of Julius Caesar, as written by
Plutarch. It's a wonderful story. And I was reading this, and I thought, this guy is a real risk taker. You
know, you read all the details of his life. He just went for it every time. And he ended up emperor of Rome.
But you know what happened to him, he got assassinated. So, it was--you know, it turned out not entirely a
happy story. So, maybe it's all those poor, all those ordinary people, who live in the little house, the
$400,000 house, they don't risk it. Maybe they're the smart ones. You just don't ever hear of them.
Well, these are issues for finance. But you wonder, what are all of these things, all of these big movements?
This is the worst one here, where it lost about a third of its value in one month. And I researched it. What
was it? Does anyone know what caused it in 2008? Well, I'll tell you what caused Apple to lose a third of
its value in one month. Steve Jobs, who is the founder of Apple and genius behind the company, gave a--
was at an annual meeting or press conference, and people said, he doesn't look well. And so, they recalled
that he had pancreatic cancer in 2004, but the doctors then said it's curable, no problem, so the stock didn't
do anything. But reporters called Apple and said, is he ok? And their company spokesman wouldn't say
anything. So, it started a rumor mill that Steve Jobs was dying of cancer. It quickly rebounded because he
wasn't. That's how crazy these things are, these market movements.
So, now the next plot, and this is important for our concepts here. I can plot the same data in different ways.
This shows a different sort of complexity. Let me just review what we've seen here. We started out with
Apple stock. This is the stock price normalized to 100 in 2000. OK? And it goes up to 2500. Then, the next
thing I did is I did capital gains as a percent. The percentage increase in price for each month. It looks
totally different, and it shows such complexity that I can't tell a simple narrative. I've just told you about
one blip here, but they were so many of these blips on the way, and they all have some story about the
success of some Apple product, or people aren't buying some product. Every month looks different.
But now, what I want to do--and I have here the blue line is the return of the S&P 500. Now what I want to
do is plot a different sort of plot. It's a scatter plot. I'm going to plot the return on Apple against the return
on the S&P 500, OK. Do you know what I'm referring to here? So, this is scatter plot. On the vertical axis I
have the return, it's actually the capital gain on Apple, and on the horizontal axis I have the capital gain on
the whole stock market. OK? And each point represents one of the points that we saw on the market.
Actually I think it was, I was telling you the second lowest story [return]. Steve Jobs, I'm not sure which
point it was. One of these points in 2008 was when Steve Jobs looked sick. So, each point is a month, and I
have the whole decade of 2000, of the beginning of the 2000s, plotted.
So, the best success was in December, January of 2001, where the stock price went up 50% in one month. I
tried to figure out what that was about. Why'd they go up 50% percent in one month? It turns out that the
preceding two months it had gone down a lot. They were down here somewhere. There were these big
drops, and people were getting really pessimistic because Apple products weren't going well. They had
introduced some new products, Mobile Me, I think, we forget about these products that don't work, that
didn't work very well. And then somehow people decided it really wasn't so bad, so we have plus 50,
almost 50% return in one month. The reason why it looks kind of compressed on this way is, because the
stock market doesn't move as much as Apple.
So, basically Apple return is the sum of two components, which is the overall market return, and the
idiosyncratic return, OK. So, the return for a stock, for the i-th stock, is equal to the market return, which is
represented here by the S&P 500, which is pretty much the whole stock market, plus idiosyncratic return.
OK. And if they're independent of each other, the variance of the sum is the sum of the variance. The
variance of the stock returns is the variance--the variance of the Apple return is the sum of their market
return and their idiosyncratic return.
Well, let me be clear about that. Let's add a regression line to the scatter point [correction: scatter plot].
OK? It's the same scatter that you saw--is it clear? Everyone clear what we're doing here? I've got S&P on
this axis, and Apple on this axis. And now I've added a line, which is a least-square fit, which minimizes
the sum of squared deviations from the line. It tries to get through the scatter of points as much as it can.
And the line has a slope of 1.45. We call that the ", all right? These are concepts that I'm asking Elan to
elaborate for you in the review session. But it's a simple idea here. What it means is that it seems like Apple
shows a magnified response to the stock market. It goes up and down approximately one and a half times as
much as the stock market does on any day. So, the market return here is equal to the " times the return on
the S&P that you see here.
So, I wonder why that is? Why does Apple respond more than one-for-one with the stock market? I guess
it's because the aggregate economy matters, right? If you think that maybe because Apple is kind of a
vulnerable company, that if the economy tanks, Apple will tank even more than the economy, than the
aggregate economy, because they're such a volatile, dangerous strategy company. And if the market goes
up, then it's even better news for Apple. But even so, the idiosyncratic risk just dominates. Look at these
observations, way up and way down here. Apple has a lot of idiosyncratic risk. And I mentioned one
example; it's Steve Jobs' health.
The Steve Jobs story is remarkable. He founded Apple and Apple prospered, and then he kind of had a
falling out with the management, and got kind of kicked out of his own company. And then he says, all
right, I'll start my own computer company, my second, I'll do it again. So, he founded Next Computer. But
meanwhile, Apple started to really tank. This is in the nineties. And they finally realized they needed Steve
Jobs, so they brought him back. So, the company's ups and downs, the idiosyncratic risk, has a lot to do
with Steve Jobs, and what he does, the mistakes he made. Those are what causes these big movements.
This line, I thought it would have an even higher ". But I think it's this point which is bringing the " down.
And this is, I think this is the point--the month after it turns out that Steve Jobs really wasn't sick. OK? And
it turned out to be the same month that's the Lehman Brothers collapse occurred. So you see, this point here
is between September and October of 2008. And that's the point--it was September 15th that we had the
most significant bankruptcy in U.S. history. Lehman Brothers, the investment bank, went bankrupt. It threw
the whole world in chaos. So, the stock market and S&P 500 stock market return was minus 16% in one
month, horrible drop. But for Apple, it really was only about minus 5%, because they're getting over the
news of Steve Jobs. So, that's the way things work.
Chapter 6. Fat-Tailed Distributions and Their Role during Financial Crises [00:58:59]
So, I want to move on now to next topic, which is outliers, and talk about another assumption that is made
in finance traditionally that turned out to be wrong in this episode. And the assumption is that random
shocks to the financial economy are normally distributed. You must have heard of the normal distribution.
This is the bell-shaped, the famous bell-shaped curve, that was discovered by the mathematician Gauss
over a hundred years ago. The bell-shaped curve is thought to be--this particular bell-shaped curve which is
the--the log of this curve is a parabola. It's a particular mathematical function. The curve is thought by
statisticians to recur in nature many different ways. It has a certain probability law.
So, I have plotted two normal distributions, and I have them for two different standard deviations. One of
them, black line, is the standard deviation of 3, and the other one, the pink line, is the standard deviation of
1. But they both look the same; they're just scaled differently. And these distributions have the property that
the area under the curve is equal to 1 and the area between any two points, say between minus 5 and minus
10, the area under this curve is the probability that the random variable falls between minus 5 and minus
10.
So, a lot of probability theory works on the assumption that variables are normally distributed. But random
variables have a habit of not behaving that way, especially in finance it seems. And so, we had a
mathematician here in the Yale math department, Benoit Mandelbrot, who was really the discoverer of this
concept, and I think the most important figure in it. [Correction: Pierre Paul Levy invented the concept, as
discussed in the next lecture.] He said that in nature the normal distribution is not the only distribution that
occurs, and that especially in certain kinds of circumstances we have more fat-tailed distributions. So, this
blue line is the normal distribution, and the pink line that I've shown is a fat-tailed distribution that
Mandelbrot talked about, called the Cauchy distribution.
You see how it differs? The pink line looks pretty much the same. They're both bell-shaped curves, right?
But the pink line has tremendously large probability of being far out. These are the tails of the distribution.
So, if you observe a random variable that looks--you observe it for a while, maybe you get 100
observations, you probably can't tell it apart very well from a normal distribution. Whether it's Cauchy or
normal, they look about the same. The way you find out that they're not the same, is that in extremely rare
circumstances there'll be a sudden major jump in the variable that you might have thought couldn't happen.
So, I have here a plot of a histogram of stock price movements from 1928, every day, I've taken every day
since 1928, and I've shown what the S&P Composite Index--it didn't have 500 stocks in 1928, so I can't call
it S&P 500 for the whole period--but this is essentially the S&P 500. And I have every day. There's
something like 40,000 days. And what this line here shows is that the stock return, the percentage change in
stock price in one day, was between 0 and 1% over 9,000 times. And it was between 0 and minus 1 percent
around 8,000 times. OK? So, that's typical [per] day. You know, it's less than 1% up or down. But
occasionally, we'll have a 2% day. This is between 1 and 2% that occurred about 2,000 times. And about
2,000 times we had between minus 1 and minus 2%. And then, you can see that we've had--you can see
these outliers here. These look like outliers, they're not extreme outliers. So, if you look at a small number
of data, you get an impression that well, you know, the stock market goes up between plus or minus 2%,
usually not so much, that's the way it is.
After here they don't seem to be anything, which means that, it looks like you never see anything more than
up or down 5% or 6%. It just doesn't happen. Well, because it's so few days that it does those extremes.
Can you see these little--that's between 5 and 6. There were maybe like 20 days, I can't read off the chart
when it did this since 1928. You can go through ten years on Wall Street and never see a drop of that
magnitude. So, eventually you get kind of assured. It can't happen. What about an 8% drop? Well, I look at
this, I say, I've never seen that. You know, I've been watching this now, I've seen thousands of days, and
I've never seen that. But I have here the two extremes. Stock market went up 12.53% on October 30, 1929.
That's the biggest one-day increase. That's way off the charts, and if you compute the normal distribution,
what's the probability of that? If it's a normal distribution and it fits the central portion, it would say it's
virtually zero. It couldn't happen. Anyone have any idea what happened on October 30, 1929? It's obvious
to me, but it's not obvious to you. I'm asking you to--I won't ask. What happened in October, anyone know
what happened in October 1929?
Student: That must be right before the crash.
Professor Robert Shiller: You're close. You're right. But someone else?
Student: Wasn't it the rebound after the crash?
Professor Robert Shiller: Yes, absolutely, it was the rebound after the crash. The stock market crash of
1929 had two consecutive days. Boy is that probability, independence doesn't seem right. It went down
about 12% on October 28, and then the next day it did it again. What's going on here? We were down like
24% in two days. People got up on the 30th and said, oh my God, is it going to do that again? But it did just
the opposite. It was going totally wild. So, we don't know whether covariance broke down or not. I guess it
didn't, because it rebounded, and that was the biggest one-day increase ever.
But if that weren't enough, however, let's go back to October 19, 1987. It went down 20.47% in one day. It
went down even more on the Dow. Some people say it went down more than that, didn't it? But on the S&P
that's how much it went down. So, I figured, well if this were normally distributed with the standard
deviation suggested by this, what's the probability of a decline that's that negative? It's 10
-71
.. So, you take 1
and you divide that by 1 followed by seventy-one zeross. That's an awfully small number. If you believe in
normality, October 19, 1987 couldn't happen. But there it is. It happened.
And in fact, I was, I told you I've been teaching this course for 25 years. I was giving a lecture, not in this
room, but nearby here, and I was talking about something else. And a student had a transistor radio.
Remember transistor radios? And he was holding it up and listening to it. Then he raised his hand and said,
do you know what's happening? He said the stock market is totally falling apart. It just came as a complete
surprise to me.
So, after class, I didn't go back to my office. I went downtown to Merrill Lynch. And I walked up; it's a
story I like to tell. It's not that good. I walked up and I talked to a stockbroker there, and I said, I was about
to say something, but he didn't let me talk. He said, don't panic. He thought that I had shown up as someone
who was losing everything, his life savings all in one day. And he said, don't worry, it's not going to--it's
going to rebound. It didn't rebound. I showed up at lunchtime and it kept going down.
So, anyway, there was something wrong with independence. Let me just recap. The two themes are that
independence leads to the law of large numbers, and it leads to some sort of stability. Either independence
through time or independence across stocks. So, if you diversify through time or you diversify across
stocks, you're supposed to be safe. But that's not what happened in this crisis and that's the big question.
And then it's fat-tails, which is kind of related. But it's that distributions fool you. You get big incredible
shocks that you thought couldn't happen, and they just come up with a certain low probability, but with a
certain regularity in finance. All right, I'll stop there. I'll see you on next Wednesday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 3 - Technology and Invention in Finance [January 19, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: OK, good morning. Today I decided not to use PowerPoint, I'm using index
cards. This is traditional lecture style. I want to talk today about--this is our third lecture for financial
markets. I wanted to talk today about invention in finance. I think of finance, I don't know whether this will
encourage you to be interested or not, but I think of it as a form of engineering. Finance is all about
inventions. Devices that solve problems and that help people do things and get on with their purposes in
life. And the inventions have many small details, just like any invention.
Like an airplane. You look at an airplane, how many parts are in there? How many different people worked
on the different parts? And it's so complicated that you might have disbelief that this whole thing is going
to work, but somehow it does work. And another part that I want to emphasize in today's lecture is that
engineering requires a human element. Engineers know that their devices will be run by people, and people
are imperfect. And so, they have a course in engineering schools called Human Factors Engineering. And
that's about designing machines, so that human beings won't mess up when they try to use them. That gets
us into psychology. To me, when we talk about behavioral finance, which is going to be a theme of this
course, human psychology and finance, it's fundamental to the inventive side of finance.
So that's what I want to talk about. I'm going to give you some examples of invention and talk about how
they solve the risk problem. The fundamental problem of maintaining incentives in the face of risks. But
before I start this lecture, I wanted to just briefly review the last lecture, which was a very important lecture
for this course, because it talked about the underlying probability theory and applications of probability
theory to finance.
Chapter 2. Review of Probability Theory and the Central Limit Theorem [00:02:38]
So, let me just mention some of the concepts that I talked about last time. The first one was return. We
talked about the return on an investment which has two components, the capital gain, which is the increase
in the price of the investment, and the other is the dividend, which is something that comes separately in the
form of a check maybe, or electronic entry. But we then moved quickly to probability theory. We talked
about random variables. A random variable is a quantity that's created by some kind of experiment or event
that is uncertain in advance and becomes known later. And then, we talked about measures of probability
distributions.
We talked about central tendency, we talked about the average or mean, and the geometric average, and we
talked about measures of risk, notably variance. But then, there are also measures of co-movement between
two random variables. We talked about covariance and correlation, and we talked about regression. And
then finally we talked about distributions of random variables, and the normal distribution, which is
famous. It's the famous bell-shaped curve, which is thought by many people to represent a typical
distribution.
And then finally, we talked about failures of the--the idea of independent random variables that are
normally distributed is a powerful idea. That we have some idea that there's a bell-shaped curve. We know
something about what relates to something and what doesn't relate to what. These ideas are partly intuitive,
and they're partly wrong. And so, the concluding element of the last lecture was that the financial crisis that
has enveloped the world starting around 2007 seems to be related to people's failure to understand the limits
of the independence assumption they were making, and also to the limits of the normal distribution.
Namely, failure to consider outliers.
So, let's just think about independence briefly for a moment. It's inherent in the intuitive view we have of
the world. When you toss a coin, every time you toss it, you think each toss has to be independent of the
previous toss. They're not going to come up the same, because there's nothing relating the two tosses. So,
you have a strong intuitive sense that some events are independent. You might also think that returns on the
stock market from day to day are independent. Why is that? Because they relate to news, right? What
changes the stock market on any day? Its news, and by definition news has to be new. So, it can't just be
yesterday's news. So, it has to be something fresh. And I showed you a plot of the stock market and of
Apple stock, and in this plot it came out that the stocks look roughly independent, the returns from day to
day. But they're not necessarily independent, and they can surprise you, and that's when crises occur.
We also talked about idiosyncratic risk and market risk. Remember we regressed Apple stock's returns on
the stock market's returns and we got a fitted value, which was " times the market return. And that's the
market component of Apple risk. And then we saw that the extra component, idiosyncratic, is uncorrelated
with the market risk. But in this case it's uncorrelated by construction, so it has to be uncorrelated. Oh by
the way, I don't know if you caught the news. It's just coincidence that I mentioned Apple stock in my last
lecture. You must've heard the news. It was headline news on the Wall Street Journal.
We had a three-day weekend because of the Martin Luther King holiday in the U.S. and, over the weekend,
Apple announced that Steve Jobs is taking a long leave of absence from Apple because of his health. And
so, we talked about that Steve Jobs is viewed by a lot of people as the genius behind Apple, and the last
time he left for a long time Apple didn't do well. And so, you wondered what would happen to the stock.
Well, since they announced it on a day just before the market was closed, and so it opened in Europe and
there was a 7% drop in Germany of Apple shares. It opened down 5% on Tuesday in the U.S., but then it
recovered and it wasn't really down that much, probably because there was good earnings news at the same
time. That's just completing our little story about Apple.
I don't know if I gave enough emphasis to the central limit theorem last lecture. This is a fundamental
theorem from probability theory, which says that if you have independent identically distributed random
variables. That is, every random variable is independent of the other, and they're all of the same
distribution, and if it has a finite variance, then the distribution of an average of these variables converges
to the normal distribution as the number of elements in the average is increased. In other words, averages
are approximately normally distributed.
The bell-shaped curve works as well as it does, because so many things we observe in nature are averages.
So many things that we observe are the sum of many affects. This is what history is all about. Anytime big
events occur, it's probably because a number of things chanced to happen at the same time. And that's why
Probability Theorists think that we kind of know the probability distribution, and that's this bell-shaped
curve which I had on the slide last period. The critical thing about the bell-shaped curve is that the tails
drop off really fast, after you get a certain distance up on either end. They essentially hit zero. They never
hit zero. The probability is never zero. Anything can happen with a normally distributed variable. But the
normal distribution does not have fat tails. After two or three or four standard deviations, basically the
probability is zero that that kind of thing will happen, that a return--if we're applying it to returns, that that
would occur.
So, the problem with the central limit theorem is that it's only as good as its assumptions. And it assumes
that the underlying variables have a finite variance, that they themselves are not so fat-tailed that the
variance of them in infinite. And in fact, that assumption might be wrong, because we see, especially in
finance, we see big outliers coming from time to time. And so, I present a theory, and I must say I like the
theory. The Central Limit Theory is an important theory, but it's also wrong. And that's the problem with
financial theory. It's not quite as good as the theory that physicists or chemists use. It has its limitations.
Nonetheless, that's what we have to talk about. We have to make do with that as much as we can.
I'm almost done with my review of the last lecture. I wanted to just correct what I said. I said that fat-tailed
distributions were discovered by Benoit Mandelbrot, but that's--I have to give credit properly. It's actually
his teacher, so I've got this now. Paul Pierre Levy was a mathematician who lived from 1886 to 1971, who
really first developed a theory of fat-tailed distribution. And he was at the Ecole Polytechnique in France.
And his student was Benoit Mandelbrot, who was one of the great mathematicians they were both among
the great mathematicians of the twentieth century. Our knowledge of fat-tailed distributions comes down to
us through word of mouth. From Levy, who was Mandelbrot's teacher, to Mandelbrot, to me, and then to
you, I think. So, we don't require any printed word to know this. That's the way the history of thought goes.
There's an old joke about the normal distribution. The joke goes as follows. The mathematicians think that
the normal distribution is ubiquitous in nature because applied workers have discovered that everything is
normally distributed. But applied workers think that the normal distribution is ubiquitous in nature because
mathematicians have proved that it's ubiquitous in nature. In fact, it's sort of ubiquitous, but it sort of
surprises you. And that's one of the fundamental lessons in finance. The fundamental lesson in finance is
that you might go through years observing some random return, or some random variable in finance, and
you kind of think you know how it behaves, and you've learned some confidence. There will come a day
when it defies all of your expectations, and that's what fat-tails are all about.
Chapter 3. The Role of Finance in Society [00:14:21]
OK, I want it to move on now to today's lecture, which is about invention, and particularly financial
invention. How should I start here? Let me start by recalling how much finance has changed since 1970.
OK, that's 40 years ago. In 1970, there were no options exchanges. Well, there were options, but they were
not traded on any exchange. There were no financial futures. There were no swaps. I haven't defined what
these things are for you. What else did they not have? They didn't have electronic trading. They would do
trading by word of mouth. They would meet together on the floor of an exchange and shout at each other
and talk. I guess they had telephones, but it was all words and people and writing on paper.
So, the proliferation of financial instruments in 40 years is stunning. So, I wanted to use that as a
springboard to think about what is the next 40 years going to be like? And if any of you go into finance,
this would be your career. I think that it's reasonable to suppose that the transformation that we see in the
next 40 years is going to be just as dramatic as the last 40, or more so, because technical progress doesn't
slow down. I don't see any reason to think that it's slowing down. So, I like to think about the future, but it's
hard to talk about the future because we're not there yet.
I've written a couple of books. One of them is about the future of finance. One of them is called Macro
Markets, which I wrote in 1993 about the big market. Macro means big markets that we'll be seeing in the
future. And the other one was called The New Financial Order, which I wrote in 2003, and we have the
introductory chapter there on the reading list for this lecture. What I see is happening with all of these--
incidentally, we have a lot of questioning of these inventions now because they kind of blew up on us in
this financial crisis.
So, it's a little bit like after an airplane crash. People are kind of critical of the aeronautical engineers for a
while. Or when they invented steam engines, some of them blew up, and it was bad. You know, when a
boiler blows up, it scalds all the people around it, awful. So, people were mad at them for a while. I think
that's what we're going through now. And people are angry about some of these inventions, but that's just
part of progress. Well, it doesn't mean that we don't want to regulate them. We regulate boilers and
airplanes right now to prevent crashes, and we need to regulate our financial markets just as well.
The financial markets that we have, they're based on mathematical models. This is a mathematical
discipline, but the mathematical models depend only on certain intuition. Maybe, a core part of the intuition
that underlies financial inventions is the idea of independence. I'm going to try and talk in really basic
terms. If risks are independent of each other, then we can pool them and they go away. That's the core idea.
But how to make that happen, requires some thought, and some devices.
The intuitive idea that we can exploit independence to improve our lives goes back to ancient times,
actually. A lot of things that people do are done in recognition of what is independent and what is not. I
think, even in big causes that people get emotional about over the ages are causes that--I can think of them
as examples of the application of probability theory in modern finance. So, you might not agree with me,
but this is my view of it.
Think of socialism. What is socialism? Well, you know it was invented by the philosopher, entrepreneur
Robert Owen. The word was invented by him in the early nineteenth century. What is it? It is that society
gets together and pools all of its activities. I think, well, why would you want to do that? One reason you'd
do that is that it improves human welfare because it shares risks, and we're all in it together, and, you know,
we won't have rich and poor. I think that's part of Robert Owens' idea. He was worried about inequality,
that some people are much better off than others, and that's bad, and so let's create a socialist society.
So, he had an invention of sorts, but it didn't seem to be a very--in his form it was not a very successful
invention, because it didn't work somehow. He set up a town called New Harmony in the United States,
which was supposed to be harmonious, by the name of the town, and everything was shared. And
unfortunately, they ended up arguing and fighting amongst each other, and they were not happy. He didn't
get it figured out right. He was trying to pool risk, but he didn't do it. There are other idealistic societies that
try to do it, like the kibbutzim in Israel. That's one of many where people get together and form a
community, and they pool everything, and it kind of works for some people. But only a tiny fraction of the
population in Israel lives on a kibbutz now. Why not? I think most people just don't fit in that way. We
share everything. After a few months living there you might think, I'm out of here. I don't want to share
everything with everybody.
So, people do things. In the Old West, the pioneers in America, they had a kind of a social contract, that, if
one farmers house burned down, everyone will come by and help and erect a new house for that person. So
that's, again, risk management. That's it. And it works. It sounds almost like a moral thing, but it works
only because they don't all burn down at the same time. It would be totally worthless if they all did. And so,
there are primitive ideas of insurance that underlie that, but the ideas aren't worked out well. And it doesn't
perhaps work well to do it on such an informal basis. So, our society has particular inventions that, we call
them financial or insurance inventions, that make these things work better. What we're talking about is
motivated by theory, the mathematical theory of finance, but that's not the subject of this course. I want to
in this course talk more about the inventions themselves and in particular we'll be talking about risk
management.
Now, this brings up a basic issue about finance. Is finance good? Is it helpful to people? You know, a huge
issue in the history of humankind is inequality. And that people get upset when it seems like other people
have an unfair advantage over us. But inequality is something that you'd think finance works against.
Modern finance is about risk management. So, you can get rid of the purely random elements in people's
lives, that should make people more equal. It should be a good thing. That is the way I view it.
But the other side of finance is that it also creates opportunity, and opportunity is very important also. We
can all be equal and living in poverty, and we don't particularly like that. So, that's why financial inventions
eventually inspire and get people excited. I always remember Deng Xiaoping's famous statement in the late
1970's, when China was adopting modern financial methods. And some people were getting rich, and
someone asked Deng, isn't this inconsistent with our ideology? And he said, well, and I'm quoting
approximately, we're all going to get rich, but somebody has to get rich first. And that's the way it is.
Financial markets do manage risk. But they also create opportunities and that can actually increase
inequality. So, you have to consider both sides of it.
Maybe the most important concept in finance really is risk. And risk is all about limiting inequality, or at
least the random, gratuitous inequality, right? People are troubled by inequality if it's arbitrary, but, you
know, most people wouldn't begrudge someone who works very hard and shows real genius and insight,
and makes a lot of money, most people say that's all right.
Part of the way we deal with risk is our taxes, tax and welfare system. I'm going to come back to that,
mostly in our second to last lecture. We have a progressive income tax that taxes rich people more, and we
have welfare. And we also have, I should add, it's not counted as welfare, but free public education, which
is a form of, I wouldn't call it welfare, but it's an equalizing expenditure. These are actually our most
important risk management devices. That's what makes life tolerable in modern society, that we do have
progressive taxes and welfare. But we don't rely on those exclusively. And so, finance is getting into the
other dimensions. And we kind of want to let insurance, private insurance, rather than social insurance,
flourish. Because when the government handles everything, it doesn't seem to work as effectively or
creatively as it can if we let private entrepreneurs handle things.
So, what we're talking about here, and to always put it in perspective, what we're talking about in this
course, is about something that is an add-on to an existing welfare and tax system. But an add-on that is, we
hope, particularly effective. And it's added-on by people in their own self-interest, or maybe for their own
purposes, but something that ultimately contributes to a, I think, a better world. That's what I want to.
I have several themes in this lecture. The first is a risk theme, which I've just discussed. Another theme I
want to talk about here is a framing theme. Psychologists use the term framing to refer to the context and
associations that we have with some thing. So, the way people use things depends on what they see them
associated with, because people can't think through to the fundamental theory all the time. So, we have to
frame things in a way that's convenient to people. And this is part of financial engineering. I'll come back to
that in a minute. Framing has to do with language, names that we give to things. We have to design
inventions, so that they're framed in good ways. I'll explain that in a minute.
Chapter 4. A Selection of Modern Inventions [00:28:52]
And then, I have a device theme, that finance is really about devices like steam engines. We call them
financial contracts. Devices are complicated structures that we set up for a certain purpose, like airplanes or
automobiles, and we learn through time how to make them better and better. And they tend to come on the
world with a flourish or surprise. There's some new invention. You know, when the Wright Brothers first
exhibited the airplane in the Paris Air Show in 1904, I think, people were stunned. They were actually
flying. And it immediately set up around the world the aircraft industry. If you look around the world, these
devices look very similar. Automobiles, airplanes they look almost the same in every country. But that's
because they have an internal logic to them that makes them work well. And the logic may not be apparent
to you. You might not, probably don't, fully understand why a device works as well as it does.
Well, I have an example of a simple invention. I was curious, I haven't used this example before, how many
of you use this invention? You know what a gimlet is? How many of you own a gimlet? Nobody. Nobody
owns a gimlet. Can someone tell me what a gimlet is? It's amazing. A gimlet is a simple tool that everyone
used to have 100 years ago. And what does it look like? It's made out of wire. This is a handle. OK, do you
have a gimlet now that I've drawn a picture of it?
So, what you did with those--they were really cheap. You could buy one in 1820, go to a hardware store in
downtown New Haven. They'd have a whole set of them. And you use it to make holes. And it works really
well. I find you can buy them on the Internet. I bought one out of curiosity, and now I use it. The point it
that inventions come and go. The nice thing about a gimlet is, it's really nice, it comes to a pin point. And if
you want to make a hole in wood, you just push it in, and it goes exactly where you want it. And then you
just turn it a little bit and it goes right in.
But we have electric drills now, right? We're kind of used to them. The problem, you know, once you start
using a gimlet, you love it. Because you can control it so well. That drill, when you start drilling, it kind of
bounces around, and it doesn't make the hole where you want it. So, there's something good about this
invention. But you can go out and buy one now for very little money on the Internet. It'll be mailed to you.
Now that I have it, I'm thinking about it all the time for using it. But somehow it comes and goes.
Inventions are part of our culture that appear and disappear through time.
I wanted to talk about another invention. This is by way of inspiration. I'm getting to finance in a minute,
but I have to do these simple--maybe someone will reintroduce the gimlet. I don't know. It's probably gone
forever. It illustrates the fact that modern electronic technology has given us something maybe better. But if
you were used to using this, you'd want it. You know, I just don't want to use that electric drill because I
know how to use this, and I can control it.
I'll give you another example of an important invention which I saw come in my lifetime and that's wheeled
suitcases. OK, I bet you have one of these. Right, a suitcase with wheels on it? When I was a boy there
were absolutely none. Nowhere. No one had a wheeled suitcase. Isn't that strange? You'd be carrying these
suitcases around. You put it on wheels, and so I looked up the inventors of this.
It's not that long ago. The wheeled suitcase was invented by Bernard Sadow in 1972. And his was the first
one. He had a suitcase with little wheels, four little wheels, and you had a strap and you'd pull it, and it
would trail behind you. But then the other, the really important invention, was by Robert Plath. This isn't
finance, but I kind of think of it as finance. It was 1991. And he called it the Roll Aboard. This is what you
own, right? You own a Roll Aboard, right? It has a rigid handle that collapses into the suitcase, and has two
wheels that are horizontal.
The problem with Bernard Sadow's invention is that it tended to flop over. You're pulling it with a strap
behind you, and then you look back and it's flopped over. You can't go around corners very well. So, we
lived with Sadow's for 19 years. It took 19 years to invent the modern Roll Aboard. I actually heard from
Bernard Sadow. I wrote about him in The New Financial Order. And I got a letter from him about two
weeks ago, or email from him. And he said, I heard about your book and that you talked about me in your
book. And he said you he'd like to get me to autograph it for him. So, I said fine, I'll send you the book.
And I sent him an autograph with appreciation. That just shows, it's not long ago.
So I guess, I could ask you to reflect, why didn't people have wheeled suitcases? But you weren't born yet,
right, so you can't reflect on it. I'm thinking back to myself. You know, it's almost something that I would
do myself. I would put wheels on it. But I guess you were embarrassed to do it back then. Because maybe it
seemed sissy. But was everybody worried about being a sissy? Not everybody. Why doesn't anybody do it?
Well, Bernard Sadow, I had my student interview him, and he had listened to objections, and people told
him in 1972, no one's going to buy that. Because if the suitcase is too heavy, you just get a redcap. You
know what a redcap is? A redcap is someone, a poorly paid person, who stands around at train stations,
with wearing a red cap, and helps you with your luggage. Right? That's not a good answer, right? There
isn't always a redcap to help you, and so obviously you need wheels on suitcases. But this illustrates how
technology moves. It moves sometimes slowly.
I'll give you a couple other examples from my book about the slowness of inventions. One is just the
invention of wheels. Did you know that in the Americas before Columbus there were no wheels? No
wheeled vehicles. The American Indians had no wheeled vehicles at all, not even suitcases. Nothing. No
wagons. Nothing. And then to complicate it, they've discovered, from the late classical period in Mexico,
they've discovered wheeled toys. And if you go to a museum in Mexico you can see them. They made toys
for their kids. They're not cars, they're little jaguars and animals, and you could roll them along the floor.
So, they made the toys, why didn't they think of making a wagon? It just never occurred to them.
And another example I give in my book that I really like is the movie subtitle. This is an amazing thing.
When they invented movies--I gave you a Thomas Edison sound movie, but it didn't work. He couldn't
make a sound movie. They didn't find out how to make sound movies until the 1920's. So, they did, in order
to give dialogue to a movie, they'd give what they called intertitles. They would show the movie, you know
what I'm saying? Then they'd stop the movie and there would be a title with some phrase that someone said,
and then it would go back to the movie. But it's obviously better just to put subtitles on the bottom of the
screen, right? Let the movie proceed. You've seen movies with subtitles, right? It works fine.
Well, it turns out that someone tried it in 1920. There was a movie called The Chamber Mystery. And
someone made us a subtitled silent movie, but the response was bad. It seemed like nobody liked it. And so,
it wasn't for another--subtitles didn't come in until after sound movies were invented. After sound movies
were invented, they wanted to make movies in one language and show them in another country, so they had
to put subtitles in, so that people in another country could see the movie. And then that's how it came in.
There's a slowness to understand or appreciate invention.
Chapter 5. Corporations and Limited Liability [00:39:14]
Anyway, I want to move to invention in finance, and the analogies that I just talked about are important.
So, let me start with an important invention in finance that goes way back. Well, I think I mentioned last
time, the very simple idea of setting up a company and dividing up shares in the company, that's a really
old invention. That's thousands of years old. All right, you and your friends are going to do a business, how
do we divide up the profits? Well, let's give shares to each of us. And the guy who's contributing more gets
more shares, right? And someone who's contributing less gets less shares. But then, we all have an
incentive to make the company go, and that's the idea of a corporation. Corporation comes from the Latin
word corpus, which is body. It becomes like a slave owned mutually by all the people in the company. And
your share in the company is determined by the number of shares that you own. But I wanted to focus here-
-that's an old idea. It's an invention.
But I wanted to really focus on a particular nuance that developed. It's limited liability. A limited liability
corporation is a corporation that guarantees that you as a shareholder will not be liable for the debts of the
company. In England, they sometimes will put limited. The name of the company, after it we'll say limited.
But in the U.S., we just say incorporated, so that tells you that it's limited liability. What it's talking about,
limited liability means that somebody sues the company, and the company can't pay, they can't go after the
stockholders.
Limited liability has kind of a complicated history. But according to a history by David Moss, who was a
Yale history graduate student when he wrote this, but is now at Harvard Business School, limited liability
really took hold in 1811 with a corporate law in the state of New York which represented a significant
invention. The corporate law of New York in 1811 actually had two important components. The first
component was, anybody can start a corporation. Just file the papers with the government of New York,
and you've got a corporation. There may have been some regulatory requirements, but the point was, you
didn't need an act of congress, or an act of parliament, to start a corporation. It used to be very hard to start
a company, because people would say, well, what's your purpose? And you know, we don't just do this
automatically. That was the first part of the New York law in 1811.
But the second part is particularly interesting. They said under no circumstances can the shareholders be
sued. You put in your money to the company, that's it. You are protected by the law. No worries about that.
Now, this was the first corporate law in the world, according to Moss, that imposed limited liability as a
clear right of the shareholder. There were limited liability clauses before, but it was never so crystal clear.
At the same time, around 1811, other states in the United States were looking at New York and saying,
you're crazy. What are you doing? You can't sue the shareholders? They could do something irresponsible.
And so, the state of Massachusetts, at around the same year, made a completely opposite law. They made it
clear that the shareholders are responsible. You invest in a company, you're responsible. And that's the only
way it's fair, they thought. Well, guess what happened? New York became the financial center of America.
Nobody wanted to set up a company in Massachusetts anymore, because they couldn't raise money. The
capitalists were at risk. If you bought one share in a company in Massachusetts, and the company did
something criminal, let's say, or bad, I don't know, something bad, then they come, they might sue the
company, and then come looking for anybody who is among the shareholders. You owned one share in the
company, so we can take everything from you. We can take your house, your car. Well, you didn't have a
car. Take whatever you have. So the rule was, be really careful before you invest in any company. And
you've got to watch them all the time. But you know what that did? That kept Massachusetts down.
Because nobody wanted to do that. I mean you'd only invest with trusted friends. You'd never invest in just
some random company.
But what happened in New York was that companies started appearing rapidly because of this. And as
many critics said, a lot of these companies are fly-by-night, they're going to go under, we're going to find
out that they weren't doing a good business. They were just show-offs. And they go bankrupt. But some of
those companies did extremely well, and they created a powerful New York economy. Then people
learned, well, you could invest in 100 companies. And 99 of them will go under. They're all wild. Not all of
them. There's one of them that would be the Walmart and make you rich. So, the example set by New York
was eventually copied by Massachusetts, by every state in the United States, by every country in Europe,
and now every country in the world.
See, it was an experiment that might not have gone well. You know what David Moss thought, and this has
to do with framing again. Moss thought that, why is it that New York became such a capital of finance?
Because of this law. And because it made investing fun. And this is a matter of framing. Moss emphasized
that when you buy a share in a company, and it's limited liability, you know that you have already put out
all the money that you'll ever put out. But you could get an infinite amount, well, there's no limit to the
amount of money on the upside. And he thought that just framed better as a psychologically appealing
gamble.
It's like a lottery ticket. People like lottery tickets, right? They just enjoy the thought. I don't do this, but
apparently a lot of people do it. You go and you spend a dollar for a lottery ticket, or two dollars for a
lottery ticket, and then you think, tonight I could be a millionaire, all right? That's just so much fun that you
want to do it again. But if the lottery ticket said, well you have a small probability of being a millionaire,
but you also have a small probability of going bankrupt, we're going to come after you and take everything.
You wouldn't like that. That wouldn't be so much fun. You like to savor the possibility of getting rich. And
so, people flock to these stocks. It's like a sport. It's an invention of something fun to do for a lot of people.
But it has this productive side to it that it funnels capital to where it's needed. So, that was an important
invention.
I want to give you another example that is a variation on this. I'm going to move forward in time. My next
invention is theuh, Im breaking chalk here.
This goes now to China, Township and Village Enterprise or TVE. I'll try to say it in Chinese. Xiang zhen
qi ye, did I say that right? Close anyway. So, what was this? When China emerged from a communist,
strictly communist state, in the early period in the--maybe starting in the late '70s, but more in the 1980's,
the Chinese economy increasingly became built on a certain kind of organization called a township or TVE.
And the TVE was like a company, a corporation, except that it always involved the town. So, in other
words, if you wanted to start a business, making something, making toys for export to the world, you
wouldn't just start a toy company. You would go to the mayor of your town, and you'd talk to the mayor
and say, I want to start a toy company as this town's enterprise, and I want to share the profits with you,
with the whole town.
Now, this is kind of unique. Well, I don't know if it's unique, but we don't see this in the United States. But
it proliferated. It was actually the invention that led [to] initial successes of the Chinese economy. By 1985,
I believe, I have the statistics here, there were 12 million TVEs in China. By the mid-1990's, most of the
industrial production of China was done by TVE. So then you have to ask why--this is an invention, but we
don't see it in other countries. Why in China? Well, people who look back on it think that it was inventing
around certain constraints at the time in China. And that the invention got around a legal constraint. That
China, having been a communist country, did not have all these financial lawyers. And they did not have
courts that enforced legal contracts the way we do in the U.S.
And that entrepreneurs in China were inhibited from starting an enterprise, because they thought it would
just be usurped by the village. You live in a village, you start a toy company, as soon as you start making
money, they'll just put a tax on you. Or, they'll take it. That was your worry. So, you had to involve them. It
was a fact of life, a very important fact of life. You had to involve the whole community. You could not
start a business without involving the community. But it was a very successful invention, because it
actually led the Chinese economy on its first huge successes.
Chapter 6. Inflation Indexation [00:51:33]
I'm going to move to another example now of an innovation in finance. I want to talk about inflation
indexation. And I can pick many. These are examples that I like personally. There's an infinite number of
examples. It doesn't matter exactly which example we pick. But there's a fundamental financial problem,
and that is that the value of money changes through time. We have inflation measured by a Consumer Price
Index. And when inflation proceeds, the prices go up, and so the buying power of money goes down. And
it's uncertain. There's inflation risk that we face because of the uncertainty about prices. This is an inflation
risk that's under concern right now after the quantitative easing that the Fed--we'll come back to that. The
Federal Reserve is expanding the money supply dramatically in an effort to deal with this crisis, and some
people are worried about inflation risk. But it's a longstanding worry. It goes way back in time.
Most debts are done in nominal terms. And that means they're written in currency units, and if the currency
becomes worthless, you're wiped out. Why do people write contracts in currency units? Well, it's because
it's familiar with them, and so it's framing. We're used to thinking in terms of money and so we write
contracts in terms of money all the time. So the idea is, maybe we should start something else. Let's not
write contracts in terms of money, let's write in terms of something else. And that's an invention. But it's
another invention that seems obvious. Let's index our debts to some measure of inflation.
The invention I want to talk about first goes back to 1780. I believe that the first indexed bond was issued
in the state of Massachusetts in 1780 by the Massachusetts government. And that was an indexed bond.
They defined a consumer price index, they didn't call it that, and they said that the bond would pay you so
many pounds, they weren't using dollars yet, they were using pounds, British pounds, the amount of pounds
you would get would be increased if inflation were to start. So, they defined an index of commodities that
you might purchase. And that index was used to input a formula that created inflation correction to the
bonds. So, these bonds were issued in 1780. And it served an important purpose, because the U.S. was
fighting a war with the United Kingdom at the time, and there was tremendous inflation. So, they were very
important. But after the war, after the Revolutionary War ended, they stopped issuing these bonds, and they
forgot about them in the United States until 1997.
It's amazing. Why did the invention disappear? It's like gimlets. I think maybe gimlets will make a
reappearance. Maybe some of you will buy a gimlet. They're very cheap, by the way. And theyre very
useful. It seems like there's a psychological barrier toward adopting something that's a little bit
complicated. And people have trouble understanding index bonds, and they have trouble understanding,
how the formula works. They think, you know, I just want money. But, then you ask, well, why didn't
people learn? If you look through history, we've had bouts of inflation so many times, in so many different
countries. And you know, if you buy a nominal bond, it's risky, especially if you buy a 30-year bond.
People are doing that even today all over the world. They buy these 30-year bonds denominated in dollars
or euros or some other currency, and what's going to happen to those currencies?
So, why don't you denominate your bond in something more realistic? Well, after 1997, the introduction in
the United States of index bonds, the reintroduction in 1997, seems to be started by one person. Larry
Summers, who is Assistant Treasury Secretary, just believed in this. And he did it. And so, we still have
them. It got up to over 10% of the U.S. debt. Now, under Bush and Obama, they're kind of letting them sag
now, they're down to 6% of the U.S. debt. But it really should be 100% of the U.S. debt should be indexed.
So, this is a kind of example of progress that is made gradually through time. And maybe you'll see that in
the next 40 years. I'm trying to think of how we can make these things happen. That's an agenda for people,
younger people who can start innovating and changing our financial system.
I wanted to talk about an invention that particularly intrigues me that comes from the country of Chile. It's a
financial invention, that overcomes framing problems. Psychologically salient--it's an important invention,
and illustrates some of the basic concepts. So, let me talk about Chile. We're jumping around the world
here. Chile had a problem with, like many Latin American countries, especially of that time, with inflation.
So, they had a currency called the peso which inflated enormously. It went up, I don't have the numbers on
it, but it went up, you know like, prices went up a thousand-fold. And people were saying, we can't trust
anything. I wouldn't take a contract paying pesos. The peso is gradually becoming worthless.
So, Chile switched to another currency called the escudo in 1960. They said, OK, we're starting fresh, we're
not going to have inflation. And this is brand new. Now we're an escudo country. No inflation. Then, in
1975, they switched back to the peso. The exchange rate, peso to escudo, was one escudo was 1,000 pesos.
OK? Because they'd had something like a 1,000-fold price increase. And then, in 1975, the exchange rate
was one new peso is 1,000 escudos. So, a new peso was a million old pesos. OK, this is getting
embarrassing. I mean like, can we trust anything or anybody in Chile?
So, the invention started in 1967. People in Chile were saying, we just want stability. You know, this is
crazy, our prices. If I owned one peso--I have a nice 1,000 peso note from 1955 and I pull it out in 1975
and it's worth nothing. It's not even worth the paper it's printed on. So, we've got to get stability somehow.
So, somebody in Chile had the idea, all right, maybe we can't protect, we don't know how to protect the
currency, but we can create a unit of account that is stable in value. And let's write contracts in this unit of
account rather than pesos. So, in 1967, in Chile they created something called the Unidad de Fomento.
That's Spanish for Unit of Development. But what it was, was a unit of account that is indexed to inflation.
And they said, write your contracts in terms of--and they called them UFs, okay? So, everything could be
written in UFs. Forget pesos, because you don't trust pesos anymore. Let's write contracts in terms of
something else.
And that stuck. It started out as 100 escudos. I think it was one UF was 100 escudos in 1967, but, by 1977,
a UF was 450 new pesos. Now, if you want to know what a UF is worth now, you just go on the Internet
and it gives it for every day. And the website is--I think the website is valoruf.cl, but that's from my
memory. And so, I looked up what a UF is worth today, and it's, I'll use the dollar sign for peso, 21,468
pesos. So, that means that since 1977 prices have gone up about 50-fold in Chile. OK. But if you signed a
contract written in UFs, you're completely protected from that. And so, it's a very important invention.
Why is it an important invention? It's important, because without it Chileans wouldn't index. We don't
index much in the United States, nothing, almost nothing is indexed to inflation. Why not? I don't know. It's
like resistance to wheeled suitcases. You almost can't figure it out. It's so obvious. When you rent an
apartment, they should index it to inflation. They should tell you, our apartment rent goes up every month,
or down, depending on the price level. When you advertise a house for sale, it should be indexed to
inflation. Otherwise you're just making it crazy. You're just making--Yale tuition should be indexed to
inflation. It should go up and down with the level, that keeps its real value constant.
But we don't seem to do it, because we can't--something is blocking our thinking about it. So, we have to
do something like this, I believe. And so, that's what Chile has done. So, this is the way things are done
today in Chile. It became an invention that took hold and never left that country. If you rent an apartment in
Chile, good chance that your rent will be quoted in UFs, OK, and if you're paying a monthly rent check,
this is what you do. So, your rent is I don't know how many UFs. You go to valoruf.cl, you find out how
many pesos it is, you write out a check for that number of pesos. OK? And they do this out of habit.
The amazing thing I discovered is that in the United States, and in just about every country in the world
except Chile, alimony payments are defined in currency, all right? You get a divorce. The mother, let's say,
has to support children. The father is required to pay alimony for the next--until the children grow up, or
indefinitely. All right? That's a long-term contract. What if there's inflation? What does it do to the value of
the alimony? Well, of course, the real value goes down. So, shouldn't courts just index it to inflation? Well,
they do in Chile. Because they've got a habit of doing things in terms of UFs. So, this is an important
financial innovation.
By the way, guess how much consumer prices have gone up in the United States since we created the
consumer price index in 1913. It's 22-fold. We've had a lot of inflation in this country. 22-fold. Something
that cost $1 in 1913 will cost $22 today. That means, if you held cash between 1913 and today, basically
you're completely wiped out. But the inflation rate is only 3% a year. That's 3% a year for almost 100 years
is a 22-fold increase. So, we're living with this kind of uncertainty in the United States today. We have not
adopted the Chilean invention of UFs.
It's interesting that this invention spread, somewhat, throughout Latin America. And it stopped at the Rio
Grande. Mexico has something called UDI. Which is the Mexican version. It's U-D-I. Which is the
Mexican version of Unidad de Fomento. But the rest of the world doesn't want to copy this idea. Why is
that? I think it's partly, because this idea emerged out of embarrassment. Chile had had a massive inflation
which is embarrassing, and nobody wants to copy anything from someone having that bad experience. It's
also cultural, that we're not used to Latin American things. Just like we're not used to using gimlets. So, we
don't have them.
Chapter 7. Swap Contracts [01:07:42]
Let me just give one more invention. It's important. And then I'll stop. This is another financial invention,
more recently. It's the invention of the swap. I like to give this example, because it relates to a couple of our
speakers. What is a swap? Well, the swap is a financial contract that was invented by none other than David
Swensen, who will be speaking soon. He is the Chief Investment Officer for Yale University. He invented
this before he came to Yale, when he was working for Salomon Brothers, which was a major Wall Street
investment bank that no longer exists. But back then, in the early 80's, he apparently--I've got a couple of
sources. I think he is the real inventor of it.
What is a swap? It's a contact between two parties, usually a fairly long-term contract, to exchange cash
flows. So, the simplest swap would be a currency swap where one country--there's two parties. Two
different companies, let's say. One of them who promises to exchange euros for dollars every month for the
next five years, and the other one promises to exchange dollars for euros every month for the next five
years. It's a swap, but we decide in advance on what the conversion is, what the swap rate is, between euros
and dollars. So, that's useful for risk management purposes, because somebody, someone in Europe may be
getting dollars revenue in their business. They know they're going to get this revenue over the next five
years. It's kind of a long-term contract, long-term business they're in. They might want to go twenty years.
But they don't know at what rate they can convert it back into euros. And on the other side, we have the
Americans who may be doing business in Europe, and they get euro income and they want to convert it to
dollars. So, they can make a contract that swaps these cash flows.
And that was the invention. And it didn't come until the 1980's. It's amazing that these simple ideas weren't
out there. And why weren't they out there? Well, it may have something to do with legal uncertainty,
regulatory uncertainty. There's something called ISDA which was founded since the 1980's. That's the
International Swaps and Derivatives Association. And what it does is, it lobbies lawmakers for laws that
permit swaps to work efficiently and effectively. And so, you need an organization like ISDA that will
make these contracts work as effectively as they are. Now swaps are a hugely important contract.
My last example, which is a sub-example from this, is the credit default swap, which is something that I
won't put David Swensen's name on. The credit default swap is a--again a contract between two parties that
has to do with the risk of a credit event. So, there's a protection buyer. There's two parties. One we'll call
the protection buyer, and the other is a protection seller. And it would have to do with--basically the buyer
promises to pay the seller, at regular intervals for some period of time, and the money just flows regularly
from the buyer to the seller, until an event occurs. We could say a bankruptcy of some company. It's
defined in the contract. In which case, then, the protection seller has to pay the protection buyer. Now you
might ask, isn't this just like an insurance contract? Wouldn't you call this insurance? If I'm paying regular
payments to somebody else, and then, if an event occurs, I'm getting insurance against default by some
company. And I maybe doing business with the company, or I may be investing in the company's bonds, so
I may want this protection. But it looks like insurance, right?
Well actually, there's something else called credit insurance, which goes back to the nineteenth century.
There were companies in like 1880 that would allow you to buy insurance against default, or some failure
of a company. So, this was an institution and an invention of the nineteenth century. But credit defaults
swaps are--what's the difference? Well, the difference is, that there [is] a whole culture and regulatory
environment developed around credit insurance that limited it. They didn't have ISDA. They had state
insurance regulators, OK, and they just didn't have the same conceptual framework. It's complicated. The
credit default swap was boosted by ISDA and other thinkers, who thought of how to make this into a huge,
huge business. Credit insurance ended up being kind of limited in its application. And often, the credit
insurers were more like consultants. They would say, we'll insure your credit. It will insure you against the
default by someone you lend money to. But we want also to be involved in helping you avoid making bad
contracts like that. So, the credit default swap became huge.
Let me just conclude with this. This brings us back to one of our outside speakers. Hank Greenberg is going
to talk about his company AIG, which failed because of errors--it didn't fail, it got bailed out by the
government. It got bailed out because of errors made in credit defaults swaps. I don't think that these errors
were his fault, because this happened after he left the company. But I just want to mention this, because it's
all part of a big picture. We had a financial invention, the swap. Then we had the credit default swap. And
these are important inventions. They caused a leap forward in our ability to do risk management. But they
created attendant risks. They were new, and they weren't understood well enough. And so, a big part of
what happened in this crisis was a failure of the credit default swap market. But that's not to me an
indictment of financial innovation. I think the credit default swap was an important innovation, and we will
see more like it, and it will help make for a better world.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 4 - Portfolio Diversification and Supporting Financial Institutions
[January 24, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: OK, so this is the fourth lecture for Economics 252, Financial Markets. And I
wanted today to talk about some really basic concepts, about portfolios. A portfolio is a collection of
investments. And I want to talk about risk and return, and eventually get into the core theory, which is the
Capital Asset Pricing Model, in finance.
But first I wanted to say something about last lecture. Last time, I talked about innovation in finance. And I
presented finance as a sort of branch of engineering in a way. We invent financial devices. And the devices
serve certain functions, and, in order to serve those functions, they have a number of details that have to be
gotten right. Moreover, there's a process of invention, and the process of invention involves
experimentation, and when an experiment doesn't work, we forget about it and we move on, but when it
does work it gets copied all over the world.
Chapter 2. United East India Company and Amsterdam Stock Exchange [00:01:14]
So, I thought a nice way to transition to today's lecture would be to talk about one very important moment
in the history of finance: when the first real important stock was invented. And it was, see if I can spell it
right, Vereenigde Oost-Indische, I might be misspelling this, Compagnie 1602. This was the first--Did I get
that all right? I think got it right! That's Dutch for the United East India Company. It was founded in that
year. It was a time, when Holland was at war, and the government was worried about the economy and
willing to experiment with raising capital to keep the economy prospering. And someone had this idea.
Let's start a company with shares in it, and let's trade them.
And in the same year, and I can't write this in Dutch, but they created the Amsterdam Stock Exchange. And
initially it had only one stock. And so this is called VOC. OK? And it was a trading company. They were
going to set them up, and they were going to buy ships, and they're going to sail all over the world, and they
were going to trade in various commodities. So, it sounds pretty basic. But no one had ever done this
before. So, it's interesting how much got invented in this one year, 1602.
First of all, they invented a corporate logo. I don't know if I have it right. It was something like V-O-C, I
don't know if I did that right, just like we would put on, you know, advertisements for a company today.
Maybe that's not very important. But what's really important, also, is that this was a long-term venture.
There were lots of ventures already in Europe, where a group of merchants would get together and they
would pool their money for one trip. They would send ships out, and these ships would trade and come
back, and then they'd dissolved the whole thing. But this was different. This one was going to go
indefinitely. And in their initial announcement, they said, we're going to set up operations all over the
world. We're going to have an office in India, and another one, I don't know, in Indonesia, and, it's a big
thing. And in the New World, in America, but primarily East Indies, from the name.
But the interesting thing is they set up a stock exchange to trade shares in it. And the stock exchange
arranged that you could trade every day. So, there was lively trading. This was part of the idea. Because
when they set up a company in those days, you could get your shares when they founded the company, and
that was it, right? I mean, you couldn't trade them, or maybe you could infrequently. The company might
open its books once a year, and they would take new shareholders in. But someone had--hey, this is an idea.
Even though the VOC doesn't open its books regularly, we can trade them every day. What difference does
it make? You know, so we're going to have stockbrokers on the Amsterdam stock exchange. And maybe
they'll own some shares in VOC, OK? And then they'll have an inventory of shares. And then somebody
wants to buy some, you buy them from the broker. You don't have to contact the company. And then the
broker will, you know, maybe at the year-end, will report to the company that you own the shares. But
doesn't have to, right? The broker does it. All right.
So, the broker says you own these shares. You trust the Amsterdam Stock Exchange, because they have
rules and code of ethics, so you think you own, well, you do own VOC shares if you buy them from a
broker. The VOC doesn't know it yet, but you've got the shares, because the broker is a member of the
Amsterdam Stock Exchange and says that you have the shares. Then, almost immediately after 1602, a
funny thing happened. Can you guess what it was? The brokers started selling more shares than they had,
right? What's to stop them from doing that? Or some of them did that, right? So, the broker maybe owns
some shares in VOC and he gets lots of buyers and the broker ends up selling more, more shares than he
has. And he thinks, well, I'll get them later, you know. And he says, what do my customers care, if they
own shares, because I don't report to the company right away anyway. I'll make good on this. I'm a broker. I
know what to do. I'll buy them later and I'll get them.
So, you see what starts to happen? There are more shares out there being traded than there exists in the
company, because the broker is selling shares that he doesn't own. And so there began in, way back, even in
this time, there began what we call short-sales, or short-interest. It happens when you set up a stock market
and you allow, well, we would call it today street name, owning a stock in street name. We have stock
exchanges, many stock exchanges in the world today, and they, including--by the way, the Amsterdam
Stock Exchange is the oldest stock exchange in the world and it's still trading. But it has merged. First, it
merged with Brussels, and Paris, and now they're called Euronext Amsterdam. But they're still doing this.
Nothing stopped them in over 400 years. They keep doing it.
But this stock exchange, and many others like it, allows brokers to sell you stocks in what's called street
name, OK? And what that means is that when you buy shares, the broker puts in your account that you own
these shares, but the company doesn't know it, because the actual ownership is registered in the name of the
broker, OK. And so, the broker is selling you shares. And it's only through the broker that you know that
you have shares. So, the broker on the stock exchange may be short. May have sold more shares then he or
she has. That's all right, OK? It happened as long ago as right from the beginning of the stock market.
There was a scandal. I was reading the history of this, and, who was the guy? Isaac La Maire, a Dutchman,
in 1609. He was not a broker, he was a businessman. He was able to sell more shares than he had. So, he
had negative--a broker allowed him to do that. And so, he had a short-interest in VOC, massive short-
interest. And people who own VOC shares started thinking, what's going on here? Someone is selling, he's
borrowing shares from a broker and selling them. That tends to bring down the price. And there was a
downward movement in the Amsterdam stock market. And this guy was blamed for having shorted the
stock, and forcing down the price. And so, the Amsterdam Stock Exchange, for two years from 1609 to
1611, banned short-selling, but then they decided to let it go again.
The point of all this discussion--I'm telling you a story about Holland 400 years ago, but the reason I'm
telling you the story is to try to emphasize how certain things just happen naturally. Once you set the
framework up, you set up a big company, and its a company that lasts a long time, OK. It's very valuable.
Anybody can buy shares in it, OK, so it's democratic. And the value is very uncertain, because this
company is going to be in business into the far future. And it's building a whole arrangement, an empire of
trading posts and ships, and who knows what it's worth. So, the price is very uncertain, and buying it is a
sort of a gamble. And so, the price starts fluctuating wildly. And it attracts all kinds of interest. And some
people think it's going to go up, and some people think it's going to go down, and they start debating about
this, and wondering about this.
And some guy like Isaac La Maire thinks it's going to go down, so he wants to short the stock. He wants to
sell, he doesn't want to buy it, he wants to short it, so that he can have a negative quantity. Other people are
really positive and excited about it, and they want to buy all they can get. And they want to even buy more
than--they want to borrow money to buy the stock. So, you have this tension between the shorts like Isaac
La Maire and the gung-ho traders who want to buy it. And it creates a lot of volatility in the market. But the
whole effect of this is to create interest in the stock. So, it brings in money. And it ultimately made the
VOC very successful, because so many people wanted to give money to this trading company. So, they
were able to build hundreds of ships, and set up big outposts all over. And it became very valuable.
And it was an invention, kind of a social invention. I'm thinking, it's kind of analogous. We have recent
inventions that we think about, the social media. We have, you know, Facebook and other recent
inventions. This was an invention like that. It was an invention that got people together and communicating
and excited about something. And it created a sort of a game that people were playing that turned out to be
productive. That's why it was copied all over the world. So, the core concepts, which began in Holland in
1609, are everywhere now. Every country of the world has this.
I should also add, by the way, that the VOC was a limited liability corporation. Amazing. When I told you
that limited liability came in in 1811 in New York. I think I qualified that. It used to be that some
companies had in their charter an agreement with the government, that the stockholders had limited
liability. What came in in 1811 in New York was a law that said all companies are limited liability. And
moreover, anybody in the world can start a--well, anyone in New York can start a company, and it will
always be limited liability. So don't worry, you can invest in any company. And you can not worry about
being sued for the debts of the company.
Well, back then, Holland didn't go that far, but they did create one company that did have limited liability.
So what that meant was, you could invest in this company, and it's just a game, you know? I can't lose more
than I put into it. And if these guys turn out to be crooks and some of them are hanged for their crimes, no
problem with me, because I'm an innocent investor. The law doesn't require that I investigate, you know,
whether the guys who run the company are really honest. Let's protect investors. So, all you can lose is the
money you put in.
So, it created a tremendous opportunity. It was talked about, because the stock price went up and up and up,
and it made people rich who invested in it. But it was also very volatile. It went up and down. People had
never seen anything like this before, because nothing was so actively traded, and had such an interesting
story that you could change your mind about from one day to the next. Anyway, I didn't want just tell
stories. This is a story, though, that illustrates our last lecture. It was a breakthrough innovation. It was a
kind of gambling, but not gambling. It was gambling on real things. And so, you know, people like to
gamble, but, you know, it's usually a waste of their time. This is not a waste time. This was setting up
trading around the world. And so, it was important, it was a very important innovation.
Chapter 3. The Equity Premium Puzzle [00:16:19]
But now I want to use it as a lead-in to the main theme of this lecture, which is about portfolio management
and risk. And the first concept I wanted to talk about is leverage. Well, and also let me add the equity
premium. These are the two main concepts. Maybe I'll do equity premium first. Here's the conundrum that
people were presented with. And I'll stay on the VOC story, but it's much more general than that. VOC,
after a few years out, people thought, you know, this company is amazing. It's just growing so fast, it's
making so much money, it might have a really high return, like unbelievably high, like 20% a year, or even
more, but let's say 20% a year. And that's what generated the excitement.
But some people wondered, well, how can it be? Maybe it's earned 20%, but how can it consistently do
that? So, let me put ''puzzle.'' We've gone through 400 years of history since the VOC was established. And
since then, it seems to be remaining true that companies' shares do extremely well. And that's a puzzle.
Because you know, if you can make a high return on some investment, wouldn't you think that enough
people would flock into the investment, so that it no longer--you know, too many people trying to do this,
so it's no longer performing so well? But in fact, it seems like the average return on stocks has been very
high.
This is a theme in Jeremy Siegel's book Stocks for the Long Run, which I have on the reading list. Siegel
has data, doesn't go back to 1602, but it goes back to the nineteenth century. And he says that the geometric
average return, annual return, on the United States stock market from 1871 to 2006 was 6.8% a year,
corrected for inflation. That's 6.8% a year after inflation. So, if you're at 3% or 4% inflation, right, that's
10% a year. Let's compare that with short-term governments [correction: government bonds], which are the
safest thing in the United States. The average real return on them was only 2.8% a year. So, the difference
is 4% a year. So, for well over 100 years in the United States, stocks performed extremely well.
Moreover, he points out there was no 30-year period since 1831 to 1861 when stocks under-performed
either short-term or long-term bonds. So, the stocks have been good investments. What do we make of
that? Don't people learn? You'd think if people learn, they would all want to do the good thing. Why does
anyone invest in something else? That was the puzzle here.
It's not just a United States phenomenon. The London Business School professors Dimson, Marsh, and
Staunton wrote a book called The Triumph of the Optimists. That is, optimists about the stock market. And
they looked at the equity premium in many different countries around the world. And they found that all of
the countries, and this is looking over much of the twentieth century, all of the countries had an equity
premium, that the stocks did better than the bonds of that country. The lowest of the countries they studied
was Belgium, which had an equity premium of only 3%, and the highest was Sweden, which had an equity
premium of 6%.
Chapter 4. Harry Markowitz and the Origins of Portfolio Analysis [00:21:09]
So, that's an interesting question. How can it be that some asset, namely stocks, outperforms all other
assets? That comes up then to, what is the standard answer? Why is it? And standard answer is risk. Stocks
are riskier. The price jumps up and down from day to day, so the extra return is a risk premium. That is
what I want to pursue today in this lecture. Does that explain the equity premium? How should we think
about the equity premium? So, what I'm going to do is feature the theory that was originally invented by
Harry Markowitz when he was a graduate student at the University of Chicago. And shortly after he was a
student, in 1952, he published a classic article in the Journal of Finance that really changed the way we
think about risk in finance, changed it forever.
It gets back at this core idea, you know, people looking at, going back to the days of the VOC, people had
the idea, you know I think stocks are the best investment. OK, I'm writing that down, and I'm putting it in
quotation marks, because it's not a term that I would use. What is a best investment? Well they say, look,
the VOC is just returning tremendous amounts. Any smart person would just put as much as he can into
that investment. Something seems wrong about that. I mean, it can't be true that--so what Markowitz--when
I went back and read his Journal of Finance article in 1952, it's kind of remarkable to me that what he was
talking about wasn't known yet in 1952. He was getting at this core idea of what's the best investment. And
how do you judge what's the best investment. And judging from his article, to me it sounded so basic and
simple. Of course, I've studied finance. But it seemed odd to me that everyone didn't know that in 1952. So
let me--the question is--I'll kind of paraphrase what Markowitz said.
Let's imagine that you've got a job as a portfolio manager, OK? And you're kind of mathematically
inclined. And you know numbers, and statistics, and you know how to compute standard deviations and
variances, things like that. So, what is the first thing you do? You're a numbers person, OK, youre a math
person. But now imagine you've been entrusted with managing a portfolio for some investor. And the
investor gives you a horizon, you know, let's say you're managing it for one year. OK? And you're thinking,
all right, what should I do? Well, I want to collect data on every possible investment I could make. Not just
stocks and bonds, but real estate, commodities, whatever, OK? And I can for each of these--I can compute
what the average return was on those investments. OK? And I can compute the variance, and I can compute
the covariance and the correlation, right? So Markowitz, do you see it? I've got all the data. Now I could
say, I don't believe these data are relevant to the future, because I'm smarter, or I can predict that some
company's going to do better than it did in the past, or some asset class will do better than it did in the past.
But let's step back. Let's do it basic. Let's just think like a mathematician here, all right? Let's just take as
given all the historical average returns and variances and co-variances. So Markowitz says, well what's the
best portfolio given that? Ok? I could compute all these numbers. What's the best assembly of all these
things? And you know, he realized that nobody had ever thought like that. Isn't that a well-defined
problem? I give you all the variances, I give you all the covariances, I give you all the average returns. And
I say, let's just assume that this is going to continue like this, what should I do as an investor?
And it's funny, Markowitz said, he was reminiscing. He won the Nobel Prize later. And deservedly, I think.
This was a breakthrough idea. He said as a graduate student he was chatting with someone in the hallway
and thinking about this. And he said, it suddenly hit me as an epiphany. If I have these statistics, I ought to
be able to compute the optimal portfolio. It's mathematical, right? It's just one thing. What is the optimal
portfolio? It took him like two or three days to figure the whole thing out.
You know, it's almost like, haven't I set it up in your mind? You see the problem. You could figure this out
too, right? If you put your ingenuity onto it. The funny thing is, nobody thought about it before Markowitz.
So actually, I was intrigued by that. So, I went back trying to find, what people were talking about before
1952. And we have a new thing on the web, relatively new, called--you ever play with this? It's called
ngrams.googlelabs.com. And what you can do is, you can put in any phrase you want and search it for the,
it goes back like 400 years. In English, you can't do Dutch. I don't think. Maybe you can do that, too. I
didn't try.
And you can start to see what people were talking about in books. They have all these books scanned-in
now. Now you can search for key words. And so, I did a search on ''portfolio analysis.'' That's what this is
all about, right? Figuring out what the optimal portfolio of stocks, bonds, commodities is. Hardly anyone
even used the term before 1952. I guess, it didn't exist. There was no theory of--you kind of imagine. How
can that be? I mean, you had all these sophisticated banks in finance. They had no theory of portfolio
analysis. And I looked at portfolio variance, portfolio return. It all started with Harry Markowitz. Again,
this is another testimony to how there are sudden breakthroughs. It should've been obvious. But somehow
people didn't think of it.
Then, I found one thing though. I did a search on Ngrams on "eggs in one basket." There's an old adage,
"Don't put all your eggs in one basket." And that's kind of what we're coming to with Markowitz here. He's
got a whole theory of it, but I found an investment manual from 1874--I can't find it here--this is from a
book, 1874, about investing. "There is an old saying that is inadvisable to put all your eggs in one basket."
So, it was already in there and he says diversify. OK? And then he's done. He doesn't tell you, how do you
diversify? How do I know what I should do? It just stops there.
Chapter 5. Leverage and the Trade-Off between Risk and Return [00:29:41]
There was no theory of risk until 1952. So, let's think about that. You see the concept I have? You know all
the variances. This isn't a judgment thing. You know all the covariances. What should I do? Well, the first
thing I want to talk about is the very simple case of pure leverage. Let's go back to 1602. OK. And there's
only one stock, that's VOC. OK, and there has to be something else, otherwise there's nothing the other
thing I'm going to say is there's an interest rate. Riskless interest rate. So, I can invest in, let's say, Dutch
government bonds, which are completely safe. Of course, you might say they're not completely safe, but
they're much safer than VOC. VOC was wild. The price was going all over the place. So let's, as an
approximation, say there's an interest rate. You can borrow and lend at the interest rate. We'll call the
riskless rate r
f
. OK? And let's say, that's 5% a year. OK? We're investing for one year. So, I can invest at the
interest rate and this is a boring investment. It's just getting interest. It's 5%. But I can also borrow at the
interest rate. There's a market rate, and I can borrow at 5%.
You know in practice, I would probably have to pay a little bit more as a borrower than I could get as an
investor. But let's assume that away. There's just an interest rate, and anybody who wants to can borrow
and lend at the interest rate. I'll make it 5% just for a round number. OK. And let's say VOC, the Dutch East
India Company, has had a historic average return of 20%. This is spectacular investment, right? But let's
say it is, so that's its mean, its !, the mean of the investment. But let's say, it's really risky, so the standard
deviation is 40%. All right? So, what can I do? Suppose I have only--this is the first--let's do the simple
problem first, OK? I have only one asset, VOC, and I have riskless debt. I'm going to draw a chart here
showing--I'm going to do # on this axis, and r on this axis. So, # is the standard deviation of my portfolio,
OK? And r is the expected return on the portfolio, OK? All I'm going to do is choose mixtures of the stock
and the riskless rate. So, for a couple of points, I'm going to plot what the available options are. I can see
right here that I can invest at 5%, right, the riskless rate, and then I'll have no risk. So, do you see this? This
is r
f
. This is 0, OK, and these are positive numbers. See what I've plotted here? This is just the most boring
investment. Because there's no risk at all, and I'm earning 5%.
I can also plot this one, right? So, here is VOC. Is this big enough for you to see back there? OK. So, VOC
is up here, and this is a risk of 40, and a standard deviation of 20. Sorry, an expected return of 20 and a risk
of 40, right?
So, those are two points, but I can do other things, too. What if I borrowed money to buy--let's say I have
100 guilders. I'm talking Dutch. OK, that was the currency of the time, the guilder. I'll write it for you.
Guilder. OK. So, I have 100 guilders to invest. I could put it all on VOC stock, and I would expect to get 20
guilders profit, and I'd have a standard deviation of 40 guilders, right? But what if I said, I'm going to
actually borrow another 100 guilders. I only own 100 guilders, but I'm going to borrow another 100
guilders and put it in VOC stock. That means I'll own 200 guilders of VOC stock. And I'm going to have a
debt of 100 guilders. So, what's my expected return then? Well, my expected return is going to be 35%.
Because, look, I'm owner of 200 guilders worth of VOC stock. The expected return is 20%, so I'm going to
get 40 guilders out of that. But then I have a debt. I've got to pay five guilders to my lender. So, 35 is what
I've got. And as a percent of my initial investment, that's 35%.
So, I've got another point out here. This is 35 and down here is 80. See my standard deviation is 80 guilders
now, right? Because I have 200 dollars and the standard deviation was 40%. All right? Here, I am 2-for-1
leveraged. I have $100 but I've put $200 in the stock. OK, it's easy to do. You know, you could do this in
1602. So, you can see, obviously, this is a straight line here. I can do anything along this straight line. Here
would be putting half of my money in the riskless asset and half into VOC. This would be putting one-and-
a-half, 150 guilders, in VOC and borrowing 50 guilders. See, I can go out as far as I want. Then, there's
another branch to this. What if I short 200 guilders of VOC stock, OK. So, I go to the broker, and I say, I
want to sell VOC stock. I don't own any. And the broker would say, all right, fine, I'll lend you some shares
and then you can sell them. But you owe me the shares, all right? So, then I have minus 200 guilders worth
of VOC stock. So, what is my expected return then? Meanwhile, by the way, the broker says, after you sell
the shares, I will get 200 guilders from the person who bought them from you, and I'll hold that, and I'll pay
you interest on that.
OK. So, what do I get? I expect to lose 40 guilders, because I've got $200, 200 guilders of the stock. But
meanwhile, I've got my original 100 guilders, and now I've got another 200, and they're all there earning
interest at 5%. So, I will get 15 guilders. So, the expected return is 15 minus 40, or minus 25. So, that's this
point down here. But you can see that you can also do anywhere you like on that line. So, what we have
here is a broken straight line. I can get anything I want, right? This is kind of obvious right now. Anywhere
I want on that line, on that broken straight line. And I can do that.
So, here's where you got saying, what is the optimal portfolio anyway? I can get any return I want. You
know, my client, who's asking me to invest, says, I want 100% return, expected. You say, got it. I'm no
genius, right? I'm just doing the most obvious thing. Anyone who wants a 100% return can get it. I'm just
going to leverage. So, then I create an investment. If I have an investment company that merely buys VOC
stock and leverages it, my investment company can have any expected return that you want.
So, this is what Markowitz was wondering about. What does it mean to have the optimal investment,
anyway? And the core thing that he talked about in 1952 is, there is no best investment. There's only a
trade-off between risk and return. And we have to think about the best trade-off. In this case, I've shown the
trade-off here. This is what you can get. Any one of those points is available. And so, anyone who wants to
invest with you has to choose between risk and return. There's no optimal portfolio in that fundamental
sense. It's a matter of an optimal trade-off. And, you know, nobody knew that before 1952.
Chapter 6. Efficient Portfolio Frontiers [00:39:55]
So, let me just show formally this--what I just did on the blackboard. I've switched to dollars from guilders.
Now we're in the USA. And so, put x dollars in a risky asset, 1-x dollars in the riskless asset. The expected
value of the return on the portfolio is r. That's equal to
all right? It's linear, that's because that's how expected values work. The variance is x
2
times the variance of
the return. And so, if I want to write the portfolio standard deviation as a function of the expected return, I
solve for x. Taking this equation for x, solve for x in terms of r. So,
And then, I substitute that in to this equation. Well, I want to take the square root of it, because this is #
2
.
And so, I've got
[Correction: This fraction is multiplied by the standard deviation of portfolio return 1]
Well actually, I have these absolute value marks. If that's negative, I switch sign and make it positive. So,
that gives the formula for this broken straight line right here. So that's pretty simple. That's the expected
value [correction: portfolio standard deviation].
So now, I want to move ahead, move on from this simple idea to--we haven't really gotten fully into
Markowitz yet. Because this is a very simple story. By the way, this broken straight line is what we call a
degenerate case of a hyperbola. You know the, remember in math, hyperbola is a curve, a certain
mathematical curve. And we're seeing a hyperbola here, but I'm going to show you other hyperbolas in a
minute. What Markowitz really said--well OK, this is simple. This is all, just pure leverage is a simple
thing to understand. By the way, it's also called gearing in the United Kingdom.
But let's think about now--suppose I have more than one risky asset. Let's get past the year 1602. And let's
think about assets in a more modern context. I want to move to another example, which is two risky assets.
We've moved past 1602 and now we have two stocks. And for the moment, I'm going to forget about
leverage. And let's just say you can put x
1
in the first risky asset, that's stock number one. And I can put 1-
x
1
in the second risky asset. That's stock number two. OK? So, what do I get here? The portfolio expected
return is just the linear combination of the two expected returns. So, r
1
is the expected return on the first
stock, and r
2
is the expected return on the second stock.
Well actually, I'm assuming you have $1 to invest in this example. I'm sorry. I was assuming you had 100
guilders over there. Now, I just made it $1. Unrealistically small amount, but I just wanted a nice number,
OK? So, let's say $1 is 100 guilders, and then I haven't changed anything. OK. So, I start out with $1, so if I
put x
1
dollars in the first one, I have 1-x
1
left for the other one. So it's very simple. And this is the formula
for the variance of the portfolio, which we saw--essentially we saw that in the second lecture.
So, what I can do is, go through the same sort of exercise I did there with two risky assets, all right? And
so, what I want to do is, draw a curve something like this. But I'll solve for x
1
in terms of r, just like I did
for the riskless asset. And I'll plug it into the equation for the variance. I'll have to take the square root of
that, and I can plot that, OK? And you might think it would look something like that. Well, it's not going to
look exactly like that, because it's risky. Something's risky. So, I did that. And incidentally on your problem
set, you're going to have to think about issues like this.
But what I did is, I took data on the average return for the U.S. stock market, as measured by the S&P 500,
and the variance. And then, the alternative investment I took was 10-year treasuries for the United States
government. Long term, because they're 10 years, but we're only investing for one year. So, they're risky,
because the market price goes up and down. They're not riskless. I call those bonds. There's other kinds of
bonds. And I computed the relationship between the standard deviation of the portfolio and the expected
return, just as I showed you. Again, using data from 1983 to 2006. And it kind of looks like this curve,
doesn't it? Except, this is a degenerate parabola, but it looks like this. I'm sorry, parabola. I said it wrong.
Hyperbola.
You know how hyperbola--remember this from math? Hyperbolas, well they look like that, and they
approach asymptotes, which are straight lines. So, here is the hyperbola for stocks and bonds. So, just as I
had a point here which represented 100% VOC, I can have over here a point which represents 100% U.S.
stocks. OK? And I can take another point which is 100% bonds, that's here. This point is 25% stocks, 75%
bonds. This point is 50% stocks, 50% bonds. OK? This is the choice set that I as an investor have between
stocks and bonds. So, is that clear?
You see, all these are different portfolios. If you're just going to do stocks and bonds and nothing else, what
you choose to do depends on your taste, on your risk tolerance. I could go 100% stocks, but I'm going to
have a lot of risk. I'm going to have a nice expected return, it looks like it's about 13%, 14%. But I'm going
to have a high variance. Looks like it's about 18%. This is the S&P 500 stock market. And so, it has a lot of
variance. I could be safe, and I could go all in bonds. I could be here. Then I'd have, you know, a lower,
much lower return, but I'd have a lower variance. So, what should I do?
Well, what do you learn from it? First of all, you learn there isn't any single optimal portfolio, but there is
something. Let's talk about being 100% bond investor. What do you think of that? Is that a good idea?
Youd get this point right here. Well, you definitely should not be a 100% bond investor. That's one thing
we just learned. Why's that? Because if I go up here, I have no more--see that's the same standard deviation,
the same risk, but I have higher return, right? Higher expected return. So, what did we just learn? We
learned that if you just stay in this space of stocks and bonds, maybe you could be 100% stock investor, but
never in a million years should you ever even think of being 100% bond investor. OK, because, look, it's
just simple math. I can figure it out. I can figure out that I get a higher expected return and no more risk.
So, this is lesson number one that Markowitz showed us. Amazing. It's so simple and obvious, right? It's
not so simple, because, at the time Markowitz wrote, Yale University was probably 100% bond investor,
believe it or not. They couldn't figure it out in those days. So, we've made progress. That's why I think
Markowitz is among the most deserving of the Nobel Prize winners in economics. This is really basic. It
actually intrigues me. I don't know how much you like math, but going back to my childhood I was
interested in geometry. These simple mathematical curiosities like hyperbolas are just fascinating to me.
It goes back to Apollonius of Perga, writing in around 200 BC, wrote a book on conic sections. And he
invented the word hyperbola, parabola, ellipse. So, I was thinking of looking back at his book. I think it still
survives, and seeing what he says about finance. But I can be sure he had no idea that his theory would
apply to finance. I wish I could go back in a time machine and talk to him. He would be so happy to know
that his theory of conic sections--it, you know, it ended up applied to astronomy by Kepler and Newton.
And now it hits into finance. Isn't it amazing how there's a unity of thought? And this simple diagram has
just taught us something about investing. That's not obvious. Not obvious until you think about [it]. I've just
told you, never invest only in bonds. But it doesn't tell you how much stocks and how much bonds. You
know, once you're above this point, it seems to be a matter of taste. There isn't any single decision that you
can make.
So, now, I want to move to a more complicated world where we have three assets. OK. We're starting from-
-we had one risky asset, then we had two, now let's go even further. Let's say three risky assets. Well, the
expected return is the same, it's the weighted average. Now we have three weights, x
1
, x
2
, and x
3
, and they
have to sum to $1. I could have written x
3
as 1-x
1
-x
2
. I wrote it differently here. It looked messy to write it
the other way.
And this is the formula for the portfolio variance. It's the (x
1
)
2
, times the variance of the return on the first
risky asset, plus (x
2
)
2
, times the variance of the return on the second risky asset, plus (x
3
)
2
, times the
variance of the return on the third risky asset. And then you have three more terms representing
covariances. You have to take account of the covariances of the assets. Because if they move together, if
they all go in the same direction at the same time, that's going to make your portfolio riskier. And so, that's
the portfolio variance. And the portfolio expected return is just--why didn't I write it there? It's x
1
r
1
+
x
2
r
2
+ x
3
r
3
, where the sum of the x's is 1, $1.
So, it's something that you can do to calculate what is the optimal portfolio. So, I decided to add a third
asset to my diagram. The pink line up here is the same. We call that an Efficient Portfolio Frontier. I have
that in the title of the slide, for stocks and bonds. That's the pink line here. But I've added the Efficient
Portfolio Frontier for three assets. Stocks, bonds, and oil. Oil is an important investment, because our
economy runs on it. And the total value of oil in the ground is comparable to the value of the stock markets
of the world. It's big and important. So, let's put that in. And what I have actually here is the minimum
variance mixture for any given expected return for the three assets. And you can see that it's possible, when
you add a third asset, oil, to bring the Efficient Portfolio Frontier to the left. OK? Because we've got
another asset. And it's also paying a good return. And it's not correlated. Oil doesn't correlate very much
with the stock market. So, we're spreading the risk out over more assets.
We're putting more eggs in our basket. [Correction: We are providing more different kinds of eggs for our
basket.] OK? And so, we have a better choice set now, right? We can pick any point on that blue line. And
so, we shouldn't just have stocks and bonds. We've learned we should have stocks, bonds, and oil. We're
leading toward a fundamental insight, which is due to Markowitz, which is, the more the merrier. The more
different kinds of assets you can put in, the lower you can get the standard deviation of your return, for any
given expected return. So, the better off you are, this is diversification. So, while diversification was
applauded in the nineteenth century, no one had ever done the math like this before. And now we can see,
that when you do the math, you want to have all three in your portfolio. And yet people don't know that.
They don't, there's an emotional resistance to this implication.
I once went to the government of Norway. I gave a talk at their Norges Bank, which is the central bank of
Norway. I told them in my talk, I calculate that Norway has something like 70% of its portfolio in oil. I
don't remember the exact number, but it was something close to that. Why do they have so much in oil?
Well, because they have the North Sea Oil. And so, I asked them at the bank, don't you realize, where are
you on this portfolio? You're not on the frontier. What Norway should be doing is something like 15%,
they could pick this point right, that would be reasonable. 15% oil, 53% stocks, 32% bonds, which would
give them that point. Or they could pick this one. I have a point labeled up here. That's 21% oil, 79%
stocks, no bonds. All right, those are all choices depending on your risk tolerance.
But they're not going to just pick 100% oil. That would be way over here, much higher risk. So, I asked
them about that. Why do you do this? And I don't know if I got a good answer from them, but basically it
was, well, we don't want to sell the oil [correction: oil fields], because it's our national heritage, you know,
we own it. And I said, well you don't have to sell it, you can just do a derivative transaction. You can short
the futures market for oil and reduce your exposure. And then, they said, well, some people have mentioned
that, but its politically difficult. So, they're not doing it. Maybe next year. Maybe the next government will
do that. So, they still aren't there yet. They're not managing their risks well. So, it's a powerful and
important thing, because if the market for oil collapses, Norway is in big trouble. They're not diversifying
enough. I don't mean to put them down. They're smart people, but like in any country --
I did the same thing with Mexico. I went to the Banco de Mexico. And I talked to Guillermo Ortiz when he
was director of it. Same thing in Mexico. It's not as dependent on oil, not as dependent on oil as Norway is.
It's not so obvious for Mexico. But it is politics that came in. The question of, are you really saying Mexico
should go into the futures market and take a massive short-position of billions of dollars of oil? Again, it
was like, this isn't reality. We're not going to do that. But I tried to make the point.
Now, another thing is, I have shown here three assets. The pink line is irrelevant once we realize we have
three assets, we have stocks, bonds, and oil. So, you should choose on this curve. And, of course, you
should never take down here, even though that's possible. In other words, you could say, what portfolio
would give me 9% return with the least risk? Well it turns out it's 100% bonds. But I just told you, never do
100% bonds, because you can go up to this point, all right? So, you never do down here. So, the Efficient
Portfolio Frontier is really the part of the hyperbola that's above the minimum variance.
And you don't want to do minimum variance either, right? This is the lowest possible risk portfolio. You
can't get down to zero risk if all of your assets are risky. So, you're stuck here. That's not necessarily the
best thing, because people allow some risk. This is having the minimum risk, but I can get my return up
much higher without taking much risk, so I'd probably do that. OK. Now, I can do this with more than three
assets. I can do it with 1,000 assets, now that we have computers. Back in 1952, I erased it, but I had 1952
here, Markowitz had do it all by hand. But now that we have computers, it's so easy. You know, there are
all kinds of programs. In fact, on your problem set, we have Wolfram Alpha, which will do all these
calculations for you for its own data. So, these are easy to do now.
Chapter 7. Tangency Portfolio and Mutual Fund Theorem [01:00:21]
But what I want to do now is add the riskless asset. So, what we've done, the blue line takes three risky
assets. It looks only at assets with a standard deviation greater than zero. Now I want to do the optimal
portfolio when there are four assets. I've got stocks, bonds, oil, all risky. And now I have the thing that isn't
risky, would be your 1-year governments [correction: government bonds]. Right? It's not risky, because the
maturity matches my investment horizon. I know exactly what I'm going to get. It's 5%, let's say. So, what
can I do investing in these four assets?
Well, here it goes back to what I did over here with this simple diagram. I can pick any portfolio on the
Efficient Portfolio Frontier and consider that as if that were VOC, right? And then, I can compute just how
leverage allows me to combine that with the riskless asset and that portfolio. So, I can pick a point, like I
can pick this point here. And then, I could achieve, by combining that portfolio, which is 15% oil, 53%
stocks, and 32% bonds--I could combine that with any amount of risky debt. And I would get a straight line
going between--actually, this diagram doesn't show zero, I should have maybe done it differently--but
between 5%. So, actually that point right here, I can do it on this diagram. That point here is like 12%
expected return and 8% variance. So, it would be some--well, it would be here, except this would be 12%
and this would be 8%. I can pick any point. And this would be 5%. Any point along the straight line
connecting those points is possible.
So, what do I want to do? I want to get the highest expected return for any standard deviation. I want to
take a line that goes through 5% on the y-axis and is as high as possible. So, I'm taking a point right over
here, at 5%, and trying to get as high as I can. It turns out then, that I want to pick the point which has a
tangency with the Efficient Portfolio Frontier. And so, that means the highest straight line that touches the
Efficient Portfolio Frontier. And so, now I can achieve any point on that line. And that's again Markowitz's
insight. So, if I were to pick that point, I would be--what does it look like? I don't have it indicated.
Probably something like 11% oil, 30% stocks, 50% [government bonds], something like that, it doesn't add
up. [Clarification: these guesses do not add up to 100%, but the actual numbers do.] And that would be
holding no debt, right? [Clarification: No debt, in the sense of shorting the risk-free rate.]
But I could get even higher returns, if my client wants that, by leveraging. I would borrow and buy even
more of this risky portfolio. So, this portfolio here is called the Tangency Portfolio. And what Markowitz's
theory shows is that, once you add the risky asset [correction: riskless asset], the relevant Efficient Portfolio
Frontier is now really this tangency line. And so, I want to do a mixture of the riskless asset and the
Tangency Portfolio that accords with my risk preferences. But I don't want to ever just move to one of these
other portfolios. Because, [each of] these other portfolios, like 15% oil, 53% stock, 32% bonds, is
dominated, has a higher expected return for the same risk, by a portfolio of the Tangency Portfolio,
leveraged up a little bit by borrowing.
I don't know if it was clear in Markowitz's paper, but it became clear soon after. There really is, in a sense,
an optimal portfolio. It's the Tangency Portfolio. Because everyone wants to invest on this line, and any
point on this line is a mixture of the riskless asset and the Tangency Portfolio. And so, everyone wants to
invest in the same portfolio. So, there is an optimal portfolio, in a sense. It's in a sense that everybody wants
to do the same risky investments. People will differ in their risk preferences, and so some of them will want
to do a riskier, a more leveraged version, and some of them will do a less leveraged version of the
Tangency Portfolio, but everyone wants to do the Tangency Portfolio. So, that is the key idea of
Markowitz's portfolio management. And it's been expressed by some as the Mutual Fund Theorem.
First of all, I have to just to define for you, what is a mutual fund? You may not know that. A mutual fund
is a certain kind of investment company aimed at a retail audience. They could have just called this the
investment company theorem, but history--I can't tell you the history of thought on this. A mutual fund is a
certain kind of investment company that is mutual. That means that the owners of the shares in the fund
are--there's no other owners. There's just one class of investors. You're all equal, so it's mutual. But that's
irrelevant to you. The idea is that, all we need is one mutual fund. There's thousands of mutual funds to
serve investors. Because I had that everyone is investing in the Tangency Portfolio. So, they should call
their fund the Tangency Portfolio fund. And our fund is the optimal mix of stock, bonds, oil and whatever
else. And then, you don't necessarily want to own only that mutual fund, but you want to own mixtures of
that mutual fund and the riskless asset.
So, you only need one investment company. See, I told you this story. I said, imagine that you were
mathematically inclined, and you have all the statistics, and you're going to figure it out. What's the best
thing to do? We've just figured it out. I haven't gone through all the math details. There is a best thing to do.
You should offer, as your investment product, the Tangency Portfolio. And that's it. Once you've figured it
out, there's nothing more to do. There's no need to hire any more finance people. You've figured it out,
according to Markowitz's theory. And all the investors in the world will just invest in this one. And that's
[it]. Case closed. We don't need thousands of mutual funds. Under the assumptions of Markowitz, which is
that we're agreed on the variances, and covariances, and expected returns, there's a single optimal risky
portfolio. And then the instructions to investors are very simple. All you need is two assets in your
portfolio. The mutual fund that owns the Tangency Portfolio, and whatever amount of debt you want. So, if
you're footloose and fancy free, you can even leverage it. You can borrow and [do] 2-to-1, 3-to-1, it's up to
your tastes. But you don't need to look at anything other than the mutual fund.
Chapter 8. Capital Asset Pricing Model (CAPM) [01:09:20]
So, that's an important insight. And what it means, then--that leads to something else. Markowitz didn't get
this idea. It came out later. Someone was thinking, well, if everyone should be investing in the same
portfolio, it doesn't add up unless that portfolio is equal to the total assets out there in the world, right? If
there's twice as much oil as there is stock, then there has to be twice as much oil as stock in the Tangency
Portfolio. Otherwise, it doesn't add up, right? Everyone has to own everything. Supply and demand have to
equal. So it means, the Mutual Fund Theory implies that the market portfolio equals the Tangency
Portfolio, OK. And now I've pretty much finished the theory. I should say, it implies, if investors follow
this model that we're having, that they all want to--that Markowitz's model--if all investors think like
Markowitz says, they all want to do the same thing. They all want to invest in the same best portfolio. So,
that has to be proportional to the market portfolio. So, the Tangency Portfolio equals the market portfolio.
So, I was saying earlier, why is it that everyone doesn't invest in VOC stock? How does it add up, right? If
VOC stock is just better than something else, then that suggests everyone wants to put all their money in
VOC stock. But we're realizing, they don't. Because they're concerned about it. They see this trade-off
between risk and return, and they want to hold some proportion of VOC stock and the riskless asset. It has
to add up, so that the market is cleared and all the VOC stock is owned. And more generally, if there are
many assets, all the assets have to end up owned by someone. So, the cardinal implication of this theory is
that the market portfolio, which is everything that's out there in the world to invest in, has to be
proportional to the Tangency Portfolio [correction: has to be equal to the Tangency Portfolio]. And so, one
of the implications is, if that's true--and I have just a couple more slides here.
Now it's called the Capital Asset Pricing Model in finance. So, that's Capital Asset--which is [a] pricing
model, which was not invented by Markowitz, but was invented by Sharpe and Lintner somewhat shortly
after Markowitz. The Capital Asset Pricing Model--and I'm not going to derive this equation. But it says
the expected return on any asset, the i-th asset, equals the risk free rate, plus the " of that asset times the
difference between the expected return on the market and the expected return on the riskless asset.
I was just going to try to explain this intuitively, and then I'll be done. I have one more slide about the
Sharpe ratio. But the intuitive idea--let me just say, everything should have a very simple explanation. And
the intuitive idea is this: Starting from Markowitz, we got an understanding of what risk is. People didn't
clearly appreciate that. People used to think that risk was uncertainty, right, in finance. If a stock has a lot
of uncertainty, that uncertainty means that it's a dangerous stock, and people will demand a high expected
return, otherwise they won't hold the stuff. But the CAPM says no, people don't care about the uncertainty
of the stock. Because if it's one stock out of many, they'll put it in their portfolio, and if it's independent of
everything else, it all gets averaged out, and so, who cares? So, people don't care about variance.
Well, what is it that people care about? People care about covariance. This is the basic insight that followed
from Markowitz. People care about how much a stock moves with the market, because that's what costs me
something. I don't care, I can own a million little stocks that all have independent risk. It all averages out,
doesn't mean anything to me. I'll put them in tiny quantities in my portfolio. But if they correlate with the
market, I can't get rid of the risk, because it's the big picture risk. That's what insurance companies, that's
what everyone cares about. It's this market risk. The big risk. You only care about how much a stock
correlates with the big picture in its risk.
So, that's measured by ". The " is the regression--the slope coefficient, when you regress the return on the
i-th asset on the return of the market. So, high " stocks are stocks that go with the market. We found out
that Apple has a " of 1.5, or roughly that. That means, they respond in an exaggerated way. It's not 1, it's
greater than 1, they more than move with the market. And so, investors will demand a higher return on
Apple stock, because its " is greater than for other stocks. That's the core idea that underlies it. Do you see
that intuitively? So, you have to change your idea of what risk is. Risk is covariance. It's co-movements.
I have just one more slide here. It's named after William Sharpe, who is the inventor, with Lintner, of the
Capital Asset Pricing Model. The Sharpe ratio is, for any portfolio, the average return on the portfolio
minus the risk-free rate, divided by the standard deviation of the portfolio. And if you take the CAPM
model, the Sharpe ratio is constant along the tangency line.
This is a way of correcting the average return from some investment for leverage. The idea is--some
companies used to advertise, we've had a 15% average return, and then investors would say, but wait a
minute. You didn't tell me what your leverage is. That's the first thing you should learn from this course.
Someone advertises that they had 15% return, you say, ha, I want to know what your leverage was. I want
to know--you were just leveraging it up and taking big risks, and on average you'll do well, but it's risky.
So, this is the correction you make. How do you correct for leverage? You might say, well I want to look at
what fraction of the investment portfolio is in the risky asset, and what fraction is in the riskless asset. But
it's not so easy to do that, because the company can cover up its tracks. It can invest in a company that's
leveraged, right? And so, you have to go one step further and undo the leverage for that company. It's hard
to do that. But the easy thing to do is just calculate the Sharpe ratio for the investment company. So, if
some guy is investing and claiming to have done 15% of return per year on his portfolio, well, I'm going to
look at the standard deviation of the portfolio. That's evidence of how leveraged this guy was. And I
compute the Sharpe ratio. And unless it's bigger than the Sharpe ratio for the, you know, the typical stock,
I'm not impressed.
Anyway, so I think, I've come to the end of this lecture. So, what you should have gotten from this lecture
is a concept of risk return trade-off, a concept of optimal portfolio as being something subtle and related to
Apollonius of Perga in difficult ways. But there's also very simple things about how to evaluate portfolios
and portfolio managers that comes out of this.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 5 - Insurance, the Archetypal Risk Management Institution: Its
Opportunities and Vulnerabilities [January 31, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: OK, good morning. I've been running to get over here. I just got back from The
World Economic Forum. We talked to a lot of the world's financial leaders. And I was thinking what I
would tell you about it, but then I realized, it's all off the record, so I'm not supposed to say anything to you.
I was going to talk instead today about insurance, which is one of the major risk management institutions
that is not always considered part of finance, because people think of finance and insurance as separate.
[SIDE CONVERSATION]
Professor Robert Shiller: We talked about basic principles of risk management in the preceding lecture.
It's all the same for finance and insurance. And yet, we tend to consider them as separate businesses. That's
partly, I think, an accident of history, and it's partly a product of regulation because of certain ideas--that
we'll come to in a few minutes--that has kept the insurance industry separate from other financial industries.
Last period, we talked about the mean-variance risk management problem, and about the Capital Asset
Pricing Model. That's fundamental to insurance as well. The basic idea is pooling of risks and preventing
people from being subjected to extreme risks through the concept of risk pooling.
So, what I wanted to start today is talking about insurance, starting with the concept of insurance. And then,
I wanted to reiterate a theme of this course, that financial institutions are inventions, they're structures that
someone had to design and make work right. Sometimes they don't work right. Then, I wanted to move to a
particular example of insurance, which was until recently the biggest insurance company in the world,
called the American International Group, or AIG. And it's particularly important that we talk about this
example, because on March 2 we have the former CEO of AIG, Maurice "Hank" Greenberg, coming to our
class. So, I thought it's appropriate that we use AIG--well not only because it was the biggest insurance
company in the world, but also because he's coming here.
And then, I want to talk about regulation of insurance, that the insurance industry has always been subject
to government regulation. I'll talk about types of insurance. Your chapter in Fabozzi et al. is mostly about
types of insurance, so I think you can mostly get that from the textbook, but I wanted to say some things
about it. And then, I was going to conclude with thoughts about insurance, and how important it is to our
lives, and what progress it still has to make.
Chapter 2. Concepts and Principles of Insurance [00:03:53]
So, insurance, it doesn't sound like a very exciting topic, does it? I'm going to try to make it more exciting.
I guess you think of the insurance salesman coming, knocking on your door. They don't do that so much
anymore, they used to go around door-to-door. And that was a depressing moment, when the life insurance
salesman came. And if you invited this person into your house, he would tell you about the probability of
dying, how tough it will be on your family, that sort of thing. But, to me, I think insurance is an exciting
issue, because it's about making our lives work. And it's really about preventing horrible catastrophes from-
-and it involves mathematical theory that underlies the concept. To me, it's exciting, but I don't know if I
can convey that.
The fundamental concept, again, is risk pooling. The idea of insurance goes back to ancient Rome, but only
in very limited forms. But the idea of risk pooling is kind of an obvious one. People form organizations
partly to risk-pool. So, in ancient Rome, a common form of insurance was death insurance that would pay
funeral bills. People in the ancient world believed that you had to get a proper burial, or your soul would
wander forever. So, insurance salespeople associated with guilds or business organizations would sell
funeral insurance. But they didn't have a very clear idea of the risk pooling concept. It must have underlain
their thinking.
But it wasn't until much later that people began to understand the concept. There were examples of
insurance throughout ancient and medieval times, but they're very blurred and sparse. I remember reading
an insurance, supposedly, an insurance contract written in Renaissance Italy, translated into English, but it
was hardly recognizable to me as an insurance contract. They didn't have the concepts down. It seemed to
have a lot of religious language in it, which normally we don't think of as something that's part of an
insurance contract. But it seems like insurance came in in the 1600s, at the same time that certain concepts
of mathematics began to be developed. Notably, the concept of probability became more widely known in
the 1600s. According to one historian, the oldest known description of the insurance concept goes back to a
Count Oldenburg. Actually, it's an anonymous letter to Count Oldenburg, written in 1609.
And the letter says, why don't we start--I'm paraphrasing at the moment--why don't we start a fund, in
which people pay 1% of the value of their home every year into the fund, and then we will use the fund to
replace the house if there's a fire? And now, quoting this anonymous writer, this writer said he had "no
doubt that it would be fully proved, if a calculation were made of the number of houses consumed by fire
within a certain space in the course of 30 years, that the loss would not amount, by a good deal, to the sum
that would be collected in that time." OK? It was just intuitive. He said, there can't be that many fires. And
if we collect that amount of money every year, we can pay for all the houses that are burned down. So, he
didn't express any mathematical law, but it's the concept of insurance. You don't find that before that,
before 1609. So, I guess we don't have any clear statement of insurance before then.
Actually, you can find an approximate statement of the law of large numbers--and I'm thinking of Aristotle,
the philosopher. This is in ancient times, and I'm quoting from De Caelo, his book. Aristotle: "To succeed
in many things or many times is difficult. For instance, to repeat the same throw 10,000 times with the dice
would be impossible, whereas to make it once or twice is comparatively easy." He doesn't have the
language of probability, but he knows you can't throw the dice 1,000 times and come up with the same
number every time.
Now, we have a probability theory about it. So, we know that if you have n events, each occurring with the
probability of p, then the average proportion out of the n events that occur--I'm sorry, we have n trials, an
event occurring with probability p--then the standard deviation of this proportion of events that occur is
And that's a theorem from probability theory. The standard deviation of the proportion of trials for which
the event occurred, assuming independence, is given by this. And so, you note that it goes down with n. As
n increases, it goes down with--I should say, the $n. So, that means that if n gets very large, if you write a
lot of policies, then the probability of deviating from the mean by more than one or two standard deviations
becomes very small, which is what Aristotle said.
But making insurance work as an institution, to actually protect people against risk, is rather difficult to
achieve. And that's because things have to be done right. So, let me just remind you, what are the basic
types of insurance? This is what Fabozzi talks about. There's life insurance that insures people against early
death. Of course, you still die. What it really insures, is your family against the loss of a bread winner, the
father or the mother. So, life insurance is suitably given to families, especially with young children, to
protect the children. It used to be very important when there was a lot more early deaths. Now, very few
young people lose their parents. So, life insurance has receded in importance.
Another example is health insurance. This is insurance, of course, that you get sick and you need medical
care. Then, there's property and casualty insurance, insuring your house or your car. And then, there's other
kinds of [what] you might call investment-oriented products, like annuities. This is a table in your textbook
by Fabozzi, which lists these categories of insurance. But any of these insurance types are inventions, and I
want to specify that. We have the idea that an insurance company could be set up that would, say, insure
houses against fires. And we just heard it, intuitively, in this letter to Oldenburg long ago. But to make it
work, and to make it work reliably, involves a lot of detail. You can think of the idea of making an airplane,
but to make it really work, and to make it work safely, is another matter.
So first of all, insurance needs a contract design that specifies risks, and excludes risks that are
inappropriate. An issue that insurance companies reach is moral hazard.
[SIDE CONVERSATION]
Professor Robert Shiller: Moral hazard is an expression that appeared in the 19th century to refer to the
effects of insurance on people's behavior that are undesirable. So, the classic example is, you take out fire
insurance on your house, and then you burn it down deliberately in order to collect on the house. Or another
example is, you take out life insurance, and then you kill yourself to support your family. These are
undesirable outcomes, and they could be fatal to the whole concept of insurance, because if you don't
control moral hazard, obviously the whole thing is not going to work. So, what they do in an insurance
contract is they exclude risks that are particularly vulnerable to moral hazard. And so, that means you
would exclude certain causes of death that might look like suicide. You can do other things to control moral
hazard than excluding certain causes.
You can also make sure that you don't insure the house for more than it's worth. Right? If someone insures
a house, and the insurance does not cover the full value of the house, then there's no incentive to burn it
down. You might as well just sell the house, right? No point in burning it down if you'll still lose a little bit
of money. So, that's one of the problems that insurance companies face. And part of the design of [the]
insurance contract has to prevent moral hazard from becoming excessive.
An analogous thing is selection bias. That occurs when--chalk keeps breaking--selection bias occurs when
the people who sign up for your contract know that they are higher risk. For example, health. People who
know they have a terminal disease and are about to die, they'll all come signing up for your life insurance
contract. That will put immense costs on the insurance company, and if they don't control the selection bias,
they will have to charge very high premiums. And that will force other people, who don't know they're
going to die, out of buying insurance. And so, that's the fundamental problem. Again, something has to be
done to define the policy. So, one thing you can do is, exclude, in life insurance, certain causes of death that
are likely to be known. And you only put on causes of death that people wouldn't be able to predict about
themselves.
Another aspect of insurance is that you have to have very specific, precise definitions of the loss, and what
constitutes proof of the insured loss. If you're not clear about that, there's going to be ambiguities later,
which will involve legal wrangling and dissatisfaction. We'll see, in a minute, that these problems are not
minor and they keep coming up. It's a constant challenge for the insurance industry. Third, we need a
mathematical model of risk pooling. Well, I just wrote one down here, but it might be more complicated in
some circumstances. This is assuming independence. If you don't assume independence, you can make
more complicated models. Then, fourth, you need a collection of statistics on risks, and you need to
evaluate the quality of those statistics. So for example, in the 1600s, people started collecting mortality
tables for the first time. There was no data on ages at death. It began in the 1600s, because people were
building an insurance industry and they needed to know those things.
Then, you need a form for the company. What is the insurance company? Who owns it? It could be a
corporate form. There are shareholders who are investing in the company. And they're taking the risk that
some of our policy modeling, or handling of moral hazard, or selection bias wasn't right. Some insurance
companies are mutual, rather than share. The insurance is run for the benefit of the policyholders, and
they're like a nonprofit in the sense that the founders of the company pay themselves salaries, but the
benefits go entirely to the policy holders.
Then, you need a government design, so that the government verifies all of these things about the insurance
company. The problem with insurance is that people will pay in for many, many years before they ever
collect, right? Especially if you're buying life insurance, you hope never to collect. And so, you don't know
whether it's going to work right. That's why you need government regulation, you need government
insurance regulators. And that's part of the design of insurance. It doesn't work if you don't have the
regulators, because you wouldn't trust the insurance company. So, these are problems that have inhibited
making insurance work.
Chapter 3. The Story behind AIG [00:19:14]
I wanted to give you an example. I think it makes it more concrete if we start off with talking about a
particular example. And I said I was going to talk about AIG, which is a very important example, not only
because it was the biggest insurance company. It was also the biggest bailout in the entire financial crisis
we've seen now. And it has an interesting story.
[SIDE CONVERSATION]
Professor Robert Shiller: So AIG, it's an interesting story. It was founded in 1919 in Shanghai. And you
wonder, why is it called American International Group if it's founded in Shanghai? It was founded in
Shanghai, called American Asiatic Underwriters. And it was founded by Cornelius Vander Starr, who was
an American who just decided to go to Asia and start an insurance business. Shanghai, in 1919, was a
world city. It was not really under the Chinese government, it was something like Hong Kong. It had
constituencies representing many different countries. And so, it was a very lively business center. It's kind
of interesting that the biggest insurance company in the world emerged from Shanghai, and also one of the
biggest banks in the world, HSBC. You know what HSBC means? They don't emphasize it anymore. It's
Hong Kong and Shanghai Bank Corporation [correction: Hong Kong and Shanghai Banking Corporation].
So, AIG was founded by Mr. Starr in 1919, and started doing an insurance business in China. And moved
their headquarters to New York just before Chairman Mao took over at China. And then, it became kind of
a Chinese investment company in the United States.
Cornelius Vander Starr ran the company from 1919 until he died in 1968. So, he was CEO for 49 years, a
half-century. And then, just before he died, he appointed Hank Greenberg, who will visit us, as the CEO in
1962. So, that was 49 years under Starr, and then Greenberg took on, and then ran the company until 2005.
So, it was 37 years under Greenberg. So, two men ran the company for almost a century. Since 2005,
Greenberg has been succeeded by three CEOs, the usual thing. The usual company turns over CEOs.
There's another interesting story that we might ask about Hank Greenberg.
He joined the U.S. Army and fought in World War II. And among his jobs, then, was to liberate Dachau,
which was a concentration camp. This is not one of the extermination camps, it was a concentration camp
for Jews and others under the Nazis. And people were starving and dying, it was awful. At a Council on
Foreign Relations meeting, Greenberg met with Mahmoud Ahmadinejad, who is the president of Iran. And
Ahmadinejad said something about the Holocaust, doubting that it ever happened. Greenberg stood up
indignantly and said, it happened. I saw it. I was there. It's kind of interesting to me to think about this.
This is an aside, momentarily. The other person I've met who--do you know Geoffrey Hartman, who's a
professor here at Yale in literature? He and his wife, both Jewish, were teenagers during World War II. And
Hartman escaped by what they called Kindertransport. But his wife, Renee, was in another concentration
camp. Not Dachau, it was in Bratislava. And she was starving to death. And it really happened, by the way.
It's awful. And I asked her, why do you think they were starving you to death? And she said, we didn't
know. We thought maybe they were keeping us as hostages, or something. So anyway, we could ask him
about that.
What did these people do? Both Starr and Greenberg created a wide variety of risk management products.
It became the largest underwriter of commercial and industrial insurance in the world. It became a very
large automobile insurer, and also a travel insurance company. But Greenberg was forced out of the
company after 37 years, when Eliot Spitzer, who was the Attorney General for the state of New York,
claimed that there were some irregularities. And Greenberg was forced to resign. It turns out, though, that
nothing that Spitzer said has held up, so apparently Greenberg was innocent of any of the allegations. The
real problem occurred with AIG after Greenberg left. So, Greenberg left in 2005, and then the company
absolutely blew up, and it absolutely had to be bailed out.
The reason they had to be bailed out was, it was almost entirely due to a failure of the independence
assumption, I would say. That under their risk modeling, namely, the company became exposed to real
estate risk. And the idea that their risk modelers had was that it doesn't matter that we take on risk that
home prices might fall, because they can never fall everywhere. They can fall in one city, but it won't
matter to us. That's just one city, and it all averages out. But what actually happened after Greenberg left
was the company took huge exposures toward real estate risk and it fell everywhere. Home prices fell
everywhere, just exactly what they thought couldn't happen.
So, the company was writing credit default swaps--I told you about those before--they were taking the risk.
They were insuring, basically, against defaults on companies whose credit depended on the real estate
market. They were also investing directly in real estate security, in mortgage-backed securities that
depended on the real estate market for their success. And when all this failed at once, the AIG was about to
fail. That meant that the federal government decided, in 2008, to bail out AIG. And the total bailout bill,
well, the total amount committed by the U.S. federal government was $182 billion. It didn't all actually get
spent. It was $182 billion committed to bail out AIG. That's a lot of money, I think that's the biggest bailout
anywhere, at any time.
A lot of people are angry about this. Part of this bailout came from what we called TARP. This is the
Troubled Asset Relief Program, which was created under the Bush administration. And it was a proposal of
Treasury Secretary Henry Paulson. It was initially run by Paulson. But it was not just TARP. There was
also loans from the Federal Reserve. It was a complicated string of things that were done to bail out AIG.
So, why did they do that? Why did the government bail out this insurance company? The main reason why
they did so was their concern about systemic risk. I'll come back to other kinds of bailouts of insurance
companies.
The problem was that AIG--if it went under, all kinds of things would go wrong. All kinds of things would
go wrong. All these insurance policies that it wrote on people's casualties, their travel insurance, any of
these policies, would all now be subject to failure. Because people who had these insurance would find that
the company that they bought it through was disappearing. But it would go on even beyond that. Lots of
other companies, investment companies, banks, would fail too, or may fail too, because they're involved in
some kind of business dealings with AIG, which would now become part of the AIG bankruptcy. If AIG
failed, anybody who had any business with AIG would be starting to wonder, what's this going to mean to
me? AIG owes me money, what's going to happen? And so, there was a worry that it would destroy the
whole financial system.
This was big enough to cause everybody to pull back, and if everybody pulls back, then the business world
stops. It would be like a stampede for the exits. Everyone hears, AIG goes under, and so many people do
business with AIG, they decided it was intolerable. And so, the government came up with the money,
massively and quickly. If you remember the story, Henry Paulson, who was Treasury Secretary, first went
to Congress asking for a blank check. He didn't say to bail out AIG, but that's what he did. He got sort of a
blank check from Congress, because Paulson told the story that if we don't do this, if we let the company--
he didn't say AIG, he actually asked for the TARP money before the AIG bailout--but he said if we don't do
something to prevent a collapse, we could have the Great Depression again.
Nobody liked to hear that, but they believed him, and they didn't know what else to do. And so, they
allowed the TARP money, and they allowed the Federal Reserve to bail out this company. Some people
misunderstand what this in fact means, though, for the shareholders in AIG. The AIG shareholders lost
almost everything, because the government arranged the bailout in such a way that AIG got practically
wiped out. The government took preferred shares in the company at a very low price in exchange for
helping the company survive. And that diluted down the other shareholders in the company into a very low
status. The company lost over 90% of its shareholder value, despite this bailout.
In July of 2009, AIG did a 1-to-20 split. Remember, I told you about splits before? That's a reverse split.
Usually, the stock goes up in a company and the shares, which originally sold for $30 a share, are now
selling for $100 a share. And they think, well that's too high a price per share, so let's do a three-for-one
split, and let's make every share into three shares. That's the usual split story. This is going the other way
massively. They made every 20 shares into one share. So, if you look at the price recently, it's been
something like $30 to $40 dollars a share. That's what we do on the stock exchange, we always like to keep
it, it's an American tradition. Not so much true in other countries, they have different traditions about what
is the preferred price about a stock. So, AIG lost--the shareholders lost just about everything. So, the public
anger about a bailout of AIG is really a little bit inappropriate, because they lost almost everything. They
could've lost everything. This company did not fail, it was bailed out and it survived. But it lost almost
everything. I think the real anger is not anger about the shareholders of AIG, who lost almost everything.
The real anger is that the business partners of AIG didn't lose anything, notably Goldman Sachs, which was
a major partner taking the other side of contracts with AIG. It didn't lose a penny, all right? But, of course,
Goldman Sachs was not being bailed out. It was not in danger. The government didn't know what to do
with AIG, because it felt that it was such a big company doing so many things that if we let them fail, who
knows, Goldman Sachs might fail. The government didn't know, they didn't know whether Goldman Sachs
might fail. Because it didn't have the information, because the regulators had not collected such
information. So, they decided the only thing they could do responsibly was to keep AIG alive, somehow
alive, as an insurance company. Maybe, they lose almost all of their value to the shareholders, but they
keep going. So, that's what happened. And AIG continues to this day. It survived after the bailout.
Chapter 4. Regulation of the Insurance Industry [00:35:51]
Now, I wanted to talk about something else that many of you may not know about insurance companies.
Mainly, that we do have something like deposit insurance for insurance companies. You know, when you
go into a bank, there will be a little sign saying FDIC Insured? Do you notice that when you go into a bank?
They're required to post that. Bank accounts are insured by the Federal Deposit Insurance Corporation up to
a limit, $250,000 now. It's only for relatively small savers, because $250,000 is not big time, a lot of
money. We don't want innocent people who walk into a bank and put their money there to lose their money.
So, you wonder about insurance. Do we have something like that for insurance? Yes we do.
We have state insurance guarantee funds that protect insurance companies. They're not as old, though. The
oldest insurance guarantee fund is 1941, and that's in New York. And this fund was the first, but now
virtually every state in the United States has these funds. Connecticut got its first insurance guarantee fund
in 1972. So, these are supposed to protect you, as an individual, if you take out an insurance policy, and
then your insurance company, like AIG, blows up. So, then you wonder, well, why didn't the insurance
guarantee fund handle AIG? Any idea where the answer is? Why did we need the special bailout? Well,
maybe the answer is obvious. The insurance guarantee fund, like the FDIC, is to protect the little guy,
right? AIG was way too big for these state insurance funds. There's a limit to how much you can collect
from a state insurance fund if your insurance company goes under, and in New York it's $500,000, and in
Connecticut it's the same. These are two of the most generous states. Typically, in a state in the United
States, you only collect $300,000 maximum.
That may sound like a lot of money to you, but think of it this way: Suppose you bought a life insurance
policy for your family. What would you typically buy? Ever thought about it? Well, you have two children.
You're thinking of sending them both to Yale, or some place like that. It's going to cost you like $500,000
right there, just sending them to college. So, if that's all you get in your insurance, it's not enough, not big.
So, these are small, they don't guarantee you enough. There's another thing about, at least I know about the
Connecticut insurance guarantee fund, and that is that you can't play the trick that you do with the Federal
Deposit Insurance Corporation. The Federal Deposit Insurance Corporation insures bank accounts for
250,000, all right? But all you do is, you put your money over many different banks. So, if you've got $2.5
million, you put it in 10 different banks. The FDIC will insure every one of those, so you can insure $2.5
million. But the Connecticut insurance guarantee fund won't do that, they'll limit you to $500,000, no
matter how many different policies you got.
There's another important difference between deposit insurance and banks and state insurance guarantee
funds, at least in Connecticut. I know Connecticut does not allow an insurance company to advertise that
they're insured. It's quite the opposite with deposit insurance, where the FDIC requires that they post that
they're insured. So that's why you don't hear about this. But there's a fundamental lesson that I'm trying to
get to with all of this, and that is that you have to look at the insurance company that you buy insurance
from. It's still a wild world out there in the sense that if you buy insurance from an insurance company that
goes under, well, you're protected up to $500,000, but beyond that, not. And you're supposed to watch out.
Now, we also have state insurance regulators who are supposed to watch out that insurance companies are
good, but they won't make good on you. So, we have a Connecticut Insurance Department, for example,
which regulates insurance companies.
Now, another interesting thing about insurance that separates it from finance is that insurance is done by
the state government. It's regulated and the guarantee funds are state. The Federal Deposit Insurance
Corporation is a federal--it's a national insurance program. But insurance is done entirely by the states. This
makes it difficult to do business as an insurance company, because you have 50 different regulators in the
United States. The United States is [a] particularly difficult place to handle. That's because we have the
McCarren-Ferguson Act in 1945, which specified that insurance regulation is entirely for the state
governments. So, in the United States, regulation of insurance is divided up across 50 different states,
which is kind of, makes it very difficult. It's very difficult, because that's a lot of different regulators to deal
with.
One thing that we have is something called the National Association of Insurance Commissioners. It's not a
government organization, it's an association without any constitutional or any government definition. The
NAIC. But what it does, is it brings representatives from the different state governments and they meet
together, and they decide on model legislation that each state government could adopt to allow insurance to
be standardized across different state governments. Otherwise, we'd have a total chaos in our insurance
regulation.
You might be aware that under the Dodd-Frank Act, which is the major legislation that was passed in 2010,
the Dodd-Frank Act creates a new federal insurance office. So, it sounds like the federal government in the
United States is getting into insurance. But, in fact, no it's not. The federal government doesn't have any
real involvement in the insurance industry,, its all done, it's all regulated at the state level. Well, it does
have an involvement in a sense, because here's how it's going to work apparently. The Federal Insurance
Office was created to look at systemic risk of insurance, because the AIG problem turned out to be a
federal problem, because it was so massive. The federal government doesn't want AIG bailouts to happen
again. So, the proposal was made by a number of people, well, why don't we regulate insurance at the
national level? Other countries do that, why don't we do that? But the American tradition is too strong to
make such a major change.
So, what the Dodd-Frank Act did, is it created this new office. And the Federal Insurance Office is going to
collect information about insurance companies in order to discover which of them are posing the kind of
risk that AIG did, a risk that could bring down the whole system. So again, they're just looking at the
problem that I highlighted at the beginning, that the whole insurance model assumes independence of risk,
some kind of independence of risk, so that pooling occurs. But if it's not really independent, then pooling
isn't going to be successful. So, here's what the Federal Insurance Office does--what it will do, it hasn't
done anything yet, I suppose. It will monitor insurance companies for posing systemic risks. And if it
decides that there is a systemic risk, another AIG brewing, then this office can recommend to another
agency called the Financial Stability Oversight Commission, created by Dodd-Frank--people call it F-SOC.
It can recommend that the insurance company be designated as a threat to the system of the United States.
In that extreme case, it would be put under the regulation of the Federal Reserve Board, and it would be
handled in bankruptcy by the Federal Deposit Insurance Corporation. So, what Dodd-Frank has done, is left
the state-regulated insurance companies unchanged, except as regards to systemic risks. And they have set
up a procedure that would get the federal government involved if the Federal Insurance Office concludes
that a systemic risk is happening. And the Dodd-Frank Act says very clearly, we will not bail out another
insurance company the way we did AIG. We can get back into the details of what might happen in another
AIG circumstance, but it's not supposed to be the same thing.
Well, I wanted to mention that there are other countries that have insurance guarantee funds like the
insurance guarantee funds that I mentioned in regards to Connecticut and New York. In many cases, they're
newer and they're not as effective. So, I wanted to mention--in the country of China, they have just created
the China Insurance Protection Fund. It's like one of our state guarantee funds, but it has a limit. The
amount that it will insure is limited to CNY 50,000, or about $6,000. It's $500,000 in the United States. At
least, they've got it now. Until 2008, there wasn't even any such insurance guarantee fund.
Chapter 5. Specific Branches of the Insurance Industry - Life and Health Insurances [00:50:04]
So anyway, the Fabozzi book talks about various kinds of insurance, and I was going to say something
about [the] types of insurance. The biggest category of insurance privately offered is life insurance, which
in 2009 was almost $5 trillion. Privately offered health insurance is actually smaller than that, and property
and casualty insurance is only about $1.3 trillion. Nonetheless, these are big industries. You go through
Fabozzi, and it will describe the different types of life insurance. There's term insurance, which insures you
for a certain term of time. It's terminates after one year, but is typically automatically renewable. Then
there's whole life, which gives you insurance over a long time interval and builds cash value over the years.
There's other types--there's variable life, which has no guaranteed cash value, but invests in an account for
you. And the insurance, then, has an uncertain payout.
Life insurance goes back to the 1600s, as I was saying, because that was the most important kind of
insurance. The most important risk that people faced was the death of a parent. I mentioned that the first
multinational corporation and the first stock exchange appeared in the 1600s, the same time as the first
insurance policies appeared. The first health insurance policy was proposed in 1694 by Elder Chamberlain.
And the first U.S. health insurance plan was the Franklin Health Insurance Company of Massachusetts,
which started in 1850.
I wanted to talk a little bit about health insurance, because it's something that has been an important
problem. Many countries have adopted national health insurance plans. The government has come in,
fundamentally, and has actually required insurance for everyone. The government has not allowed
insurance to proceed along private lines. The United States, however, has had a tradition of more private, or
free enterprise, and has tried merely to regulate insurance and not to impose it as a government plan. But
there have been problems in the United States, in that many people do not get insurance. Because if you
don't have a government plan on insurance, you start to deal with problems of moral hazard or selection
bias that encourage many people not to buy insurance. If you think that the people who buy health
insurance are the sick ones, and you're not sick, you're not going to buy insurance.
Moreover, there were other problems of moral hazard with insurance. One problem was, if you have a
private health insurance plan, the doctors have, maybe, an incentive to milk the insurance company, right?
They can order too many procedures. Doctors don't care about you, the patient, living a long time. They
just have an incentive to do a lot of procedures, so they won't do preventative medicine to protect your life-
-they will, if they have moral character--but the financial incentives are wrong. So, the government in the
United States has tried repeatedly to do things that would improve this problem. But see, this is what I'm
getting back in the initial point. Designing insurance is a matter of invention. We have to figure out some
system that incentivizes doctors right, and incentivizes people to sign up--both sick people and healthy
people all sign up--and things are done right. So, how do we get that?
I was going to give some milestones in this. One was the HMO Act. The government is always getting
involved and trying to--this is 1973. HMO stands for health maintenance organization. A health
maintenance organization is an insurance plan that tries to deal with the moral hazard problem. Doctors are
paid salaries, they're not paid for procedures. So, doctors are employees of the HMO and they have no
incentive to give you an operation that you don't need, because their pay won't go up. The HMO Act of
1973 required employers with 25 or more employees to offer their employees a federally certified HMO
Plan. One of the first HMOs--I'll say this, because you know about them--was the Yale Health Plan.
Actually, the Yale Health Plan dates to--I'll say YHP for Yale Health Plan--1971. It actually got started
before the HMO Act.
That's because people here at Yale were thinking along the same--there was talk then, already, about the
importance of preventive medicine. And Charles Taylor, who was the Yale provost, liked the idea. It was
being talked about in Congress, but Yale didn't even wait for the government to require it, we did it in
advance. So, quoting Taylor: "Social responsibility of the university extends to the pioneering and the
demonstration of improved methods for the provision of health services to population groups." The concept
is that it was a Yale community. Everyone at Yale belongs--or has the option of belonging--and you have a
primary care person there, whose instruction is to preserve your long-term health.
Another milestone was the Emergency Medical Treatment and Active Labor Act in 1986, or EMTALA.
See, so many people in the United States have no health insurance, and it's because of these problems I'm
telling you about, the moral hazard problem, the selection bias problem. People say, I'm not going to buy it,
it's too expensive because I'm not sick. That defeats the whole concept. You're supposed to buy whether
you're sick or not. So, we had so many people that didn't have insurance, so what would happen when they
got hit by a bus, they're lying on the street? Well, people would bring them into the hospital and, typically,
hospitals would sew them up and take care of them. But they often gave really bad service, because they
weren't getting paid for this person. So, what the EMTALA did in 1986, is it requires hospitals to take you
in and take care of you. Anyone needing emergency treatment, according to EMTALA, can go to any
hospital with an emergency room and be taken care of. So, that's the law. So, we do have national health
insurance in that sense.
This is an example of what's called an unfunded mandate. The government just says the hospitals have to
do it. How do they pay for it? Well, that's their problem. The government isn't offering them any money to
do it. So, what the hospitals do, is they say, OK. Suppose you get hit by a bus. If you can't talk, they just
treat you. If you can talk, they're in there asking you to sign papers promising to pay for it eventually. So,
you go deeply into debt. That's one thing that happens. So, EMTALA didn't really solve the health
problem. We still have the selection bias problem preventing people from signing up. The HMO Act was
supposed to put us all--did I spell maintenance? I spelled this wrong. The HMO Act was supposed to get us
all into HMOs. Well, you are all in an HMO, because you're part of a community that gives it to you. But
there's over 40 million uninsured Americans, not even on any insurance plan. And people who don't have
any health insurance miss diagnostic procedures, they get diabetes, they get high blood pressure. And so,
they're not treated until they're flat out and they're in the emergency room. And that's not the way to handle
these conditions. So, it's really not good what has happened.
But that brings us to the 2010 health care acts that were created by President Obama. There's actually two
of them, I won't write their names. So, in 2010, the U.S. government passed a landmark pair of bills that
were addressed to solving the selection bias and moral hazard problems and reduce the number of people
who are uninsured dramatically. So, this is what the government did. It hasn't happened yet, but the
procedures are there to set it up. They're creating new insurance exchanges that will offer insurance to be
purchased by the general public. And they're not going to require you to buy the insurance, they're going to
put a tax penalty on you if you don't. You don't have to buy insurance, because you're a student here, and
you've got insurance.
But suppose you're just out there in the world, and youre not affiliated with any insurance plan, then you'll
actually have to pay a penalty of something like $700 year if you don't. So the idea is, you pretty much are
going to do it, because you don't want to pay the penalty. That solves the selection bias problem, because
by forcing everyone to sign up, insurance companies no longer have the problem that only sick people sign
up. Everyone signs up, so they can lower their premiums, because it doesn't cost them as much per person
when they've got healthy people now. So, there's a penalty for individuals in not buying insurance, and
there's a penalty for companies who do not buy insurance for their employees. That's another part of the
selection bias problem. So, we get almost everyone covered by insurance, and that will bring the cost down.
Moreover, insurance companies that are on the new insurance exchanges cannot say no for pre-existing
conditions. This happens all the time now. If you already are sick, an insurance company is going to offer
you a really high--they'll say, we'll insure you, but we'll demand a really high monthly premium. So you
say, I can't afford that, because it doesn't work. Now, that won't happen.
Chapter 6. Insurance in the Face of Catastrophes [01:03:18]
I wanted to conclude with some thoughts about the insurance industry and where it's going. It seems
painfully slow to me. I talked about insurance being invented 1600s, that's 400 years ago, and still we have
over 40 million Americans with no health insurance. Pretty obvious that we should have it, but we have
problems making it work. And we still have problems, especially in less developed countries.
Let me mention another insurable risk, which was being taken care of very badly. You know that last year,
there was a terrible earthquake in Haiti. The loss of life in Haiti, and the loss of damages, was generally not
insured. There were efforts to get more insurance to Caribbean countries. In 2007, the Caribbean
Catastrophe Risk Insurance Facility was trying to promote insurance for the Caribbean region, but it had
reached only $8 million dollars in insurance as of the Haiti earthquake. What that meant is that most
buildings were not insured in Haiti. And that meant not only that people couldn't collect when the building
collapsed, but it also meant that the building really collapsed, because there were no insurance companies
imposing building codes and standards. If an insurance company is bearing the risk, they will then go in
and make sure that the building is constructed right, and so the risk is dealt with properly.
In contrast, a similar catastrophe in the United States was the Hurricane Katrina, which destroyed much of
the city of New Orleans. But in contrast, many, or most people in New Orleans had insurance on their
house. And studies show that the insurance--while there were complaints--the insurance actually worked.
And most people--I think about 200,000 homes were severely damaged, and payment was about $40,000
per home. Still, there were problems in New Orleans. When New Orleans came, there were two kinds of
risk. One was wind damage and the other one was flood damage. I was saying earlier that an insurance
policy tries to define the loss very carefully and precisely, because it's going to end up costing the insurance
company billions of dollars, they got to get it exactly right. But they had different coverage for wind loss
and flood loss. Now the problem is, when you have a hurricane, which is it? What was the problem that hit
your house? Because it was both wind and flood. So, there was wrangling over the definition.
Another problem--I'm almost done here--I just wanted to talk about another kind of risk, that worries us a
great deal, that tends not to be covered well by a traditional insurance company. And that's terrorism risk.
Most insurance policies traditionally have excluded acts of war or terrorism from coverage. And they feel
that they have to exclude it, because those are correlated risks, right? If there's a war, it's going to cause--
there are not independent probabilities of damage. And so, insurance companies have excluded it. But it
turns out, these are some of the risks that we worry most about.
So, what we had in the United States was TRIA, which was the Terrorism Risk Insurance Act in, well, it
started out in 2002, then it's been renewed. The act requires insurance to offer terrorism insurance, but it
also agrees that the government will pay some of the amount of losses if there is a major national
catastrophe. So, it becomes a government-funded--in the case of a huge, let's say, systemic problem caused
by a massive increase in terrorism, the government will take up the major losses. So, that is another
important step, that we now have insurance against terrorism. It was something that had been excluded
because of the systemic problem.
The last thing I'll mention is catastrophe bonds. This is an insurance-like institution that has been
developing slowly. A catastrophe bond is a bond that is used to finance the management of large risks. I'll
give you an example. The Mexican government, in May of 2006, issued bonds totaling $160 billion, which
need to be repaid only if Mexico does not have a major earthquake. So, if you invest in Mexican
catastrophe bonds, or cat bonds, they're called, then you are helping Mexico against a systemic, big risk. If
Mexico City is hit by another earthquake like the one that they had--it was about 20 years ago--it would be
a huge cost to Mexico. The Mexican government is not big enough to manage such a risk effectively. It's
better if the risk is spread out over the whole world.
So, this is an example of a kind of risk management contract that extends the scope of insurance, actually
making it more financial. These bonds are actually sold and put into portfolios, and it doesn't look like
insurance. It looks like a bond that deals with the insurance risk in a financial way.
I'm about done, let me just say the insurance industry manages important risks that matter to our life. Risks
to our health, to our children, to our businesses, to things that we do. And it still suffers from various
imperfections that we can see. It seems like we're just dealing with some of the problems. I mention these
new innovations. But there are still problems in the insurance industries.
I could just mention a few of them. One of them is that we don't well-insure against changes in
probabilities. So for example, recently in the American South, for unknown reasons, there's been a growing
mold problem. The funguses are growing in houses, and it can damage the house and it has to be torn
down. So, the probability of this risk is going up. So, insurance companies are raising their rates reflecting
the probability, but there was no insurance against raising the rates. Also, hurricane risk seems to be going
up, right? Because of global warming, hurricane risk is going up. So, insurance companies have been
raising their insurance premiums for that reason. But that is not a risk that's insured against. So, if you buy
a house down in Florida and then hurricanes get much worse, you might not be able to afford your
insurance policy. We also have problems that insurance policies are not indexed to inflation. We have life
annuities--I haven't really discussed those, but they're policies that would benefit from inflation indexation.
So, these are still some examples. I think that the insurance industry is a--let me just conclude with this
thought--it's like any other industry. It deals with very important, real problems that require technological
solutions. The solutions are difficult and we are slowly moving ahead and improving our ability to deal
with these problems. But it's a science, it's a technology, it's got a long ways to go. And I'm predicting that
over your careers, in the next half century or more, we'll see a lot of advances, a lot of changes, in the
insurance industry, like the changes I talked about here. And these changes will lead to much better lives
for all of us. So, I'm talking about efficient markets next period [correction: after the guest lecture by David
Swensen], which is a favorite topic of mine. It's about why you can't beat the market. Or maybe you can.
That's what I like about it.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 6 - Guest Speaker: David Swensen [February 2, 2011]
Chapter 1. Introduction, Overview, and Barron's Criticism of the Swensen Approach to Endowment
Management [00:00:00]
Professor Robert Shiller: We've already talked about our guest today. This is David Swensen. Remember,
I said he was the inventor of the swap, which is a real claim to fame, because swaps total in the hundreds of
billions --
Professor David Swensen: Trillions.
Professor Robert Shiller: It's amazing.
Professor David Swensen: I thought this was going to be a polite introduction. I used to be proud of the
swap thing, but that was before the crisis.
Professor Robert Shiller: Well, that's financial innovation. I think, swaps are a very important new
technology. We've been talking about that. So anyway, just to remind you--David Swensen came to Yale in
1985, when the portfolio was worth less than $1 billion. And as of June, 2010, it's $16.7 billion.
Professor David Swensen: And climbing.
Professor Robert Shiller: And climbing. And this is a financial crisis, but between 2009 and 2010, the
portfolio went up $1.4 billion, so there's no crisis around here. Well, there was a little hitch at one point.
But that kind of thing happens. I take pride in training young people in finance. David Swensen has done
the same with many young people. Notably, Andrew Golden, who heads the Princeton portfolio, is one of
your trainees. And he's had an almost as spectacular record as well. Well, with that introduction, I will turn
it over to David Swensen.
Professor David Swensen: Thank you.
[APPLAUSE]
Professor David Swensen: So, I've been at Yale for, I guess, more than 25 years now. And for most of the
25 years, if there was any publicity, the publicity was pretty good. For the past couple of years, it's been a
little bit mixed. And, I liked it better, before the publicity was mixed. I liked it, when every article that you
would read had something great to say about the Yale Approach or the Swensen Model. But after the
collapse of Lehman Brothers and the onset of the financial crisis, it didn't take very long for the negative
headlines to appear. As a matter of fact, I carry around this Barron's article that appeared in November
2008, and the title was ''Crash Course.'' And it talked about colleges cutting budgets, freezing hiring,
scaling back building projects.
And it blamed the Yale Model and the Swensen Approach for being too aggressive. They said in Barron's
that university endowments should own more stocks and bonds, less in alternatives, because the
alternatives provided too little diversification and too little liquidity. So, I thought what we could do today
as a jumping off point is, talk about what it is that Barron's meant when they were talking about the
Swensen Approach or the Yale Model and--I think, when it was successful, it was the Yale Model, and
when it failed, it was the Swensen Approach, which I really don't like. There's an asymmetry there. I keep
thinking that I should name it after one of the guys in the office. Maybe it should be the Takahashi
Approach instead of the Swensen Approach. It's time for him to have some glory, right?
Talk about what it is that Barron's meant by the Swensen Approach or the Yale Model, and see, whether,
indeed, the criticisms that they levy, that there's too little diversification and two little liquidity, whether
those criticisms are valid. But to do that, let's go back to 1985, when I first arrived at Yale. It was April 1,
1985, for those of you who care about April Fools' Day. I came from a six-year stint on Wall Street, and I
had no significant portfolio management experience. As Bob mentioned in his introduction, I'd been
involved with structuring the first swap transaction in 1981, when I worked for Salomon Brothers. It was a
swap between IBM and the World Bank. And later, Lehman Brothers hired me to set up their swap
operations. So, generally what I was doing on Wall Street was working with new financial technologies and
being involved with the early days of swaps transactions. It was a much smaller market then, it wasn't
hundreds of trillions. And it was a much less efficient market then, so the trades were incredibly profitable.
Commodity swaps today trade on razor thin margins, and tend not to be anywhere near as profitable as they
were when the markets were much less efficient.
How did I end up at Yale? Well, one of my dissertation advisors called me and said they needed somebody
to manage the portfolio. And after coming to New Haven and talking to them about the job, I realized that
my heart wasn't in Wall Street. My heart was in the world of education, and at Yale in particular. So I came
up here, amazed that I was responsible, as Chief Investment Officer, for this portfolio. It was less than $1
billion, but close to $1 billion. And the first thing I did was, I looked around to see what other people were
doing. That seemed like a sensible way to approach the portfolio management problem. There must be
some smart people at Harvard or Princeton or Stanford putting together portfolios that make sense for
endowed institutions. What I saw was that colleges and universities had, on average, 50% of their portfolio
in U.S. stocks, 40% of their portfolio in U.S. bonds and cash, and 10% in a smattering of alternatives.
Even though I had no direct portfolio management experience, I had studied at Yale and Jim Tobin and Bill
Brainard were my dissertation advisors. And I understood some of the basic principles of corporate finance.
And one of the first things that you learn when you study finance theory, is that diversification is a great
thing. Jim Tobin won the Nobel Prize in part for his work related to the subject of diversification. In fact,
when a New York Times reporter asked Jim to explain, in layman's terms, what it was that he won the Nobel
Prize for, Jim said, well, I guess you could say, don't put all your eggs in one basket. I didn't know you got
a Nobel Prize for that, but that's --
Professor Robert Shiller: We told our students that that phrase goes back to 1802. [correction: Lecture 4
mentions dont put all your eggs in one basket in an investment manual from 1874. According to
ngrams.googlelabs.com, the phrase can actually be traced back to 1800.]
Professor David Swensen: OK, so if it goes back to 1802, Jim was just picking up on the vernacular and
used it as a way to describe what it is that he did his work for. And Harry Markowitz, who actually did a
fair amount of his work on modern portfolio theory at Yale's Cowles Foundation, has said that
diversification is a free lunch. I mean, didn't you learn in introductory economics and intermediate
[clarification: intermediate economics] that there ain't no such thing as a free lunch? Economists are always
talking about trade-offs. If you want more of this, you have less of that. Well, with diversification, that's not
true, right? If you diversify your portfolio for a given level of return, you can generate that return at lower
risk. If you diversify for a given level of risk, you can generate higher returns. So, diversification is this
great thing, it's a free lunch, it's something that everybody should embrace.
Well, if you look at the portfolios that I saw in the world of endowment investing in the mid-1980s, they
weren't diversified, right? If you've got half of your assets in a single asset class, U.S. stocks, and you have
90% of your assets in U.S. marketable securities, you're not diversified. Half your assets in a single asset
class is way too much. And the 90% that are in stocks and bonds under many circumstances will respond to
the same driver of returns, interest rates, in the same way, right? Lower interest rates, mathematically, are
good for bonds, and lower interest rates lower the discount rate that you use to discount future earning
streams, so they're probably going to be good for stocks too. And vice versa.
And the second thing I thought about was the notion that endowments have a longer time horizon than any
investor that I know. And if you've got a long time horizon, you should be rewarded by accepting equity
risks. Because those equity risks, even though they might not reward you in the short run, will reward you
in the long run. So, with a mission, as a manager of an endowment, to preserve the purchasing power of the
portfolio in perpetuity, I expected that other endowments would have substantial equity exposures, to take
advantage of the fact that, in the long run, that's where you're going to generate the greatest returns. But if
you think about those endowment allocations that I saw in the mid-1980s, 40% of the assets were in bonds
and cash, which are low expected return assets. So, the portfolios that I saw when I got to Yale failed the
basic common sense test of diversification and equity orientation, and it prompted me and my colleagues to
go down a different path, to put together a portfolio that had reasonable exposure to equities, and put
together a portfolio that was sensibly diversified.
So, I'd like to talk about how it is that we got from where we were in the mid-80s to where we ended up in
the early- to mid-90s, and where we remain today. And to do that, I'd like to put it in the context of the
basic tools that we have available to us as investors. And these tools are the tools that you can employ if
you're managing your portfolio as an individual, or the tools that I have to employ when I'm managing
Yale's portfolio as an institutional investor. And there are basically three things that you can do to affect
your returns. First of all, you can decide what assets you're going to have in the portfolio and in which
proportions you'll hold those assets. So, that's the asset allocation decision. How much in domestic stocks,
how much in foreign stocks, how much in real estate. If you're an institutional investor, how much in
timber, how much in leveraged buyouts, how much in venture capital. The fundamental decision of how it
is that the portfolio assets are allocated.
The second thing that you can do is make a market timing decision. So, if you establish targets for your
portfolio--targets with respect to how much in domestic socks, how much in domestic bonds, how much in
foreign stocks. And then, because in the short run, you think that--let's say domestic stocks are expensive
and foreign stocks are cheap--you decide to hold more foreign stocks and less in domestic stocks. That bet,
that short-term bet against your long-term targets, is a market timing decision. And the returns that are
attributable to that deviation from your long-term targets are the returns that would be attributable to
market timing.
And the third source of returns has to do with security selection. So, you've got your allocation to domestic
equities. If you buy the market--and the way that you buy the market is to buy an index fund that holds all
of the securities in the market in the proportions that they exist in the market--if you buy the market, then
your returns to security selection are zero, because your portfolio is going to perform in line with the
market. But if you make security selection bets, if you decide that you want to try and beat the market, then
that bet or that series of bets will define your returns attributable to security selection.
So, if you decide that you think the prospects of Ford are superior to the prospects of GM, well, you want
to overweight Ford and underweight GM. And if that turns out to be a good bet and you're rewarded,
because Ford outperforms and GM underperforms, then you have a positive return to security selection. If
the converse is true, then you have a negative return to security selection. But one of the really important
facts about security selection is that, if you play for free, it's a zero sum game. Because if you've over
weighted Ford and underweighted GM, there has to be some other investor or group of investors that are
underweight Ford and overweight GM, because this is all relative to the market. And so, if you're
overweight Ford and underweight GM and somebody else is underweight Ford and overweight GM, well,
at the end of the day, the amount by which the winner wins equals the amount by which the loser loses.
And so, it's a zero-sum game.
But of course, if you take into account the fact that it costs money to play the game, it turns into a negative-
sum game. And the negative-sum is the amount that's siphoned off by Wall Street, right? And Wall Street
takes its pound of flesh in the form of market impact, in the form of commissions, in the form of fees that
are charged to manage the portfolio actively, and then sometimes there are even fees to consultants to
choose the manager. So, there's an enormous drain from the system that causes the active investment
activity to be a negative-sum game for those investors that decide to play.
Chapter 2. Asset Allocation [00:15:52]
So, let's take these in turn and start out with asset allocation. Asset allocation is far and away the most
important tool that we have available to us as investors. And when I first started thinking about this 25
years ago, I thought, well, maybe there's some financial law that says that asset allocation is the most
important tool, because it seems pretty obvious that that was going to be the most powerful determinant of
returns. But it turns out, that it's not really a law of finance that asset allocation dominates returns, it's a
behavioral result of how it is that we as individual investors, or we as institutional investors, manage our
portfolios.
If I make it back to my office, traversing these icy sidewalks, I could go back, I could take Yale's $17 or
$18 billion dollars and put it all in Google stock. If I did that, Im not sure how long I'd keep my job. It
might be fun for a while, but that would probably be damaging to my employment prospects. But if I did
that, asset allocation would have almost nothing to say about Yale's returns. It would be the idiosyncratic
return associated with Google that would determine whether the endowment went up or down or stayed
flat. And so, security selection would be the overwhelming important determinant of returns for Yale's
endowment. And if it wasn't exciting enough to sell everything and put it all in Google stock, maybe I
could go back to my office and start day trading bond futures.
Well, if I took Yale's entire $17 or $18 billion dollars and started trading bond futures with it, asset
allocation would have very little to say about Yale's return. Security selection would probably have very
little to say about Yale's return, so it would all be about market timing ability. And if I'm great at following
the trend--the trend is your friend--of course, that's true until it's not. Or if I've got some sort of marvelous
scheme to outsmart all the other smart people, who are trading in the bond market, I could generate some
nice returns. But those returns would have nothing to do with asset allocation, nothing to do with security
selection, and everything to do with market timing.
Of course, these sound like ridiculous things, right? I mean, everybody in this room knows, that I'm not
going to go back and put Yale's entire endowment in one stock. And we also know, that I'm not going to go
back and day trade futures with the endowment. I'm going to go back, and the portfolio is going to look a
lot like it looked yesterday, and the day before, and the month before that, and the year before that, because
as investors, whether we're individual investors or institutional investors, we tend to have a sensible, stable
approach to asset allocation. And within the asset allocation framework that we employ, we tend to hold
well-diversified portfolios of securities within each of the asset classes. So, that means that asset allocation
is going to be the predominant determinant of returns.
Bob Shiller and I have a colleague at the School of Management, Roger Ibbotson, who's done a fair amount
of work looking at the various sources of returns for investors. And a number of years ago, he came out
with a finding that more than 90% of the variability of returns in institutional portfolios had to do with the
asset allocation decision. And that was a very widely read, and widely accepted conclusion. In that same
study, I thought that there was a more interesting conclusion, and that was that asset allocation actually
determined more than 100% of investor returns. How could that be, how could asset allocation determine
more than 100% of returns? Well, it goes back to the discussion that we had about security selection and
the fact that it's not free to play the game, and the same thing's true about market timing. Right? If
somebody is overweighting a particular asset class relative to the long-term targets that they've got, well,
there's got to be an offsetting position in the markets.
Market timing is expensive in the same way that security selection is expensive. And so, it, too, is a zero-
sum game, even though the analysis that you'd apply to market timing isn't quite as clear and crisp as in the
closed system that you've got with any individual securities market. So, if security selection and market
timing are negative-sum games, then asset allocation would explain more than 100% of the returns. And,
on average, for the community as a whole--because investors do engage in market timing, investors do
engage in security selections--those are going to be negative-sum games, and you have to subtract the
leakages occurring because of security selection and market timing, in order to get down to the returns that
you would get if you just took your asset allocation targets and implemented them passively.
So, it turns out that asset allocation is the most important way that we express our basic tenets of
investment philosophy. I talked about the importance of having an equity bias. Well, these are some of
Roger Ibbotson's data. He's got this publication called Stocks, Bonds, Bills, and Inflation, although he might
have sold it to Morningstar, so maybe it's Morningstar's publication now. And it actually is an outgrowth of
some academic research that he did decades ago. And the basic drill was, starting in 1925, looking at a
number of asset classes--the ones that I've got here are Treasury bills, Treasury bonds, large stocks, small
stocks, and then, as a benchmark, inflation--starting the investment at the end of 1925, taking whatever
income was generated from that investment, reinvesting it and seeing where you end up at the end of the
period. I've got here the numbers from 1925 to 2009.
And if you did that with Treasury bills, which are short-term loans to the U.S. government, one of the least
risky assets imaginable, you would have ended up with 21 times your money over the period. If you think
about that, 21 times your money, that's pretty good. But if you think about the fact that inflation consumed
a multiple of 12, well, you didn't end up with a lot after inflation. And if you're an institution like Yale and
you only want to consume after-inflation returns, so you can maintain the purchasing power the portfolio,
well, 21 times, but taking off 12 times for inflation, not so good.
One of the interesting things about the Stocks, Bonds, Bills, and Inflation numbers over long periods is that
they correspond to our sense of the relationship between the riskiness of the asset, and the notion that, if
you accept more risk, you should get higher returns. And so, if you move up the risk spectrum and, instead
of looking at Treasury bills, you look at Treasury bonds, you end up with a multiple of 86 times. That's
pretty good, 86 times. I mean, it's a lot better than, whatever, 21 times for bills. It's still not a huge return
for decades and decades of investing. So, what happens if you move away from lending money, in this case
lending money to the government, to owning equities?
The multiple over this period--and this includes the crash in 1929, the market collapse in 1987, and the
most recent financial crisis. In spite of those blips, you would've ended up with 2,592 times your money.
That's stunning, that's way more than 86 times and way more than 21 times. So, over long periods of time,
you do end up being rewarded for accepting equity risk. And what would've happened if you would have
put the money in small stocks and let her run? 12,226 times your money. So, the conclusion is pretty
obvious. This notion that, if you've got a long time horizon, you want to expose your portfolio to equities,
makes an enormous amount of sense.
As a matter of fact, the first time I took a look at these numbers was back in 1986, when I was teaching--
probably a predecessor to the class that Bob Shiller's teaching, it was a lecture class in finance--and I was
preparing the lecture that had to do with long-term investment philosophy. And that's when I first saw these
numbers, and I was little bit disconcerted when I put them together. Because I thought, gee, 21 times for
bills, 86 times for bonds, 12,226 times for small stocks. Maybe the right thing to do is to just put the whole
portfolio into small stocks and forget about it. And my first problem was that, if that were true, what was I
going to say for the next ten weeks of lectures? My longer-term problem was, that, if the investment
committee figured out, that all we needed to do is put the whole portfolio in small stocks, and that that was
the way to investment success, I wouldn't have a job. They wouldn't need me to do that. And I had a wife
and young children, and I like getting a paycheck and being able to feed and house them.
So, I took a look at the data more carefully, and theres a number of examples of what it is that I'm going to
talk about. But the most profound example remains around the great crash in 1929. And if youd had your
whole portfolio in small stocks at the peak, by the end of 1929, you would have lost 54% of your money.
By the end of 1930, you would have lost another 38% of your money, by the end of 1931, you would have
lost another 50% percent. And by June of 1932, for good measure, you would've lost another 32%. So, for
every dollar that you had at the peak, at the trough you would have had $0.10 left. And it doesn't matter,
whether you're an investor with the strongest stomach known to mankind, or you're an institutional investor
with the longest investment horizon imaginable, at some point, when the dollars are turning into dimes,
you're going to say, this is a completely ridiculous thing to accept this much risk in the portfolio. I can't
stand it. I'm selling all my small stocks and I'm going to buy Treasury bonds or Treasury bills. And that's
exactly what people did. And there was this sense in the 1930s, 1940s, even into the '50s and '60s, that
heavy equity exposures weren't a responsible thing for a fiduciary.
When I was writing my book, I was fooling around looking at articles from the Saturday Evening Post--and
I know everybody here is too young to [have] seen the Saturday Evening Post when it was still publishing,
but you've all seen Norman Rockwell prints, right? Well, he was famous for doing covers for the Saturday
Evening Post. And there was this article in the 1930s--that's actually before my time, so I was looking at
things in the library, not things that actually had been delivered to my doorstep--and the commentator said
that it was ridiculous that stocks were called securities. That they were so risky that we should call stocks
insecurities. There was just this visceral dislike for the risks that were associated with the stock market,
because it had caused so many investors so much pain. So yes, stocks are a great thing for investors with
long time horizons, but you need to diversify, because you've got to be able to live through those inevitable
periods, where risky assets produce results that are sometimes so bad as to be frightening.
Chapter 3. Market Timing [00:30:42]
Second source of return, market timing. A few years ago, a group of former colleagues of mine gave me a
party at the Yale Club, and they presented me with a copy of Keynes's General Theory--because back,
when I used to teach a big finance class like this, the last class always involved reading from Keynes. And I
think Keynes is one of the best authors about investing and financial markets, bar none. I remember one of
my students telling me afterwards, that I was reading from Keynes as if I were reading from the Bible. And
I had this paperback copy that was falling apart, and my former students remembered this and they gave me
this beautiful first edition of Keynes. And I was on the train back from New York, where the party had
occurred, to New Haven and I found this quote. "The idea of wholesale shifts is, for various reasons,
impracticable and indeed undesirable. Most of those who attempt to, sell too late and buy too late and do
both too often, incurring heavy expenses"--there's that negative-sum game thing--"and developing too
unsettled and speculative a state of mind." And as, in most things, the data support Keynes's conclusions.
Morningstar did a study of all of the mutual funds in the U.S. domestic equity market, and there were 17
categories of funds. And what they did with this study is, they looked at 10 years of returns and compared
dollar-weighted returns to time-weighted returns. The time-weighted returns are simply the returns that are
generated year in and year out. If you get an offering memorandum or a prospectus, they'll show you the
time-weighted return. If you look at the advertisements, where Fidelity is touting its latest, greatest funds,
the returns that you see are time-weighted returns. Dollar-weighted returns take into account cash flow,
right? So, in a dollar-weighted return, if investors put more money into the fund in a particular year, that
year's return will have a greater weight in the calculation. So, here we have all the mutual funds in the U.S.,
17 categories, time-weighted versus dollar-weighted. In every one of those categories, the dollar-weighted
returns were less than the time-weighted returns. What does that mean? That means that investors
systematically made perverse decisions, as to when to invest and when to disinvest from mutual funds.
What investors were doing, they were buying in after a fund had showed strong relative performance and
selling after a fund had shown poor relative performance. So, they were systematically buying high and
selling low, and it doesn't matter whether you do that with great enthusiasm and in great volume, it's a
really, really bad way to make money. Very difficult. So, the conclusion for these individuals that operate
in the mutual fund market, is that their market timing decisions were systematically perverse. I also took a
look at the top 10 Internet funds during the tech bubble, something I published in my book for individual
investors.
And if you looked at the top 10 Internet funds three years before and three years after the bubble, the time
weighted return was 1.5% per year. You look at that and you say, 1.5% per year, well, the market went way
up and way down, but 1.5% per year, that's not so bad. No harm, no foul. Investors invested $13.7 billion
and lost $9.9 billion, so they lost 72% of what they invested. How could it be that they lost 72% of the
money that they invested, when the time-weighted return was 1.5% per year for six years? Well, they
weren't invested in the Internet funds in '97, and they weren't invested in '98, and they weren't invested in
early '99. It was in late '99 and early 2000, that all the money piled in at the very top. And then, in 2001 and
2002, bitterly disappointed, they sold. So, they lost 72% of what they put in, even though the time-weighted
returns were 1.5% per year positive.
So, institutions don't get a free pass either. If you look at the crash in October, 1987, which was an
extraordinary event--I think, the calculation I did put it at a 25 standard deviation, which is essentially an
impossibility. But however you measure it, it was an extraordinary event. And what happened on October
19
th
, 1987? Well, stock markets the world around went down by more than 20%. What people forget is,
along with the stock markets going down, there was a huge rally in government bonds, flight to safety. So,
stocks were cheaper, bonds were more expensive. What did institutional investors do? Well, they got
scared, and they sold stocks and bought bonds. Same thing, buying high, selling low. As a matter of fact,
endowments took six years to get their post-crash equity allocations back up to where they were before the
crash, arguably underweighted in equities in the heart of one of the greatest bull markets of all time. So, it
seems that investors, whether they're individual or institutional, have this perverse predilection to chasing
performance. Buying something after it's gone up, selling something after it's gone down, and using market
timing to damage portfolio returns.
Chapter 4. Security Selection [00:37:19]
The final tool that we have available to us as investors is security selection. I cite a study in my book,
''Unconventional Success,'' conducted by Rob Arnott, that does a very good job of looking at 20 years
worth of mutual fund returns. And he says that there's about a 14% chance that--or historically there was a
14% chance--of beating the market after adjusting for fees and taxes. So, youd think a zero-sum game
would be a coin flip, 50-50. But because of the leakages from the system, and because of taxes, the
probability of winning goes down to 14%. But oh by the way, that 14% ignores two very important things.
One is that a huge percentage of mutual funds have front-end loads. If you call your friendly broker to buy
a mutual fund, they'll extract a payment of 2% or 3% or 4% or 5% or 6%. Those numbers aren't included,
so, if you included the loads, that would make the likelihood of winning substantially less than 14%. But
even more important is the concept of survivorship bias. If you look at 20 years worth of returns, the only
returns you can look at are the returns of the funds that survived for 20 years. Well, which funds didn't
survive? Almost always, the funds that don't survive are the failures. So, you're only looking at the winners.
If you look at the winners and you only have a 14% chance, if you take into account the losers, that 14%
chance has to go to, essentially, zero.
And is survivorship bias an important phenomenon? It is. The Center for Research in Securities Prices has
a survivorship bias-free U.S. mutual fund database, meaning that it tracks the funds that fail. There were
30,361 funds in the database. 19,129 were living. 11,232 were dead. So, more than a third of the funds in
this survivorship bias-free database were ones that had died. And they died mostly, because they failed.
And that's kind of an honorable way to die. There are other ways to die. If you're a big mutual fund
complex like Fidelity and you've got an underperforming fund, what you tend to do is something like, oh,
let's merge that into this fund that has good performance. And guess what happens? Fidelity loses a fund
that has bad performance, and one that has good performance has more assets, because they merge the
underperforming fund into it, and makes them look like they're a more successful fund management firm.
There's one other aspect of security selection that's important, an aspect other than the fact that it's a
negative-sum game [that's] very tough for practitioners to win. And that has to do with the degree of
opportunity that you've got in various asset classes. A number of years ago, I wanted to come up with a
way of identifying, in an analytical manner, where it is that we could find the most attractive investment
opportunities. And, as far as I know, financial economists haven't determined a way to directly measure,
how efficient individual markets are. So, I took a look at distributions of returns for various asset classes.
And I had this notion that, if a market priced assets efficiently, the distribution of returns around the market
return would be very tight. Why would that be? Well, if somebody makes a big bet in an efficient market,
by definition, whether that succeeds or fails has to do with more luck than sense. Right? Because the
premise is, that these assets are efficiently priced, and you don't make a big win on a big bet, unless there's
an inefficiency that you're exploiting.
So, if you're making big bets in an efficiently priced market, you might win one year and gather more
assets, and you might win another year and gather more assets, but, ultimately, your luck is going to run out
and you're going to fail. And then, people will fire you, and you'll lose your assets, and lose your income
stream. So, the right thing to do in an efficiently priced market is to hug the benchmark. People call it
Closet Indexing, look like everybody else. And we're human beings, we don't like firing people and we
don't like admitting we're wrong. And so, if somebody has market-like performance, and maybe it's not all
that outstanding, say, OK fine, we'll just continue with this particular investment strategy, even though it's
not doing great things, at least it's not doing terrible things. On the other end of the spectrum, maybe there's
not even a market that you can match with your investment strategy. I mean, think about venture capital. I
mean, how is it that you could index venture capital? You can't, it's a bunch of private partnerships and a
bunch of idiosyncratic enterprises. And, even if you wanted to, you couldn't match the market. So, you're
forced to go out and forge your own path, and live and die by the decisions that you make.
So, how does this thought piece translate into real numbers? So again, we're looking at 10 years worth of
returns for various asset classes. I look at the difference between the top quartile manager and the bottom
quartile--the difference between first and third [correction: fourth] quartile, you can use any measure of
distribution that you want. And in the bond market, which is probably the most efficiently priced of all
markets--and the reason it's most efficiently priced is, because bonds are just math, right? You've got
coupons, you've got principal, you've got probabilities of default, it's the most easily analyzed of all the
assets in which we invest.
The difference between top quartile and bottom quartile is 0.50% per annum. Almost nothing. All bond
managers are jammed together right in the heart of the distribution, because if they were out there making
crazy bets and generating returns that were fundamentally different from the market, they'd be in that
category of, yes, sure, it's great, when it works, but when it doesn't, you're dead. Large cap stocks, less
efficiently priced than bonds, but still pretty efficiently priced, two percentage points per annum difference
first to third [correction: fourth] quartile over 10 years. Foreign stocks, less efficiently priced than those in
the domestic markets, four points per year. Then you move into the hedge fund world, the part of the hedge
fund world that we call absolute return at Yale, 7.1 percentage points, first to third [correction: fourth]
quartile. Real estate, much less efficiently priced than marketable securities, 9.3 percentage points, top to
bottom quartile. Leveraged buyouts, 13.7% difference, top quartile to bottom quartile. And the venture
capital, 43.2 percentage points difference, top to bottom quartile.
So, the measure that we have here of market inefficiency points us toward spending our time and energy
trying to find the best venture capital managers, trying to find the best leveraged buyout managers, and
spending far less of our time and energy trying to beat the bond market or beat the stock market. Because,
even if you win there, even if you end up in the top quartile, you're not adding an enormous amount of
value relative to what you would have had, if you just would have bought the market.
Chapter 5. Barron's Criticism Revisited [00:46:05]
So, with that background, let's revisit the criticisms that Barron's leveled at the Yale Model and the
Swensen Approach. First of all, they talk about diversification failing. And the fact is that, in a panic, only
two things matter: risk and safety. And I saw this in 1987, saw it in 1998 with the collapse of Long Term
Capital, and saw it in 2008 in a way that was even more profound than in '87 and '98. Investors sold
everything that had risk associated with it to buy U.S. Treasuries. Safety was all that mattered. And of
course, in that narrow window of time, diversification does fail. The only diversification that would matter
in that instance is owning U.S. Treasuries. But if you owned a substantial amount of U.S. Treasury bonds--
and what's a substantial amount? 25, 30, 35% of your portfolio. Then, under normal circumstances, under
the circumstances in which we live most of our lives, you're paying a huge opportunity cost.
So, you could have a portfolio with 30% in U.S. Treasuries, and year in and year out you would pay this
opportunity cost. And then, when the crisis comes, you can be happy for six or 12 or 18 months, and then
you go back to paying the opportunity cost. And I would argue that, if you expand your time horizon to a
sensible length of time, that the strategy, where you hold relatively little in the high opportunity cost U.S.
Treasuries, is the best strategy for a long-term investor. And there are those, who say that, well,
diversification doesn't protect you in times of crisis. What does it matter? Why would you want to
diversify?
Well, think about Japan. If you were local a Japanese investor and you wanted to have an equity bias in
your portfolio--so, you owned lots of Japanese stocks--in 1989, at the end of the year, the Nikkei closed at
about 38,000. At the end of 2009, 20 years later, the Nikkei closed at 10,500. So, with your long time
horizon and equity bias in your portfolio over two decades, you would have lost 73%. So, diversification
makes an enormous amount of sense in the long run, even if there are occasional panics, where you're
disappointed that the diversified approach that you had to managing the portfolio didn't produce results.
The second criticism, overemphasis on alternatives. Let's just look at the last decade in Yale's portfolio.
Over the 10 years ended June 30, 2010, domestic equities produced returns of negative 0.7% per year,
bonds produced returns of 5.9% per year. Let's look at the alternatives, as opposed to domestic marketable
securities. Private equity, 6.2% per year, real estate, 6.9% per year, absolute return, 11.1% per year, timber,
12.1% per year, and oil and gas, 24.7% per year. I think the numbers speak for themselves.
If you have a sensibly long time horizon, these basic principles of equity orientation and diversification
make an enormous amount of sense. And if you look at the bottom line, which is performance, when I
began managing Yale's endowment in 1985, it was less than $1 billion. The amount that we distributed to
support Yale's operations that year was $45 million dollars. For the year ended June 30, 2010, the
endowment stood at a little bit above $16 billion dollars. The amount that we distributed to Yale's
operations was $1.1 billion.
So, an enormous positive change over 25 years. If you look at Yale's performance over the last 10 years, it's
still better than that of any other institutional investor, 8.9% per annum. And that compares to an average
for colleges and universities of about 4.0% per annum. And that translates into $7.9 billion of added value,
relative to where we would have been had we had average returns over the past 10 years. And the
comparable numbers for 20 years are Yale at 13.1% per annum, again, the best record of any institutional
investor in the United States. Relative to an average for colleges and universities of 8.8% per annum, and
$12.1 billion of value added. So, the slings and arrows of outrageous fortune. I would suggest that the
Barron's articles really took far too short a time horizon. And looking at Yale's performance and then
looking at the Yale Model, which emphasizes a portfolio that's well diversified and has a strong equity bias.
And I think if we were back in this room five years or 10 years from now, we'll see that the portfolio will
continue to produce the same kind of strong long-run results as it has for the past 10 and 20 years.
With that, I'd love to answer any questions that you might have.
Chapter 6. Questions & Answers [00:53:01]
Student: How is your job similar or different to what a hedge fund manager would do? And what are the
concerns that an institutional investor has to have, versus a personal investor, a wealthy individual?
Professor David Swensen: So, the fundamental difference between what we would be doing at Yale, as
opposed to a hedge fund manager, or a domestic stock manager, or a buyout manager, is that we're
essentially one step removed from the security selection process. So, our job is to find the best hedge fund
managers, find the best domestic equity managers, find the best buyout managers, and put together
partnerships that work for them and work for the university.
And it's a tricky thing to do, because, in the funds management world, there are all sorts of issues with
respect to what economists call the principal-agent problem. And we're principals for the university,
engaging agents, the hedge fund managers or the buyout managers, and trying to find ways to get those
agents to act primarily in the university's interests, to get rid of those agency issues. And it's a challenge,
but a fascinating challenge, because in doing this, you end up meeting an enormous number of incredibly
intelligent, engaged, thoughtful individuals that are involved in the funds management business. And it's a
fabulous career, at least from my perspective, because I get to do this and do it to benefit one of the world's
great institutions, Yale.
In terms of differences between individuals and institutions, there's some structural differences. We don't
pay taxes. And taxes are an enormously important determinant of investment outcomes for individuals. As
an individual, you want to avoid paying taxes or defer paying taxes, because taxes are just a huge drag on
investment returns. We don't have to worry about that, by and large, in managing Yale's portfolio.
Another very fundamental difference has to do with the resources that we can bring to the investment
management problem. Most individuals, and many institutions, just don't have the wherewithal, either the
background or the time, to make high-quality active management decisions. Markets are incredibly tough.
Beating those markets is an incredibly difficult challenge. And doing it, by spending a couple of hours on a
weekend once a month, isn't going to cut it. And so at Yale, we've got 20, 21, 22 investment professionals,
who are dedicating their careers to trying to make these high quality active management decisions, and so
we can go out and have a decent shot at beating the domestic stock market and the foreign stock market,
and putting together a superior portfolio of venture capital partnerships and hedge fund managers. And over
the past five, 10, 15, 20 years, we've produced market-beating results.
In contrast, an individual has almost no chance of beating the market. So I've written two books, one,
Pioneering Portfolio Management that talks about how it is that, I think, institutions should manage their
portfolio. And if they've got the resources--and it's not just dollars, it's the human resources--to make those
high quality decisions. They can follow what Barron's referred to as the Yale Model or the Swensen
Approach.
But the book that I've written ostensibly for individuals, but it's really individuals and institutions that don't
have the same resources that Yale does to make these high quality active decisions. That book says,
basically, what you should do, is come up with a sensible asset allocation policy, and, then, implement it
using index funds, which are low-cost ways of mimicking the market. And oh, by the way, because they
have very low turnover, generate very little in terms of tax consequences for the holders of those funds.
So, it's kind of an interesting world, where the right solution, I think, is either one extreme or the other
extreme. You're either completely passive or you're aggressively active. But as in most things, most people
are kind of in the middle, right? They're neither aggressively active nor completely passive, but in the
middle you lose. Because you end up paying high fees for mediocre active results, and that's where most
people end up, and most institutions.
Student: Hi, so, my question is about--given you were talking about your equity orientation and bias, and
given what's going on right now with the stock market, just what your views are. Whether or not the stock
market is currently expensive, and whether or not you have any money in tech stocks, with all the
valuations and IPOs that have been going in that space. What do you think about that? And also, what
would you do in terms of investing it in response to what your view is? Thank you.
Professor David Swensen: So, one of the great things about having a diversified portfolio is that you can
worry less about the relative level of valuation of various assets in which you invest. So, if you go back to
the mid-'80s and you've got a portfolio that's 50% in domestic stocks, you have to worry a lot about the
valuation of that portfolio, because half of your assets are in that single asset class. But if you've got a well-
diversified portfolio with, let's say, minimum allocation of 5 to 10%, and now a maximum allocation of 25
to 30% in an individual asset class, the relative valuation of each of those asset classes matters less.
And there's another nice aspect to a rebalancing policy. If you set up your targets and you faithfully adhere
to those targets--suppose, the domestic equities have poor relative performance. Well, then you're going to
buy domestic equities to get them back up to target, selling whatever it is that had superior relative
performance to fund those purchases. And vice versa. If domestic equities have great relative performance,
you'll be selling to get back to your long-term target and buying other assets that have shown poor relative
performance. So, if you're in a circumstance, where domestic stocks are expensive, where you're selling
into this superior relative performance that the domestic equities are exhibiting, thereby maintaining your
risk exposure at a level that's consistent with what's implicit in your policy asset allocation.
So, that's kind of a long way of saying, that, if somebody asked me whether stocks are expensive or cheap,
my first line of defense, it doesn't really matter all that much to me, because we're well-diversified and
because we do a great job of rebalancing. But the reality is that those questions are just incredibly tough to
answer. If they were easier to answer, I guess I'd be much more excited about market timing as a way to
generate returns.
In terms of the second question, with respect to technology, Yale's had a long-standing commitment to
venture capital. And over the decades, it's produced extraordinary returns for the university. And we
continue to have a world-class group of venture capitalists. We've got exposure to companies like LinkedIn
and Facebook and Groupon. And I hope that this wave of IPOs that people are writing about in the press
actually occurs, because that would be very good for the university's portfolio. It's been a long time, right?
We benefited enormously in the Internet bubble in the late 90s, and the last decade has been a bit fallow.
We also find, on the marketable securities side, that technology stocks tend to be less efficiently priced than
many other securities. And so, we have a manager that is heavily focused on information technology stocks
and another manager that's very heavily focused on biotechnology stocks. And both those managers have
produced very handsome absolute and relative returns. And that's an important part of our domestic equity
strategy.
Student: Thanks for coming. So, in recent years, the number of hedge funds, private equity firms, has gone
up. And I wasn't sure, how that's changed the efficiencies of these alternative asset allocation markets. And
if it's changed the efficiencies, how have you changed your investment philosophies? And I was wondering,
also, what are the structural patterns of these markets that would prevent the market from becoming very
efficient, even if there are a lot hedge funds and a lot of funds of funds. Thanks.
Professor David Swensen: That's a really good question. I think, the most fundamental issue with the
explosion of hedge funds and the explosion of private equity funds has to do with this negative-sum game
that we were talking about. If you go back to the 1950s, the most common way that institutional assets were
managed would be for an institution like Yale to go to a bank like Chemical Bank or JP Morgan. And they
would pay a small fraction of 1% for a reasonably diversified portfolio, stocks, bonds, and there'd probably
be some foreign stocks, and some domestic stocks. But the leakage from the system was very small. You
look at hedge funds and private equity funds, they're essentially dealing with the same set of securities that
an institution used to pay two-tenths of a percent a year, or three-tenths of a percent a year for admittedly
sleepy bank management.
But it's the same set of securities. Now, those securities are traded in a hedge fund format, or taken in a
private equity fund format. And the fees that youre paying are a point, a point and a half, two points. The
typical ''two and 20.'' And you're paying a significant percentage of the profits. The 20 in the ''two and 20.''
Think about that. The leakage from the system that goes to Wall Street is enormous, compared to what it
was 10 years ago, or 20 years ago, or 30 years ago. So, there's that much less left for us as investors. And I
think that has huge consequences for endowments, foundations, pension plans, institutions of all stripes.
And to the extent that individuals get exposure to these types of assets--and they're largely wealthy
individuals that end up getting the exposure--they're going to suffer the same consequences of this huge
leakage of higher fees and the profits interest to Wall Street.
The question as to whether or not the money flowing to hedge funds is going to make markets more
efficient and take away opportunities--I don't worry too much about that. I think, the best talent is going to
hedge funds, because if they're in a long only domestic equity environment, maybe they can charge three-
quarters of a percent or a percent, or if they're in the mutual fund world, maybe they charge a percent and a
half, or something like that. Well, you'd rather have ''two and 20'' than 0.75, right? That's easy. So, there's a
huge migration of talent to the hedge fund world. But, what I care about, when I look at the degree of
investment opportunities, is this dispersion we talked about, and I haven't seen the dispersion of results, top
quartile to bottom quartile, compress at all. So, I don't think, that we're increasing the efficiency of the
pricing of assets. I still need to go out there and be able to identify people in the top quartile or top decile,
so that we can win relative to the markets, after adjustment for the risks that we take. So, as long as we
have plenty of dispersion in the results, it's still an interesting activity for us to pursue.
Student: Can I ask?
Professor David Swensen: It better be good, it's the last question.
Student: I'll try. So, my question is about performance of the Yale portfolio, and we heard that it grew
from less than $1 billion--but close to it, apparently--in 1985, to $16 billion, which is very impressive. And
it's documented in newspapers, it's online, Wikipedia, Professor Shiller introduced you with these facts. But
what about the Sharpe ratio? And why do you think that people talk more about total returns than, say, the
Sharpe ratio?
Professor David Swensen: So, I think that one of the things that needs to happen in the funds management
world is, that we need to have better measures of risk. And so, one of the reasons, why I don't talk about the
Sharpe ratio, is, that just looking at standard deviation of returns doesn't capture risk in a way that is
meaningful. I mean, I've seen other people do an analysis of the Yale portfolio, and show relative Sharpe
ratios. And, obviously, because our returns have been so good, if you just look at the pattern of those
returns, we end up scoring high when looking at Sharpe ratios across different institutional portfolios.
But the risks that exist in the portfolio aren't really captured by the standard deviation of the returns. Just a
quick example: If you look at real estate, or timber, or even any of our illiquid assets, they're appraised
relatively infrequently. There tends to be a huge stability bias in the appraisals. If somebody looks at a
piece of real estate 12 months ago, six months ago, and today, they're likely to see pretty much the same
thing that they saw over that period. You can compare and contrast that to the volatility they've got in the
stock market. I think Bob Shiller deserves credit for coining the term "excess volatility." There's no
question that stock prices are way more variable than they need to be to adjust for changes in the
underlying fundamentals.
So, if you've got a portfolio that's largely marketable securities, you're going to see a lot more standard
deviation of returns than if you've got one of illiquid assets, where you've got this stability built-in because
of the appraisal nature of the valuation process. And if you end up comparing those two portfolios, one
dominated by marketable securities, one dominated by private assets, you're going to end up with measures
that are apples and oranges. Thank you very much.
[APPLAUSE]
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 7 - Efficient Markets [February 7, 2011]
Chapter 1. Swensen's Lecture in Retrospect and Manipulations of the Sharpe Ratio [00:00:00]
Professor Robert Shiller: And I want to talk today about efficient markets, which is a theory that is a half-
truth, I will say. Before I start, I wanted to just give a few thoughts about David Swensen's lecture last
period. Let me say, first of all, the Efficient Markets Hypothesis or the Efficient Markets Theory is a theory
that markets efficiently incorporate all public information. And that, therefore, you cannot beat the market,
because the market has all the information in it. You think you're smarter than the market, that you know
something? No, the market knows more than you do. And you'll find out that the market wins every time.
That's the Efficient Markets Hypothesis. So, it's a very far-reaching hypothesis. It means that, don't even try
to beat the market. That was a very rudimentary introduction to today's lecture.
But here I brought in David Swensen, who is claimed to have beaten the market consistently since 1985,
and dramatically. And so, what do we make of that? That's the subject of today's lecture. By the way, after
class one of you came up--thank you, it was nice, I don't know where you are--one of you came up and
thanked Swensen for his scholarship at Yale. Yale now has need-blind admissions for the world. And so
people, not just from the United States, people are helped out, so that people who have managed to meet
the high admission standards here, makes it possible for them to actually come here. And that's
substantially David Swensen who did that, because it's not just the generosity of the university. They have
to have the money to do it. And so, somehow he seems to have made it.
Now, I know that there are still many cynics--the Efficient Markets Hypothesis has a lot of adherents still.
And as I say, it's a half-truth. So, some people will say, well, Swensen was just lucky. And I say, how could
he have been lucky for 25 years in a row? Well, not every single year, but pretty much. And they say, well,
you're picking the one guy out of millions who is just the luckiest. So, those arguments are made. Anyway,
one of you asked a question, which I thought it was very good, at the end. And that is why, in all of my
discussion about Swensen and all of his talk he never mentioned the Sharpe ratio? Because as we said, the
Sharpe ratio corrects for risk taking. That was one of our fundamental lessons. When we showed you the
Efficient Portfolio Frontier, and the tangency line. You can get any expected return you want at the expense
of higher uncertainty. You do a very risky portfolio, and you have high-expected return, because of the risk.
If the risk is measured right.
But I think that's a good very good question. I caught myself not correcting for it, I just said Yale's portfolio
had a high return. I didn't correct for standard deviation of return. So, David Swensen, in his answer, as you
recall, essentially said he doesn't believe in Sharpe ratios, because we can't measure the standard deviation.
The Sharpe ratio is the excess return of a portfolio over the market, divided by the standard deviation of the
return. And that scales it down, so if the excess return is very high but also has a very high standard
deviation, that shows they were just taking risks. And so the Sharpe ratio would reveal that. But Swensen
said, I don't think that you can measure the standard deviation of return. Isn't that what is answer was? You
were here. I may not be quoting him exactly right.
So, why wouldn't you be able to measure the standard deviation of returns? He gave a reason, which was
that, well, when you're looking at a broad portfolio like Yale's, a lot of the things in there are private equity-
-that means privately held, so it's not traded on stock exchanges. Or it's real estate. Real estate is only
traded every 10 years or 20 years, and so who knows what it's worth? All you have is an appraisal, but
that's just some appraiser's estimate, so the standard deviation would be artificially low. He's right about
that, but I think there's even more to that. I know there's more to this. There's a literature on this.
The point that I wanted to make is that you can do a--suppose you're managing money. And suppose the
world out there is evaluating you by your Sharpe ratio. And suppose you have no ethics. You just want
money. This isn't so obviously criminal, this is not criminal I suppose. So, you say, I just want to have the
best Sharpe ratio for a number of years running. I'll get more and more people that will put money in my
investment fund, and eventually I don't care what happens. I'll move to Brazil or something. Some foreign--
pick out one. I want to get out of here with the money. So, all I have to do is fool people into thinking I
have a high Sharpe ratio for a while. So, what do I do? Well, there's an interesting paper on this by--there's
a lot of papers on this, but I'm going to cite one--by Professor Goetzmann and co-authors, here at Yale. It's
actually Goetzmann, Ibbotson, Spiegel, and Welch. Maybe I'll put all their names on. Roger Ibbotson is a
professor here, Matt Spiegel, and Ivo Welch.
What they did is they calculated the optimal strategy for someone who wants to play games with a Sharpe
ratio. So, you want to fool investors and get a spuriously high Sharpe ratio. And they found out what the
optimal strategy is. And that is to sell off the tails of your distribution of returns. So, if your return
distribution looks like this--this is return, OK? And you have a probability distribution; say a bell-shaped
curve, OK? And so the mean and standard deviation of this would be the inputs to the Sharpe ratio. But if
you're cynical and you want to play tricks, what you can do is sell the upper tail. These are very unlikely
good events. Sell them and get money now, and then double up on the lower tail. So, you push the lower
tail to something like that, and you wipe out the upper tail, so it goes like that, all right? So, that means
you'll get money, because you sold the upper tail. You would do that by selling calls--we haven't talked
about options yet--but you can do it by selling out-of-the-money calls. And you would do this by writing
out-of-the-money puts.
OK, but what you do it you make it, so that if there's really a bad year, it's going to be a doozer bad year for
your investors. And if there's ever a good year, then, hey, you won't get it. But these good or bad years
occur only infrequently. So, in the meantime, you're making profits from these sales and you have a high
Sharpe ratio. But little do they know that you sold off the tails. And so, nothing happens for many years and
you just look like the best guy there. So, it turns out that this is not just academic. There was a company
called Integral Investment Management that did something like this strategy. It was a hedge fund. So, it
was Integral Investment Management. It did something like this, by trading in options. And, it got lots of
investors to put millions in them.
Notably, the Art Institute of Chicago put $43 million into this fund and its associated funds. And then, in
2001, when the market dropped a lot, Art Institute of Chicago was wiped out. They lost almost all of their
$43 million. And so, they got really angry, and they sued this company. Because they said, you didn't tell
us. What have you been doing? And then, the company pointed out, in its defense, that it actually said
somewhere in the fine print, that if markets go down more than 30%, there would be a problem. And
somehow, nobody at the Art Institute read that or figured it out. They thought the guy was a genius,
because this company had the highest Sharpe ratio in the industry, all right? You see what they're doing?
They're playing tricks. They're making it look like there's less risk than there really is. And there's a
strategy to do that.
It didn't end well for Integral Investment Management, because the Art Institute of Chicago managed to
stick them on other things--they disclosed it. They told people that they were doing this strategy. The artists
didn't figure it out. But there were other dishonesties that they nailed these guys on.
What Goetzmann and his co-authors did is, they showed that you can play tricks with the--you can play a
lot of tricks in finance. But one of them is to play a trick with the Sharpe ratio. But their trick was very
explicit. It involved particular portfolio composition involving options, and any professional would
immediately know that that's a trick. And it didn't work for these guys; they were too aggressive in their
manipulation. But you can do subtler things as a portfolio manager to get your Sharpe ratio up. Instead of
manipulating with special derivatives positions, you could just buy companies that have large left tails.
They have a small probability of massive losses, right? And you haven't done anything but pick a stock.
And nobody knows whether it really has a small probability of massive losses, and you could
systematically invest in that. And then you'd have a high Sharpe ratio for a while, and then you'd just blow
up and lose everything eventually.
I was thinking of an example from recent news. What about the strategy of investing in Egyptian
companies that are tied to Mubarak? It might have looked very good for a long time, right? But the
companies might have been underpriced, because people sensed there's some instability in Egypt. And look
how fast it came on, right? I don't know what the outcome will be at this point, but it just happened--bang.
That's a tail event, right? You might look at Egyptian securities and think everything is stable and fine, it's
been 30 years, nothing has happened. But someone knows or suspects that there's something maybe
unstable. And you, as an investor, wouldn't know that by looking at the numbers.
What I'm getting at is really what is the essence of Swensen's skill or contribution? It's not his ability to
manipulate Sharpe ratios or numbers like that. I think what it has, to me, in my mind, is something to do
with character and his real self and his real objectives. And this gets at what people in finance are really
doing. I think that when you take a finance course in a university, you may not get a proper appreciation of
how one, in a career in finance, develops a reputation for integrity. Nobody can really judge what you're
doing as an investor, because they can't judge it from the statistics. Even though we've developed this nice
theory about Sharpe ratios and the like, you end up judging the person and what the person's real objectives
are. I'll probably come back to that theme again.
Let me also say that's about doing the Goetzmann--you understand the strategy? It's like investing in
securities with time bombs in them. They're going to go off eventually, you don't know exactly when. And
they look good for a while, but they'll blow up. What does the law say about this? Well, the law in the
United States and other countries emphasizes that an investment manager must not fail to disclose relevant
information about a security. And it has to be more than boilerplate disclosure. For, say Integral Investment
Management, you could write up a prospectus and then say, but of course past returns are not a guide to the
future and something could go wrong. That's a boilerplate disclosure, because people think, well, that's
what everybody says. The law says that you have to actually actively disclose. If there's something that's
relevant that would make your statistics misleading, you have to get their attention and explain it to them.
That's the law. So, I think it's laws like that, and it's the development of--it's not something that we
specialize in academia. Well, we are, we're trying to develop character I suppose. But it's not just Sharpe
ratios. And, I think that tendencies to rely on numbers like this has led to errors in the past.
Chapter 2. History of the Efficient Markets Hypothesis [00:16:06]
So, let me go more directly into today's lecture. It's about the Efficient Markets Hypothesis, which is, to
me, a fascinating theory, which is not completely true, which makes it all the more interesting. The first
statement that I could find--I'm interested in the history of thought--so, the first statement of the Efficient
Markets Hypothesis that I could find was in a book by George --
[SIDE CONVERSATION]
Professor Robert Shiller: George Gibson, who wrote a book in 1889 called The Stock Exchanges of
London, Paris, and New York. And, he wrote, I'm quoting George Gibson, 1889: "When shares become
publicly known in an open market, the value, which they acquire there, may be regarded as the judgment of
the best intelligence concerning them."
He described the stock market as a kind of voting machine where people vote. If you think a share is worth
more, you vote by buying it. If you think it's worth less in the market, you sell it. And everybody in the
world can do that. It's open to the public. So, the smartest people get into it, and then they soon make a lot
of money doing it, so they have a lot of votes. So, the smarter people have more votes. And you've got
everyone there. If anyone has a special clue, they go right in and they buy if it's positive, or they sell if it's
negative. So, the smartest people go right in there and aggressively affect the value. Until it's right, and then
there's no there's no incentive to buy or sell.
The other thing about Gibson--I should have copied the quote, but as I remember from the book, he says
something ''in our modern electric age, information flows with the speed of light.'' I say, what is he talking
about in 1889? Well, you know what he's talking about. The telegraph. And, in fact, they had ticker
machines. They were electronic printers that would print out stock quotes. So, they were really in the
information age by 1889. So, this is what happened, Gibson said, you can't beat the market. It's just smarter
because--it's like Wikipedia is smarter than any one of us, right? Because it puts together all the thinking of
all the people. Well, they had Wikipedia of a sort, because they had the stock market. They had the price.
So, that is the statement that--he didn't use the word ''Efficient Markets.'' Actually, tried to find the origin of
"Efficient Markets." Sometimes in the 19th century, people would say ''Efficient Markets.'' But it wasn't a
clich yet; it wasn't a phrase that would be recognizable. Even in this context, they would use it. But it was
not a name for a theory yet.
The next Efficient Markets theorist--and I put this on your reading list--Charles Conant, who wrote a 1904
book called Wall Street and the Country. I put one chapter on that on the reading list, because it was a
statement of the Efficient Markets Hypothesis, which was remarkably well written, I thought. He starts out
the chapter by pointing out that a lot of people think speculation is a kind of gambling, or a kind of evil.
Speculating on the stock market, that sounds like some wild activity that ought to be ruled out. Then he
said, how can that possibly be true? The stock market is a central institution of all modern economies. To
think that it's just gambling just defies common sense. But then, he goes on and describes what it is that it
does. And there's some really nice passages in Conant's book. In one passage he says, suppose for a
moment that stock markets of the world were closed, what would happen? And he said, no one would know
what anything is worth; no one could make any calculated decisions. He said that, in fact, capital moves
around from one industry to another in respect of the prices that are quoted in these markets. And if you
didn't see the prices, you would be blind.
It's often said about the Soviet economy--which did not have stock markets or financial markets--that they
relied on prices in the rest of the world. Nobody in the Soviet Union could plan very well, because they
didn't know what anything was worth. But at least they had the rest of the world, and they thought, well
that's an approximation to what prices ought to be in the Soviet Union. So they were really relying on these.
I just wanted to reiterate a little bit about the intuition of Efficient Markets. The idea is that if you trade
securities, the advantage to being there a little bit ahead of anyone else is enormous. If you know five
minutes before the other investors about some good news or bad news, either way it doesn't matter--you
know it five minutes earlier, you jump right in and trade. You trade ahead of them and prices haven't
changed yet, you make money. So, that has created an industry that speeds information.
The first such industry that I would tell you about is Reuters. Mr. Reuters, I think in the 1840s before the
telegraph, created a financial information service using carrier pigeons. You know, these are birds. And so,
when he was in London with some information, they had carrier pigeons that were brought from Paris, and
as soon as new information came out, they would tie it to the foot of the little bird and they'd let it go, and it
would fly to Paris. It would go to its roosting place, the message would be read, and subscribers would be
notified. And that was no joke, that really worked, because you would have information hours or even days
before everyone else in Paris. So, you could make a killing. So, Reuters today, it's now called Thomson
Reuters, is still in that business. The carrier pigeons were a brilliant idea. But they had to keep up with the
times, because, shortly thereafter, telegraph was invented and pigeons no longer were the leading
technology. But maybe that was the beginning of the information age, with pigeons.
Now we have beepers, and we have the Internet. A beeper is something you can carry in your pocket that
beeps when there's financial news. So, suppose a company makes an announcement that that it has, say, a
new drug that's successful in trials. As soon as they make the announcement, it then goes out electronically
everywhere, and the beepers start beeping. And all the investment analysts, they drop their morning coffee,
because they know they got to act fast. So, you get this new announcement. Now it's t plus 20 seconds. He's
got his drug specialist on the phone, OK? What does this mean? Quick, how much is it going to go up? And
so the guy says, I don't know, first thought, maybe it's going to go up $2 a share. OK, it's only gone up $1 a
share; I'll buy right now. And now it's two minutes after the announcement, and then the analyst says, I've
thought about it a little bit more. No, I only think it's $1.50 a share. This is homing in, and so the price is
jiggling around rapidly as all this is happening for a few minutes, and then it settles down. Because after--I
may be exaggerating--after 10 minutes, theyve kind of gotten it, they've kind of figured it out and it's
reached its new level. They'll be thinking about it the next morning when they're taking their shower, and
they'll get a better and better, more refined idea of what the price is.
But here's the Efficient Markets theme. You, the next day, read about it in the Wall Street Journal in the
morning. You're now 24 hours late, OK? So, you call your broker and say, maybe I should buy this stock,
they've got this new breakthrough. Your broker might laugh at you, right? Because you're 24 hours late.
And what do you know, anyway, about pharmaceuticals? That's where the Efficient Markets Hypothesis is
true. You can't expect to routinely profit from information that's already out there. If you're going to profit,
you've got to come up with something faster, something that you can get faster.
I think this is somewhat what David Swensen was referring to yesterday [correction: last lecture], when he
talked about different asset classes. Remember how he talked about comparing the top quartile and bottom
quartile of investment managers, in terms of returns, or at different asset classes? Well, the managers
weren't able to beat the bond market very much. The top quartile wasn't able to beat the stock market very
much. But when you get to unusual assets, private equity, which is not traded on stock exchanges, or
absolute return investments that he talked about--they're unusual, smaller, rare investments that the public
doesn't have a lot of information about. And these guys can get ahead on those things.
So, part of what makes Swensen a success is picking his game. Even so, the stock market is not completely
efficient, but it's so much more efficient, because it's so many people involved in it and watching it. So,
maybe I should write here, because this is what we're talking about here. The Efficient Markets Hypothesis.
I'll write it down. This is the name for this idea that was coined--or sometimes people say Efficient Markets
Theory. They're referring to what Conant and Gibson and other people had been talking about for a long
time, and it was common knowledge. But the first person to use this term apparently was Harry Roberts, a
professor at the University of Chicago. But he was made famous by Eugene Fama, who referred to it as
Harry Roberts's idea. Eugene Fama is maybe the best-known finance professor in the country, I think. He is
also at the University of Chicago. He's been talked about as a Nobel Prize candidate for a long time, and he
should have won probably, even though his theory is not entirely right. I think his chances of getting it have
dimmed a little bit, because the theory is not looked upon as quite such an absolute truth as it used to be. As
I said, it's a half-truth.
What Conant said is all well taken and right, but there's other nuances and it's not exactly--when you first
read Conant, you think, the guy is brilliant. That's what I thought, this is right on. Then you read it again,
you think, well, you know maybe there is a little gambling in the financial market. Things don't always
work right. So, he was maybe a little bit too positive.
Chapter 3. Testing the Efficient Markets Hypothesis [00:29:10]
I can give a little history of this. It was in 1960. The University of Chicago is kind of the forerunner in this.
In 1960, Ford Foundation gave a grant to the University of Chicago to assemble all stock price data back to
1926. And to get it right, OK? So, they set up the Center for Research in Securities Prices at Chicago. The
Center for Research in Securities Prices, or CRSP, as it's called, had a Ford Foundation grant to go to the
stock exchanges in the United States and get all the data, and get it right.
Remember, I told you they have splits in stocks. So, youll see the price of a share, and then suddenly the
price will fall in half or maybe it will double, because they changed the units of measurement. If you
wanted to know, what is the price history of stocks over the long haul, no one had ever organized that and
figured out things like that, and got it right. And when were the dividends paid? When did you actually get
the dividends? So they said, let's get it right. Let's put it on--hey, this is really super modern--a UNIVAC
tape, OK? That's a computer tape, all right? We'll put it on a tape and we'll sell it at cost to anybody in the
world. And so the Ford Foundation, which is a non-profit, said: Good idea, let's do it. So, that CRSP tape
has launched a revolution in finance, because nobody had the data. They were throwing it away, it was not
used. How do you know what Sharpe ratios are if you don't have the data? I mean, you could find it in
newspapers, but it wasn't organized right, it wasn't set up right.
So, with the invention of the CRSP tape in 1960, it really gave impetus to the Efficient Markets revolution.
And by the end of that decade, there were thousands of articles testing market efficiency using the CRSP
tape. And, in particular in 1969, Eugene Fama wrote one of the most cited articles in the history of finance.
It was called "Efficient Capital Markets: A Review". So, he reviews all of these studies of the CRSP tape.
And it looked authoritative for the first time, because we were using the whole universe of stocks, all the
way back to 1926. That sounded like a long time, and a lot of data. And Fama said it's not uniform, there
are some negative results, but the evidence is that markets are remarkably efficient. And this is a truth that
we've discovered. And that, it was really a bombshell, because he was discrediting, or seeming to discredit,
practically all the investment managers in the country. It was a huge industry. And he's claiming the
successful ones must have just been lucky, because the market is so efficient that we can't see any way that
you could make money in the market.
The high point of the Efficient Markets Hypothesis was probably in the 1970s. I'll call that the high point. It
seemed, at that time, that all of the scholars were finding that there was no way to beat the market. But it
started to deteriorate, the support for the Efficient Markets Hypothesis. There's been a change in thinking.
Efficient Markets is still regarded with respect, but not the same respect that it had in 1969 or in 1979. I
have here some indication of how thinking has changed about Efficient Markets. The textbook that I used
to use for this course--I've been teaching this course for 25 years--Fabozzi et al. wasn't even written when I
started, so I was using a textbook called Brealey & Myers, Principles of Corporate Finance. I still have all
these old editions. It's a very successful textbook. Since I was teaching out of it all those years, I went back
and looked--I don't have the first edition of that book, I have the second edition, 1984--and I was teaching
out of it in this same class in 1984.
At the end of that book, there's a chapter on the seven most important ideas in finance. And one of the ideas
is Efficient Markets. And quoting the textbook, Brealey and Myers say: "Security prices accurately reflect
available information and respond rapidly to new information as soon as it becomes available." They do
qualify it, in 1984. "Don't misunderstand the Efficient Markets idea. It doesn't say there are no taxes or
costs. It doesn't say there aren't some clever people and some stupid ones; it merely implies that
competition in actual capital markets is very tough. There are no money machines and security prices
reflect the true underlying value of assets." OK? Let me repeat that: "Security prices reflect the true
underlying value of assets." OK? That's a pretty strong statement, right? But that's Efficient Markets. They
just said it in their second edition of the book.
Not many people would say that, right? Trust the stock market, don't trust people you know and love and
trust. Trust the stock market. Well, they deleted that from later editions of their book. I think that's a sign of
changes. So, I was looking at the 2008 edition. They've now taken on a third author. They're getting tired of
coming out with more and more editions of their book, so they've taken on Franklin Allen from the
Wharton School. They've deleted what I just read, and now it says--I'm quoting from them: "Much more
research is needed before we have a full understanding of why asset prices sometimes get so out of line
with what appears to be their discounted future payoffs." That's a complete turnaround in the textbook. This
is one of the most popular textbooks, and they've changed completely. So, I think we have an idea that
started around the 1960s. It was somehow associated with computers, and electronic databases, and modern
thinking, and mathematical finance. They kind of went too far with it. They concluded that you just can't
beat the market.
Another thing I put on the reading list is a reading from The New Yorker magazine. It just came out in
December. I thought it was relevant. It's by Jonah Lehrer and the title of the article is "The Truth Wears
Off, subtitle, Is There Something Wrong With the Scientific Method?" I don't know there's anything
wrong with the scientific method, but I was interested in this article, because what The New Yorker article
points out is that a lot of scientists--and this is outside of finance, I'm making a parallel here--a lot of
scientists who follow careful scientific procedures seem to generate results that are later discredited. And
nobody can figure out why. It's like the universe is changing.
He gives an example in The New Yorker article--and this is from drugs--there's a class of drugs called
second-generation antipsychotics. These are used for people who are either schizophrenic or--I guess it can
be used more generally than that--some of the drugs are called Abilify, Seroquel, Zyprexa. When these
drugs were first introduced, careful studies that passed muster in the best medical journals found that they
were highly effective. And they were written up as a godsend, a way of dealing with problems that used to
weigh on people. Wonderful. The medical procedures involved careful controls on studies including a
double blind procedure. When you want to test a drug on human subjects, both the subject doesn't know
whether he or she is getting the drug, and the experimenter, who runs experiment, doesn't know which one
is the drug. So, you give bottle A and bottle B to the experimenter, and the experimenter is never told,
which one is Zyprexa and which one is a placebo. And then the experimenter has to write up a whole report
on drug A and drug B, not even knowing, OK? This is to eliminate any possible bias. So, these drugs
passed that. You see what I'm saying? The controls were right, everything was good.
And as years go by, the tests start coming out--the new attempts to replicate those start coming out more
negative. They didn't disprove the drugs; they just weren't such wonder drugs as they thought. So, how can
that be? And what the article says, well, it must be that somehow scientific bias, when there's an enthusiasm
for some new theory, it creeps in even if you try to make the strongest controls. You say, how could that
happen with a double blind procedure? Well, maybe they broke the double blind somehow. They tried, but
the guy, experimenter, figured it out. And then he started not deliberately fabricating results, but it's the
kind of thing where one subject says, I didn't take my Abilify regularly. I took two tablets last week. I have
to decide whether to throw this person out of the sample, and then I kind of remember that the drug wasn't
working for this person, and it colors my judgment, so I throw them out.
And another thing that happens is that the studies that didn't find it might have been suppressed, right?
Someone might have done an Abilify test and gotten bad results. And then showed it to their superior and
said, should I publish this? And the superior said, wait a minute, there must be something wrong here.
Abilify is wonderful, so let's look. And then they find something that might be wrong, and he says, you
shouldn't publish this, because they find something. So, the publication process is biased for a while, but
eventually it catches up. So, I think the same thing happened with the Efficient Markets Hypothesis. In the
initial enthusiasm, anybody who found that the Efficient Markets Hypothesis wasn't supported by the
evidence, that person would be told, look again. Maybe you've done something wrong. So that's what
happened.
Chapter 4. Technical Analysis and the Head and Shoulders Pattern [00:40:49]
I wanted to do a little bit more history and describe the concept of Random Walk, which is central to the
Efficient Markets Hypothesis. Let me start, though, with a little bit more history. Technical analysis. This
term goes back--must be over 100 years. Technical analysis is the analysis of stock prices, or maybe other
speculative asset prices, by looking at charts of the prices and looking for patterns that suggest movements
in prices. The classic text of technical analysis is Edwards and McGee. McGee, there's a famous story
about him. He was not a professor; he was a Wall Street analyst. And the story about him is that he
believed that you look at the prices and you can predict prices. And in fact, he said, I don't want to look at
anything else. I just want to see prices. I'll do plots, and I can--using my judgment, I can figure out what it's
going to do. And so, the story about McGee is, everyone on Wall Street wants the corner office overlooking
the World Trade Center, whatever. He said, I wanted an interior office with no windows. I don't want any
distractions; I don't want the real world impinging on my judgment. And so, that's McGee.
But he said that there are certain things that you see obviously. For example, resistance level. When the
Dow Jones Industrial Average approached 1,000--I think it was in the 1960s--it's way above that now, as
you know. But when it first approached 1,000, technical analysts said, you know maybe it's going to have
trouble crossing 1,000, because that's a psychological barrier. That's sounds magical, how can the Dow be
worth over 1,000? Wow, I'm going to sell. And so, the idea was that people would sell when it approached
1,000. And the technical analysts seemed to be right, because the Dow bounced around just below 1,000 for
a long time. I guess it was months or a year, like it couldn't cross the resistance level. That's one example.
I have another example, which is from Edwards and McGee's book.
[SIDE CONVERSATION]
Professor Robert Shiller: That's Edwards and McGee; this is one of the patterns. McGee was actually a
student of psychology, and he thought certain kinds of patterns seemed to have really spooked people. And
this is one pattern, which he called ''Head and Shoulders.'' That's the head, that's one shoulder, that's the
other shoulder. He said, when you see this pattern, watch out. It's going to, actually, totally collapse, as it is
shown doing. These are stock prices plotted against time. These are days, each of these points is a day. And
this is from their book, so it's a hypothetical. You hardly ever see such perfect Head and Shoulders patterns.
And so, maybe that's Edwards and McGee's most--Head and Shoulders.
So, the question is, does it work? Does it really work? In the early 1970s, when the Efficient Markets
Hypothesis was really strong, Burton Malkiel, who was a professor at Princeton, and then later he was the
Dean of the Yale School of Management, wrote a book called A Random Walk Down Wall Street, which
claimed that technical analysis was bunk. And he said, many studies have shown that it doesn't work. This
Head and Shoulders doesn't work. None of Edwards and McGee's stuff worked. There were lots of studies,
but I actually met him at a cocktail party after his book came out. And I said, you didn't footnote all those
studies about technical analysis. Where are they? I can't find them. I did a search. Not on the Internet, I did
it on something else, but I was able to search. I couldn't find them, where are they? And I found that he
didn't have an immediate answer.
I suspect that he was extrapolating--there was a literature on testing market efficiency. They looked for
things like momentum, whether that continued. But there was something a little bit wrong with the
literature. Not many people really confronted technical analysis. Later, there were people who did look at
some of Edwards and McGee's points, and they found some element of truth to them. So, I think the answer
is, McGee wasn't a total idiot, as you might infer from the Efficient Markets Theory. But it's not going to
make you rich, either. If anything, technical analysis is a subtle art that can augment trading strategies. I bet
David Swensen doesn't do it at all. I could have asked, I don't know for sure.
Chapter 5. Random Walk vs. First-Order Autoregressive Process as Stock Price Model [00:47:04]
Let me talk about Random Walk, which is a central idea in finance. The idea is that, if stock prices are
really efficient, then any change from day-to-day has to be due only to news. And news is essentially
unforecastable. Therefore, stock prices have to do a Random Walk through time. That means that any
future movement in them is always unpredictable. The changes are totally random. So, the term Random
Walk is an important term. It was coined not by a finance theorist, but by a statistician, Karl Pearson,
writing in the scientific journal Nature in 1905. Now, he didn't link it to finance. But what he said is, the
movements in some--well, he was thinking theoretically. Actually, I believe he used the example of a
drunk. Let's take someone who is so drunk that each step is random. This person has no direction at all,
staggering randomly, OK? So, he starts out at a lamp pole. And what would you predict--this is what
Pearson asked--what would you predict is his position in 10 minutes? He happens to be at a lamp pole right
now. And what Pearson said is, well, your best forecast is that he's right where he is now. Because you
have no bias. He could go in any direction, equally likely. So, what's most likely? It's that he stays right
where he is.
And what is the probability distribution? Well, it turns out that the standard deviation around that point
goes up with $n steps, OK? Because each step is independent of the other, so the square root rule applies.
So, if you're asked to forecast his position after an hour--that's a lot of steps--you would say, I predict he's
right where he is now, but I now have a big standard deviation around it. Pearson's article is a very simple
idea. Among the readers, apparently, was Albert Einstein and then Norbert Wiener, the mathematician who
had invented a continuous version of the Random Walk, called the Wiener Process.
But it got into finance later. And in the Efficient Markets revolution, they started to realize that stock prices
look more like more like a Random Walk than a Head and Shoulders. You look at these Head and
Shoulders patterns and they're hard to find. So, what is a Random Walk? Let me just define it. A Random
Walk is where you have a series


where %
t
is noise. Just unforecastable noise: mean 0 and some standard deviation, OK? Ideally, it would be
normally distributed, so it would have a bell-shaped curve, and then the math would be very easy and very
simple.
So, I want I want to contrast that with an alternative, which is called a ''First-Order Autoregressive.'' Let me
get my notation here. Let's take a process that starts at 100--that's like the lamppost. We'll say



So, this is an AR-1. That's First-Order Autoregressive. It's like a regression model where 100(1-&) is the
constant term. And the coefficient of the lagged x is &. And we usually require that & is between -1 and 1.
Normally, & is positive. So, that means that it's mean reverting, but slowly. First of all, in the special case
where &=1, I wouldn't call it an AR-1 anymore, because it reduces to a Random Walk, right? If you make &
1, then the constant term drops out. I've got 100 minus 100--there's no constant term--and then I've got


that's a Random Walk, right?
So, in the extreme case where & gets to one, then a First-Order Autoregressive process converges to a
Random Walk. I wanted to show you some simulations of it.
[SIDE CONVERSATION]
Professor Robert Shiller: OK, this here is a plot I had. Let's first look at the black line. The black line is
the Standard & Poor's composite stock price index in real terms. I have that from 1871 until recently. That's
just there for comparison, that is the actual stock market. The pink line is a Random Walk that I generated
using this formula [correction: The pink line is a Random Walk with a time trend, to be explained below.],
and a random number generator that generates random normal variables, OK? I started them out at the
same level, but don't they look kind of similar? If you look at the stock market without comparing it with a
Random Walk, it looks like it has patterns in it. In fact, here's a Head and Shoulders, right here. Bang, bang,
bang. When is that? I think this is 1937. This is--I am not sure--1930, 1931? And this is just before the war.
I'm not sure exactly. It's a nice Head and Shoulders. Hey, Edwards and McGee are sort of right, right? It
dropped a lot after that. You know, I can find Head and Shoulders up here, too, right? Maybe.
The black line is actual U.S. history, that's the stock market. The pink line is a fake stock line generated
with pure random noise. And the fact that it's going up is just chance. I can actually use this program to
generate other examples. This should change, let me see, make sure it's working here. The black line is the
same. I'm not going to change the black line, the black line is history. I just did a brand new Random Walk
calculation using my random number generator, which is there on Excel. That looks pretty good, doesn't it?
I'm going to do more for you. Which one is the real stock market? I find that hard to tell, right?
The insight is that people get deceived when they look at stock price charts. They think they see patterns.
That pink line is guaranteed to have no patterns, because I generated it, so that there are no patterns, except
random patterns. But when I look at this pink line, which just came up, look at that up-trend. Wow. That's
called a bull market, when it goes up. And I can make all kinds of theories about why that's happening, but
you know those would be fake theories, because I know what's really happening. This is pure randomness.
I'll do it again, I can do this forever. That's another one. Here the trend wasn't quite so positive.
Oh, actually, I have to say one thing, I forgot. I did put an up-trend in the Random Walk. I am sorry. In this
simulation, I did add a constant, so that it pushed it up. Otherwise, it was a Random Walk. I forgot what I
did. It was a Random Walk with trend. But it doesn't guarantee that it will go up, because it's random. I'll
do another simulation. See, how fast I can do these? It's the wonder of modern computers. If this were our
history, people would say, the amazing stock market of the first half--look at that stock market in the first
half of the 20th century! We would be devising all kinds of theories to explain it, but in fact it's just
nonsense. It's just randomness. I'll do a few more. Look at that. Boy, that would be a hump shape for the
whole 20th century. We'd have historians trying to figure that one out. Oh, this one downturned. This is a
bad outcome. Jeremy Siegel would not be pleased with this outcome, because it has the stock market
gaining nothing in 100 years. These are all equally likely outcomes. Look at that one. If that was the world
that we inherited, we would really think there was a linear trend in the market, right? People would be
making models, saying--look at how straight that line is.
The point is that you start to see a sort of reality which is really just randomness. That's why Nassim Taleb,
a friend of mine, wrote a book called Fooled by Randomness. I thought that was a great title for a book and
a great book. People don't understand how things are just purely random, and your mind tries to make sense
out of them. And you start looking at patterns and the patterns don't mean anything. So, I can just keep
doing this, but maybe I'll stop. Look at that one. Of course, I'm helped along by the trend that I added in.
So, I want to see if I can get a downtrend one. Because I put a trend in, it's hard to get a real downtrend.
That's sort of a downtrend. That's where there were a lot of negative shocks.
So, you see the comparison of the Random Walk with the actual stock market. So, the actual stock market
looks a lot like a Random Walk. One thing is different, though, you don't--look at this pattern, here. 1929,
and this is the crash, after '29. You know, I'm not getting that in any of my simulations, and you know why
I'm not? Because I chose a normally distributed shock. No fat tails, I didn't put fat tails into my simulation.
And you didn't notice that, right? But in this simulation, we never see such sudden drops. So, there's
something that, if you spend time searching on it, you might see something not quite right. But basically,
the Random Walk looks a lot like the actual stock market. I'm trying to get one that really matches up, but
I'm not quite succeeding. That's pretty good, isn't it? In this simulation, 1929 wasn't quite as strong and the
Depression wasn't as bad.
Anyway, what I want to do now is compare the Random Walk with the AR-1. Now I'm going to do the
same thing, but I'm going to do it with --
[SIDE CONVERSATION]
Professor Robert Shiller: I know what I did, sorry. The pink line is now an AR-1 process, which is this
process. So, it's mean reverting now. I'm not comparing the Random Walk with the AR-1, I'm just doing
the same thing now with an AR-1. Now, the thing about AR-1 is, you realize that it wants to come back to
100. I put a trend in. So, it's actually coming back to a linear up-trend. What I did is I put in a time trend as
well. But the point is that it tends to hug the trend somewhat. I have it here shown not around a trend, but
around 100. What an AR-1 does is, say & is 1/2. If & is 1/2, then it means that if x
t-1
was above 100--last
period it was above 100--it will be above 100 this time, but only half as much above 100, so it's going back
to 100. And then the next time, it'll only be half, again, as much above 100 as it was the last time. So, it
tends to go back to a trend.
But what I've shown here is a simulation with a random number generator of an AR-1 around a trend,
where the trend matches the actual trend in the stock market. Now, in this case, this is not Random Walk.
And there is a profit opportunity, and the profit opportunity is when it's below trend, buy, when it's above
trend, sell. Because it will tend to come back to trend. I chose a &, which was very small, something like
1/2, I think, so it tends to come rapidly back to trend. This does look different than the actual stock market,
doesn't it? You see how much it hugs the trend? So, it doesn't seem to fit as well. I can do simulations of
this, too.
This is different. This is a different world. You can see the difference, right? This pink line doesn't look as
much like the actual stock market, because it really wants this trend. We saw trendy ones occasionally, by
chance with a Random Walk, but here we're seeing it's always on a trend. And so, in this world, if the stock
market were an AR-1, there would be a profitable strategy. Always buy when it's below trend, and sell
when it's above trend. Because you know it'll come back, you see how reliable this comes back to a trend?
So, you can see that there's a fundamental difference, the Random Walk seems to fit the data better than the
AR-1. The Random Walk theory says that stock prices are not mean reverting. Where they go from today is
all random. If they're above the historical trend--meaningless. The historical trend is just nonsense. It's just
random. And forget trends, forget anything. It's always the drunk at the lamppost, no matter where you are
in history. But this one, if & is substantially less than 1, it looks a lot different doesn't it? With & = 1/2, this
is not the world we live in. It would be too easy to make money. All these little oscillations around the
trend I could profit from. But in the real world, it's not like that.
But, what about, suppose the real world is AR-1 with & equal to 0.99, OK? What about that? Well that's not
much different from a Random Walk, is it? It's going to be hard to tell the difference. In the Efficient
Markets Theory period, people were really excited about the Random Walk Hypothesis. That's why Burton
Malkiel's book, A Random Walk Down Wall Street, which he came out with--I think it was in 1973, right
after Fama. It became a huge bestseller, it sold over a million copies, because at that time people were
thinking, this is exciting new wisdom. We've learned the stock market is a Random Walk. And there's all
kinds of implications for that.
The problem is and I have to wrap up--that the Random Walk Hypothesis wasn't exactly right. It's sort of
right, you've gotten some insights. But you know, maybe the real world is AR-1 with a & close to 1. And in
that world, there are profit opportunities, but they take a long time to come. So, if the real world is AR-1
with & equal to 0.99 or 0.98, that means you can buy stocks when they're below trend. But then you have to
wait 10, 20 years for them to get back to trend. So, it's like the drunk on the lamp pole. The drunk is
standing next to a lamp pole, it was a Random Walk. But now we put in elastic band around the drunk's
ankle and tie it to the lamp pole and it pulls him back. Now, if we have a very loose elastic, this guy can
wander for a long time, but will eventually be pulled back. You'd never know when. But if you have a tight
elastic, then it would be obvious that the drunk is coming back.
The problem is that the real world seems, maybe, to be more like the drunk with the loose elastic. And so,
it's kind of unsatisfying. You can beat the market, but simple trading rules like Edwards and McGee are not
powerful, short-run profit opportunities. In that sense, the Efficient Markets Hypothesis is right. So, don't
forget the Efficient Markets Hypothesis. I'll repeat what I said at the beginning. It's a half-truth, it's half
true. Remember that, but don't put too much faith in it, either.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 8 - Theory of Debt, Its Proper Role, Leverage Cycles [February
11, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller:. We're talking about the theory of debt and interest rates. So, I want to talk
about a number of technical topics first. We're going to start with a model, an Irving Fisher model of
interest. And then I'm going to talk about present values, and discount bonds, compound interest,
conventional bonds, the term structure of interest rates, and forward rates. These are all technical things.
And then, I want to get back and think about what really goes on in debt markets.
There are two assignments for this lecture. One is several chapters out of the Fabozzi manuscript. And then,
there's a chapter from my forthcoming book that I'm currently writing, but that is the most meager chapter
that I've given you yet. The book is not done, so I think the real reference for this is the Fabozzi et al.
manuscript, at this point. And then, Oliver will give a TA section that will clarify, I think, some of the
points.
Chapter 2. Theories for the Determinants of Interest Rates [00:01:24]
So anyway, what we're talking about today is interest rates. The percent that you earn on a loan, or that you
pay on a loan, depending on what side of it you are. And interest rates go back thousands of years. It's an
old idea. Typically, it's a few percent a year, right? The first question we want to try to think about is what
explains that. Why is it a few percent a year? And why not something completely different? And why is it
even a positive number? Ever think of negative interest rates? Well, these are basic questions.
So, I wanted to start with the history of thought and an economist from the 19th century, Eugen von
Boehm-Bawerk, who wrote a book on the theory of interest in the late nineteen century. Actually it was
1884. And its a long, very verbose account of what causes interest rates. But basically, he came up with
three explanations. Why is the interest rate something like 5%, or 3%, or 7%, or something in that range?
And he said, there are really three causes. One of them is technical progress. That, as the economy gets
more and more scientific information about how to do things, things get more productive. So, maybe the
3% percent, or the 5%, whatever it is, is the rate of technical progress. That's how fast technology is
improving.
But that's not the only cause that von Boehm-Bawerk talked about. Another one was advantages to
roundaboutness. That must be some translation from his German. But the idea is that more roundabout
production is more productive. This isn't technical progress. If someone can ask you to make something
directly right now, you've got to use the simplest and the most direct way to do it, if you're going to do it
right now. But if you have time, you can do it in a more roundabout way. You can make tools first and do
something else that makes you a more efficient producer of this. And so, maybe the interest rate is a
measure of the advantages to roundaboutness.
And the third cause that von Boehm-Bawerk gave is time preference. That people just prefer the present
over the future. They're impatient. This is behavioral economics, I suppose. This is psychology. That, you
know, you've got a box of candy sitting there. And you're looking at it and you're saying, well, I should
really enjoy that next year. Well, maybe it would spoil by next year. Next month. But somehow you don't.
You have an impulse to consume now. So maybe the rate of interest is the rate of time preference. Why is
the interest rate 5%? It's because people are 5% happier to get something now than to get it in the future.
So, he left that train of thought for us. This was not Mathematical Economics. It was Literary Economics.
But the next person I want to mention in the history of thought is Irving Fisher, who was a professor at
Yale University. But he wrote a book in 1930 called [The] Theory of Interest. And it is the all-time classic,
I think, on this topic. So, Irving Fisher is talked about in your textbook by Fabozzi, and he's talked about in
many textbooks. He graduated from Yale. I mention this, since you're Yale undergrads. He was a Yale
undergrad. He graduated, maybe it was in 1885.
And he got the first Economics Ph.D. at Yale University in the 1890's. And he just stayed here in New
Haven all his life. And if you were living in New Haven in the early twentieth century, you'd know him
because he was a jogger. Nobody else jogged. He would exercise and run around campus, so everyone
would see him. In the 1910's or '20's, nobody did that. But he did. He was a health nut, among other things.
I could talk a lot about him; he's a fascinating guy.
I'll tell you one more story about him. He would invite students to his house for dinner. And he would
explain to them before dinner that he believed that proper eating required that you chew every bite 100
times before you swallow it. So, he would tell his students to do that. And it slowed down conversation at
dinner a great deal.
But that's not what he's known for. What he's known for is, among other things, his theory of interest. So,
this is what's talked about in your textbook and I wanted to start out with Irving Fisher because--by the
way, I don't know when this room was built. Does anyone know? Because he died in '47. He probably
lectured from this same blackboard, right? So, I don't know, this same slate, it could be, right? It could go
back to that time. So, I'm going to put back on the board what he had on this board, I'm assuming in some
time in the 1930's.
What your author, your textbook author, Fabozzi, emphasizes for a theory of interest is something that
came from Fisher that's very simple. And he says, the interest rate--this is Fabozzi's distillation of Irving
Fisher--the interest rate is the intersection of a supply and demand curve for savings. So, I'm going to put
saving, s, on this axis. And on this axis, I'm going to put the interest rate, call that r. I don't know why we
commonly use r for interest. It's not the first letter; it's in the middle of the word. And the idea is that there's
a supply of saving at any time. That people then wish to put in the bank or someplace else to earn interest.
And the theory is that the higher the interest rate, the more people will save. So, we have an upward-
sloping supply curve. Now this S means supply, whereas this S down here means saving, OK?
And then there's a demand for investment capital, right? The bank lends out your saving to businesses, and
the businesses want to know what the interest rate is. The lower the interest rate, the more they'll demand.
So, we have a demand curve for saving. And then the intersection of the two is the interest rate. Well, it
gives the interest rate on this axis and the amount of saving on the other axis. That's a very simple story.
And that's what Fabozzi covers in your text.
But I wanted to go back to another diagram that Fabozzi et al. did not include in your textbook, but it also
comes from the 1930 book, [The] Theory of Interest. That is a diagram that shows a two-period story. And
the thing I liked about this two-period diagram is that it brings out the von Boehm-Bawerk causes of
interest rate in a very succinct way. So, this is the second Irving Fisher diagram. I'm going to do a little
story telling about this.
Remember the book, Robinson Crusoe. It was written by Jonathan Swift in the 1700's. It was the story of a
man named Robinson Crusoe, who was marooned on an island all by himself and had to live on his own
with no help. This is a famous story; we call it a Robinson Cruise economy. There's only one person in the
economy, so, of course, there's no trade. But we'll move to a little bit of trade. I'm just telling you a story of
the rate of--there'll be a rate of interest on Robinson Crusoe's island.
I'm going to show here consumption today. And on this axis, consumption next year. All right. I don't
remember the novel. Did anyone here read it? Somebody must have read Robinson Crusoe. But I'm not
going to be true to the story. The story I'm going to tell is that Robinson Crusoe has some food. That's all
that the whole economy just is, let's say it's grain. I don't know how he got that on the island. But he's got
grain. And he's deciding how much to eat this year, and how much to plant for next year.
So, the total amount of grain he has is right here. So, that is his endowment of grain. That's the maximum
he could eat. But if he eats it all, there won't be any grain to plant for next year, OK? So, he better not eat it
all, OK? Or he'll starve next year. Now, in a simple linear production--with technology that's linear, he can
choose to set aside a certain amount of grain, which is the difference between what he has and what he's
consuming. And then that will produce grain next period.
So, I'm going to draw a straight line. That's supposed to be a straight line. These are all supposed to be
straight lines here. And that is his choice set under linear technology. I'm drawing it with no decreasing
returns. The idea is that for every bushel of grain that he plants, he gets two bushels next year, or whatever
it is, OK? And so, if he were to consume nothing this period, he would have--if I drew this thing with the
right slope of -2--he would have twice as much. This is the maximum he could have next period, OK? And
so, he could consume anywhere along this point, this line. And this would be the simplest Robinson Crusoe
economy.
So, what does he do? Remember from elementary micro theory, he has indifference curves between
consumption today and consumption tomorrow. Remember these? These are like contours of his utility.
And we typically draw them like this. So, what does he do? He maximizes his utility and chooses a point
with the highest indifference curve touching the production possibility frontier. This is the PPF, the
production possibility frontier. And that determines the amount that he consumes and the amount that he
saves. And he consumes this amount here. And the difference between his endowment and his consumption
is his saving. And then, next period, he consumes this amount. All right, that's simple micro theory. That's
familiar to you? So in this case, the interest rate, the slope of this line--this slope is equal to (1+r) where r
is the interest rate.
So in this case, I've told a very simple story. It has only one von Boehm-Bawerk cause, its roundaboutness.
But maybe there's technical progress, too, I don't know. It has maybe a couple of his causes. If, as time goes
by, Robinson Crusoe figures out better how to grow grain, there could be a technical progress component.
But preferences don't matter in this story, right? The preferences I represented by his indifference curves.
And since I've got a linear production possibility frontier, impatience doesn't matter. The interest rate in this
case is decided by the technology, the slope of the curve.
So, we don't have all of von Boehm-Bawerk causes yet. OK. Next step. That was the simplest Irving Fisher
story. The next step is, let's suppose, however, that there are diminishing returns to investment in grain, all
right? That means, for example, maybe when he grows a little bit of it he's very good at it and he produces
a big crop. But as he tries to grow more grain, he gets less productive. Maybe he has to do it on the worst
land or he's running out of water, or something is not going right.
Then we would change the production possibility frontier, so that it concaves down. Something like that.
Do you see what I'm saying? Diminishing returns to investment. As you keep trying to add more and more
grain to your production, as you save more and more, you get less and less return. So now, we have a new
production possibility frontier that is more complicated.
So now, what happens? Forget this straight line, which I drew first, and now consider a new production
possibility frontier that's curved downward. Well, what does Robinson Crusoe do? Well, Robinson Crusoe
picks the highest indifference curve, right, that touches this production possibility frontier. So, that means
he finds an indifference curve that's tangent to it. And he chooses that point. OK? So, this is what Robinson
Crusoe would do.
Now, the interest rate is the slope of the tangency between the indifference curve and the production
possibility frontier. It's the same for both. And this was the insight that von Boehm-Bawerk maybe had a
little trouble getting. There's two different things determining the interest rate. One of them is the
production possibility frontier, and the other one is the indifference curves.
Now, we have all of von Boehm-Bawerk causes. We've got roundaboutness, we have technical progress,
and we have impatience. Well, the impatience would be reflected by the slope of the indifference curves.
So, let me put it this way. Suppose Robinson Crusoe really wanted to consume a lot today. He was very
impatient. That means that his indifference curves--did you give me colored chalk?
Student: There's a little bit of yellow.
Professor Robert Shiller: Oh, we have a little yellow. All right. Suppose Robinson Crusoe is very
impatient. He wants to consume. Now, he doesn't care about the future. Then, his indifference curves might
look--I'll just draw a tangency--his indifference curve might look different. They might look like this. So,
he would have a tangency further to the right, consuming more today and less in the future.
Now, the slope here is different than the slope here, right? Because I haven't changed the production
possibility frontier but I've moved to a different point on the production possibility frontier. So, you can see
that if Robinson Crusoe becomes more impatient, his interest rate goes up. Now you understand that the
interest rate in the Robinson Crusoe economy is not just about Robinson Crusoe. Even though there's only
one person in this economy, it's about all of Eugen von Boehm-Bawerk's causes. The technology is
represented by the technical progress and the roundaboutness, and the preferences are represented by the
indifference curves. And you can see that the actual rate of interest in his economy is determined by the
tangency.
Now on the other hand, suppose Robinson Crusoe were very patient and really wants to live for the future.
Then the highest indifference curve that touches the production possibility frontier might get up here, right?
Now that's another Robinson Crusoe with a different personality, who's more patient. Then the tangency
would be up here and the interest rate would be much lower, because the interest rate would be the slope of
the line that goes through that tangency point, tangent to both the indifference curve and the production
possibility frontier. So, this is just a one-person economy. Is this clear? So, I've drawn a lot of line, maybe I
should start all over again.
We've now gotten all of von Boehm-Bawerk's causes of interest. And we've got an interest rate. We've tied
it to production--technology, represented by the production possibility frontier, and taste, represented by
the indifference curve. But now I want to add a person to the economy. So, let me start all over again.
There's two Robinson Crusoes in this island. And let's start out with autonomy. They haven't discovered
each other yet. They're on opposite sides of the island. They have the same technology. They have the same
production possibility frontier, but they live on opposite sides of the island, and they don't trade with each
other.
So, let me start out again. This is the same diagram. We have consumption today, and consumption next
year, again. And we have a production possibility frontier. That's the same curve that I drew before. And
the technology is the same for both of them. And let's suppose they have the same endowment.
But let's suppose that Crusoe A is very patient, and Crusoe B is very impatient. [Correction: Crusoe A is
impatient, Crusoe B is patient, to be explained below.] So, Crusoe A, his indifference curves form a
tangency down here. So, this is A. And Crusoe B's indifference curves are up here. This is B. And so, they
are planning to plant. That means that Crusoe A will be saving very little. I mean, will be consuming a lot.
A is the impatient one, the way I've drawn it. Consuming a lot now and not saving much for the future, but
is maximizing his utility. That's why we have the highest indifference curve shown here with this tangent.
And Crusoe B is the very patient one. And is consuming very little this year and plans to consume a lot
next year. So, let's say they're about to plant, according to these tastes. And then they find each other. Now,
they realize, there's two of us on this island. Now, we're getting a real economy with two people. So, what
should they do? Well, the obvious thing is that there are gains to trade. And the kind of trade would be in
the loan market.
This Crusoe B is suffering a lot of diminishing returns to production. So, he really shouldn't be planting so
much grain, because he's not getting much return for it. Whereas this other guy on the other side of the
island has very high productivity. He can produce a lot for a little bit of grain. So, he should tell Crusoe A,
you should plant some of this grain for me. You are more productive, because you're not doing as much.
Well, in short, what will happen is, they'll do it through a loan. I will loan you so much grain. There's no
money. A wants to consume a lot. So, B will say, instead of planting so much, we'll strike a loan to allow
you to consume along your tastes.
And what will happen in the economy is, we'll find an interest rate for the economy that looks something--
I'm going to draw a tangency. Like, that's supposed to be a straight line. And on this tangent line, we have
Crusoe B has maximized his utility subject to that tangent line constraint. And Crusoe A maximized his
utility subject to the same constraint. And it has to be such a way that the borrowing market as shown over
here clears. And, when we have that kind of equilibrium, you can see that both A and B have achieved
higher utility than they did when they didn't trade.
So, this is the function of a lending market. So, A who wants to--did I say that right? A, who wants to
consume a lot this period--the production point is here. And B lends this amount of consumption to A, so
that A can consume a lot. He can consume this much. And B, since he's lent it to A, consumes only this
much this period. But you see they're both better off. They've both achieved a higher utility. And what is
the interest rate in the economy? The interest rate is the slope of this line. Well, the slope of this line is -
(1+r). So, that is the Fisher theory of interest.
And now, it's much more complicated. You can see how all of Eugen von Boehm-Bawerk's causes play a
role. But the interest rate is not something you could have read off from any one person's utility. It's not just
impatience. We're both complicated people. We both have a whole set of indifference curves. And it's not
necessarily easy to define whether or how impatient am I. It interacts with the production possibility
frontier in a complicated way to produce a market interest rate. So, this is the model for the interest of the
economy that Irving Fisher developed. And so, I wanted to just take that as a given.
Now, when you put it this way, it all looks indisputable that the loan market is a good thing, right? I can't
think of any criticism of the two Robinson Crusoes going together and making a loan. There's nothing bad
about this loan, right? They're just both consuming more as a result. But I want to come back to criticisms
of lending at the end of this lecture, because I want to try to make this course into something that talks
about the purpose of finance and the real purpose of finance. And this story is not the whole story about
real people and how they interact with the lending market.
Chapter 3. Present Discounted Values, Compounding, and Pricing Bond Contracts [00:28:11]
But before I do that, though, I want to do some arithmetic of finance. Let me move on to what I said I
would talk about, mainly different kinds of bonds and present values. The Irving Fisher story was very
simple, and it had only two periods. So, that's too simple for our purposes. So, what I wanted to talk about
now is different kinds of loan instruments. And the first and the simplest is the discount bond, OK? When
you make a loan to someone, you could do it between a company or between a government and someone.
A discount bond pays a fixed amount at a future date, and it sells at a discount today. It pays no interest. I
mean it doesn't have annual interest or anything like, it merely specifies this bond is worth so many dollars
or euros as of a future date.
Now, why would you buy it? Because you pay less than that amount. So, let's say that it's worth $100 in T
periods. T years. I'll say T years. And I made that a capital T. So, what is a discount bond worth today?
Now, we have an issue of compounding, which I want to come to in a minute, but let's assume, first of all,
that we're using annual compounding, and T is in years. Then, the price of the discount bond today, the
price today, is equal to $100/(1+r)
T
. Where T is the number of years to maturity. T years to maturity, OK?
And that's the formula, OK? In other words, (1+r)
T

So, $100/P is the ratio of my final value to my initial investment value if I invest in a discount bond. And I
want to convert that to an annual interest rate. So, this is the formula that allows me to do that. So, r is also
called yield to maturity. And the maturity is T, the time when the discount bond matures. So, it says if it's
paying an interest rate, r, once per year for T years--we can infer an interest rate on it even though the bond
itself has a price, not an interest rate. I mean, we can calculate the interest rate by using this formula.
Now, let me come back to compounding. This is elementary, but let me just talk about putting money in the
bank here. So, compounding. If you have annual compounding, and you have an interest rate of r, and you
put your money in the bank with annual compounding, and the interest rate is r, that means you don't earn
interest on interest until after a year. If you put in $1 today, 1/2 a year later you'll have 1 + r/2 dollars,
right? With an interest rate r. 3/4 of a year later, you'll have 1 + 3/4r dollars. And then a full year later you'll
have 1 + r. But now, after one year, you start earning interest on the 1 + r. So, a 1/2 year after that, you
would have (1 + r)(1 + r/2). And then two years later, you'd have (1 + r)
2
, and so on. That's annual
compounding.
But the bank could offer you a different formula. They could offer you every-six-months compounding--
twice-a-year compounding. Then, here's the difference, after 1/2 a year, you'd have 1 + r/2, as before. But
now, after 3/4 of a year, you would have, instead, (1 + r/2)(1 + r/4), and so on. Now, what Fabozzi likes to
do is compounding every six months. This is what might make the textbook a little confusing. Because we
naturally think of annual compounding. A year seems like a natural interval. But in finance, six months is
more natural. Because, by convention, a lot of bonds pay coupons every six months.
So, Fabozzi uses the letter z to mean r/2. And his time intervals are six months long. So, that means that the
formula that Fabozzi gives for a discount bond assumes a different compounding interval. The Fabozzi
assumption. He writes P=100/(1+z)
t
where the lower case t is 2T. And so, that's the Fabozzi formula for the
price of a discount bond. And, of course, it only applies at every six months interval. He's not showing
what it is at six and a half months, or something like that. So, is that clear about compounding and about
discount bonds?
Now, a fundamental concept in finance is present discounted value. If you have a payment coming in the
future--So, I have a payment in T years or 2T six months, or we could say semesters. Then, the present
value, depending on how I compound--well, let's talk about annual compounding. The present discounted
value of a payment in T years is just the amount, which is $x/(1+r)
T
. Or if you're compounding every six
months, it would be $x/(1+z)
t
.
Lower case t equals 2T. So, whenever we ask a question about present values we'll have to make clear what
compounding interval we're talking about.
By the way there's also--I shouldn't say by the way, it's fundamental. There's also continuous compounding.
I talked about compounding annually, or twice a year. I can do it four times a year. If I do it four times a
year, that means I pay 1/4 of the interest after three months, and then I start earning interest on interest after
three months, and so on. What if you compound really often? You could do daily compounding. That
would mean you would start earning interest on interest 365 times a year.
The limit is continuous compounding. And the formula for continuous compounding is e
rT
, where e is the
natural number 2.718, r is the continuously compounded interest rate. So, your balance equals the initial
amount--what did I say? $1 ' e
rT
. That's continuous compounding. The unfortunate thing is that present
values allow us to compute present values in different ways, depending on what kind of compounding I'm
assuming. But if I have a sequence of payments coming in, the present discounted value of the sequence--
and suppose they come in once a year--then it'd be natural to use annual compounding. And then the
present discounted value, PDV, is the summation of the payments.
And what am I calling them here? x
i
/1+r.
Oh no, I say (
[addition: t is no longer equal to 2T, but is used as a summation index from now on.] And that's the present
discounted value for annual compounding of annual payments. And suppose the payments are coming in
every six months, as they do with corporate bonds, then it might be natural to do compounding every six
months. So then, we do PDV=(
If I wanted to do continuous compounding--suppose I have payments that are coming in continually--then
the present bond's discounted value would be the integral )
And that would be a continuously compounded present value for a continuous stream of payments.
So, if someone is offering me payments over time, then the payments have to be summed, somehow, into a
present value. In finance, it often happens that people are promising to pay you something at various future
intervals over time, and you have to recognize that payments in the future are worth less than payments
today. Just as a discount bond is worth $100 in five years, but it's not worth $100 today, it's worth
$100/(1+r)
T
.
appropriately compounded. And that's true generally. Anything in the future is worth less. So, present
discounted value is one of the most fundamental concepts in finance. That whenever someone is offering
me a payment stream in the future, you discount it to the present using these formulas.
So, for example, if you are lending to your friend to buy a house, and the person is promising to pay you
over the years, then you've got to figure out, well, what is that payment worth right now? And you would
take the present value of it. There are a few present value formulas that are essential. And I'm going to just
briefly mention them. The present value of a consol, or perpetuity. A perpetuity or a consol is an instrument
that pays the same payment every period forever. It was named after the British consols that were issued in
the 18th century. They were British government debt that had no expiration date. And the British
government promised to pay you forever an amount.
OK, what is the present value? Now, we'll call the amount that the consol pays its coupon. And let's say the
coupon were GBP 1 per year. If it was paying GBP 1 per year, and we're using annual compounding, then
the present discounted value is equal to GBP1/r.
GBP 1 over the interest rate. That's very simple, because this bond will always pay you GBP 1. And so,
what is the interest rate on it? Your GBP 1 is equal r/PDV.
So, the prices of the bond of the consol should be the payment divided by the interest rate.
Another formula is the formula for an annuity. An annuity is a different kind of payment stream. It's a
consol for a while and then it stops. An annuity pays a fixed payment each period until the expiration of
thethe maturity. So, it pays, let's say, GBP x. Let's not say GBP 1. If it pays GBP x every year, then the
present discounted value--it pays GBP x from t equals 1 to T. And then it stops. T is the last payment. Then
the formula is x/r[1-1/(1+r)
T
].
So, that's the annuity formula. And that's very important, because a lot of financial instruments are
annuities. The most important example being a home mortgage, a traditional home mortgage. You might
take out a 30-year mortgage when you buy a house. And the mortgage will generally say in the United
States--it's not so common in other countries--but in the United States it will say you pay a fixed amount--
well, usually it's monthly, but let's say annually for now--a fixed amount every year as your mortgage
payment. And then you pay that continually until 30 years has elapsed, and then you're done. No more
payments. OK.
The final thing I want to talk about is a corporate bond, or a conventional bond, which is a combination of
an annuity and a discount bond. And so, a conventional corporate bond, or a government bond, pays a
coupon every six months. So, a conventional bond pays coupon c, an amount c, in dollars, pounds, or
whatever currency, every six months. And principal plus c at the end.
So, that means that it's really an annuity and a discount bond together, right? And so, the present discounted
value for the conventional bond would be the sum of the present discounted value using the annuity
formula for x=c plus the present discounted value of the principal, which is given by the--well, it would be
this one, where you have r/2, because it's every six months.
Chapter 4. Forward Rates and the Term Structure of Interest Rates [00:47:50]
And then the final--I think it's the final concept I want to get at before talking a little bit about other
matters. I want to talk about forward rates, and the term structure of interest rates. Now, at every point in
time there are interest rates of various maturities quoted. And we want to define the forward rates implicit
in those maturity formulas. And this is covered carefully in your textbook of Fabozzi. I'm just going to do a
very simple exposition of it. The concept of a forward rate, forward interest rate, is due to Sir John Hicks,
in his 1939 book, Value and Capital.
About 20 years ago, I was writing a chapter for the Handbook of Monetary Economics about interest rates.
And I was trying to confirm who invented the concept of forward interest rates. So, I'll build a little story
around this. I thought it was Sir John Hicks, reading his 1939 book, and I couldn't find any earlier
reference. So, I asked my research assistant, can you confirm for me that the concept of a forward interest
rate is due to Hicks. And my graduate student looked around and tried to find earlier references to it and he
could not. Then, one day the graduate came to me and said--this is like 20 years ago. The graduate said,
why don't you ask Hicks? And I said, wait a minute. This book was written in 1939. Is that man still alive?
And he said, I think he is.
So, I wrote to the United Kingdom. I found his address. I forget, Cambridge or Oxford. I forget. And I said,
did you invent the concept of forward interest rates? And then six months went by and I got no answer.
Then I got a paper letter--they didn't have email in those days--from Sir John Hicks. And it was written
with trembling handwriting. And he said, my apologies for taking so long to answer. My health isn't good.
But he said, to answer your question, he said, maybe I did invent the concept of forward interest rates. But
he said, well maybe it wasn't. Maybe it was from coffee hour at the London School of Economics, where he
was visiting in the 1920's. So, here we go, OK? Sir John Hicks is reminiscing to me about what happened
in coffee time in the 1920's. So, I'm just trying to convey what he told me they were thinking.
At any point of time, you open the newspaper and you see interest rates quoted for various maturities.
That's called the term structure of interest rates. For example, you will find Treasury--well, you'll find one-
year rates quote, there'll be a yield on one-year bonds. There'll be a yield on two years. There'll be a yield
quoted on three-year bonds. Right? Let me tell you right now, for most of the world today, if you want to
borrow money for one year, it's really cheap. In Europe, or U.K., U.S., over much of the world it's like 1%.
U.S., it's less than 1%. It depends on who you are, what your borrowing rate will be, depending on your
credit history. But if you have excellent credit, one-year interest rates are really low.
But if you want to borrow for 10 years, it's more like 3.5%. It's higher, right? And if you want to borrow for
30 years, they might charge you 4% or 5%, OK? This is the term structure of interest rates, and it's quoted
every day in the newspaper. Well, I should say, I'm thinking 1925. In 1925, you'd go to the newspaper to
see it. Now you go to the Internet to see it. So, newspapers don't carry this anymore. But I'm still in the
mode of thinking of Sir John Hicks. We're in 1925. So, you open up the newspaper in 1925 and you get the
yield to maturity, or the interest rate on various maturities. All for today. Everything that's quoted in today's
paper is an interest rate between now, today, and so many years in the future. The one-year interest rate
quoted is the rate between now and one year from now, right? And the two-year interest rate quoted is the
rate from now to two years from now, and so on.
So, Hicks and his coffee hour people were saying, well, it seems kind of one-dimensional, because all the
rates that are quoted are rates between now and some future date. But what about between two future dates?
And then they thought about this at coffee hour, and someone said, well, it's kind of unnecessary to quote
them, because they're all implicit in the term structure today. And this is where the concept of forward
interest rate comes. And it's explained in Fabozzi. But I thought, I'm going to just try to explain it in the
simplest term. Once we get the concept, it's easy. And I'm going to assume annual compounding to simplify
things. But in Fabozzi, he being a good financier, does it in six-month compounding.
So, now the year is 1925, OK, and we're in coffee hour. Suppose I expect to have GBP 100 to invest in '26,
OK? It's '25 now, this is a whole year from 1926, OK? And I want to lock in the interest rate now, OK? Is
there any way to do that? I mean, I could try to go to some banker and say, can you promise me that you'll
give me an interest rate in 1926 for one year. The banker might do it, you know, but I don't need to go to a
banker to do that. Once I have all of these bonds available, and if I can both go long and short them, then I
can lock it in.
So, here's what I want to do. This is what they were discussing at coffee hour. Buy, in 1925, two-year
bonds in an amount--you've got to buy the amount right--you've got to buy (1+r
2
)
2
/1+r
1

bonds, where r
2
is the two-year yield. [addition: r
1
denotes the one-year yield.] Discount bonds. They'll
mature in two years [addition: at GBP 100]. And then I have to short, in 1925, one-period bond that
matures at GBP 100 [addition: in order to finance the first purchase]. So, suppose I do that, what happens
after one period? Well, after one period, I owe GBP 100, right? Because I just shorted a one-period bond.
So, I pay GBP 100, that's like investing GBP 100. At the end, I get this amount times GBP 100, right?
Because this is the number of bonds that I bought.
So, what is the return that I get? The return that I get is the ratio-well, we'll call that the forward rate
between '26 and '27 as quoted in 1925. And so, that forward rate, we'll say 1+
It's just the amount that I get. What I'll get if I bought this number of bonds, I get GBP 100 times this
number in two periods in 1927, but I put out GBP 100 in 1926. So, the ratio of the amount that I got at the
end, to the amount that I, in '27, that I put in in '26 is given by this. So, that's 1 plus the interest rate I got on
the bond.
So, you can compute forward rates. I'm just showing it for a one-year ahead forward rate for a one-year
loan. But you can compute it for any periods further in the future over any maturity. And this is the formula
given, it's on page 227 of Fabozzi. I'm not going to show you the general formula.
The expectations theory of the term structure is a theory that--I'll write it down. Expectations theory says
that the forward rate equals the expected spot rate. So, do you see what I'm saying? Here in 1925, I open
The London Times, and right there I have printed the whole term structure today. And I can then compute,
using forward rate formulas, the implied interest rates for every year in the future. Even out to 2010, they
could have computed--if they had bonds that were that long--I think they had a few. See, 1925. Some bonds
go out 100 years. If you wanted to do the one-year rate in 1925, for the year 2011, you'd have to find a pair
of bonds. One of them maturing in 2011, and another one maturing in 2012. And if you did that, you could
get an interest rate for this year. So, that was kind of the realization that Hicks got, that the whole future is
laid out here in this morning's paper. All the interest rates for--maybe not out to 2011--but out to a long
time in the future.
And so, what determines those interest rates? So, Hicks, in his book, wrote, the simplest theory is the
theory that these forward rates are just predictions of interest rates on those future dates. So, we could go
back and see, what were they predicting? They weren't thinking so clearly, definitively, about 2011, but
they must've been, because they were trading these bonds. And so, you could test whether the expectations
theory, whether people are forming rational expectations by looking at those forecasts and seeing, were
they right?
Now there's a huge literature on this, but Hicks said that--just stop with this--Hicks said that the
expectations theory doesn't quite work, because there's a risk premium. That the forward rates tend to be
above the optimally forecasted future spot rates--spot meaning, as quoted on that date--because of risk. And
people are uncertain about the future, so they demand a higher forward rate then they expect to see
happening in the spot rate. So, I will stop talking technical things. I wanted to say something. I have so
much more to say, but I'll have to limit due to time.
What I've laid out here is a theory of interest rates. And I've done some interest rate calculations. And I've
pointed out the remarkable institutions we have that have interest rates for all intervals, out maybe 100
years. And so, it's all kind of like the whole future is planned in these markets. It seems impressive, doesn't
it? And when I told you the Robinson Crusoe story, didn't that sound good? Like when the two Robinson
Crusoes discover each other, aren't they obviously doing the right thing to make a loan from one to the
other? And I like that. I think basically everything I've said here is basically right. But I wanted to say that
one of the themes of this course is about human behavior and behavioral economics. And I wanted to talk a
little bit about borrowing and lending, and how it actually plays out in the real world. And how our
attitudes are changing, our regulatory attitudes are changing.
Chapter 5. The Ancient History of Interest Rates and Usurious Loans [01:03:29]
So, let me just step back. You know, I think this literature, Irving Fisher and von Boehm-Bawerk, and
many others who've contributed to the understanding of interest rates, is very powerful and important. And
it supersedes anything that had been written in the last thousands of years. They had interest rates for
thousands of years, but that simple diagram, that Fisher-diagram, came just a short time ago. It's hardly
long ago at all. But I wanted to step back and think about what people said about interest rates going way
back in time. And so, I was going to quote the Bible. There's a Latin word. Do you know this word?
[writes "USURA"]
Do you know what that means in Latin? Well actually our English word "use" comes from it. I don't know
how to pronounce it. ''Usura'' in Latin means use. And it means, also, interest. Because, what is interest?
You're giving someone the use of the money. You're not giving them the money. They're getting the use of
the money. And they had other words for interest. But this ancient word had a negative connotation. It
sounded bad. It kind of meant something immoral, OK? And so, we have a word called usury. You know
this word. This is English now. It goes back more than 2000 years. I actually have it here in Latin. I'm just
curious about these things, but I can't pronounce it right. It must have been written in Greek, or Aramaic, or
something originally, but it uses the word, "usury," usura.
But the quotation, it says in Exodus, "If thou lend money to any of my people that is poor by thee, thou
shalt not be to him as an usurer. Neither shalt thou lay upon him usury." Now what does that mean?
Because usura could mean both interest and excessive interest. So, it's not clear what the Bible is saying
about lending. It sounds like it's telling you, you can't lend--you can lend someone money, but don't take
any interest. That's what it seems to be saying but it's ambiguous. I was going to quote the Koran. I don't
speak Arabic. I think there's a similar ambiguity in Arabic. And I'm quoting an English translation of the
Koran: "Oh you who believe. Be careful of Allah, and give up the interest that is outstanding." Or usura.
That has been interpreted by modern Islamic scholars as that charging interest is ungodly. And it was
interpreted by Christian scholars. They go back and they try to figure out what was meant, and they
couldn't figure it out, either. Times change over the centuries. But for thousands of years the Catholic
Church--or maybe not thousands, I don't know the whole history of this. It depends on which century you're
talking about. But for many centuries, the Catholic Church interpreted this, as do many Muslims today, that
interest is immoral. And therefore, the only people who were allowed to loan were Jews, because they
weren't subject to the--even though it's actually the Book of Exodus--but they weren't subject to the same
interpretation. So, it was considered immoral. I wonder, why is that? Why is it immoral? Because we just
saw the logic of it.
Now, the Robinson Crusoe story. I had two different men on the other side of the island. And I had one of
them wanting consumption today and of one of them wanting consumption later. Your first question is,
maybe they were wrong to be different. Maybe they should both be doing the same thing. Why is one of
them different than the other? The guy who's going to consume a lot today, maybe I should have a word
with this guy. You know, don't do it, you're going to be really hungry next year. Why you doing this? So,
instead of forming a loan between the two, we should advise them. And maybe they don't need a loan.
So, this comes back to, what are we doing with our loans? And, are we giving people good advice? Or do
we have a tendency in the financial world to be usurious? Are we going after and victimizing people by
lending them money? I think that there is a problem. And this thousands of years of history of concern
about usury has to do with real problems that develop. So, just in preparing for this lecture, on an impulse, I
got on to Google, and I searched on vacation loans. I found 1.6 million websites that were encouraging you
to take out a loan to go on a vacation, OK? Now, is that socially conscious? I was wondering about that. Is
it ever right to borrow money to go on a vacation? I mean, I've thought about it.
And then I remembered, Franco Modigliani, who was one of the authors of your textbook, and he was my
teacher. I still remember these moments from classroom. And he was teaching us about these subjects. He
was thinking about examples of investments--and he said, you know? One of the best investments I can
think of is a honeymoon. When you get married, you go on a vacation. Now, why are you doing that? Is it
for fun? Probably not. In fact, I have a suspicion that most honeymoons are not fun. I think it's just people
are too uptight and tense. What have we just done? And I bet that's right. So, why do you do it? Well, you
do it as an investment, right? You want this photograph album. You want the memories. You're kind of
bonding. I think he's absolutely right. You should go on a honeymoon.
So, I did another search. I searched on honeymoon loans, OK? And I got 1.7 million hits. It beat vacation
loans. So, there are many lenders ready to lend. And you should do it. If you're just getting married and you
don't have any money, go to the usurious guy and ask for the honeymoon loan. So, I'm not sure whether it's
bad. This is a question. I think that there are abusers.
Chapter 6. Elizabeth Warren and the Consumer Financial Protection Bureau [01:11:08]
And I wanted to just close with Elizabeth Warren. I first met her just a few years ago. Well, actually, I
remember her book. She wrote some important books. She's a Harvard law professor who wrote books.
One of her books was published by Yale, called The Fragile Middle Class. And it's about people who go
into bankruptcy. And she points out that in the U.S., even back in the old days when the economy was
good, we had a million personal bankruptcies a year. This is because of borrowing.
You don't know how many bankruptcies there are, because people are ashamed when they declare
bankruptcy. And they try to cover it up from as many people as possible. There are as many personal
bankruptcies in a normal year as there are divorces. But you don't hear about them, right? You hear about
all kinds of divorces. People are ashamed of divorces, too. But they can't cover them up because everybody
knows. But they can pretty well cover up a bankruptcy, and so they don't talk about it. So, what Elizabeth
Warren is saying, she thinks that the lending industry is victimizing people. It's advertising for vacation
loans and the like, and then they don't tell people about the bad things that will come.
So, she wrote an article, and this is interesting, it was in Harvard Magazine. And that's a magazine that I
suspect none of you read. Anyone read Harvard Magazine? OK. It's the Harvard alumni magazine. It goes
out to all graduates of Harvard. So, you don't read it, and you probably will never read it. You will be a
reader of the Yale Alumni Magazine, which will start arriving in your doorstep after you graduate. And it
will also include your obituary in the next century when that comes.
But the Harvard alumni magazine published this wonderful article about Elizabeth, describing all of the
abuses that happen in lending in the United States. I don't know how I ended up reading it. I think it was
just such a nicely written piece that it just became one of their success stories. Most people don't read that
magazine, but I read it, and a lot of people read it. And she was so successful in convincing the public--this
is just two years--or 2008, three years ago--she was so successful that she got a Consumer Financial
Protection Bureau inserted into the Dodd-Frank bill.
And we now have a regulator, a new regulator, that's supposed to stomp on these usurious practices. It's
kind of an inspirational story, but the downside of it is, she got too carried away criticizing the lending
industry in that nice article. And it makes them sound worse than they really are, and so Obama could not
appoint her to head the Consumer Financial Protection Bureau, because it would be too politically
controversial. So, she is now the person trying to find someone to head her bureau.
But I think that this is just another step, and it's happening in Europe and other places. The financial crisis
has made us more aware of bad financial practices. And so, usury is again on our mind. Usury is abusive
lending that's taken without concern for the person who's borrowing. And I think what it means to me is
that--we'll come back to talk about regulation in another lecture--but that the original Irving Fisher story
and von Boehm-Bawerk story about interest was right. And even vacation loans, especially honeymoon
loans, are right. But we need government regulation to prevent abuses. And we do still have abuses in the
lending process. So, I'll stop with that and I'll see you on Monday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 9 - Corporate Stocks [February 14, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: We're talking about corporate stocks this time. We've talked already about them
a little bit. We talked about how people would set up a corporation and then divide it up into shares. And
then, the company grows, more shares are issued, and some people sell their shares. It's a way of creating
an organization that works. We talked about the first real corporation with traded shares, that was the Dutch
East India Company in 1602. It was an idea that took hold and became a scheme for organization of
business and has become extremely important around the world.
Chapter 2. Professor Shiller's Personal Experiences of Founding a Corporation [00:00:55]
I actually had my own personal experience. I've created two corporations in my life. The first time, it was
one of my students here at Yale, Allan Weiss. Actually, he was not an undergraduate. He was getting an
MBA from the School of Management. But he came to me after he graduated and said, I see that you create
home price indexes. I'd like to start a company and sell them, OK? And so, he wanted me to advise the
company. And then we decided to make it a corporation. We brought in my colleague, Chip Case, who's at
Wellesley College, and it's called Case Shiller Weiss Incorporated. We brought in a fourth, a real
businessman, but he said it would be ridiculous to have four names on the company, so he generously
allowed his name. It's Chuck Longfield. But then we set up the company, and I remember saying, I'm not
going to be that involved. I'll be somewhat involved, but I'm going to keep teaching at Yale and I can't do
more than a day a week at most or less than that.
So, we had to decide how many shares we got, all right? The only guy who gave it money was the
businessman. That's how you do it. He put money into the company. The rest of us just agreed to put in
time. So, the question is, how do we divide up the company? Who gets how many shares? The businessman
put in money. I'm putting in time. How do we do that? And I know I'm not going to put in as much time as
Allan Weiss, who is actually running the company. But you know what we did? We just divided it four
ways and we set it up. And it's not a big company, but I'm saying it, because it's my own personal
experience having done this. That was 1991. We sold it in 2002 to Fiserv, Inc. And at that time we had 12
employees. It never got that big. But then later on, S&P bought the index. The home price index is called
the S&P/ Case-Shiller Indices, which are now quoted a lot. I thought it was a success. It didn't get really
big, but it was a success.
One thing that I learned from this experience is, have appreciation for lawyers, OK? Because I had never
funded a company before and I didn't know what kind of things would happen. Incidentally, in dividing up
the company, I think it was just fairness. We thought, we'll all make our own contribution in our own way.
We can't decide who's more important. But you know, honestly, I didn't really care about the money. For
me, it was just a new experience. It was like, we could all be in this together. We're all trying to make
money and making something big. It was just a kind of a story for me, that made it a little bit of an
adventure. I was in it for the fun of it, because I really don't feel like I need any money. I have a job. I don't
aspire to a mansion or anything like that. But we just did it. It was fun.
The reason why I appreciated lawyers is that they seemed to anticipate all of our conflict and they wrote
things. We had a corporate charter, a long document, but it actually made sense, because we did get into
some conflicts. This is what happens in a company. Somebody isn't working as hard as somebody else, and
then some resentment develops. So, what do you do? The salve is more shares. If one guy's doing more
than another, it gets brought up at the board meeting, and someone says, well let's give this guy more
shares--it's called a bonus, right? So, we discovered the wisdom of this system. And I think a lot of people
around the world have discovered it, and that's why corporations are such an important component of our
economy.
Chapter 3. Worldwide Importance of Corporate Stocks [00:05:05]
So, that's just my own personal story, but I wanted to talk about big and important corporations, not mine.
But first, I wanted to give you some sense of perspective on how important corporations are. Corporate
stock as traded on stock markets. So, I have data here from the World Bank. And that's the website. You
can get all the countries of the world from it if you want. And the latest data they have is 2008. And for
various countries or various regions of the world they have the value of the stock market, of the listed
stocks in those countries in trillions of U.S. dollars. That's this column, the trillions of dollars. They also
have the fraction of GDP represented by the stock markets in that country.
So, you can see that the biggest stock market in the world is the United States. So, it's $11.7 trillion in 2008
according to the World Bank. Second biggest is the euro-area, $5 trillion. And U.K. is very big, because the
United Kingdom was very early to become a financial center. And it's an enormous financial center now.
The interesting thing though is as a fraction of GDP. People are confused when we talk about fraction of
GDP, because it's one year's GDP we're talking about. We're comparing a stock with the flow. A stock of
wealth in the stock market, dividing that by one year's GDP.
So, it shows here that the United States' stock market in 2008 was worth almost a year's GDP and it was
higher than any other, at least, major country. Again, this is a symbol of capitalism. If you want to invest in
stocks anywhere you live in the world, you're going to probably come to the United States, because it's
much higher. I mean, you could do Asia. Asia and the Pacific, $3 trillion, but the U.S. is almost four times
as large. That's because of the long history. This is a capitalist country. And as I was saying, the New York
corporate law of 1811 kind of got this ball rolling, and so it has led the world on that. But I think if we look
at this chart again in 10 or 20 years, it's going to look different, because stock markets are growing around
the world, as a form of organization for enterprise. So, these numbers on the rest of the world are all going
up, and we'll see more and more value elsewhere. And the reason is, because it works. The system
coordinates the activity. It allows people to work together. And it allows them to avoid conflicts and
motivate people to work and get things done. And it creates wealth, and people like that. And so, it seems
like something that was learned.
We had a big grand experiment with socialism obviously in many places of the world, and the socialists
kind of gave up on it. They decided, this works better. That's why we have in China now market socialism.
It's still socialism in a sense. It's transformed and it's different, but it does have a stock market and it's
growing rapidly there. But I don't want to exaggerate the importance of these, either, because the total value
here for the United States is only 82% of one year's GDP. Another way of putting it is: let's round that to
$12 trillion, and there were about 300 million Americans in 2008. That's $40,000 per capita as the total
value of the stock market. Now does that sound like a lot of money to you? Well, think of it this way. For a
family of four, that's $160,000. That won't buy you a house, so it's not that big. It's big, but it's not that big.
What you have to remember is that corporate stocks are claims on the profits of corporations, but most of
what corporations do is, take money in and pay it out. They pay it out to their employees and to other
people, bondholders and taxes, lots of other places that money goes to.
So, the actual value of the stock market, I think most people exaggerate it in their mind. It's not that big. It's
big, but not that big. It's smaller in other countries. You might wonder, why is it that in Europe it's only
38% of GDP? That sounds funny, right? In Europe, they're moving I think in the direction of more modern
corporations with big exchange traded corporations, but they often do things on a smaller scale still.
So, for example in Germany; you notice that often companies in Germany, after the end of their name they
have AG. That stands for Aktiengesellschaft, and that means stock market company. But others have
GmbH. Do I have that capitalized right? Gesellschaft mit beschraenkter Haftung. That means a family
company. It's a company that's not traded on the stock exchange. What we're looking at here are traded
stocks. Actually, my company that I was just telling you about was never traded. That's called private
equity. If it's on the stock exchange, it's public equity. And if it's not traded, it's private. So, this is private,
and this is public. And there are similar distinctions in other countries, but this is Germany.
I just wanted to be clear about one thing. The word equity; It has many different meanings, but the meaning
that we have here is shares in a corporation. I was curious about how far back that term goes. That word
equity, referring to shares, was not coined until, I think, it was 1904 according to the Oxford English
Dictionary. And it was American. That's an American term that's now spread over the world. But we use
equity. I was trying to think, why do we call it equity? I think equity means equality and fairness, and so,
what it means is, each share is equal. I think that's what it means. We're treating people with equality. So,
that's what we--we have an equitable division of profits among owners of a corporation.
By the way, I was making a comparison. I said the value of shares in the United States is $40,000 per
capita, and it must be much less in Europe, like $20,000 or less of traded stocks. I just want to compare that
with houses. I said $160,000 would be the share of a family of four in that value of the U.S. stock market.
Actually, it is quite clear that the value of houses in the United States is greater than the value of the stock
market. According to the Federal Reserve, the total value of houses in the United States in 2010 was $18
trillion. That's quite a bit higher than the value of the stock market. Incidentally, the Federal Reserve
estimates the total assets of households in the United States, and in 2010 that was $69 trillion.
So, people own a lot of other things besides stocks. So, I'm kind of minimizing the importance of the topic
of my lecture, because stocks aren't that valuable. We couldn't solve the poverty problem by redistributing
the stocks among all the people. Suppose we did that, all right? Supposed we said, let's grab all of the
stocks away from the wealthy people and let's just share them equally among the whole people. So, some
poor family would get $160,000 one time only, right? Remember, one time only. It's a stock, it's not a per
year amount. So, would that lift them out of poverty? Not if you have to live the rest of your life on
$160,000. You'd still be in poverty. So, the solution to poverty is not redistributing stocks. I think the
solution to poverty is instead making these markets work better, so that we produce more.
OK. So, I'm going to talk about stocks and the different kinds of stocks and the laws of the stock market
here today. And then, I'm going to come at the end with a couple of examples of companies. I have an
example of Xerox and Microsoft, both high-flying companies in their days.
Chapter 4. The Structure of a Corporation [00:15:46]
Another term that I just want to use, corporation. Corporation comes from the Latin corpus, meaning body.
The idea of a corporation is like a legal person. The lawyers say natural person. Each one of you is a natural
person, but there are artificial persons as well, and the corporation is called an artificial person, even though
it really only is owned by people. It's like a slave belonging to the shareholders. So, that's the origin of the
term. Actually, corporations go back to ancient Rome where they were called publicani, and they had a
stock market in the Roman forum, but they were never allowed to proliferate. The laws encouraging them
did not create a swell of new companies. They were very few of them. It wasn't until the 19th century that
corporations really became important.
Now, a corporation is owned by the shareholders, and in most corporations all the shareholders are equal.
That's why we call it equity. And they all have one vote. It's one share, one vote. Not always. There have
been exceptions. There are non-voting shares, but usually they all vote. And the idea is that the
shareholders vote to elect a board of directors. This is what they call shareholder democracy. It's inspired
by political democracy. They were going to set up a company that's democratic, but it's not democratic in
that every person has a right to vote. It's each share has a right to vote. And so, that's the essential idea.
When you form a company in the United States, you have to choose a state to incorporate in. And then,
each state has its own corporate laws. So, my company, we did it in Massachusetts. A lot of people like to
do it in Delaware, because they like those laws of Delaware and the taxes of that state. So, you choose, and
then the state will dictate some basic rules, typically that you have to have an annual shareholders meeting
where you vote. That's the idea. And you know, we did that. I remember. We followed the law. Someone
had a plan, and it worked.
And so, what do you do at the shareholders meeting? Well, according to the bylaws of the company, certain
things have to be decided there, but not many. The basic thing you do is you hire a chief executive officer.
You agree to hire that person. And then this chief executive officer reports to the board as an employee of
the company. And in the U.S., the chief executive officer has by tradition often been named as chairman of
the board, but in Europe, that's less likely. There are some different traditions in the rest of the world. A lot
of people say it's not good to have the CEO as chairman of the board.
The board of directors are not generally working at the company. The board of directors are people who
were brought together to give wisdom to the company. And this is what happens. You're setting up a
company and you don't know where to go and what to do. You need someone to run the company. That's
the CEO. And the CEO is probably a gung ho guy who is going to work 80 hours a week and he's ready to
go. But he needs guidance, he or she needs guidance. So, you get people with different perspectives,
someone who ran a business years ago and is retired or any number of different kinds of people.
And the board will meet more regularly than the shareholders. Shareholders don't want to get involved
typically, because they typically own many companies. They don't have time to worry about it. If you keep
a board small enough, so there's not too many people, like 6 to 10 people, and they know everything about
the company, they're privy to all the information. And they talk to each other at regular meetings and they
call each other up on weekends. It's part of the concept of a director that you just take responsibility for this
company. You don't run it, but you're responsible for it.
The law says in the United States that if you join the board of directors, you have a duty of loyalty to the
shareholders, OK? That you were elected by the shareholders to be on the board, and you have a duty. You
may not own any shares in the company. Typically, you don't. And a member of the board is paid some
token amount of money. You wonder why people do it. They often do it just to kind of stay involved and
keep themselves learning. They can make substantial money, but they're not the owners of the company.
They don't get rich by it. They're the wise people that were brought in. You know, you joined the board.
You're taking on a responsibility. You're not taking on a massive responsibility. You only meet a minimum,
maybe, of four times a year. You'll be on phone calls. But you have some responsibility for the company.
And some people like that. They kind of sense that, well, I'm a productive part of society. I have this
company. I'll learn all about and think about it in a broader perspective. So, that seems to work. This sort of
organization seems to work really well.
You know what will happen? The board will be talking informally among themselves and they'll say, is this
CEO really doing a good job? And they think about it. I want to just ask around with our customers. What
do they think? And so, someone might say, we could just get a new CEO. Let's do it. And then the guy's out
immediately, if they vote at the board meeting. This is a structure that keeps companies really good.
In one of the previous semesters, I had Carl Icahn come, who is a notorious board breaker. Well, he comes
in--he told our class here that he likes to buy enough shares in a company to get himself on the board, and
he loves to go and show up at board meetings. He buys companies, where there's relatively ineffective
boards and the board is not really paying attention. They're kind of lazy. And he comes in and makes
shocking statements, like fire the CEO right now. This guy's a loser. And the board gets all upset, because
they kind of like the guy. It's cozy. But Icahn says, you know I can do it. I go in there and I lay it all out.
And it may take a few meetings. I can bring them around and get the company straightened out. So, this is
shareholder democracy, how it works well. Not everyone agrees with Carl Icahn's interpretation. He's a
controversial guy.
Now, another thing I want to say, there are basically two kinds of corporations. There's for-profit and
nonprofit. I've been talking about for-profit. And all these people [correction: companies] I had on the
screen as listed shares are for-profit. That means they have shareholders. There's another kind of a
corporation, which is called nonprofit. And we're standing in one right now. It's called Yale University. It's
a nonprofit corporation. And it has a board of directors. They call it the Corporation. They meet regularly.
It's like other corporations, but there are no shareholders. So, how can that be? Who owns Yale? Well, it's a
person. Yale University, like other universities, is a legal person, and its rights are defined by law. And the
profits go back to Yale and accumulate there and are spent for a cause, namely education and research. So,
the board of directors of Yale has a different purpose. They don't have any duty of loyalty to shareholders,
because there are no shareholders. I mean we could call you shareholders, I guess, if you are students here,
but that's not what you're called, and you don't have any right to the profits. The profits are spent for good
causes.
So, you kind of wonder, well, those two sound very different, don't they? Because a for-profit is trying to
make money, and the nonprofit is doing something for a cause. That seems totally different. But they're not
always totally different, because a lot of what happens in corporations is determined by the kind of
sociology or the organizational structure. Some people serve on multiple boards. They'll be on Yale
University and they'll be on some other company, for-profit, but the same person probably behaves
similarly in both places. So, oddly enough, for-profit and nonprofit don't often mean that much. We're
going to come back to nonprofits later in this semester, but I'm really talking about for-profit. Now, that
sounds kind of selfish in a sense. A lot of us like nonprofits better. They have a different cachet in our
society.
I was talking to Peter Tufano, who's a professor at Harvard Business School, who set up a nonprofit
company called ''Doorways to Dreams.'' That's the name of his company. There's a website. Search on
Doorways to Dreams. And it's all about finance for the poor, the less represented people. And he said
setting up a nonprofit was the greatest thing he ever did, because it opens doors for him. He walks in and
says, I'm running a nonprofit to benefit poor people in the United States, getting their financial things in
order. He said, everyone respects me. If I say I'm trying to make a profit, they were skeptical.
We have one professor in our econ department, Dean Karlan, who set up a big nonprofit at Yale. That's
kind of rare. His is called ''Innovations for Poverty Action.'' And just last night, I had a door-to-door
surprise. I had a young Yale freshman come by asking me to donate here in New Haven. I guess Yale gets
donations. It's all ambiguous, but private companies don't get donations generally.
Chapter 5. Corporate Financing through Equity [00:28:28]
All right, the value of a share in the company is equal to the total value of the company divided by the
number of shares. So, the market cap of a company is equal to the value per share times the number of
shares. Market cap is short for market capitalization, and that is the value of the company. The key thing
you have to know about a company is, how many shares are there and how many shares do I have? Maybe
I'm repeating myself, but if there's a million shares outstanding and I own 1,000 shares, I own 1/1000 of
everything the company owns after their debt. But if there's 10 million shares and I own 1,000 shares, then
I own only 1/10,000. So, you have to know the number of shares. The number of shares that you own is
meaningless, unless you know the total number of shares in the company. And all the different shares are
treated equally. If they pay out any money to one shareholder, they've got to pay it out to all the other
shareholders in proportion to the number of shares.
Now, companies issue dividends. A dividend is paid to shareholders when the board of directors decides to
do it. And the board of directors doesn't have to do it. I'm talking now exclusively about for-profit, all
right? So, at a board meeting, they can say, hey, let's pay a dividend. I remember this, because we had
exactly this meeting at our little company. We gave shares to all of our employees to motivate them.
Everyone's a shareholder. But they had tiny numbers. Some of them had very little shares. And we had a
board meeting and we said, you know we've never paid a dividend. Should we do it? Should we pay a
dividend? And then we had a discussion, and someone said, well, you know all these employees wonder if
their shares are worth anything. Maybe, if they got a check in the mail, they'd feel better. But you see, the
dividend is subject to the discretion of the company.
Ultimately, people own shares to get dividends, right? The dividend is the distribution of profits. If a
company never distributed dividends, it would be like a nonprofit, right? If they kept all the profits. They
can do that. There's no law saying that they have to distribute dividends. They can just keep it in the
company and, like Yale University, get a huge endowment and just let it get bigger and bigger. But the
whole purpose of a for-profit company is to pay dividends. And so, sooner or later they do it, but typically,
young companies don't pay dividends. Why not? Because everybody knows that our money is in the future.
We're starting up. We're not making a lot of money. In the future, we'll have a lot of money, so let's pay
dividends later. For example Microsoft, that I'm going to describe, went through decades without ever
paying a dividend. They just kept plowing it back into the company. Now, if you knew that they would
never pay a dividend, then you wouldn't want to own Microsoft shares. But you think, well, eventually
they're going to, so that's why you own the company.xxz
This is a very common misunderstanding. A lot of people think that you buy stocks because the price will
go up. Well, the price will go up only because people think there are more dividends coming. At least in
theory, that's the way it should be. The price ought to be--and we'll question this later--the present value of
expected future dividends. So, the true value of a company is entirely in the dividends. It seems a little
funny, because you think, well, the board of directors doesn't have to pay a dividend and they could just get
nasty and never pay it out. But remember, you elect the board of directors. And so, if you're frustrated that
our company is accumulating lots of money and it's not paying it out. I want the money, right? So, I'm not
going to vote for this board. I'll put Carl Icahn on or someone else. Pay it out. And then that's what
happens, they start paying it out. When they pay out a dividend, the share price falls generally, right? Very
simple. Why would the share price fall when they pay out a dividend? Well, because the company is worth
less. They had this money and they paid it out, so it should fall by the amount they paid out divided by the
number of shares, right? And companies do that routinely. When they declare a dividend, price falls.
It's called the ex-dividend price, and they show it in newspapers. They used to show it in newspapers. Now,
it would be on the website. They put a little x by the stock price on the day after a dividend is paid to tell
you that the price decline that you just saw is not anything to worry about. It doesn't mean there's bad news
about the company. It just means they just paid a dividend. So, the price routinely goes down by the
amount of the dividend. It doesn't mean anything.
Some stockbrokers have tried to alarm investors about dividend payment dates and mislead them. Some
stockbrokers would say, why don't you buy the stock right now, because if you buy it right now, you'll get a
dividend. They're going to pay a dividend in three days. Hurry up and buy it and you'll get the dividend.
That's called selling dividends and it's considered unethical for a broker ever to tell you that, because it
really doesn't matter. Because if you buy it later, you won't get the dividend, but you'll get the share
cheaper. And it all comes out to about the same. You don't have to worry about dividend payment dates,
because the stock price jumps down right after a dividend. Except maybe from second-order effects, it
doesn't matter whether you buy before or after a dividend.
All right, so, you see the idea here. The idea of a corporation is we have these shares, and the shares are
always salable. So, let's say four of us young people form a company. And then after a couple of years, one
of us says, I've got another job. I'm tired of this. I want out. And you say, fine. We'll buy your shares back,
OK? And we agree on a price. So, it's very fair and easy. People can get in and out as they please. And the
only people involved are people who want to be involved. And then you'll find some new person. The four
of us set up a company. There's some new guy who just heard of us. And he thinks, this a great idea. I want
in. So, then you say, all right. We'll sell you shares in the company. But maybe the price has changed.
When we started, we might have been worth a lot less. The guy has to come in at a new price, and the price
is changing every day. It makes very good sense.
So moreover, if the company needs to raise money to go do business. So, we've started a company and we
need to build a new factory, let's say, to expand our operations. Well, we can go out and issue more shares
to buy the factory. So, we go to a stockbroker, who is like a real estate broker, who deals in markets for
shares. I'm talking about a small company, so I'm thinking of a private company for which there's no stock
market price. But the stockbroker can go out and say, I'll find a buyer. I have various contacts. I know
people who deal with wealthy individuals looking around for an investment. Maybe this person will buy
some shares, and then you'll get the money. That's an alternative. That's called equity financing. That's an
alternative to financing by debt.
Chapter 6. Different Forms of Corporate Financing [00:37:10]
Your company could also go to a bank and ask for a loan, called a corporate loan. Or your company could
borrow money on the bond market, by issuing bonds. You can go to a broker and say, we want to sell
corporate bonds. But the difference of those is that it's at a fixed interest rate and it's not a share in the
profits. So, equity financing tends to attract lively investors who take risks. If a company gets debt, then the
debt leverages up the risk of the company, because you as a shareholder now are paid only after the debtors
are paid. You own the value of the company, which is the assets minus the liabilities, as a shareholder. But
you've got to subtract off the liabilities. So, companies have a choice of how to finance their operations.
Typically they start out with equity. I guess they could start out with debt as well, but in our case of our
little company, it was all equity at first, and then we got bank loans and so we started to get leveraged. And
that's what happens. Big companies do the same thing.
I'd like to talk about the simple company that you might set up with your friends, because it seems so
personal and you can imagine doing that, right? You can imagine the kind of conflicts that you would have.
But these little companies have a way of growing really, really big. So, I'm going to talk about a little
company set up by Bill Gates and Paul Allen in 1975. Bill Gates was an undergraduate at Harvard and he
saw an opportunity and he dropped out. He was right. He never got his Harvard degree. I suggest that if you
see such an opportunity, you do the same thing. I hate to say it. If you can see an opportunity like that. It
started out with just Bill and Paul and their little company. But they have a way to grow into bigger and
bigger things. The question is, are they really different later?
So, one important question is about whether big companies really use equity financing. Are they still
functioning the way I'm describing? See, I set the idea of a company up as a structure that lawyers invented
that allows people to work together and allows them to get in and out of the company. Does it really still
work that way for really big companies? There's been a complaint about the stock market, that the
companies generally don't issue any more shares once they're big. This is a complaint. I'm not saying it's
right. And that the stock market ends up as a market for existing shares. The idea is, are the stock markets
of the world functioning to make capitalism work better? Well, I could say, they should be, because the
price of a share in a company is an indicator of the value of the company and it directs resources. I mean,
people look at that price and they decide where to invest. But if they're not issuing any more shares, does it
matter?
I had a quote from Karl Marx here. You've heard of Karl Marx, the founder of communism. In his book,
Capital, Das Kapital, his classic work, said:--I'm quoting Marx--"Since property here exists in the form of
stock, its movement and transfer become purely a result of gambling on the stock exchange, where the little
fish are swallowed by the sharks and the lambs by the stock exchange wolves." OK. That was Marx's view,
but even in communist countries, that view doesn't seem to be holding sway anymore. The thing that lent
some credibility to these theories is that it often seems that big companies don't issue many shares anymore.
I'm going to qualify that.
But there was a very influential article written by Stewart Myers, who's a professor of finance at MIT. And
that was in the Journal of Finance in 1984. And he gave some statistics. This was an influential article,
making it sound like shares don't really matter for big companies. He said, how do companies really finance
their needs? And he came up with data. This is Myers's data from 1973 to 1982. And he found that 62% of
corporate financing needs came from, in the United States, retained earnings. What he's saying is,
companies, they didn't sell new shares, they just accumulated profits. And then, when they had to build a
new factory, they went to their own piggyback and they bought the new factory or whatever it was they
needed. And only 6% was equity issued. This is for the whole U.S. stock market. And the rest was debt that
they would borrow money for.
So, Stewart Myers said, you know all this idea that stock markets function to allocate resources and the
share market means something is really misleading. So, what he proposed is what he called the Pecking
Order Theory. What he meant is, companies really don't want to issue new shares. They just don't want to
do it. We own this company. We're not letting more people in. So, what they first do is they just try to save
their own money. This is Myers' explanation. Companies save money and when they have money, they
spend it on expanding. That's the highest on the pecking order. They like that the best. But if they really
need money and they can't save enough to expand, they have a lot of expansion opportunity. They'll go to a
bank and borrow. They'll go to an investment bank and issue bonds. And then, only if it's really, really
important and they can't get enough money, they will go to selling their shares. So, I don't know if Stewart
Myers said Karl Marx was right, but he seemed to be saying that equity issuance just wasn't that important.
However, I think that is misleading.
I'm going to refer now to another article that came in much later criticizing Myers. And the article is by
Eugene Fama and Kenneth French, thats at Chicago and Dartmouth respectively. They wrote an article in
2005. This is in the Journal of Financial Economics 2005. They said that the problem with Myers's
Pecking Order Theory is that Myers was looking at aggregate data and he was looking at a time period
when there was relatively little issuance of equity. When Myers said only 6% of corporate financing comes
from equity issuance, they were talking about net equity, that's total new sales of shares by companies
minus repurchases of shares by companies. And so, it averaged out to be a low number. But in fact, as
Fama and French point out, in the same year that Myers studied, from 1973 to '82, 67% of U.S. companies
issued new shares each year. And also in subsequent years, the percentage went up. From 1993 to 2002, it
was 86%. So, they're all issuing shares. It's just that some are issuing and some are buying back. So, I think
that we should conclude that companies really do use equity financing, even big companies. And the stock
market is important for the price discovery.
Chapter 7. The Interplay between Corporate Decisions and Financial Markets [00:46:56]
I wanted to remind you of the term dilution. Dilution refers to what happens when a company issues more
shares. So, imagine that you are showing up at a shareholders meeting. The board has decided to issue--
let's say our company has a million shares outstanding. They've decided to issue another million at $10 a
share. And so, what do you think about that? Well, if the company had a million shares, and I owned 1,000
shares, then I own 1/1,000 of the company, right? If they issue another million shares, then there'll be two
million shares, and I'll own only 1/2,000 of the company. So, my first thought is I don't like that. I owned
1/1,000 of the company, and now I'm falling in half. But they would say, on the other hand, look, we're
selling them for $10 a share, so the company will have $10 million to invest. So, even though your fraction
of the company has been diluted, the company is worth more. Then, you have to decide whether $10 a
share is a good enough price. Is it worth that? And so, it's never obvious. You always have to consider
dilution, because anything that expands the number of shares decreases your interest in the company.
The opposite of dilution occurs when the company buys back its shares. That's repurchase of shares by a
company. A company can always do that. They can decide to go either way. If they need more money, they
can issue shares, and if they want to get money out, they can buy back shares. And these things are very
common. There are statistics, like what Fama and French showed for equity issuance, which show that
repurchases are very common. And it happens all the time in the market. That's what makes the stock
market so active.
One reason traditionally for share repurchases is tax reasons. If a company pays a dividend, that goes in as
income to the shareholders and it's taxed. It used to be taxed at a higher rate than capital gains, so there was
an advantage to share repurchases. Instead of paying dividends, I should just buy back shares. And then the
shareholders would have a better tax--they would be taxed at a more advantageous rate. But now the tax
rate on dividends and the tax rate on capital gains is the same, but still there's always going to be
complicated tax issues. And so, issues of taxation may still motivate some decisions about share
repurchase. But you have to understand that it's getting money out of the company. And as a shareholder, if
the company wants to send me a dividend, I say fine, I've got money. If the company says I want to buy
some of your shares back, you say fine, I've got money. I don't care. And so, if they buy back 5% of all
their shares, then the total number of shares goes down. My fraction of the company is the same
[correction: the fraction increases], and I've got money. It's the same as getting a dividend. So, you can be
confused by these things. Dilution and repurchase are neither good nor bad. It depends on circumstances.
And you have to look at the business and what's being done with the money.
I wanted to mention, there's another kind of share called preferred. I've been talking here about common
stock. Common stock is the real ownership in the company. In other words, you take all the profits. They're
the ultimate owners of the company. Nobody is above them in the hierarchy. But there's something close
that's considered close but different. It's called preferred stock. And preferred stock has a set dividend. The
contract says that the dividend is so many dollars per year, and the board doesn't have to pay it. But
typically, the contract says, they cannot pay a dividend to the common shareholders until all the dividends
to the preferred shareholders are paid up. And the preferred shareholders typically don't have a vote. OK.
So, this is it. You could buy preferred stock in some company and then you would know exactly what your
dividend is. Usually, they just pay a dividend. It's like owning a bond. And it's always the same amount. So,
you're not betting on the company doing better or worse generally, but if it does badly, you might lose your
dividend for a while. If a company goes bankrupt, well, then you're out. But if the company starts doing
well again, they've got to go back and make up for all the dividends they missed. So, preferred shares are
safer than common shares, but they lack the upside potential. They're not as exciting as common shares.
So, when General Motors got into a crisis, the U.S. government bailed out General Motors. What they did
was to buy preferred shares in General Motors. So, the U.S. government was a preferred stockholder in
General Motors. Why did the U.S. government do that? Why did they buy preferred shares rather than
common? Well, they now do have common shares as well. I think the government wanted to not be a
stockholder, not to be a voter in GM. They wanted to keep their distance, because this is America. This is a
capitalist country. If the U.S. bought common shares in General Motors, it's like nationalizing the company,
right? The government would be on the board. They would have the votes. They just didn't want to go that
far, so they bought preferred shares in General Motors. Later, General Motors got on its feet again and
bought back the government's preferred shares. So, the government is no longer a preferred shareholder in
General Motors. Common is much more important than preferred.
OK. Now, I'm going to talk a little bit about dividends. What determines whether a firm pays dividends?
There's a famous article by John Lintner. John Lintner was a professor at the Harvard Business School and
also one of the inventors of the Capital Asset Pricing Model. He wrote an article in--when was it? It was a
long time ago--about why firms pay dividends. Remember, it's a judgment call by the board of directors.
So, he interviewed people who were involved in those judgments and asked them, why do you pay
dividends? Why did you decide to pay a dividend of a certain amount? And he wrote a long article about
this. And he found out that it was impossible to summarize everything they said. They said so many
different things.
Corporations are very complex, and there's a lot of different people, who have different feelings. And we're
trying to keep people happy. And you want the company to do well and be perceived well. One thing he
learned is that companies think that thats our job is to pay dividends. You don't have to earn an income
now. You're young, right? Eventually people are going to get fed up with you if you don't earn an income.
So, it's the same thing. As a company matures, it's part of life's passage. You start paying dividends and you
take pride that you're paying dividends and people are getting money out of you. You hear a lot of
generalities like that, but what really decides?
And one thing he learned from them is, they told him, you know one thing we don't ever want to do is cut
our dividends. Once we start paying a dividend, if we stopped, it'll get a lot of attention. Well, it's like for
you. You're young people. You don't have a job. Nobody is complaining. You could go for a while like this
and say, you're still young. But once you start in a job and then you quit, it looks bad, right? If you're 40
years old and you say, I'm just dropping out, it looks worse than if you do it at your age. It's the same for
companies. Once they start paying a dividend, they've got to keep paying it. Otherwise people get angry.
So, that was one theme.
But what Lintner said, even that doesn't tell the whole story. So, he tried to build a mathematical model of
dividends. And the model that he came up, which he then fit to the data, and found that it worked very well,
was that these boards of directors have a target payout ratio of earnings basically. This is the bottom line.
They think they should pay out a certain fraction of their earnings, because the shareholders will get mad if
we're making a lot of money and we're not sharing it with you. So, maybe we'll pay out half of our
earnings, and the other half we'll keep as retained earnings, so that we don't have to go out and issue new
equity or borrow money. It all sounds reasonable. And then, because they don't like to cut a dividend, they
don't want to adjust upward quickly if earnings shoot up. Because, if they go up and raise their dividend,
then they might have to cut it if earnings go back down.
So, this is the Lintner model. And it is that

where DIV
t
denotes the dividends at time t--year t, let's say, DIV
t-1
the dividends in year t-1, EPS
t-1
earnings
per share in year t-1, and %
t
denotes noise in year t. And * is between 0 and 1. So, they have some fraction
of earnings that they want to pay out. And if earnings per share rise, so that * times earnings per share is
greater than dividends, then they increase their dividends. And & is between 0 and 1. That's the Lintner
model. And he showed with the data that it pretty much summarizes what firms are doing. So, they have a
payout ratio out of earnings. And the payout ratio has been declining over the last century. It used to be
typically 60 to 70%. In 1900, shareholders were impatient with companies. They wanted to see the money,
but they let them keep 30 or 40%. But now we've become more and more believers in the stock market and
we allow companies to do better things.
Chapter 8. The Balance Sheets of Xerox and Microsoft [00:58:54]
So, I said I would talk about some examples of specific companies. Let me get back to my slides here. I
wanted to start with Xerox. Xerox Corporation, you've heard of it? You've heard of Xerox? It's still there. It
exists. Xerox Corporation was founded in 1906. It wasn't called Xerox. It was called the Haloid
Photographic Company, and they produced photographic equipment. But they had a big impetus forward
when they met Chester Carlson, who was an inventor. And what Chester Carlson invented was a copying
machine that used plain paper. They used to have copying machines going all the way back to 1906, but
they were very expensive. To get a copy of something, a photographic copy, it cost you maybe $1 a page,
extremely expensive for that time. But what Carlson invented was a dry copier. It used to be that what they
had to do was take a photograph of the document that you wanted a copy of and then process it through the
different chemicals that they use. It comes out wet, and you have to hang it out. That was expensive and
inconvenient. They did have copying machines; they just didn't work very well. But he invented this
process that you could take any paper and put it through, plain paper, and it would come out hot and dry,
and cheap.
So, Xerox became an overnight success, because they had a patent on Carlson's thing. It became the
glamour company of the 1960's and 1970's. So, it was one of the Nifty Fifty. People were very impressed
with Xerox in its day. So, Xerox means dry in Greek. It's a dry copier. And it was considered a high tech
company, moving forward rapidly, but then it suffered a problem. Do you know what the problem was? It
was doing really well, until sometime in the 1990's when another invention came. And it wasn't Xerox's.
It's called digital copying machines, where the machine would have a computer that would scan-in the
document and then produce a copy. And it had a lot of advantages over the Xerox copier. So, the company
almost went under.
What I've got here is the balance sheet from Xerox Company. And this comes from a website, sec.gov. And
I got this from the 10-Q report. Xerox is a public company, not a private company. It's traded on stock
exchanges. So, U.S. law says, any public company must file a quarterly report with the Securities and
Exchange Commission, and they put it up on their website. This is the website. So, any public company's
balance sheet is on the web. And it's there, updated every three months. And I've got a couple of them here.
I've got 1999 and 2010. My little company, Case Shiller Weiss Incorporated, it was not public, so our
balance sheet was never up there on the sec.gov. That's one of the disadvantages, many people say, of
becoming public. If you start out as a private company, then and you want to get listed on the stock
exchange, that's called going public. When you go public, the SEC is on your back and you say, you now
have to file those quarterly balance sheets. So, this is what I've got. So, this is Xerox, and it's all up there on
sec.gov. I've got it for 1999. This was right at the time when they were really in trouble, because the digital
revolution was killing Xerox.
And I just wanted to show a balance sheet of a company, because there's two sides to the balance sheet.
There's assets and liabilities. Assets are things the company owns. Liabilities are debts the company had.
So, this is one side of the balance sheet, but I've got it for two years. And everything is in millions. Xerox
had $126 million in cash in 1999 and they picked up.
The company was dying in 1999. In 2001, they hired a new CEO, Anne Mulcahy, and she is credited with
saving Xerox, turning the company around. So, by 2010, at least in terms of cash, they are doing better, but
maybe not a lot better. She saved it from extinction, but she didn't move it back on to the Nifty Fifty. So, I
just wanted to look at what a company owns, and this is just an example of a balance sheet. So, Xerox
owned $15 billion of receivables in 1999. It was a much lower number in 2010. I don't know. It might
reflect time of the year or something. Receivables is money that's owed to them. They ship their copying
machine to someone. The guy says, I'll pay you in three months. That's a receivable. And they had
inventories. That means, probably, copying machines ready to be sent out. And they own buildings. The
buildings, it looks like it went down under Mulcahy. It went down from 2.4 billion to 1.6 billion. And then,
there's a lot of other things. So, the value of everything that the company owns wasn't much changed. 28.8
billion went up to 30 billion. So, at least she stopped the company from failing.
But now that's only half of the balance sheet. I have to go to the other half. And these are the liabilities.
This is what the company owes. So, it has short-term debt. Let's talk about 2010. 1.6 billion. Long-term
debt of 7.8 billion. Deferred taxes. That means taxes that they know they have to pay that they haven't paid.
They didn't have any in 2010. And preferred stock. They did have a small amount of preferred stock
outstanding, which counts as a liability. All right. And then, other liabilities. I put them all into one
category.
Now, this last liability is unique, because it's the residual. It's called shareholders' equity. This number, the
total liabilities, has to equal the total assets. This is the same number that I showed you on the preceding
page. What's the difference? It's the shareholders equity. OK? So, it's 11.9 billion in 2010, up from 4.9
billion. So, by this measure, it's a success.
Now why is shareholders' equity--is this the value of the company? No, it's the value of the company on the
books. So, according to their books--I'll go back to it--they have all these assets, including buildings and
equipment. Where did they come up with this number? How do they know what their buildings and
equipment are worth? It's an estimate, because who knows what they could sell them for.
So, in principle, this shareholders' equity is what the shares are worth, all of the shares, $11.9 billion.
Because if you bought the company and you sold all the assets and paid off all the debts, that's what would
be left. So, you divide that by the number of shares and you can get an estimate of the value of a share. But
I say an estimate. It's not the same as the market value. In 2010, there were 1.4 billion shares outstanding in
Xerox. The price per share of a Xerox common share in 2010 was $11.80. So, if I multiply the number of
shares by the price per share, the market cap for Xerox is $16.4 billion. Compare that with the shareholders'
equity of 11.9 billion. So, the company is worth more than its shareholders equity. And you might ask, why
would that be? OK? Well, I think the answer is, you wouldn't buy this company to shut it down, right? You
could buy the company for 16 billion and then shut it down, sell off all the assets, pay off all the debts, and
you'd have 11 billion. So, that's a sign of Anne Mulcahy's success. Her company is not going to be shut
down.
If the stock price falls below the shareholders' equity, it becomes at-risk for being shut down. Somebody
buys the company and shuts it down, because I can make money. If the company were selling for 5 billion,
I might do that. Well, not me. Somebody who arranges these things could do that. So, I buy the company
for 5 billion. I tell everybody, you're all fired. We're going out of business. I sell it. I get $11.9 billion. I've
doubled my money. All right? Now, a company can sell for less than the shareholders' equity, because the
shareholders' equity is kind of a funny number. It's also called stockholders' equity by some people, same
thing. It's a funny number, because it involves all kinds of estimates. And you really try to sell that real
estate for what it says here, you might find problem.
So, the market capitalization can follow below shareholders' equity, but probably not too far below. And
this is what worries boards and CEOs. They watch their stock price every day and they've got in their mind
that, shareholders' equity. And if the stock is falling below that, then they're in danger of liquidation. So,
they worry. And that's why every morning, if you are a CEO, if you're a CEO of a public company, you
will be watching your market cap every day and comparing that with shareholders equity. So, Xerox is an
example of a company that's doing all right now. I'll show you its price. I don't have it all the way back to
1906, but this is Xerox price per share, and it's corrected for splits and other special factors, from 1977 to
2001. And you can see the incredible crash they took after digital copying came in. In the 1990's, they were
soaring. They looked great. They must have been doing something right, but they had their heyday and it's
over. So, Anne Mulcahy came in when the company was utterly collapsing, and I guess she's a success. But
it's not its former self, it's limping along.
I wanted to tell you now about Microsoft. So, that was founded in 1975 by two people your age, I guess. As
of 2000, it had assets totaling 52 billion, and in the last ten years, it's almost doubled it, so its assets are 92
billion. What does it own? Well, it has cash of about 4 or 5 billion. Short-term investments, a lot of short-
term investments, $37 billion of short-term investments. This is a company that's doing well. It's not on the
end of its life. And it has property. They have this nice campus in Redmond, Washington. They call it a
''campus.'' It's fun. Fun place. Anyway, it's not that expensive. All their real estate now is only about $8
billion, and that's all of their computers and equipment. And then, they own stock. This is really different
from--Xerox doesn't own any stock, they're trying to limp by, they're trying to get back in stride. Maybe
they have gotten back in stride. But they've got $10 billion in the stock market, other companies they own.
They own all sorts of stuff. This is a company that didn't pay a dividend until recently. And Bill Gates and
Paul Allen were still there running it.
Maybe there's a little bit of truth in this Pecking Order Model. They just wanted to save their own money
and they thought their shareholders would understand. Microsoft is doing so well. Are you really expecting
us to pay your dividend out? We have all of these opportunities, so we'll keep the money. And people had
enough faith in these guys to let them do it. So, by this account, the total assets of the company were 92
billion, but we have to look at liabilities. Remember, the shareholders' equity subtracts off liabilities. So,
here are their liabilities. They have some income taxes that have to be paid, but it's only $1 billion. That's
like small change, right? It's because of some timing effects. Accounts payable, this is some money that
they owe. They do owe money, because every company delays paying their bills for a little while anyway.
So, they had something.
Unearned revenue. Typical case is, they've sold a Windows system. They've got the money, but they really
haven't completely earned it yet, because you're going to be calling up with complaints and they're going to
have to do things in the future for the revenue that they've already earned. So, they count that as a liability.
They didn't have any debt in 2000. This is strange, right? You think they were making so much money,
why should they borrow? For some reason, it's now up to about $10 billion. I can't explain that. And so,
you add all these up and subtract them from 92 billion and their shareholders' equity is 48 billion. So,
they're doing pretty well. They're much bigger.
But is that the way to measure Microsoft? This is a measure of the value. It's really the liquidation value of
Microsoft. So, you could imagine buying Microsoft and then selling all those assets, shutting it down, firing
everybody. Would that be a smart thing to do? You fire everybody. You sell the Redmond campus. You
sell all of their computers. And what do you end up with? $48 billion. Well, let's compare that with the
market cap of Microsoft. They have 8,497 million shares outstanding, and the price per share at the end of
2010 was $26. So, the market cap is $221 billion. So, that's over five times their shareholders equity. That
means that they have some other value. I think I'm running out of time. It's interesting what happens in the
world. I'll stop with this. This is the price per share of Microsoft. I should disclose. I'm now a shareholder. I
wish I were a shareholder back then. Nobody believed it. This only goes back to '86, but the company
maybe was private. I forget when it went public. So, we don't have prices [addition: before '86], but we
have prices in '86. It really had a run until 2000, and then something broke with Microsoft as well. It looks
a little bit like Xerox, doesn't it? I think it was the end of the high tech bubble. This was a bubble in tech
prices, and Microsoft rode the bubble. But it's still doing very well. It's just not going up lately.
Anyway, this is an example. We're going to talk about real estate, the other asset class that I've mentioned,
is even bigger than the stock market, in our next lecture on Wednesday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 10 - Real Estate [February 16, 2011]
Chapter 1. Early History of Real Estate Finance & the Role of Property Rights [00:00:00]
Professor Robert Shiller: I'm going to start by talking a little bit about the history of mortgage lending.
And then, I want to talk more recently about how we do commercial real estate finance, and then,
residential real estate finance. And then, if I have time, I'm going to try to get into discussing--
[side conversation]
Professor Robert Shiller: So when we talk about real estate finance, it's really about financial contracts
that involve real estate, and that particularly use real estate as collateral. So, it's a very complicated history.
But I'd like to put things in a long-term perspective.
I want to start with the word mortgage. It actually goes back to Latin. Mortuus vadium. And that means in
Latin, death pledge, OK? And then, in the Middle Ages in France, they substituted the French word for
vadium. And that's [circles Gage on blackboard]. I don't know how to pronounce it. That means pledge in
French. And I don't know why they called them death pledges. That doesn't seem to involve death to me.
But in the long history of these institutions, it became important. The Oxford English Dictionary says the
word mortgage entered the English language in 1283. So, we've got a long history here.
Actually, I can take it back further than 1283. I was inspired by the research of Yale historian Valerie
Hansen, who has been reading old documents related to the silk trade. And her documents are based on a
trove of old documents from the Tang Dynasty in China, between the 7th and 10th centuries, which reflect
loans that were made to finance trade. So, you had people going back and forth from the Middle East to
China with silk, and other items, and they needed financing for the trade. So, shed read these old
documents in Chinese. And I was looking over her work a little bit to see whether they had mortgages. She
says that in China, it didn't seem, at least if I'm getting her generalities right, they didn't seem to mortgage
property, at least in these documents. But she says that among these documents are some--they weren't all
in Chinese because they were trading between China and many other countries. So, she found some in the
Sogdian language. She reads all these languages. It's an ancient language of what's modern day Iran. And
it's a dead language. It died out in the ninth century. But she finds some Sogdian documents that look like
mortgages. So, some people borrowed money for their silk trade, and they would mortgage their property,
or their slaves. You could mortgage slaves. It's an awful thought. And then the contracts would additionally
say that you were obligated to maintain the property or the slaves. I guess that meant feed your slaves.
Keep them healthy. Those were mortgages from over 1,000 years ago. So it's a very old institution.
But I think its formed its modern form more recently. And it became a well-known term for the general
public maybe in the late 18th century. I was trying to confirm that. I'm interested in history, just out of a
passion for understanding origins of things. So, I looked up mortgage on ProQuest to find, what were they
talking about. And I found an article in the Hartford Courant, dated 1778. Actually, it wasn't an article; it
was an ad that someone took out. And I think it's kind of revealing of what the mortgage market looked like
in 1778. We here in Connecticut, have--did you know this?--the oldest newspaper in America. That's the
Hartford Courant.
So, a man by the name of Elisha Cornwell took out an ad in the Hartford Courant in 1778. And he explains
in the ad, that he sold his farm, and, instead of taking the money right up front, he'd mortgaged the farm, so
that he sold it for GBP 800 to another farmer. And the farmer was promising to pay him. And if he didn't
pay him, he should get back the farm. The farmer subsequently mortgaged the same farm for GBP 880. So
he made GBP 80 profit. Would all be fine and good, except he still hadn't paid back the first mortgage. And
then the guy mortgaged it again for GBP 1,000. And Mr. Cornwell is protesting, "Hey, you didn't pay me
for the farm in the first place, so you don't own the farm. How are you mortgaging it multiple times?" So he
said, "I thought I better put an ad in the newspaper so that any subsequent victims of this farmer, would be
warned." So that's the end of the ad. He said, "This is my farm because he didn't pay me."
But this shows how undeveloped mortgage institutions were in 1778. Because he had to put an ad in the
newspaper to explain that. The problem was that nobody had any systematic way of representing title. The
farmer, who supposedly bought it from Mr. Cornwell, really didn't, and nobody would know that. You
know, he could fool people.
I think that's partly why you didn't see so many mortgages in those days. Because the law wasn't clear. The
institutions were not clear about property. And so you couldn't really do a mortgage business, if you
couldn't find out whether the guy mortgaging the farm really owned it or not.
And so, it wasn't until the late 19th century that government started to get rights to property sufficiently
advanced that we could develop a big national or international market in mortgages. So, an important step
is in Germany, in 1872, or Prussia, the government created a Grundbuch law that created a system for
Prussia that established in a central book, who owns what, exactly. That was in 1872. And in 1897, they
made it a national German institution. Still, the United States did not have a Grundbuch at the time.
It developed throughout the 20th century in different countries of the world, that property rights would be
clear enough that one could do a mortgage lending business. So that's why I think mortgage lending has
really taken off in the 20th century.
Hernando de Soto was a Peruvian economist, wrote a book a few years ago called Mystery of Capital. And
it's about the developing world. He argued in that book that property rights, the problems that we just heard
about from the Hartford Courant are still very big and alive around the world today. That you can't easily
establish who owns what in many or most countries of the world. So, that's a problem. That's why we don't
see mortgage finance developing there. You can't make a loan.
You know, if you go to some small town in some less developed country, you can ask around, "who owns
this property?" And they'll tell you, "that's been in the such-and-such a family for a long time." But if you
want solid knowledge of that, if you're going to base financial transactions on it, you can't base it just on
hearsay. Someone else might have a different opinion. So even today, in many countries of the world, the
laws are not developed well enough. We don't have property rights established well enough. And we have
laws that might inhibit mortgages. For example, in many countries, if you give a mortgage on a property, in
other words, if you lend on a property, and the person doesn't pay, you're supposed to be able to seize the
property, right? But if the court system doesn't function well, or if it's kind of left leaning and supporting
the rights of the person living in the home, you might not be able to get it. Or it might take you 10 years to
get the guy thrown out of the house.
Now, it seems cruel to throw someone out of a house who doesn't pay on their mortgage, but you have to
think of the other side of it. If we don't throw them out of the house, no one's going to make a mortgage.
You have to be able to get the house. Right? That's the idea of a mortgage. The guy doesn't pay, the lender
gets the house.
And so, I think there's a general process of development, improving the definition of property rights, and
improving the ability of lenders to get the property if it fails, which accounts for the advance of mortgage
lending in the 20th and 21st century. So, that's my long history of mortgage lending.
But I want to get into some specific institutions. I said, I would start with commercial real estate and then
I'll move to single-family homes or residential real estate. And Im going to talk now mostly about the
United States. There are just too many countries to think about.
One thing about finance is that it tends to develop a sort of tradition, and a sort of standard contract. It's
encouraged by laws and regulators. You kind of have to do the same sort of contract that other people are
doing in your country. And I think the standardization is kind of a limitation. We can't be creative in
financing because the public and the regulators will not be receptive to new things.
Chapter 2. Commercial Real Estate and Investment Partnerships [00:13:39]
Let me talk about some of the institutions in finance in the United States. It's natural to start with
commercial real estate. So, you see a lot of buildings. My question is, how are they owned? I don't know
whether you think about this. Who owns these buildings? In much of the 20th century and still today, they
tend to be owned as partnerships. Real estate partnerships, which is different from a corporation. In a
corporation--we talked about that yesterday--you might sell shares on the stock exchange if it's public. And
it's defined as a legal person. And it has limited liability, so that all the shareholders don't have to worry
about being sued as a result.
But a partnership is different. And most real estate, that's not part of a larger business, is owned in a
partnership, rather than a corporation. And the reason is that they're taxed more favorably. Corporations
have to pay a corporate profits tax, OK? They're double-taxed. You as an individual pay an income tax, and
your corporation pays a corporate income tax, or a corporate profits tax. So, you're taxed twice. If you
incorporate yourself, or you set up some friends to do business in a corporation, you get taxed twice. So,
you don't like that, and obviously you try to avoid that. The way to avoid it is not to have a corporation, but
a partnership.
The law allows you to form partnerships to own a building. So, you're building like 360 State Street. It's a
new building that just went up in New Haven. You know this building? The biggest construction. Does
anyone know who owns it? It's probably a partnership. I haven't investigated that. Or it's called a Direct
Participation Program.
So, the partnership is an investment that is offered only to accredited investors. It's not generally available
to the general public. And what is an accredited investor? The Securities and Exchange Commission takes
it upon itself to define, who are accredited investors that don't need the protections of the SEC. Basically,
accredited investors are wealthy people. And it's defined in the SEC laws who is accredited. You have to
have at least $1 million, or minimum income.
And so, if you are an accredited investor, you can invest in a DPP, all right? And then, the income of the
property flows through to you as your personal income. It's not corporate income, so it's taxed only once.
You think about that--well, why would anyone want to form a corporation? Because I don't want to be
taxed twice. So, why don't we do all business as a DPP, as a partnership?
The problem is that the government doesn't want you to do that, and so they have rules about what can form
a partnership. One of the rules is that they have to have a limited life. So, a corporation goes on forever.
And it derives a lot of its value from the fact that it lives forever. There's no end date. So, we talked about
that when I when I brought up the first real corporation, the Dutch East India Company. The reason it got
so valuable is, people could see that this was growing as the first multinational. This huge company that
had all kinds of deals and alliances and business arrangements. And no one wanted that to end. The value
came in the growth prospects for that. But a DPP has to end. It's well designed for a building. You buy the
building, and you depreciate it over the life of the contract. And then there's an end date, and at the end date
you sell the building to someone else, and then you close down the DPP.
You don't hear about these partnerships as much. You hear about corporations all the time. You don't hear
about DPP's. First of all, because they don't get so big. They're typically one building. 360 State, for
example. And it only lasts for 10, 20 years, and then it's gone. So, it doesn't get advertised in the public
because it's not available to the public. They can't go around trying to bring you in as an investor, because
they have to verify that you're an accredited investor. So, it tends to be a project for wealthy people.
Now, I mentioned that corporations have limited liability. Partnerships do not, in general. But you can have
a partnership that involves two classes of partners. There's a general partner that runs the business and does
not have limited liability. In other words, if the business goes bad and loses money, the general partner can
get sued. But there are other partners, called limited partners, and they have to be passive investors, and
they have limited liability.
So what often happens, is a DPP is created by someone who understands and knows real estate. Let's get
360 State Street built. You're going to know that eventually, because once they open, they're going to open
a supermarket in the first floor of 360 State. And I bet some of you will be over there. Because its going to
be the closest supermarket to Yale University. But it's all part of somebody's plan. There was some general
partner who thought up this structure, and got limited partners in, and is managing the building, or hires a
manager for the building, and has a plan and a close out plan. The building won't disappear, but they'll sell
it to someone else. I really don't know the financing structure of 360 State. But I'm just pointing out, it's
likely what's happened there. So, that has been the modern structure of real estate. And if they mortgage the
building, the DPP would mortgage the building on behalf of the partners.
So real estate finance in the United States--I might as well write it down. DPP is a Direct Participation
Program. And it's direct, in the sense that you as an investor are participating directly in the profits of it.
You are a partner; you are not a shareholder. The DPPs became criticized in the 20th century, because
small investors couldn't access these. Small investors were confined, because they weren't accredited, they
weren't big enough or important enough. They were not allowed to invest in these. It was supposed to be to
protect them, all right, I guess. But how does it protect them to subject them to double-taxation? So, it
became a cause that why in the United States do we have most of our investors closed out of these lucrative
investment opportunities? Basically, individuals couldn't invest in commercial real estate. And people said,
well people are supposed to diversify; theyre supposed to hold different kinds of investments. So why
would this be limited to them?
So, Congress in the United States, in 1960, created something new called a real--
[side conversation]
Professor Robert Shiller: Real Estate Investment Trusts. Or abbreviated REITs. These were created in
1960 by an act of the U.S. Congress. And it was another example of the democratization of finance. And I
believe it started here in the United States. Now, they're being copied all over the world. They got off to
kind of a slow start after 1960, but they have grown dramatically.
The idea is that we will allow a trust to create investments for the general public, for small investors. And
they won't be double-taxed, either, OK? So, a Real Estate Investment Trust has to follow the law, and then
it can invest in buildings. So, maybe 360 State is owned by a REIT? I don't know. But they are not subject
to the corporate profits tax.
Now once again, once Congress creates a vehicle that's not taxed, everyone is going to ask, well, I want my
company to be a REIT, OK? So, they had to define it so that isn't generally available. It's limited to real
estate. So the law says, 75% of the assets of the company have to be in real estate or cash. 75% of the
income has to be from real estate. 90% of their income must be from real estate dividend, interest, and
capital gains. This is all, I think, in your textbook Fabozzi. 95% of the income must be paid out. And there
has to be a long-term holder. No more than 30% of the income can be from the sale of properties held less
than four years. They don't want real estate churning companies.
So, if you define [correction: satisfy] all of that, you've got a REIT. So, that invention, which goes back to
1960--it's one of those things in finance. It starts out slowly, and most people don't hear of it, and then it
starts to grow. And now they're everywhere around the world. Well, maybe not everywhere, but in many
countries we have REITs.
The U.S. REITs grew in a succession of booms. The first boom was in the late 1960s, when the interest
rates in the United States rose above deposit ceilings. They used to be ceilings that the government imposed
on savings banks deposit rates. And so suddenly, the REITS were paying better than the savings bank, and
the public flocked to them.
There was a second boom, after the tax reform of 1986 eliminated some tax advantages of DPPs,
partnerships. It used to be that the government allowed generous depreciation allowances for partnerships.
And people would invest in buildings just as tax dodges. Because if you're allowed to depreciate the
building very effectively, you can kind of cook your profits so that it's not taxable. And so people we're
investing in buildings too much. The government created a distortion that encouraged too much investment
in DPPs. So in 1986, the government eliminated a lot of the advantages of partnerships. And that caused the
second REIT boom.
And then, it was starting in the 1990s with the real estate boom that suddenly lots of new kinds of REITs
appeared. And REITs that involved specialized properties, and the like. Now they're big, and everyone talks
about them. But it's interesting to me that it took 50 years to get as big as they are now.
And the recurring theme here--a couple of them. One is that the finance industry finds it difficult to
innovate, and innovations take many years to happen. And secondly, that there's a trend toward the
democratization of finance. That if you go back in history, you'll find these same mortgages and
partnerships and the like, but they were limited to a small number of wealthy people. And we're moving.
With the invention of REITs for example, more and more people are getting involved, OK? So, that's
commercial real estate.
Chapter 3. Residential Real Estate Financing before the Great Depression [00:28:12]
I wanted to talk now about residential real estate, which is actually bigger. There are more houses than
there are office buildings in this country. Or there's more value in houses. So this is bigger. In the United
States, about 2/3 of households own their own home. It varies across countries, but there are many other
countries with similarly high home ownership rates. And this home ownership is a product of government
policy that encourages mortgage lending.
So, I wanted to talk a little bit about the history of mortgage lending, and the history of problems in
mortgage lending. I already took you back to the silk trade in the Tang Dynasty, but I'm going to be less so
far back. I'm going to talk about the United States and the Great Depression. So, the Great Depression in
the United States in the 1930s after the 1929 Stock Market Crash, was faced with a severe housing crisis.
Home prices were falling, and people were defaulting on their mortgages in great numbers. In fact, the
government had to create what they called the Homeowners Loan Corporations to bail people out, and they
ended up bailing out 20% of American homeowners [correction: with mortgages]. It was a terrible crisis,
and so, what was happening?
I am pointing this out because it's important in the history of real estate finance. Before the Great
Depression, mortgages were growing. Before the Great Depression, they tended to be two to five years, and
they were balloon payment. What do I mean by that? When you bought a house in 1920, youd go to a bank
and they would give you a loan for two to five years. So, if you bought a house for $10,000, they would
typically lend you half the money. They would lend you $5,000. And the loan would say, you pay interest
every month until two years has ended, and then you'd repay the $5,000, OK? And then, you can try to get
another mortgage. You come back to us and we'll do it again, if we feel like it, OK? That was the deal.
Banks offered that, and it was becoming increasingly common thing.
When we say a balloon payment, what we mean is, it's really big, all right? Balloons are big. So you're
paying monthly interest, but then in two years you have got to come up with the whole $5,000, all right?
But people thought, it's all right, I'll just go back to the bank, or maybe I'll go to another bank. You know I
can go wherever I want and I can borrow $5,000, OK? So, this was the way things were done.
But what happened in the Great Depression? Two things happened. The unemployment rate went up to
25%; A. B, home prices fell in many cases by more than half. So, if you borrowed $5,000 against a $10,000
home, your home might be worth only $4,000 now. So what do you do now? You go to a bank, OK? Two
years is up. I got to refinance my mortgage. I go back to the bank, and I show up and I say, A, I'm
unemployed and my house is worth $4,000. The bank says no dice; you're not going to get renewed. So
what happens? You're forced to dump your house on the market. You declare bankruptcy. You've lost
everything. You've lost your $5,000 down payment. If you buy a $10,000 house, and you borrow $5,000,
then the other sum is called your down payment. So that's what happened. It was happening to millions of
Americans.
Chapter 4. Residential Real Estate Financing after the Great Depression [00:32:19]
So, the Roosevelt Administration decided that the old kind of mortgage didnt--there was something wrong
that mortgage. So, in 1934, a year after Franklin Roosevelt became President, they set up the Federal
Housing Administration. And it was trying to get lenders back in to lend to homeowners, because it was a
catastrophe in the country.
[side conversation]
Professor Robert Shiller: So, in order to get lenders back in, the FHA started insuring mortgages. And
that meant that if you're a mortgage lender, and the person you lent the money to doesn't repay you, and the
house isn't worth enough--you can get the house, but you might lose money because the house has lost
value--the government will make it up. So, the government came in with what's called mortgage insurance.
And at the same time, the government said, all mortgages that are insured by the FHA must be 15 years or
longer. And so the U.S. government imposed the long-term mortgage on the mortgage industry. And they
said, this is better. And secondly, it cannot be a balloon payment mortgage. The government said, this is
really imposing too much on ordinary people that they have to come up with a huge sum of money at the
end of the mortgage. So, they required that the mortgages be 15-year amortizing.
Such mortgages had been offered already by some banks in the United States in the 1920s, but it was
innovative finance, and too complicated for most people. They never caught on. To amortize means to pay
down the balance. So, an amortizing mortgage has no balloon payment at the end. A 15-year amortizing
mortgage has a fixed monthly payment. You make it every single month. And at the end, you're done. You
take your spouse out to dinner and you say, we paid off our mortgage, we're done. So, there's no family
crisis at the end. It's a fixed monthly payment.
Now the arithmetic of amortizing mortgages is a little confusing to some people, and in 1934, it took some
education. But I want to just describe the amortizing mortgage system. So, we're going to have a mortgage
of maturity. The maturity of the mortgage is in M, and that's in months. So, in 1934, they started out with
15-year mortgages, which I thought was pretty aggressive, but by the early 1950s, the FHA was
emphasizing 30-year mortgages. That's a long time to pay off on your house. But the idea is, you know,
your typical family, they get married, and they're buying their first house, they're 25 years old, all right? So
let's give them a full 30 years to pay off the mortgage. They'll be 55. Kids will be going off to college.
They'll still be working. That's a comfortable length of time. Why not give them 30 years? And we
guarantee the interest rate for 30 years. No surprises. You just know you have this monthly payment.
The question now is, how do we decide on the monthly payment? The idea of amortizing mortgage is that
you have a fixed payment every month. You have an interest rate. And you want to make sure that the
present value of the monthly payments equals the mortgage balance at the beginning. So, the initial
mortgage balance, that's the amount you borrowed, has to equal present discounted value of all the monthly
payments. So what will I call the monthly payment? Let's call the monthly payment x, it's the monthly
payment in dollars. So, the mortgage balance is equal to x/(r/12)[1-1/(1+r/12)
M
], where r is the annual
interest rate. That's just the annuity formula, OK? So that's the formula that's used to compute. I've shown
you that formula before. It's the present value of a stream of payments equal to x. Did I write r/2? I meant
r/12.
So what you have to do if you are calculating an amortizing mortgage, if the person is borrowing the
mortgage balance, and I quote a rate r per year, I have to plug that into the present value formula, and find
out what monthly payment x makes the present value equal to the amount loaned. Now, that is a little bit of
arithmetic that mortgage lenders would have had trouble doing. Its not that hard to do, right?
But I have here a page from a mortgage table. I found this in the Yale Library. Can you read that? This is
from a 50-year-old book. This is before they had computers. And so it was too hard to do this calculation.
Can you read it in back? Sort of. This is for a 10-year mortgage. I just picked 10 years. That was
uncommon, that's rather short. Some people would get shorter mortgages, especially older people. You
know, if you're 60 years old, you don't want a 30-year mortgage. You probably won't live that long. So they
did give out shorter mortgages as well. So, this is the page from a mortgage book for 10 years, and this is
for a 5% mortgage.
So, it shows the monthly payment for $1,000. If someone's borrowing $5,000, you'd multiply this by five.
They show it for around $1,000. And the monthly payment per $1,000 is $10.61. So what they've done is
they've found out $10.61 is the x that makes this present value for r equal 5% equal to $1,000. They've
done exactly this calculation.
Now, they show the payments schedule. The payment every month is $10.61. But what this table shows, is
the break down between amortization and interest. So, it shows the principal for each month. So, at the
beginning you borrow $1,000 on this mortgage, and you're paying $10.61 per month, all right? So, each
month your balance goes down. This balance column, they subtract--well, the question is, how do you
figure it out? You're paying $10.61 per month, but part of that is interest. What part of that is interest? Well
it's 5% divided by 12 of the $1,000 balance at the beginning. Your initial interest is $4.17, so your principle
is the $10.61 minus the interest. So then, that reduces your balance. The initial interest is $4.17, the
principal is $6.44, then the balance is $993.56 after one month.
The next month, they figure what fraction of your payment is interest by multiplying 5% over 12 times the
balance, $993.56, and then that comes out to be $4.14 interest. You see the interest is going to be going
down because you're paying off the loan. But your payment is fixed, so the payment against principal is
going up. So, the first month was $4.17 interest, the next month is $4.14 interest. Offsetting that is in the
first month, the $6.44 being used to pay off your mortgage. The second month it's more, $6.47, OK? I
couldn't show the whole page here, but here after six years, six months your interest is down to $1.74,
because your balance is down to $407.61. And so your payment of principal is much higher. The reason
this table is important is that people move and they sell their house early. They don't hold it for the full 10
years. So, you have to figure out when someone sells his house after six years six months, what do they still
owe? Well, they now owe, instead of $1,000, they owe $407.61.
So, that's the idea of a long-term mortgage. Your interest payments are changing all the time, your principal
payments are changing all the time, but your total payment is fixed. That was an invention, a financial
innovation in 1934. This is called a conventional fixed rate mortgage, and it's now offered in many
countries of the world. However, there's only two countries where it's the major kind of mortgage. United
States and Denmark. And this is a strange thing. This invention has not caught on around the world. It's
unique to only two countries, although you can get it in other countries. It's not available in Canada in any
number, I guess you could find it, but it's not common elsewhere. Every time I go to a foreign country, I
ask the people there, why don't you have fixed rate mortgages? I don't necessarily get good answers. I've
been trying to understand why it hasn't caught on.
Then I recently saw that Alistair Darling, who was under the Labour government--
[side conversation]
Professor Robert Shiller: Alistair Darling was Chancellor of the Exchequer in the United Kingdom until
the Conservative government took over. He issued a statement saying that U.K. should finally adopt the
long-term mortgage. The problem is, is that any country that doesn't have a long-term fixed rate mortgage,
runs the risk of falling into the same problem that the United States did in the Great Depression. Some kind
of crisis like that could mean that people would lose their homes in great numbers. So, he said he'd like to
see the U.K. get people borrowing at 10, 20, or even 25 years for their mortgages. But instead what
happened was, the Conservative government took over. But you can, in the U.K., get long-term mortgages.
I think it's true in most countries of the world. They're just not common there.
It's a bit of a puzzle. Why is it that only two countries do this generally? I have a couple of reasons to
offered why it is. One of them is that the general public is resistant to long-term mortgages because they
charge a higher interest. If the lender is going to guarantee it for 30 years, they're going to have to charge
you a higher rate because that guarantee costs something to them. And consumers are resistant to paying
the higher rate. And that's part of the problem.
The other part of the problem is that bank regulators might not encourage banks to make these loans,
because it's risky for banks. If banks tie their money up for 30 years, and then they have depositors who can
withdraw their money at anytime, the banks could go under, if there was ever a run on the banks. They can't
liquidate these mortgages fast at all. So, you need a coordinated effort of a government to first, make sure
the regulators accept these concepts. It puts some risk on the public of the possible bailout of the banking
system. And then, you have to get past public resistance. You have to make the public understand that,
when you get a fixed rate mortgage, it's a clean contract. We have no worries for 30 years. As opposed to
problems that have sometimes occurred.
In Canada, in 1980, the interest rates shot way up, and we had a duplicate of the problem that we saw in the
U.S. People couldn't afford to refinance their mortgages, and a lot of people lost their homes. And so, it was
a big problem. But they somehow got through that, and they're not really thinking about fixed rate
mortgages in Canada even now, today.
Chapter 5. Mortgage Securitization & Government Support of Mortgage Markets [00:48:02]
I wanted to go on talking about innovation in finance. Another very important innovation is securitization
of mortgages, and government support of mortgage markets. In the United States, in 1938, the federal
government, this is also the Roosevelt Administration, set up the Federal National Mortgage
Administration, which was a government agency that would buy mortgages to support the mortgage
market. On Wall Street they couldn't pronounce Federal National Mortgage--or is it Association? I'm sorry;
it's Association not Administration. You know what they called it on Wall Street? They called it Fannie
Mae. That was just irreverent short name for the Association. It was run by the government. However, in
the year 1968, the U.S. government privatized Fannie Mae, and it became a private corporation.
So what did Fannie Mae do? It would buy mortgages from banks. They were trying to encourage the
mortgage market. So, a bank would lend money to someone to buy a house, and then they're done. They
can't loan any more money unless they raise more deposits. Well, Fannie Mae would buy the mortgage
from them, and they'd have money again to lend again. They did this in '38, because we were still in the
Depression, and the housing market was still depressed. They weren't building homes. There were lots of
unemployed construction workers. And so, Roosevelt was just thinking how can we stimulate the
economy? And this was one of their ideas. So, Fannie Mae was the mortgage finance giant that was created
in 1968 [correction: created in 1938, privatized in 1968].
[side conversation]
Professor Robert Shiller: In 1970, the government created another Fannie-Mae-like institution. Its official
name was Federal Home Loan Mortgage Corporation. Wall Street had to invent a name for it. So, they
called it Freddie Mac. They thought, well, we gave a girl's name to Fannie Mae, let's give a boy's name. I
guess that's a boy's name.
Both of these organizations are private companies now, created by the government, they both use these
names officially now. So that's their name now. Fannie Mae and Freddie Mac.
Freddie Mac was initially different. Because what the government asked Freddie Mac to do, was buy
mortgages, and then repackage them as mortgage securities, and sell them off with a Freddie Mac
guarantee. So once Freddie Mac started doing this, Fannie Mae said, well, can't we do that too? So they
both do it. So what the government had done is create two private corporations. You kind of wonder why
did the government even do that? Anyone can create--remember we have a corporate law. I can start my
own Freddie Mac. My own Fannie Mae. But the government did create them by privatizing Fannie Mae
and by creating Freddie Mac.
And they are both in the mortgage securitization business. So, they would buy from mortgage originators--
people who lend the money. They'd buy the mortgages. In other words, they would take the IOU from
someone. They'd repackage them into securities, and sell them off to the public with a guarantee from
Fannie or Freddie, that, if there were default, the mortgage extra balance would be made up by Fannie or
Freddie, OK? Well, they did then get other companies, called mortgage insurers, to insure at least part of
the balance.
It's a complicated financial agreement. But what we had was private companies created by the U.S.
government, that created securities for investors that were guaranteed against default, and based on
mortgages. So, the government then also stated that these are private companies and the U.S. government
does not stand behind them.
People started to say the government created these two corporations, and now they're securitizing and
guaranteeing trillions of dollars of mortgages. Is this going to come back and end up being paid for by the
taxpayer? So the government stated clearly, these are now private corporations. Fannie Mae started out as
part of the government, but no longer. Now, it's a private corporation. And if Fannie Mae goes bankrupt,
woe betide to anyone who bought their securities, because their guarantee is not backed up by the federal
government.
So people complained, though. They said, you're saying that it's not backed up by the federal government,
but do you really mean that? If Fannie or Freddie goes bankrupt, will the U.S. government just let them go
under? Well, the official statement was, yes; the government will let them go under. Guess what happened?
In 2008, the real estate market crashed and we had our first housing crisis that was similar to the Great
Depression. And in that housing crisis, both Fannie and Freddie went bankrupt, OK? And now, what do we
do? We're in the Bush Administration. Republican. They don't particularly like bailouts. So you think, of
course, George W. Bush would just--it's the law, right? The federal government's not going to bail them
out. But then some people said, wait a minute, you know all over the world people are investing in these,
thinking that Fannie Mae was created by the U.S. government. In particular a lot of Chinese, those poor
innocent Chinese, are trusting the Americans, and they put many billions of dollars into Fannie Mae. Are
you going to go and tell the Chinese, Sorry, we won't back it? Well, someone can say, sure, go tell them
that. It's what we've been saying all along. But then the Chinese could come back and say, well, you've
been saying that, but nobody believed you. Everyone knew that that wasn't right.
And the federal government didn't take all the right steps to make it really clear. For example, the Wall
Street Journal used to list Fannie Mae bonds and Freddie Mac bonds in a section of the newspaper entitled
''Government Securities.'' And that's the Wall Street Journal; that's not the government talking. But, the
U.S. government should have come in and told them, no, those are not government. So we poor, innocent,
Chinese investors, we've read your paper and it said Government Securities.
Now George Bush could've said, tough luck, you know? You guys should have read the fine print, but he
didn't, all right? Why not? Because it jeopardizes too much. If the U.S. government lets these agencies that
it created go bankrupt, and it lets all those people all over the world who invested in those securities.
They're going to be mad, right? We have a reputation. The United States is able to raise so much money
from all over the world because they think that it's safe here, and if we just let these fail it's not going to
look right. So, the U.S. government took them both under conservatorship, and is paying their debts, so
those do not default. What we've learned from this lesson is that you can say a million times that you're not
going to guarantee something, but eventually you end up guaranteeing it.
I wanted to say something about other countries a little bit. Canada has something like Fannie Mae and
Freddie Mac called the Canada Housing and Mortgage Corporation. And so, I'll just talk about other
countries. The Canada Housing and Mortgage Corporation. It was created by the government of Canada,
and it does work that resembles FHA and it resembles Fannie Mae. But it's owned by the Canadian
government, it's not privatized. And so you might say, well, it's the same in Canada. But the big difference
is, it's smaller. They didn't let it get as big as Fannie and Freddie. So it isn't heard as much from.
I was a keynote speaker at a conference on February 3 that the Financial Times organized in New York
called Focus on Canada. And I had to give a talk about Canada to New York investors. They told me there
were hardly any Canadians in the audience. What are we doing here in New York talking about Canada?
Well, it's because the Americans invest heavily in Canada. So, I was up talking to all these American
people, and I was looking at Canada, and the Canada banking system. And I said to the group, Canada and
America are just so similar I can't see much of a difference. Canada didn't have Fannie and Freddie. It
didn't have these housing problems. But the worldwide recession hit Canada pretty hard. And so I said,
Canada and U.S. are kind of like two peas in a pod. Theyre so similar. People like to make much of
differences, but the Canadian economy just moves up and down in lockstep. And I also said, Canada was
saved by the oil crisis, being an oil exporter. In 2008, remember when the oil prices shot up?
But little to my knowledge, there was a reporter for the Financial Post in Canada in the audience. And my
talk got reported in the Financial Post. And then I went on their website and there was angry blogs from
Canadians. I don't think it's so insulting to Canada to say that we're just basically similar. And Ill have say
this for Canada, they did not get so gung-ho on supporting mortgages as the United States did, so they
didn't have such a big housing bubble that the U.S. did. Part of the reason the U.S. had a housing bubble as
big as it did is that these guys really weren't independent; they were taking orders from the government.
The government was telling them to increase their lending to low-income or to underserved communities.
They were promoting the bubble. And so Fannie and Freddie were told to promote lending to houses during
the real estate bubble that preceded the crisis. That didn't happen, at least not so much, in Canada. So
they've had less of a bubble. But still the two countries are basically very similar.
Chapter 6. Mortgage Securities & the Financial Crisis from 2007-2008 [01:01:06]
The textbook talks a lot about mortgage securities. I expect you to read this out of Fabozzi. I actually got
complaints in past years. Students found this the least enjoyable part of the readings for this course. But
you should know about these things. We have securities called Collateralized Mortgage Obligations. These
are mortgage securities that are sold off to investors. And they hold mortgages, but, as is explained in
Fabozzi, they will divide them into separate tranches, or separate securities, in terms of prepayment risk.
That is that there's a risk that the mortgages will be paid off early in times when it's adverse to the investor
interests. So, they would divide up the risks into different classes of securities. And some of them were
rated AAA by the rating agencies, because they thought there was almost no risk to those securities. And
others were rated differently. And these CMOs were sold to investors all over the world.
Another kind of security, which the textbook talks about, is a CDO, which is a Collateralized Debt
Obligation. These are issued to investors, and they typically hold mortgage securities as their assets. Many
of them held subprime mortgages in recent years, mortgages that were issued against subprime borrowers.
A lot of these securities that were rated very highly by the rating agencies, rated AAA, ended up defaulting
and losing money for their investors. And the investors were all over the world.
The United States is a leader in mortgage finance. And companies in the United States, not just Fannie and
Freddie, but lots of companies, were issuing mortgage securities that had AAA ratings, which meant that
Moody's and Standard and Poor's and the other rating agencies were telling you basically there's no risk to
them. And so people in Europe, in Asia, were investing in these, and they thought they were perfectly safe,
and then they went under.
Part of it was bad faith dealings by some of the issuers. Some of the issuers themselves doubted that these
mortgages were so safe. But what do I care? This is what happened. It's gotten to be a complicated set of
steps. Somebody originates the mortgage, OK? That means I talk to the homeowner. I have the homeowner
fill out the papers. Then, after they've originated the mortgage, they sell it to an investor, like Fannie or
Freddie or some private mortgage securitizer. And the private mortgage securitizer finds a mortgage
servicer; it may be the originator, who will then service the mortgage. What does it mean to service the
mortgage? It means to call you on the phone if you've missed your payment, for example. Or if you have
questions about the mortgage, there should be someone you call. So, the mortgage servicer does that. That's
a separate entity. And then we have the CMO originator, then we have the CDO originator. It's gotten to be
a very complicated financial system. And then the whole thing collapsed. So there's been a lot of reform to
try to see, what can we do to prevent this kind of collapse? Some people would say, let's end the whole
thing. Let's go back to 1778. Let's not have mortgage securitizers. But that's not the steps that have been
taken. I think that we are making progress.
But I want to just conclude with just a little reference to one important change that was made in both
Europe and the United States. The European Parliament passed a new directive that requires, or
incentivizes, mortgage originators to keep 5% of the mortgage balance in their own portfolio. That means,
if you originate mortgages, you can sell off 95% of the mortgages to investors, but you have to keep 5%.
So, this 5% limit was then later incorporated into the Dodd-Frank Act in the United States. So we again
have the same requirement. And this is supposed to reduce the moral hazard problem that created the crisis,
and retain the mortgage securitization process.
So, the idea is this--and I know, I heard people tell me. Mortgage originators sometimes got cynical. They
thought, OK, I'm helping this family fill out a mortgage. What do I care, you know? This family doesn't
look--they're not going to pay this back. But what do I care? I'll fill it out. I'll sell the mortgage to someone
else, and I'm out of here. In fact, it got bad in some cases--some mortgage brokers. A family would come
wanting to buy a house, and the mortgage broker would say, what is your income anyway? And they would
tell him the income. And he'd say, you're trying to buy a $300,000 house on that income? I don't know if I
can do this. But then he'd say. Wait a minute. Think about this again. Is that really your income? You told
me your income is 40,000 a year. Are you sure? I thought you had some other--why don't we say 50,000
thousand a year. Or say 60,000 a year. And the couple would look at him in disbelief and say, No, we only
have 40,000. He would say, Well, think about it. You have other sources, don't you? Everybody does
this, you know. So, OK, we have $60,000. He says fine. And they thought, well, the mortgage broker
gave me permission to do this. And he doesn't care, because he's not going to take the loss. So, the new law
is supposed to discourage that kind of thing. And there's lots of new laws that are trying to tighten up. For
example, mortgage brokers in the United States now have to be licensed. It used to be just five years ago,
you could be an ex-con, fresh out of jail, and you could take up a business as mortgage broker. You can't
anymore.
So, what's happening all over the world is that we've learned from this experience, but we're retaining this
basic system of mortgage securitization. Mortgage lenders that are professional. The basic industry has
been retained. And we're hoping and thinking that maybe we have a better system.
So I will stop there, and I'll see you on Monday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 11 - Behavioral Finance and the Role of Psychology [February 21,
2011]
Chapter 1. Human Failings & People's Desire for Praise-Worthiness [00:00:00]
Professor Robert Shiller: OK, good morning. So, I wanted to talk today about Behavioral Finance or
about Psychology and Finance. This is a longstanding interest of mine. I've been involved with it for over
20 years. It's not really emphasized in your textbook, Fabozzi and his co-authors talk about a lot of things
in the financial world, but not about the underlying human behavior.
Behavioral Finance, or Behavioral Economics more broadly, is a kind of revolution that has occurred in
finance and economics over the last 20 or 30 years. And it remains somewhat controversial. I don't quite
fully understand why it is that people polarize as much as they do, but some people don't like this. We're
coming along to be the majority, I think. People are now regarding Behavioral Finance as an important
element of finance. But the real problem is that people are complex and our financial institutions, as I've
emphasized, are designed for real people and their functioning depends on the behavior of real people. And
it's not as simple. You know, another revolution that's occurring parallel, of bigger significance, is a
revolution in neuroscience about the human brain. And the human brain is a very complicated organ.
Economists have liked to invoke the principle of rationality as an underlying component of their theory,
and that has been useful, but it's of limited use, because people aren't rational. They are often rational;
they're not completely rational. And very often, people behave stupidly. I'll put it that way. That includes
everyone, including me, because we're human and we have limits.
One thing about the human species is that we are aware of other people's weaknesses and have an impulse
to exploit them, OK? So when you see other people behaving stupidly, sometimes you think, maybe I can
turn this to my advantage. OK? And that becomes a problem. The history of humankind is a history of
exploitation of one person by another. Not entirely, but I'm saying it has that as an important element.
So, I'm going to talk about these human failings. It's not to say that people are stupid, I'm just saying they're
people, and we're all imperfect. We're smart in some dimensions and we can be very smart, but we can also
make important mistakes.
But before I start, I wanted to try to put this into a perspective. Maybe, I'll return to this at the end of the
lecture, but I wanted to start out on an upbeat note. I'm going to talk about all kinds of human errors, but I
wanted to start on an upbeat note that the business world generally doesn't exploit people terribly, I believe,
that very characteristically successful businesses in finance and elsewhere consider their long-term
advantage and the reputation they have. So, doing something that is blatantly exploitative of human
weaknesses will work against their long-term advantage. You'll see a lot of human failings, but we don't see
people cashing in on them as often as you'd think. And beyond that, I want to emphasize also that another
aspect of human behavior is morality. Evolutionary biologists think that this evolved along with our other
traits, that we have an impulse to be moral. And so, in the long run, you might not really gain so much
satisfaction from exploiting other people's mistakes. And so, you don't necessarily do that. So, that's why
we have a lot of weaknesses outlined and we won't see significant or serious exploitation of them as
characteristic.
Now as you know, I have chapters from my forthcoming book assigned for this course. And I looked back
on what I put up for you to read and I keep thinking, gee, this really wasn't ready. So, I had a chapter for
this section of the reading list about Behavioral Finance. And I thought, I didn't really get it right. I know
what I was trying to say, but maybe I should--what I start out in, in that chapter is talking about Adam
Smith and his book The Theory of Moral Sentiments. Now just to remind you, Adam Smith was a professor
in Scotland in 1759. He was a professor of moral philosophy, because there were no professors of
economics in those days. And he wrote in 1759--maybe I should write some of this on the board. He's
probably the most important figure in the history of economic thought.
So, in 1759 he wrote his The Theory of Moral Sentiments. And in 1776, he wrote the more famous book,
The Wealth of Nations. So, this is The Theory of Moral Sentiments. The Wealth of Nations is considered the
first real treatise on economics and it's a wonderful book. And it's still very readable today. His The Theory
of Moral Sentiments is not so widely read. But it's not really economics; it's a book about psychology and
morality. I find it very good, even 250 years later. He went through many editions on this book, because
maybe he thought it was his most important work.
But the book starts out about selfishness and altruism. And the real question, which he thinks defines
economics, is, are people really completely selfish? Sometimes it seems that way, that their presumed
benevolence is just an artifice for their own benefit. But he wonders, how does an economy work if
everyone is totally selfish? And he ends up concluding that they're not. I thought it was very interesting, the
way he put it. The thing he emphasized right at the beginning of the book is that people inherently love
praise, all right? We crave the approval of other people. And so, praise is a fundamental human desire.
But then he reflected on it and he said, do people really want praise itself or is it something else that they
want? Well, think of it this way. Suppose people made a big mistake and thought that you had
accomplished something, but there was a mix up. You know, it was really somebody else who did it, not
you. And it's just a complete mistake. You had nothing to do with it, but you find lots of people praising
you. Would that really be pleasurable? And suppose you even know that they'll never find out that I didn't
do it. Well, Smith said, it probably isn't, right? Think about it. You internally are thinking, I'm getting all
this praise, but I know I don't deserve it. So, I don't enjoy it. And then he went on to say that, especially
among people who are more mature, he says more mature people--not everyone makes this step--but he
says, adults, normal, mature adults, make a transition from a desire for praise to a desire for praise-
worthiness. I want to know that I am the kind of person who will be praised and I don't need to get the
praise.
And he said, it's that tendency ultimately, which makes an economy work, that people don't care just about
praise. He gives an example of mathematicians. And he said he's known many mathematicians in his life
and he finds that they're almost all obscure. The public doesn't know about mathematicians. They couldn't
explain to the public what they do. And they don't seem to care at all, because they know the public doesn't
appreciate mathematics. And so, there's a few mathematician friends who understand what they do and may
praise them. But ultimately, a mathematician can sometimes do the work completely unknown, you know?
And it's the praise-worthiness that drives these people.
You may think I'm being too idealistic, when I say this, but I think that the finance profession--this is what
I was trying to say in that chapter--that the finance profession, like other mature professions, is really
dominated although there's a lot of funny things that happen, it is really dominated by people who have
reached this desire for praise-worthiness. And so you're not going to exploit people extravagantly. Just
because, why would I do that? This is not a good thing. I wouldn't feel good about it. Well, some people
will.
Now, I wanted to also mention, not everyone reaches this mature state that Adam Smith describes. And
that's one of the complexities of human society. And I think that the finance profession has a problem with
other kinds of people.
Chapter 2. Personality Psychology [00:11:37]
Now there's a whole branch of psychology called Personality Psychology that categorizes people by their
personality. And we're not all the same. And in our society, we have many different kinds of personalities.
A successful society promotes people up who have the praise-worthiness desire. We try to recognize them
and we try to put people of character into important positions, with not complete success. But I wanted to
just briefly talk about--this is a lecture on psychology. I wanted to talk about other personality types. And I
was going to use a book called The Diagnostic and Statistical Manual Edition IV published by the
American Psychiatric Association. They're coming out with a fifth edition in 2014.
DSM-IV is kind of a household word around my house, because my wife is a psychologist. DSM-IV is
actually controversial among psychiatrists, because it's too cut and dry for some of them. What it tries to do
is, identify mental illnesses and personality types in a quantifiable, reproducible way, so that we can define
who has this mental illness or who has this personality type. And so it gives you checklists and it says, the
patient must have exhibited at least three of the following five behaviors. And then, there will be another
checklist. And so you keep score and you can actually diagnosis personality disorders. I'm just going to
mention one of the many personality disorders.
One of them is called APD, called Antisocial Personality Disorder. And so they have checklists, but just to
give you a sense--oh, the Antisocial Personality Disorder is called psychopathy, or one kind of APD is
psychopathy. Another one is called sociopathy and--I don't know. There's a huge literature on these.
But according to DSM-IV, 3% of the male population in the world is APD, and 1% of the female
population. A simple definition for APD is a jerk. There are more male jerks than female jerks,
apparently, according to their--this is all quantifiable and done.
But what is an Antisocial Personality Disorder? It has the following characteristics: lack of remorse,
frequent lying, lack of empathy, superficial charm, shallow emotions, distorted sense of self, constant
search for new sensations.
Have you met someone like that? You probably have, because that's 3% of the population. I'm not anti-
male, when I point out there are three times as many jerks among males as females. Females have
characteristically different personality disorders. And you can look down the list. It's much more than 3%
of the population that would be diagnosed with one or the other.
So, you know, an APD person is manipulative, feigns affectionate or warm feelings, but doesn't feel them,
and is trying to deceive you.
Once a student came to my office and asked to sign up as my research assistant. I was talking and I thought,
well, maybe. I said come back and talk to me. Later on, I read about him in the Yale Daily News. He was an
impostor student. He was not a Yale student. And he had been around to other university--he was an
impostor at like three different campuses. There was something wrong with this person, right? Kind of
made me feel--then he came later and asked me for a recommendation letter. I couldn't believe it after I
read about him in the Yale Daily News.
This is extreme, right? And so, incidentally, someone did a study of APD by going to a prison and
categorizing the inmates using DSM-IV standards. And they found that 40% of the prisoners had APD.
Also, neuroscience people have found that there are differences in the prefrontal cortex that are correlated
with APD. So it seems to be--it's a problem we have in our society that some people have a brain structure
that's a little different. And it may make it difficult for them to behave in a good way.
We're learning more and more about neuroscience. It's interesting to me that Adam Smith's book still rings
true though after--there's some basic common sense that we all learn. You have to judge people and you
have to learn their character. And you have to be a person of character for, in the long run, that's what you
want. It gives you what you want in life.
Oh, another thing I wanted to say is that people are manipulable. Unfortunately, true. And unfortunately,
we live in a world where it's hard to avoid manipulating people at all, because we have a free enterprise
system that encourages competition. And if the competition is manipulating people, how do you completely
stay clear of that? I think this is one of the contradictions of our society. A very simple and obvious
manipulation is, they'll put a price on some item they're selling, like $9.99, all right? So you're like, well,
why didn't they just say $10.00, right? Well, you know why they didn't. It's called ''pricing points'' in
marketing. Because $9.99 sounds a lot less, psychologically, than $10.00. So, everyone does it, almost
everyone does it.
But is that bad? Well, it's bad in a way. It's manipulative, isn't it? I mean I'm annoyed by it. Maybe you are,
too. But if you were in business, would you do that too? You might feel that you have to and it's a harmless
sort of manipulation. It's not hurting anyone really. They're maybe buying a little bit more than they want.
See, that's the kind of thing that comes in.
So, in looking at financial institutions, they're often manipulative in that sense. It's similar to a politician. If
you want to be a member of Congress or whatever, you can't say what you really believe, right? Because
you won't get elected. You've got to kind of doctor your opinions to the public opinion. But you might have
a moral purpose underlying it all, because you want to get elected so you can do good things. So, you do
end up saying things. So, it's hard to judge people, good or bad. It's an overall sense you get of someone's
character. That people are doing things that appear somewhat manipulative and somewhat bad, but you get
an overall sense of the person through time. And ultimately, our society, within limits, rewards people that
show character through all the confusing details.
Chapter 3. Prospect Theory and its Implications for Everyday Decision Making [00:20:14]
Now I wanted to move--that was my introduction. I wanted to move now to discussing some particular
aspects of Behavioral Finance, or more broadly Behavioral Economics. And about human failings that are
exploitable by somebody and are somewhat exploited, but remain. I wanted to start out with what's
probably the most famous element of Behavioral Economics. It's Prospect Theory and it was invented by
two psychologists, Daniel Kahneman and Amos Tversky, in the late 20th century.
They called it Prospect Theory because it was a theory of how people form decisions about prospects. And
a prospect is a gamble. It's about people's decisions under uncertainty. And in very simple terms, the
Prospect Theory says--now there's a huge literature on this, so I'm trying to give you a very quick
description of it. That there's something called a value function, which represents how people value things.
And there's a weighting function, thats the two parts, which shows how people infer or how they deal with
probabilities. And I just wrote simply what Kahneman and Tversky says. I'll draw a picture of the value
function and the weighting function. And this will be very quick and you'd have to read more, but the way
people value gains or losses--let me see. I better draw the line in the middle. OK, and these, we're talking
about financial gains, so these are gains, and this is zero, and this is losses. Well, negative. What I have on
the horizontal axis is wealth or money or something like that. Zero in the middle, OK? And then, we have
on this axis value, which is something like utility. I'll erase my zero, so it doesn't get in the way.
What they find is, that people's value has a funny shape. We don't weigh gains and losses linearly. In the
positive quadrant, when we have positive gains, there's diminishing value like that. It doesn't ever slope
down. It's concave down like diminishing marginal utility in economic theory. But for losses, it looks
something like this. It's concave up. I'm exaggerating a little bit, but this is a diagram that Kahneman and
Tversky wrote in their famous Econometrica article 30 years ago.
So, there's diminishing marginal utility for gains, but there's the opposite--well, we have concave up. And
there's a kink. Note that the value function has a kink at the origin. So, what does this mean? OK, first of
all, this origin is a--from what point do I estimate gains and losses? That's called the reference point and it's
psychological. And it's subject to manipulation. The reference point is the zero, from which I measure
things.
So, first of all, the reference point is probably today's wealth. But it can be something else if people are
manipulated by the way something is presented to them. Framing, according to Kahneman and Tversky, is
presentation. So, I can give the same prospect to people, but word it in different ways that suggests a
different reference point. And that will change people's behavior. So, you can manipulate people by
describing something in different terms, by suggesting a different reference point. But typically, the
reference point is today's wealth.
The kink means that people are very conscious of little changes in their wealth and they're spooked by
them. I'm really afraid, because my value drops very rapidly, even for a small loss. So, if you were to say,
lose $5 this morning. You had it in your pocket and you lost it on the way to this lecture, you would feel
exaggeratedly bad about that. You should really regard $5 as just nothing, because the present value of your
lifetime income is in the millions, so what's $5? But you don't think that way. So, you're spooked and
deterred by small losses, and less encouraged by small gains.
This kind of thing allows businesspeople to exploit people if they want to. If people are so focused on these
little changes, then you are encouraged in business to try to pick things out that people are paying attention
to, like small things, and sell insurance policies on just those things. Insurance should be concentrated on
the really big things, like life insurance. You know the fact that one of your parents could die and the
children's family would be out of money for the rest of their lives. That's a big thing. But it may not work to
sell that kind of insurance. You can do something that is more focused on what people are watching and
make it something little so that it doesn't require them to spend so much money.
The classic example of that is funeral insurance, OK? You go around telling people--and for some reason
this sales pitch works, and it's worked for thousands of years. They sold this in Ancient Rome. You tell
people, if someone in your family dies, you could have an expense of getting a proper burial for this
person. It costs money. And so, they would insure that one thing, OK? And it was a little thing, but it works
to sell that. Another example of it is airline flight insurance. You're insured for this flight on the airplane,
OK? I heard an ad for funeral insurance recently. They're still doing this after 2,000 years, because it still
works and it's manipulative. That's not what you should do for people. You should not pick out some little
thing.
Or they also have diamond ring insurance. After an engagement, some women will want to buy an
insurance policy on the diamond, because it can actually fall out of your ring and lose it. But that's like,
what is it? $5,000 or something? It's not big; it's not essential. And if you're insuring that and not other
things, you're making a mistake. Fortunately, the insurance industry is not too--it has come around to do
things that are more--they are doing things that matter and are big. And that's because this Kahneman and
Tversky value function is--it represents an error that people are prone to be making. But it's not total and
not complete. And so ultimately, people don't go to insurance companies that manipulate them. It gets
around and eventually people come around in wanting something better. So, while there is some
manipulation, it's limited.
The other aspect of Kahneman and Tversky is the weighting function, OK? I'm going to draw again a
picture of it. This time, it's how people psychologically think about probabilities. This again is Kahneman
and Tversky. A probability is a number between 0 and 1 or 0 and 100%. I'll put 0 here and 1 here. We can
tell someone the probability of something, but they can't accept it psychologically. The errors that people
make are described by the weighting function. What the waiting function is, it's the psychological impact.
You are behaving as if you just don't understand the probability.
So, what Kahneman and Tversky say is, that for very low probabilities people may round them to zero. And
for very high probabilities, they may round them to one. But if they decide not to round them to zero or
one, they exaggerate the difference between zero and one. You just can't think in terms of a continuum of
probability. So, this is what the weighting function--this is the weight as a function of the probability. For
low probabilities it's zero. I'm going to maybe exaggerate it here. Then it jumps up. It's something like this,
and as it gets close to one, it jumps up to one again. So you see, it's like a broken line segment. And there's
been various versions of this theory, but this is the simplest version of it.
So that means, if you're getting on an airplane, you think, well, what's the probability of this airplane
crashing? Well it's probably something like 1 in 10 million or, what is it? Even less than that. So most of
us, in our mind, just say, it's zero and I'm done. I'm not going to think about. I'm not going to worry about
it. So, we're down here. We've rounded it to zero, OK? But some people don't round it to zero. And for
them, they just blow it out of all proportion in their minds, and it becomes exaggerated. So, I have it here,
so it looks like it's a half. This would be one here and this is about 0.4. And then ultimately, if the
probability gets really high, then I'm not even going to think about it, it's one, OK?
In some of the most primitive languages in the world, there's only a couple of numbers. There's zero.
There's one. Maybe there's two or three, and then there's no more numbers. Well, our minds are still very
primitive in dealing with probability. So it's like there's only three probabilities. Can't happen, may be, and
will happen, OK?
So, I think airline flight insurance is an example of trying to manipulate this personality characteristic. So,
it means that they'll catch all the people who exaggerate it, right? They used to have vending machines
outside of airlines. The vending machines would encourage you to buy just for this flight. They put it right
there when you're getting on the flight. And so that's when you're most nervous. If you're one of these
people who's up here. And of course, most people don't buy it, but they don't have to sell it to everybody.
They just sell it to these people and they charge an outrageous price. But I haven't seen these vending
machines anymore. This is interesting.
Economists wrote about them 30 or 40 years ago and they used to be everywhere. And they just kind of
disappeared--do you ever see one of these? I think they're gone. Why is that? Well, somehow we get past
things like that. It's not like Kahneman and Tversky are representing immutable errors. These are errors that
naturally happen. But you can get past it. And you end up wanting to deal with people you trust. So, you
see some vending machine at the airport and you think, well, my insurance agent isn't recommending I get
this. I've got some kind of insurance. So, you walk past it. There's a professor in Germany at the Max
Planck Institute [for Human Development] in Berlin, Gerd Gigerenzer, who has been taking on Kahneman
and Tversky in saying that they're right that people show these tendencies for errors. But I can train people
out of them with no problem. I just tell them this is an error, and teach them then, and they don't do it
anymore.
Gary Gorton just did a seminar here on errors that people make in financial--no, Nick Barberis here at
SOM, and he was using Caltech [California Institute of Technology] students and tested their ability to
prevent certain kind of errors like this. And he found that even the Caltech students made these errors just
horribly. We're wondering, aren't they supposed to be bright? Those are young math geniuses. But about a
third of them got everything right. So I'm thinking, you know, they're only undergraduates. By the time
they get along, if they go--they'll eventually be trained out of these errors. But right now, they're behaving
just like Behavioral Finance says they will.
So anyway, I think that you will find that Prospect Theory explains a lot of things that go on in finance, but
it doesn't explain everything. And let me move on.
Chapter 4. Regret Theory and Gambling Behavior [00:35:53]
So, want to talk about--let me see. I have so many things to tell you about here. And I'm thinking about my
time.
It's a huge field, Behavioral Finance. Let me mention a few other things. Regret Theory is a theory that--it's
kind of related to Kahneman and Tversky. It says that people fear the pain of regret. There's an old
expression: I was kicking myself, because I made some bad decision. Well, that's a painful experience
when you did something wrong. This is represented somewhat in the kink in the Prospect Theory value
function. But Regret Theory says that there's actually a painful emotion that you're wired not to like to have
made a mistake. And so then, you end up designing your life around that and trying to avoid doing anything
that you might regret later. And it can create problems. You may make bad decisions, because you're overly
worried about regret.
Gambling behavior. Anthropologists have reported that gambling occurs in every human society. And so,
it's one of the human universals. Not that everyone does it, but in every society you'll find people that do it.
I have a 1974 study. It found that 61% of U.S. adults actually gambled at least once for money in that year.
I bet it has gone up. There's more opportunities for gambling and it's gone up. 1.1% of men are compulsive
gamblers and 0.5% of women. This is another male trait. Somehow men are more vulnerable to compulsive
gambling than women. But it's only a factor of 2-to-1. But it's an addiction that happens that distorts
people's thinking. And it's such an addiction that we have an organization called Gamblers Anonymous that
helps people with this. It ruins people's lives. People end up getting a divorce, because you can't stay with
someone, married to someone, who is squandering the family money. They do it. They end up sneaking
around to gamble, like drinkers sneak around for the next drink. Gambling behavior, it seems to be
associated psychologically with a self-image, a sense of who I am and why I'm an important and good
person. A sense of competence. Most gamblers do things that they think are revealing of their competence.
And they tend to pick a certain form of gambling that they become psychologically identified with. And
they avoid any other form of gambling.
Gambling behavior is part of what goes on in the stock market. Certain people who have a personality,
which makes them particularly interested in gambling, find that a life in finance can give them the kind of
stimulation. Gambling behavior, by the way, is almost like a drug addiction in a sense. People who are
depressed may go to a gambling casino as a way of getting themselves out of the depression. And they say
that when they walk into the casino, suddenly my troubles are gone. I feel invigorated and alive.
Almost like it creates a hormonal difference that they seek, and it's almost like injecting yourself with
something, so it's a very hard thing to conquer.
I mentioned before, when the New York state in 1811 created the first corporate law that produced a lot of
questionable companies, people then said, this is just gambling. It's bad. But the other side of it is that this
same gambling behavior, it's not usually a pathology. It's an aspect of human sensation-seeking of various
aspects of our psychology that drive us. What the stock market is, in some sense, is a way of channeling
this kind of behavior into something productive instead of just a game. And so, they make it very clear in
the stock markets of the world, this is about business and this is productive. The same emotional patterns
that created gambling behavior as a human universal underlie some--this is not abnormal, it's most people.
Underlie traits that work out well.
Chapter 5. Overconfidence, and Related Anomalies, Opportunities for Manipulation [00:40:40]
OK, the next major thing I wanted to talk about is overconfidence. And psychologists have found that
there's a human tendency to overestimate one's own abilities. We all think--not all of us, most of us think
we're above average. Some of us think we're way above average. And this tendency has been revealed in a
number of experiments. I thought I would try one on you. I don't know if it will work. I'll try it on this
class, if you will participate in this experiment by a show of hands.
I'm going to ask you--I have three questions here. And I want to ask you to write down a 90% confidence
interval. Do you have a pencil to write this down? And then afterwards, I'm going to tell you the answer
and see if it fell in your confidence interval. OK, so this is what it is.
What is a 90% confidence interval? It's a range of values, so that you are 90% sure that the true value lies in
this range. So, if I asked you, what is the population of New Haven? You might say, 90% confidence
interval that's between 50,000 and 150,000. That means, you're 90% sure that the population falls in that
range. And so, you should be right 90% of the time. If I ask you to give 90% confidence intervals, you
should be right 9 times out of 10. If I ask for a 99% confidence interval, you have to widen the interval and
you should be right 99 times out of 100.
So, what I'm going to ask you to do, if you will cooperate with me, is give 90% confidence intervals for--I
have three questions I'm going to give you. But I have to ask you to be honest, otherwise this thing won't
work. You could game me by just giving excessively wide confidence intervals, right? From the ''zero-to-
infinity'' type. Then you'll always be right, but you're not playing honestly. So, I have to appeal to your
character to do this honestly, OK?
So, I have three questions here. I just changed the questions. The first is--now what you have to write down
on your notepaper somewhere is your honest estimate of a 90% confidence interval. And so, the first
question is, the world population--how many people are alive in the world? As of, I think it was 8:00 a.m.
this morning [addition: February 21, 2011]. The U.S. Census has something called the World Population
Clock and just go--don't cheat. I know some of you have laptops. Don't do it. But after this you can search
Google on World Population Clock and it shows you minute-by-minute how many people there are in the
world. Every birth and death. It's not actually recording them; it's a fake. But, I mean, it's supposed to be an
estimate. So, I got the world population. So, what I want you to do, can you write down a lower bound and
an upper bound for the world population this morning as measured by the U.S. Census? OK, can you write
that down? But I don't want you to make it too wide. Remember, I only want you to be 90% sure. And I
don't want you to make it too narrow, because then you're more likely to fail. So, you've written that down,
the world population?
OK, my next question is--2. The world, what does it weigh? Well, actually, it's the mass, in kilograms, of
the world. Can you write that down? This is astronomy. Let me say, I'm asking for it in kilograms. But you
can do it in metric tons. That just knocks off three zeros. A metric ton is 1,000 kilograms, OK? And just so
you'll know for sure, that's not the same thing as a long ton, which is U.K. The United Kingdom uses the
long ton, which is 2,240 pounds. I just looked this up. And is 1.1 metric ton. And it's not exactly the same
as a short ton, which we use in the United States, which is 2,000 pounds, which is 0.98 metric tons. Just tell
me, how many tons. That's not going to affect your 90% confidence interval, right? Just tell me how many
tons does the earth weigh. OK, all right? And then that's the second and I have one more question.
How many languages are there in the world, OK? Now, I know you might complain, this is a matter of
definition, because sometimes two dialects might be considered a separate language. Well, I'm asking you
to give me the number--the world authority on languages is an organization that has a website called
ethnologue.com. And if you go to that website, they're always discovering new languages. They keep track
of it. New languages keep getting discovered, because some guy is hiking out in Siberia and they go to this
little village, and say, hey, these people are speaking a language that have never been documented before.
So, it's this process of learning languages. They also keep dying out, because there's just elderly people in
this village, and when they die you know this language is going to die with them. So anyway, the question
is, I want your 90% confidence interval for the number of languages, as defined by ethnologue.com. You
have to guess how they define a language.
But you have an idea more or less what a language is. It's more than a dialect, because they can still
understand each other if they speak different dialects. We're talking about really different languages.
OK, have you written down three confidence intervals? OK, so I'm going to write down the answers and I
hope this works. I'm trusting to your honestly in getting these things, because you good game me and make
this not work. But give me your honest count. So, I'm going to write down the correct answer. So, the
world population as of 8:00 a.m. this morning [addition: February 21, 2011] was 6,901,330,581.
Now, can I get a show of hands, how many peoples' confidence interval includes that number? OK, can
someone tell me what percent that is? That is not 90%. You're doing pretty well, though. What do you
think, Oliver?
Student: About 80.
Professor Robert Shiller: Think it's 80? See them up again. Maybe it is 80, all right. You're doing really
well. Some honest people here didn't put their hands up. All right, well, that's one. So, we did 80 instead of
90.
What about the weight of the earth, OK? In kilograms. Well, it's 5.974 x 10
24
. And I'll give you that in tons.
It's 5,974 billion billion tons. You got that, OK? You might have to do some calculation. It'd be 5.9734 x
10
18
. [correction: 5,974 x 10
18
is the weight in tons.]
OK, can we do a show of--how many people had a number in--how many people are in the confidence
interval there? All right, Oliver, what do you think? What's the fraction?
Student: 5%, maybe 10.
Professor Robert Shiller: 10%. OK. So this one, you did really well on world population. 80, 10.
The last one, how many languages are in the world? Well, according to ethnologue.com there are 6,909
languages this morning [addition: February 21, 2011]. OK? How many people got that within their
confidence interval? OK, what do you think, Oliver?
Student: About the same, 10%.
Professor Robert Shiller: 10%, OK. Why did you do so much better on world population? Well, thank
you for being honest with me. I think it worked once again. The overconfident. So, why is it that people are
overconfident like this? And psychologists have tried to describe, what it is that goes on in people's minds
that produces answers like this.
One of them is that, people seem to have a sense that they understand the world more than they really do.
It's an illusion. Actually, the world is just infinitely complicated and there are so many surprises. When you
think about a question like this, there's many different perspectives that you can take. And if you thought
more about it, your imagination might help you to widen your confidence interval. But you can't think of all
the perspectives at once. And so, you tend to gravitate to the first one that comes to mind and it gives you
an underestimate of the confidence. So, that is overconfidence. By the way, I think it's a little bit higher in
males than females. I didn't do a separate male/female count. But females [correction: males] are definitely
overconfident. That's the so-called macho personality that's supremely overconfident, which is--that's not in
DSM-IV. I don't think it is, but it is more common among males. But it's really, everyone is overconfident.
There's no important sex difference here.
Incidentally, I think that overconfidence, and this is an important phenomenon, it goes beyond yourself. It
extends to your friends. And you exaggerate--there's a tendency for people to think that I have very smart
friends, OK? I was reflecting the other day. When I was an undergraduate at University of Michigan, I was
in the honors program and we thought we were pretty smart. And I had a number of young people that I
just imagined were heading toward really great careers. There was one student that we called Young Jack
Kennedy. You know, this was some years ago. Jack Kennedy was president of the United States. We
thought he was a genius. That was probably wrong, too, right? None of these people are geniuses. I was
thinking that most of my friends ended up in very good careers, but nothing that you would think was
spectacular.
I had one friend as an undergrad, who I thought was a genius, and his name was Bruce Wasserstein.
Anyone ever heard of him? Maybe not. Well see, that's it. But he founded his own investment bank called
Wasserstein Perella, became really rich and then he bought interest in Lazard Freres, the French investment
bank. He was a real big shot on Wall Street. I met him again about 10 years ago and then he died. God. He
had a heart attack and died. So, I know his whole life. I saw him when he was 18 and I've watched his
whole life, and it's now history. It's kind of scary. But I remember thinking he was a genius as an
undergrad. I was wondering, what was wrong with my judgment? Why did I see so many other geniuses?
Now that I think back on it, he had a sort of real world common sense that amazed me. He just knew things
that--it wasn't fake knowledge. He seemed to know how things worked. So, I guess I was right about one of
them. But not enough that none of you have heard of him right? He has an investment bank named after
him, right? You should have heard of him, but maybe not.
But anyway, this thing affects peoples' thinking, too. I think that we tend to think that the head of state
whos running, the head of our central bank is a genius. And this really clouds our thinking. It's like our ego
extends to the other people that we associate with ourselves. Now, the head of a central bank in another
country we have no respect for. It's only in our own country, because it's part of our ego involvement that
produces this overconfidence.
This tendency for overconfidence produces a lot of anomalies and opportunities for manipulation. So, for
example, Rakesh Khurana, who is a professor at the Harvard Business School, has written a book called
Search for the Charismatic CEO [correction: Searching for a Corporate Savior: The Irrational Quest for
Charismatic CEOs]. He claims that there's a tendency for people to think that CEOs are geniuses. Or at
least the one that we found is a genius. And companies then seek out a genius CEO to put in charge of the
company as a kind of manipulation of the stock market. They think if we get--you know, if we got some
guy who's run other companies successfully in the past, he must be a genius. Put him in our company, our
stock price will go up, then we can sell our executive--we can exercise our options and make a lot of money
by putting in this fake genius.
And Khurana says, well, there are some people who are maybe geniuses at management, but most of the
time they're just lucky. And we tend to develop overconfidence. And then what happens, according to
Khurana, is, you put in some guy who turned around some company spectacularly, supposedly. You bring
him in to run a new company and he doesn't know anything about this new company, right? But he has to
justify himself, so he lays off a lot of people and shuffles things around, and just destroys everything in the
company, and ruins things.
This is related to another author that I recommend. I've mentioned him before, I think. Nassim Taleb wrote
a book called Fooled by Randomness. He's Lebanese, but now in the U.S. Nassim Taleb, Fooled by
Randomness, that says that most of the things that happen in life are just chance. We tend to ascribe them.
If they happen to us, we conclude--we're very quick to conclude that it's a sign of our own genius. And if it
happens to someone that is a friend of us, then you think, well, I have genius friends, isn't that nice? And
so, it leads to mistakes.
Chapter 6. Cognitive Dissonance, Anchoring, Representativeness Heuristic, and Social Contagion
[00:57:16]
OK, let me go to another--how much time do I have--cognitive dissonance. This is another psychological
principle. The term was coined by sociologist Leon Festinger in the 1950s, I believe. I actually met this
guy. That's the nice thing about being in academia, you meet all these great names if you're in long enough,
eventually.
But what is cognitive dissonance? It's a judgmental bias that people tend to make, because they don't want
to admit they're wrong. Maybe I'm oversimplifying this mistake. It's painful to think, that I believe
something and it was wrong, so people will cling to old beliefs and try to find evidence that supports their
beliefs, because they have an ego involvement with the belief. And so, I will be biased.
The famous experiment indicating cognitive dissonance, done by some psychologist, had the following
form. They got a list of people who had just bought a car and they knew what make of car. They got the list
from car dealers, so they knew exactly what car they had just bought. And they called these people up and
asked them to participate in a psych experiment. Or I think they said a marketing experiment. They didn't
let them know that they knew what car they had just bought. And then, the experiment was the following.
Let's go through a number of--what magazines do you read? And they said, let's get these out. They got all
the magazines that were on the newsstand. And they said, let's look through page by page and tell us which
ads you remember reading.
And what they found is that people read the ads for the car they just bought. And they avoided especially
the car that they thought they might buy, but decided not to buy. So, after you buy a car, you want to
confirm your belief in it. So, you selectively get information that confirms your belief. And so, this
cognitive dissonance is another factor. It's been demonstrated. It's an error that people make. It doesn't
mean that people--again, none of these errors is unviable. People will make the error and then they'll learn
from their mistakes and they'll correct. They're not totally cognitive dissonant, but it's just a kind of error
that keeps coming up.
So, I give you a couple of examples of cognitive dissonance and its effects on finance. So, Will Goetzmann
is a professor here at the Yale School of Management, and a couple of his co-authors found that mutual
fund investors--when a mutual fund does very badly in its investment performance, many or most investors
sell the stock and get out of it. But some of them hang on. And they thought that that was due, perhaps, to
cognitive dissonance. Because I bought this fund, I don't want to sell because I was right. So, what they did
is, they interviewed these people and they found that these people didn't even know how badly the fund has
done. They had blocked it out and they had an exaggerated impression. An exaggerated impression of the
success--which is characteristic of cognitive dissonance. You just forget the evidence that's contrary to your
theory and you keep assembling evidence that supports your theory.
I have another example of cognitive dissonance and this one was produced by a Professor Sendhil
Mullainathan at the Harvard Economics Department. And Mullainathan looked at financial advisors--and
his co-authors. What they did to study that's a whole big profession. I remember at the beginning I pointed
out how many hundreds of thousands of financial advisors there are. What they did, it's an interesting
experiment. They hired actors to go to financial advisors and ask for their help. And the experiment was the
following.
They would say the same thing to each financial advisor, but the different actors would present their
existing portfolio differently. In other words, you'd go to the advisor and you'd say, I have a portfolio of
investments and I'm almost entirely in money market funds. That's all. You'd just say that. You wouldn't
express any opinion at all. Another actor would go and say, I've got all of my portfolio in tech stocks, right?
Or I've got all of my portfolio in options.
Now, what should advisors tell people? Well, if they were acting really professionally, they should question
the assumptions that made the actor supposedly put all their money in one kind of investment. And many of
the financial advisors did, but usually they didn't. They didn't question the actor. They assumed that the
actor, who had put, supposedly, all of the investments in money market funds, was someone who was very
risk averse, or thought that was the right thing to do. And they didn't want to challenge them, so they would
walk out of there with maybe a slightly different mix of money market funds. And somebody else who was
in a very risky portfolio, they didn't challenge them.
And they even sent actors in with almost all of their portfolio in their own company's stock, all right? Now
if you work for Ford Motor Company--I noticed my uncle--I had conversations with him about this--who
worked for Ford Motor Company and put all of his life savings in Ford Motor Company. I said, Uncle
Ralph, you shouldn't do that. Because it's your job and all of your life savings. What if something happened
to Ford Motor Company? Fortunately, he didn't work for GM, which became worthless recently. But it can
happen. You know, Ford could be completely wiped out. That's your life savings. And you know what he
said to me? He said, you know, I've worked at Ford all my life. They treat me well; I believe in them, I'm
not going to sell. So, there's lots of people like that. So, when they show up at a financial advisor, the first
thing that they should do, the financial advisor should tell them, get out of your Ford stock. That's just too
risky. But only 40% of the financial advisors did that. The 60% left them mostly in their own company
stock.
Why did they do that? Well, Mullainathan thought, it's because the advisors know there's cognitive
dissonance, and they're afraid to drive away a new client. Maybe they'll gradually do it over a while, but
you just don't challenge their deep beliefs, whatever they say is true. And so, they're kind of yes-men. Not
all of them, and maybe they'll come around.
It relates then, again, to a moral dilemma. If you are a financial advisor working in private practice, what do
you do with people who come to you, if you know from experience that challenging their deep-seated
beliefs will drive them away? So, in the real world, this is again--I'm not sure that these financial advisors
are doing the wrong thing. If they would eventually tilt them toward a more responsible portfolio, they can't
drive them away.
I have a lot of--so many. Let me list some of the others and move on.
What else should I talk about? Anchoring. Anchoring refers to a tendency to anchor your opinions on
something that captures your attention. The famous anchoring experiment by, it was again, Kahneman and
Tversky--I could almost do this experiment here in class with you if I had a wheel of fortune. A wheel of
fortune is like on a game show. You spin the wheel and it comes up with a number between zero and a
hundred in this particular wheel of fortune.
So, this is the experiment. They asked their subjects, how many people--it had to be something that had an
answer from zero to a hundred. One of their questions was, how many nations in the world [addition: in
percent] belong to the United Nations? So, they asked the question. They said, don't answer me just yet.
Think about that question. What percent of nations in the world belong to the United Nations? Then, they
spun the wheel, and it came up and it showed a random number. And then, they asked people for the
answer. Well, it turns out that people tended to give an answer close to the number that just came up on the
wheel. This is totally irrational, right? That wheel has nothing to do with the answer. And yet people were
influenced by it. So then, they would follow-up and ask them, hey, that number you gave is the same as the
one that just came up on the wheel, or it's close to it. Why did you do that? The guy would say, just
coincidence. I wasn't influenced by the wheel. Of course not. But you know they were, because statistically
they proved that they were. So, anchoring means that people are attracted to--they're affected by
subconscious things. I shouldn't say subconscious. They didn't make a logical connection. When you face
real ambiguity and you don't know the answer and you've got to come up with a decision, you are swayed
by the most silly and random things.
There's a representativeness heuristic. This is also Kahneman and Tversky. And that is, that people
overemphasize certain patterns that they think are representative of what they've seen before. So for
example, certain patterns in the stock market that may be very rare and unusual. If they remember it, if it
somehow attracted their attention, they begin to look for that pattern again and again. And they see it too
often.
So for example, Head and Shoulders, we talked about that. That McGee, the technical analyst, he saw the
Head and Shoulders pattern in the stock market. And he saw that it crashed after that. But actually, it's
pretty hard to find those; they're kind of rare. And it's not the right way to process data, to be looking for
patterns that are representative.
And it invites manipulation. So, I'll give you some other bad behavior. If people believe in the Head and
Shoulders, if they believe that the Head and Shoulders pattern of stock price movements predicts a decline,
here's what I can do. I'll take some thinly traded stock. I'll get a friend. We'll trade back and forth and we'll
influence the price to create--we'll deliberately create a Head and Shoulders pattern, OK? And then we'll
short the stock massively, right at the time when the head and shoulders pattern would give a sell signal,
right? We can make tons of money doing that. So, why don't we do that, right? Well, we don't because it's a
manipulation.
[SIDE CONVERSATION]
Professor Robert Shiller: I want to then just conclude with social contagion, because it's so important.
This is my last--and this is really social psychology. I'm running out of room here. That's social contagion.
Social psychology reflects on the fact that people are interdependent, and what I think is affected by what
other think. There's something called herd behavior. That's a popular term. It refers to the tendency for
people to move with the herd, not consciously. They don't think that they're moving with the herd. I might
bring up a little sociology here and I'll use a term. Everything has been psychology, but the great
sociologist, one of the founders of the discipline of sociology, was the French scholar Emile Durkheim at
the late 19th, early 20th century. And he used the word ''collective consciousness.'' And that is, that our
opinions about what's happening are formed by a collective understanding of what's going on. We have a
tendency to think of ourselves as rational and common--all of our views come from common sense
processing of facts. I have a sense of belief about what goes on in the world, but I underappreciate the
extent to which my views are a little bit arbitrary and shared by millions of other people. You live at a
certain point in time in history, and there are certain kinds of facts and ideas and anecdotes that are
circulating. There's another term, this is a zeitgeist. That's German, but it's now English. That means "spirit
of the times."
So, what Durkheim and other sociologists allowed us to understand is, that the zeitgeist is determined by a
collective memory, a collective set of facts that we operate on. This herd behavior creates big swings in the
stock market and other things. So, it has a huge financial impact.
But anyway, I've listed a number of Behavioral Finance principles that really come from psychology, and
I've talked about some tests or examples of their proof of their importance in finance.
Chapter 7. Moral Judgment in the Business World [01:12:38]
But what do we conclude from this? I think that my conclusion is, that we are evolving toward better and
better financial institutions. There is a lot of manipulation and exploitation, but we, as a society, have
outlawed a lot of it. For example, I mentioned doing a stock market manipulation trick to create a Head and
Shoulders pattern. That is an offense. It will get you in jail for doing that. And we prosecute that now. So,
you can't do that. I'm going to talk more about this in the next lecture about regulation. But it's also people's
moral judgments that the people who evolve to become important in finance are people who have an
internal compass, a desire for praise-worthiness that eliminates--I'm going to give just two examples of
some recent articles about this. In the current issue of the Harvard Business Review that, I assume, is still
on newsstands. This is Harvard Business Review. There's an article by Michael Porter and co-author Mark
Kramer, Porter is a well-known professor at Harvard, in which he argues that we're coming to realize more
and more about a principle called--he calls it ''shared value.'' Or they call it ''shared value.'' And that is that
the manager of a company shouldn't be underestimating the importance of shared value creation with
society, with other people. That is, we're all in this together, and if we're mature, we recognize, for
example, that I don't want to be exploitative. I don't want to make the local people in my town upset with
our company. I don't want our labor force to become disenchanted.
Now, what he's saying it's not really about morals exactly. It's more about long-term value. But I guess
morals somehow creeps into the same judgment. That mature businesspeople see shared value and that
there was maybe not enough emphasis on that. Financial theory was leading us too much toward thinking
that a manager should be selfishly pursuing a narrow focus, like maximizing the short-run value of their
shares.
Anyway, the other example I have, which is also recent, not quite as recent as that, is a book that came out
last year by Anna Bernasek, who is actually a journalist, not an academic. But it's called The Economics of
Integrity. Is that the title exactly? Yes. [The] Economics of Integrity. And her point in that book is that, a
sense of personal integrity has dominated what people do in the business world much more than we thought
recently. There has been too much disregard of the fact that people do things because they're right.
She gives an example in the book--and I'll close with this concept. She said, let's consider milk, OK? Now,
you drink milk regularly, I hope. It's good for you. But it could poison you. People used to get sick from
drinking contaminated milk. And you don't ever hear of anyone getting sick. So she said, why is that? Well,
we have government regulation of milk production and there are laws about purity of milk. But she looked
into it and found that--actually, she didn't think it was mostly the regulation. She thought that you are safe
drinking milk because of the integrity of our people, mostly. That if you go out to some milk company and
talk to the employees, they might not generally even know about the regulations. But if you ask them,
they'll tell you--I mean, are you careful to keep this milk clean? They'll tell you, well, someone's going to
drink this, so obviously, it's common sense, I'll keep it clean. And what she says, it's not primarily the
regulation; it's the integrity of the people that makes the economic system work as well as it has.
So, anyway, I've emphasized both sides. I've talked about human failings and about people exploiting these
failings, about people with antisocial personalities. But we have a system that somehow eliminates this
from being the major factor in our markets.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 12 - Misbehavior, Crises, Regulation and Self Regulation
[February 23, 2011]
Chapter 1. The Importance of Regulation and Its Challenges [00:00:00]
Professor Robert Shiller: All right, good morning. I wanted to talk today about regulation. Well, actually,
regulation and human misbehavior. So, this is a continuation of my previous lecture, in a sense, which was
about Behavioral Finance and about human foibles. But now, I want to go on to talk about what we do
about some of these things, and that means talk about regulation. So, I think that regulation of finance,
financial markets, and institutions is substantially directed at dealing with psychological problems, and the
tendency for some people to exploit human weaknesses, and manipulate and take money from other people
rather than help them.
But I think regulation goes beyond this, because it also has another, more technical side, and that's about
making sure that the financial system works well. For example, regulation deals with monopolies and
externalities. It's been talked about a great deal that regulation has to take account of the--why don't I write
this down--the ''too big to fail'' problem, that is, regulation that deals with systemic problems. ''Too big to
fail'' refers to a phenomenon that's been observed many times in many countries, that, whenever a big firm
fails, the government bails it out. And that's because they realize that, if this firm, especially if it's a
financial firm, collapses, it will bring down the whole system with it. So, that means big firms have an
implicit government guarantee. Small firms don't. This is not the way anyone wanted it to be, but it
happens naturally, because big firms are the only ones that can bring the whole system down. So, this
tendency then creates an opportunity for big firms to take more risks than small firms, because they know
that they have this free insurance policy from the taxpayers. And so, they take bigger risks and they bring
on systemic crises.
So, dealing with this is another aspect of regulation. And it's central to regulation right now in the wake of
the world financial crisis. Another term I wanted to emphasize, well, a pair of terms: There's two kinds of
regulation, called microprudential--I think this is a relatively new word; at least it has become popular since
the financial crisis of the 2000's--and macroprudential. So, microprudential--prudential sort of means
regulation, dealing with prudent standards for business--microprudential regulation protects the small firms,
the small people, the individuals. Macroprudential protects the system. Macroprudential regulation deals
with the ''too big to fail'' problem, and it deals with other problems that affect the whole system. I think the
history of regulation involved both of these, but I think the mix was more microprudential then
macroprudential until recently. So, we'll talk about both of these here.
So, I thought I should say just something first about regulation and regulators. I'll start with an analogy. I
think regulators are analogous to the referees at a sports event. They enforce rules. They decide when
someone has broken the rules, and they can punish people who fail to adhere to the rules. But I think that's
a good analogy, because, I think, we generally all appreciate the importance of referees at sports events.
The players often argue with the referees, but the players want them, because it wouldn't be a very good
game if we didn't have a referee, right? Because the, for example, dangerous player, or player that risks
others being hurt, or deliberate hurting of other players would become almost necessary in order to succeed
in the game. So, this reflects a problem. In a competitive system, there's kind of a race to the bottom, right?
If everyone else is doing something that you think it's shady, well, you kind of have to do it too or you can't
compete.
And so that means people in the sports world or the business world will themselves ask for regulation, or
they'll try to do it themselves as much as they can. Just as children, when they play on an empty lot when
there's no adults around, will agree on some rules. And maybe they have a referee, I don't know. Usually
not. They're all referees. They're all enforcing the rules. That's what we're talking about when we talk about
regulation.
We tend do admire the players more than the regulators. This is true both in sports and in finance. You
know, one thing I'd like to also say is that we should show respect for regulators and referees. It's a
profession, and they're not losers, as some people say. It's true; the referees in the sports game probably
couldn't play the game very well. They're probably too old to play it very well. But even so, they have a
different profession, right? And some of them are very good at what they do. They don't attract as much
attention, except when they make mistakes. It's the same thing with regulators--the regulators that I've met
seem to me often to be well-meaning, intelligent people. I think it's a career that you should consider. So,
when I say I'm hoping that this class prepares you for a job in finance, I'm including in that a job as a
regulator. Some people like it better, because it adheres more to their personal sense of moral, morality, and
integrity. They would rather be enforcing good rules of financial behavior, than being compromised. I
think, maybe it's a different personality. When you're in there in the game, I mentioned this last time, you
get compromised one way or another. There's no avoiding that, because youve got to kind of play to the
rules, right? And if the rules allow something that is questionable, you may have to do that too. I think you
should try not to, but reality is something that interposes. So, some people will spend years on Wall Street
making money, and they'll switch to a regulator job. And it isn't because they failed on Wall Street. I think
it's because life offers many different kinds of rewards.
Chapter 2. Firm Level Regulation: The Board and Its Duties [00:08:10]
Anyway, in this lecture, I have five levels of regulation that I want to talk about. So, the first one is the
lowest level. It's within the firm. And maybe people don't always talk about that as regulation, but I'm
going to count that. Firms set up their own rules. There's no government involved. This is just internal.
Then, there's trade groups, all right, where a group of firms will get together and form a trade organization,
or a self-regulatory organization, and they will decide on rules among them. Then, there's a local
government. That would be at a city-, or province- or state-level. And then, there's national. And you can
see where I'm heading, to international. So, those are the five kinds of regulation. And I think that the oldest
are the ones at the top of the group, and as time moves on, we're becoming more and more broad in
geographical scope. So, I'm preserving international regulation for the end of this lecture.
So, let me start with number one, which is the within-firm regulation. We've talked about this before, about
the modern corporation as having a board of directors. And they could be called a board of regulators.
Nobody calls them that, but I think that they look a lot like regulators. But they're not imposed by the
government. Remember, I said that a team playing a sport wants a referee. So, companies want somebody
imposing some kind of standards on them as a group, so companies have boards of directors. Now, in most
companies, they have both inside directors, who work for the firm, and they have outside directors, who
have nothing to do with the firm, except that they're on the board of directors. I think that it's really the
outside directors that make the board of directors into a sort of regulator.
In the last lecture I was talking about how people are different. And some people show more character than
others. That's a problem, a fundamental problem, in human society. A lot of the people who rank very low
on character end up in jail, unfortunately. But most of the time, we don't want them in jail, but we can't put
them in positions of responsibility. So, society finds some way of kind of quarantining them so that they
don't--these are all uncomfortable problems, and, I don't know--I can't get into all of the issues here. But we
don't want them running a company. We want people of character running a company. And so, in a sense, a
board of directors imposes that. You put people on the board who have reputations as high-minded people.
That's the way it should work. Anyway, it usually does work. High-minded people who, you know, you'd
probably not want to propose some shady deal to.
So, you want to have regular meetings of these, where you talk about what the company's doing. And these
people impose a kind of community standard on what the company is doing. And it also has an effect on
the standing of the company in the community, because they see the names on the board of directors, and
they think, well, this company can't be shady, right? With these people on the board. When you join a board
of directors, you're merging your reputation with the reputation of the company. So, you wouldn't do it if
the company looked shady.
So, I'll give you an example of a board of directors. I'll use our own most familiar example, the board of
directors of Yale University. And it's called The President and Fellows of Yale College. And they meet
regularly. They come to campus and have their meetings. But it's a small group of--I don't know what the
whole number is, like 20 people. I'll give you some examples of the members of the Yale--they also call it
the Yale Corporation. Richard Levin, the President of the University, of course is Chairman of the Board.
The Governor of Connecticut, Dannel Malloy, has always been, going back hundreds of years, on the Yale
Corporation. So, we have the governor of the state.
I'll just give you several more examples. Fareed Zakaria, who was born in Mumbai, India. He's now editor
of Time Magazine, and he's the author of many intellectual books. And he has a kind of an intellectual
television show, public TV, and is a Yale alumnus. So, he's on the board. We also have Indra--maybe I
should write these names since they're hard to spell. Fareed Zakaria, I mentioned. And then, Indra Nooyi.
That one you might have trouble spelling. I don't think she went to Yale. She was educated in India. But
she's president of PepsiCo, the big international corporation. She's a director at the Lincoln Center for the
Performing Arts in New York. And this is an example of interlocking directorships. So, you judge a
director partly by what other boards they sit on. And she's chairperson of the U.S.-India Business Council.
And I have one more example who's on the Yale Corporation. Mimi Gardner Gates. You know who she is?
She's Bill Gates' stepmother, but maybe that's not the way to introduce her. I just found out that Bill Gates'
mother died in 1994, and his father remarried to a woman who ran the Seattle Art Gallery, so she's an art
conservator. All these people are people who have reputations as high-minded intellectuals and members of
our community. I don't know that Yale is in strong need of a board of directors like that. I think we would
function like an orchestra without a conductor. We could do all right. But it imposes, on any corporation, a
sort of regulatory standard that is important.
So, a board of directors has a really important function, because--let's move away from the nonprofit. Yale
is a nonprofit organization. Let's consider someone doing business in a for-profit corporation. There are
way too many opportunities for sleazy behavior. And you only are willing to invest in a company, if the
sleazy behavior is somehow under control. So, I'm going to talk about maybe the most important kind of
sleazy behavior in a company. It's called tunneling. Tunneling is sneaking away with value, putting it in
your own pocket, if you work for a company, rather than in the stockholders'. The stockholders own the
company. They're supposed to get the money. But the employees have never met the stockholders. And
they sometimes think, you know, there's a lot of things we can do and let's do them. And the money is
going to come from the stockholders, and will somehow end up in our pockets.
So I'll give you just examples of tunneling. The company has some asset and it's going to sell it, right? So,
asset sales. In part of doing business, how does the company make sure that it gets a good price? Well, if
you work for a company and you're in charge of the asset sale, you can tunnel. You say, I'll sell it to my
brother-in-law at a really low price. All right. OK? He'll wait a while and then he'll pay me off later, OK?
That's hard to detect. Because how do you know, if you are a stockholder, how are you going to find out?
That's stealing from the company, right? If you sell it at a non-market price. How does somebody know
that? I mean, the stockholders can't be looking at every deal.
So, I'll give you another example, contracts. The company is signing a contract to provide something to
them regularly. They can pay too much. Now, it could be your brother-in-law who's running. But hey, let's
not be so obvious about it. It'll just be some guy that I met, and we're both antisocial personalities. We've
just discovered each other. And, you know, it doesn't even have to be written down. I'll give this contract to
you over somebody else. And I'll pay you too much. And, you know, sometime later you take care of me.
You know, I did it for you, you return the favor, OK? This is tunneling.
Another one, executive compensation. The CEO decides to pay his friends in the company, his cronies,
very high salaries. And he would defend it, if anyone asked, by these people are worth every penny. Who
knows what somebody is worth, and who's going to judge that?
Expropriation of corporate opportunities. See, one of the most valuable things about a company is that
you're in the business and you know what's happening, right? And your company is producing a certain
kind of product. Then, someone comes along and says, you know, I don't really want your product, but you
seem like the kind of people who could produce something that I really need. Something else. And so, you
as a director, as a president of a company, you should say, OK, we can do it. But you don't do that. Instead
you say, I'm setting up a new company with my name. Or my brother-in-law is setting up a new company.
And you tell him all the corporate secrets and how he can do it. That's tunneling, again.
And of course, there's insider trading. That's when people in the company will buy or sell their own shares
based on knowledge that they have, that they haven't told the public yet. So, if you know that the company's
going to collapse, you sell your shares right away. If you know the company has some great news, you buy
them before you announce it. That's tunneling again, because you're taking money out of the company
because of the opportunities you have as part of the management of the company.
You see how many different ways, and I haven't listed them all, there's many, many ways. Companies do so
many things. So, why would you ever invest in a company? You might think there's a million ways to get
money out of the company. And the people, who are running it, don't know me. They don't care about me.
That's why a corporation is kind of a delicate thing to work at all. It has to have some way of controlling all
these things. And there's so many of them and they're so complex.
I would say, that's why we have boards of directors, and why we put people of known reputations on boards
of directors. So, this is maybe the most essential kind of regulation, and it's within firm. And you may
someday be serving on a board. The thing you have to remember is that a board member has--if you ever
agree to serve on a board, I think you should interpret it as a moral obligation that you have taken on to
prevent all of these things, OK, and to make sure that the business is run in a high-minded way. And
remember that your reputation is at stake, because you're part of the company. But it's more than that, it is a
moral duty.
So, you have what's called the duty of care as a board member. Duty of care is a duty to act as a reasonable,
prudent, rational person would. That means you have to make sure that you're getting the information,
you're watching, you're being careful about your obligation as a board member. You are not managing the
company. You are watching the management of the company. And you don't follow every detail, but you
have to follow enough that you act as a sort of regulator. And you have to know what you're doing.
You also have a duty of loyalty. And that's usually interpreted as loyalty to the shareholders. I would say,
it's expanding. Now, there's more and more talk of corporate social responsibility, and the loyalties that you
have to other people, members of the community at large. But I'd say that, let's just start from the
beginning, because there's so much temptation to steal money, to tunnel money out of corporations, it
probably remains true that your main duty of loyalty is to the actual shareholders. Because they're the ones
who put up the money, and they're expecting to get a profit back. So, if you ever serve on a board of
directors, I think you may become--many board members don't view it as a very significant thing. They
think, well, this is just an honor to be on the board, and I just show up at four meetings a year. And we
listen to a presentation from the CEO, and we say fine. That's not what you should be doing.
I think one has to kind of notice the ambience. You have to use your intuitive judgment as a board member.
Is this an up-and-up firm? Is there a good atmosphere here? So, that was my first thing, at the firm level. Of
course, firms have compliance departments. They issue rules. They issue statements of purpose. And that's
all within firm.
Chapter 3. Trade Group Level Regulation and Its Controversies [00:25:37]
But I wanted to move up now another step in my regulatory thing, and move to trade groups. And these are
groups of firms that get together to form an organization. Well, what did I say? Indra Nooyi was on the
U.S.-India--what was that? I don't remember the exact name. It sounds like a trade group. A private group
that deals with businesses in both--U.S.-India Business Council. So apparently, business people in both
countries got together and formed an organization where they discuss issues. And there may be a regulatory
function associated with them.
But I wanted to start with an example of a trade group, and that is the New York Stock Exchange, because
it's important in history. And it was founded in 1792. In 1792, stockbrokers functioned; we had a stock
market in the United States. Of course, it was a small one. The big stock markets then were in Europe. But
there was no organization for the U.S. stock market. We had our first stock market crash in 1792. The first
American stock market crash. And within two months, the stockbrokers set up a trade organization, called
the New York Stock Exchange. And they met outdoors under a buttonwood tree, so they signed a document
called the Buttonwood Agreement. Stockbrokers used to work outdoors. Even into the 20th century, the so-
called American Stock Exchange used to be called the Curb Exchange. That's because they were guys who
would stand on the curb outside of the New York Stock Exchange, which had a building, and they would
just dicker among themselves and trade. Then, they decided they better get a building, and that became the
American Stock Exchange, which doesn't exist anymore, it was absorbed by the New York Stock Exchange
eventually.
But anyway, the stockbrokers in New York got together under the buttonwood tree and signed a historic
agreement, setting up the stock exchange. And it's been described as an idealistic document about our
duties and our ethics. But I found, actually, the text of the Buttonwood Agreement, and it's really short. So,
I will read it to you. I'll read you the whole Buttonwood Agreement. "We, the subscribers, brokers for the
purchase and sale of the public stock, do hereby solemnly promise and pledge ourselves, to each other, that
we will not buy or sell from this day, for any person whatsoever, any kind of public stock at less than 1/4 of
1% commission on the specie value of gold, that we will give preference to each other in our negotiations."
Period. "In testimony, we have set our hands this day, 17th day of May, 1792, in New York." That's the
whole Buttonwood Agreement. It sounds like a price-fixing agreement, doesn't it? And excluding other
traders, so it sounds like a cartel.
I was wondering how I got the impression that the Buttonwood Agreement was so idealistic. Where is the
idealism there? So, I went and I looked on the New York Stock Exchange website. And this is their
interpretation--it's on the website right now--of the Buttonwood Agreement. It says there, "At the heart of
the Buttonwood Agreement was the need for fairness, responsibility, and trust." OK. I think, actually that
might not be as outrageous a self-serving claim as you might think. Because what had happened in the 1792
stock market crash. There was one person who figured very heavily in it. His name was William Duer. Am
I spelling that right? It's E--no, it's U-E. Maybe that was a u-Umlaut. William Duer, who was a stock
promoter. And he got a lot of people to manage their money for him, and he got buying stocks on margin,
encouraged a lot of people to buy stocks on margin. And it created a bubble in the stock market, pushing
prices up. Other people thought that Mr. Duer was not a good character, but he managed to create a bubble
in the market, and it eventually collapsed.
So, it was within two months of that. Obviously, the stock exchange was created in response to Mr. Duer.
And so, what they're basically saying is, we won't do business with this guy. We'll close him out. If we all
agree that we won't trade with him or people like that, then they'll be out of the business. The other thing is
putting a minimum commission on sale. This is the profit they get from the sale. It makes it into kind of a
gentlemen's organization, because they chose a commission, which was sufficiently high, that they could
make substantial money trading stock. I think the philosophy was, we are ethical members of the
community. We don't want this business to be turned over to discount brokers who don't care. And we will
exercise a duty of care. I wish, it said that in the agreement. I'm reading between the lines here. I think that
probably was part of the motivation. And so, we have to keep our incomes up, so that good people can stay
in the business. That was the philosophy.
And then later, the New York Stock Exchange adopted many rules about ethical trading. And so, they were
imposing standards. It was just not explicit in the original Buttonwood Agreement. So, things changed
recently. You know, our attitude toward cartels has changed over the years. And there's a couple of
important dates I wanted to emphasize. One of them is 1975, and it's May Day. It was May 1st, 1975. In the
United States, the government, under the Securities and Exchange Commission, made fixed commissions
illegal. Until 1975, the New York Stock Exchange was still following something like that 1792 rule.
Anyone who was a member of the New York Stock Exchange had to impose a minimum commission. And
then secondly, they could only trade with each other, closing everybody else out. Now, they could justify
that because they're closing out the scoundrels. And so, that prevents a race to the bottom. But it had
another effect. It was creating monopoly profits. And eventually the Securities and Exchange Commission
said, no more. We're going to have competitive commissions. Any effort to fix commissions in a trade
group is now illegal, in '75.
I think it's interesting, by the way, that the chairman--this is a local interest--the chairman of the SEC, the
Securities and Exchange Commission, in '75 was Ray Garrett, a Yale College graduate, and the President of
the United States was Gerald Ford, a Yale Law School graduate. So, this had a local beginning. But I wasn't
lecturing about finance in those days. Incidentally, 1975 is the beginning of the National Market System,
which Congress created.
So, this idea that you only trade with other New York Stock Exchange brokers was ended. Now brokers
have an obligation to find the best price for their customers on any exchange, OK? So, what the
government really did is, it broke the monopoly. And that's why the New York Stock Exchange has faltered
since. It has so many competitors now. You've got all these discount brokers. So, it hasn't done as well. If
they haven't made these changes in '75, it wouldn't have done as well [correction: it wouldn't have faltered
as much].
Right now, it's about to be taken over by the Deutsche Brse, the German stock exchange. That's still on, I
think, right? That deal? So, substantially, it was a cartel. In the United Kingdom, it took a little longer. But
in 1986, when Margaret Thatcher was prime minister, they had what's called the Big Bang. That's the
British counterpart to May Day. They deregulated commissions. And again, it had the same effect. It broke
the monopoly. So, I could go on a lot about trade groups, but I think we see some idea that--incidentally,
the New York Stock Exchange, even today, has its own market surveillance unit that looks, it goes through
trading records and it looks for examples of, say, manipulation. And they will track down and find you, if
they think that something immoral was done. So, even though they had a deregulation of their commission,
they still are doing that.
You know, this idea about allowing groups to regulate prices is controversial. Airlines used to have their
fares regulated by the--what's the U.S. government agency? [The Civil Aeronautics Board, which regulated
fares since 1937, was phased out by the Airline Deregulation Act of 1978 and finally shut its doors in
1985.] The airline fares were regulated at high levels. And in those days, airplanes would give you great
service, because they were competing on service rather than on fares. So, it used to be that when you got an
airplane, there were a lot of empty seats, because they were scheduling many more flights than needed.
And you got great meals. But it was expensive. And so, if they deregulate, fares come way down. Services,
now you're jammed in shoulder to shoulder, and if you don't like that, you can pay more. But very few
people will pay more. So, I think, on balance, it's a good thing to deregulate commissions.
And now we have all these websites now that sell on very low commissions. It's a product of deregulation. I
mean, a product of regulation, I'm sorry, regulation that prevents the cartels from forming and closing out
competitors who might charge a lower rate.
Chapter 4. Local Regulation: The Progressive Era [00:38:17]
So, the third thing I said about local regulation. This is my third category. It used to be that it was a more
local phenomenon. I'm particularly thinking of the United States, but I think it was true elsewhere as well.
Local banks would be regulated locally by the people who saw them rather than a distant national
government. In the United States, until the 1930's, financial regulation was almost exclusively local. The
federal government didn't do anything. So, we had a bunch of laws called Blue Sky laws that were put in
place by state governments during the progressive era. The progressive era was from the 1890's to the
1920's. That was an era in U.S. history when a lot of state governments started adding regulations. They did
other things like regulate food safety and other business laws. But regarding finance, it was the Blue Sky
laws.
Now, I don't know if anyone remembers why they're called Blue Sky laws, but one interpretation is, that
there were a lot of sales people for investments. And some of them would give you an exaggerated sales
job. They would say, there's no limit to how high the price can go of this stock, nothing but the blue sky
above. So, that's my story about how they got to be called Blue Sky laws, but I don't know if there's any
agreement on where that name came from. And I think the first Blue Sky law was in the state of Kansas in
1911. It was given some impetus by a book written by Louis Brandeis, called Other People's Money in
1914, I think it was. That was a book that detailed the scandals of fake securities, or dishonest promoters of
securities. So, it started in Kansas in 1911, but by the 1930's practically every state had Blue Sky laws, and
they had state regulators that enforced them.
But the problem was, that they were state laws, and it made it difficult for state governments. Theres all
these different state governments are trying to regulate an industry, which is really national or international
in scope. So people could evade the Blue Sky laws, now especially since the telephone became prominent
in the 1920's. You could set up a boiler room, so-called, in one state. A boiler room, I think I said this, is a--
you rent the cheapest space for your telephone bank, and you pick the boiler room of the basement of some
building, and you put a bunch of people manning the telephones. And they call across state lines, so this
confuses the Blue Sky regulators, because it involves two different states. And you called long distance to
the other state and you give--this used to happen a lot, doesn't happen so much anymore--they would try to
sell you on something. I've got a great stock. It's going to triple in five days. If you don't buy it today, it's
too late. And they would get people into stocks that were utterly worthless. And it was fraud.
The whole progressive movement to regulate securities was of limited success. But it left in place a huge
state and local regulatory system, that was considered inadequate to the task, but which remains today for
the regulation of smaller companies.
Chapter 5. National Regulation: The Securities and Exchange Commission [00:42:59]
The next step is the national regulation, which occurred in the United States in the 1930's under the New
Deal of President Roosevelt. So for national. Notably, in 1934, I mentioned this before, the U.S.
government set up the--it's actually, we spell it out--Securities and Exchange Commission, or SEC, which
regulates the larger firms. Practically any firm that's listed on a stock exchange would be regulated by them.
One of the first directors of the SEC was William O. Douglas, a Yale Law Professor, who wrote a book,
called Democracy and Finance, about his experience as SEC director. And he talked about the conflicts he
had with Wall Street at the time. They really didn't like this regulation. It was an antagonistic atmosphere.
The Securities and Exchange Commission was widely regarded in the business community as practically a
socialist organization--and that's a dirty word in the United States--because it seemed like the government
was involving itself in things that they had no business involving themselves in. So, Douglas fought kind of
a battle against Wall Street, as detailed in his book. But to get everything on an up-and-up format, he was
following one of the rules that Brandeis--he wanted disclosure. Louis Brandeis, there's a famous quote in
his book Other People's Money, and it is, quote, "Sunshine is the best disinfectant." That's a parable to
hanging out your clothes on the clothesline and letting the sunlight fall on them, and that disinfects them.
But the same idea applies in finance. That if everybody knows what the firm is doing, they'll figure it out
and there'll be talk. We just don't want firms to keep secrets. So, the SEC is built around disclosure. And so,
I mentioned, EDGAR is their online information system, but it's on sec.gov. They put everything up about
a company, of any public company, up on that website. And it's free, absolutely free to the world. That's
disclosure, and that was the motivating thing.
Another SEC chairman is Arthur Levitt. And he wrote a book, called Take on the Street, after he left the
SEC chairmanship. This was recently. I mean, like in the last 10 years. And he told a lot of stories about
nasty people on Wall Street. [Levitt was chairman of the SEC 1993-2001, his book was 2003.] He said he
had vivid memories of the reactions he got from proposed new regulations. And he was particularly upset
by the, kind of, ability that Wall Street had to fool people by using complex language that they couldn't
understand. They would write prospectuses that no one could understand without a law degree. He wanted
plain English.
So again, taking a job as SEC chairman, or commissioner on the SEC, is taking on a high-tension job, I
think. But it's like the same thing as in sports. You know how referees in sports get punched every now and
then by the athletes. But we all see that they're necessary.
So, one thing that the SEC does is, protect small investors by managing the distinction--I mentioned this
before--between public and private securities. So, if you want to go public and list your security, or the
shares of your company, on a stock exchange, you have to go through a procedure defined by the SEC,
called an IPO. That stands for initial public offering. And to do that procedure, you have to follow a system
of rules, dictated by the SEC, that makes it difficult for you to do any shenanigans, any tricks. It creates a
level playing field. And the rules are very strict and enforced by the SEC.
The SEC allows other companies to remain private, but it has rules about what you have to do to stay
private. When you become a public company, you are involved in the public trust. And you have to, among
other things, include all of your documents on sec.gov. But they do allow private companies. And a
particularly important category of private company is the so-called hedge fund.
Chapter 6. Minimal Regulation: Hedge Funds [00:49:41]
A hedge fund is an investment company for wealthy individuals only. And the idea is, that small investors
need to be protected, because they don't know. They don't have expensive advisors and lawyers to tell them
what to do. And so, lots of controversial things can't be done in funds that are offered to the public. A
hedge fund is a fund for these wealthy investors, and the SEC has minimal regulation of them. The Dodd-
Frank bill, we thought, would put more regulation on them, but they're still surviving as largely unregulated
organizations.
The law, the SEC code of rules, is huge and is complicated. I guess, you can read about it on sec.gov. But
there's a 3C1S hedge fund, it's one type of hedge fund, it can take on no more than 99 investors. Can't be
more than 100. And they must be accredited investors. And the SEC defines accredited investors. They
were proposing to change the definition, but I think it still stuck. To be an accredited investor--I don't have
it here--I think it's still that you had to have an income of at least 200,000 a year if you're single, or 300,000
if you're married, or $1 million in investable assets not including your house. I think that's the definition.
I've got it fairly close. [Definition is correct as stated.] So, it excludes most investors. But then, there's
others kinds of hedge funds. There's also a 3C7S hedge fund, that's allowed to take on 500 investors. But
these have to have a net worth of $5 million, or if they're an institution it can't be a little institution. So, it
would be 5 million. So, it's more than an accredited investor, it's called super-accredited. 5 million for
individuals, 25 million for institutions. That excludes most family foundations, I suspect.
So, hedge funds you don't hear about as much, because they don't advertise. And they are not allowed to
advertise. If you click on their website, they'll have a website, it will give you the contact information,
typically, and say very little more about them. They don't put anything on their website, because they worry
that they'd run afoul of the SEC, that the SEC would call it advertising. And you're not supposed to be for
the public.
This creates some conflict. Some people think, why is it that the United States has this kind of two-tier
system? It's not just the United States; other countries have this as well. But let's talk about this system.
Why is it that we have special rules for poor people, which in effect, in their estimation, excludes them
from some of the biggest profit opportunities?
Hedge funds are allowed to impose high management fees. And the typical management fee has been
called ''two and 20.'' 2% of the assets under management goes to the managers every year. And 20% of any
profit, trading profits they make, go to the managers. Nothing of their trading losses. If they lose money, it
doesn't come from the managers. Now, that sounds like a really good deal, right? Think about it. If you can
raise just $1 billion in your management fund, you're getting 2%. What is 2% of $1 billion? Thats 20
million? Did I get that right? And 20% of the profits. I mean you're going to make a huge amount of
money, right? I suspect some of you will do this, because it's so tempting.
But of course, you can't do this. It's not so easy to start a hedge fund, because the whole idea of a hedge
fund in most people's minds is, there are genius traders, and you have got to pay them, right? You can't hire
them cheap. So, the hedge funds raid all of the geniuses out of the mutual funds, which are public
investment companies for these retail investors. They get the smartest guys and pay them this huge amount,
and the idea is, they'll make a lot of money. Whether they really do make a lot of money is a difficult
question. It's hard to tell, because hedge funds haven't been around. They're changing through time. I'm
sure some of them do make a lot of money. Some of them are good investments. But it's like a Wild West.
It's a jungle out there. And the SEC doesn't think that you, the small investor, should get involved in that.
And so you won't. That's another example.
Chapter 7. Market Surveillance: Preventing Manipulation [00:55:39]
So, market surveillance is something that the SEC does, and it does it in connection with the self-regulatory
organizations like the stock exchanges. It's, again, trying to prevent manipulative behavior. See, the markets
don't function that well by themselves without some kind of referee. The 1792 stock market crash was only
one example, but market surveillance is now a well-established principle to prevent manipulators from
taking over a market.
I'll give you an example of what happens, and this is a news story from 1995. In May 1995, a secretary at
IBM Corporation was asked to copy documents related to secret plans to take over the Lotus Corporation.
Lotus was this spreadsheet--it doesn't exist anymore--spreadsheet company that was a pioneer in computer
spreadsheets. So anyway, she just commented to her husband, because she was copying these documents,
she said, oh, IBM is going to take over Lotus. Her husband saw that as valuable information. The stock
price of Lotus is likely to go up. And she said that they were going to do it in three days. So, that's a perfect
thing. So, what did he do? He merely telephoned all of his friends and told them. By the takeover date, 25
people had bought a half million dollars. These people included a pizza chef, an electrical engineer, a bank
executive, a dairy wholesaler, a schoolteacher, and four stockbrokers, OK? Well, they caught them,
because they saw this unusual activity in the stock, and they subpoenaed their phone records and they
figured out who called who, and they called them in and made them declare what they'd done, and they
were all punished for this. It's illegal. You can't trade on inside information. Again, the SEC is trying to
create a level playing field for everyone.
I'll give you another example. It was Emulex Corporation. A former employee of this company shorted
stock in his own former company. And he then decided he would try to help make the price go down. So he
sent--because he knew the company, he knew how to do this--he sent a fake press release to the Internet.
And nobody suspected it, because it looked real. He just sent it out from his own computer. Actually, it
wasn't his own computer. He thought he was being smart. He went to the El Camino Community College
library.
Student: Yes.
Professor Robert Shiller: You know the story.
Student: I know the college.
Professor Robert Shiller: Oh, you know the college. Well, he went to the library, and he sent the press
release from the library's computer. And he thought, that's going to be sure. And then it worked. It was
picked up by all the news services, the bad news about Emulex. And then, he immediately covered his short
position, and he made a big profit. And he thought, he was smart, but he wasn't smart enough for the
surveillance. Because they suspected. Well, immediately, Emulex immediately protested, we didn't send
out this press release. So, the market surveillance team went into action. And they found out. It's all in the
stock exchange record, who covered a short position right after the announcement. They got his name as
one of the people. They actually traced down where the email was sent from, and they went to El Camino
Community College, and they talked to the librarians, and they showed them photographs. And they
remembered him, and so they nailed this guy. So that's an example of what happens in our markets. And so
that makes things work well.
I also wanted to mention, what the SEC does with creating private organizations, or self-regulatory
organizations, that do some of its jobs. So, we have something called FASB, which is called the Financial
Accounting Standards Board. It's right here in Connecticut. The SEC decided that companies fake their
books in too many ways. There's too much funny business going on, and we need to manage this better. But
they didn't want to take over completely this as a government function. So, the government recognized an
industry group called FASB as the arbiter of accounting standards. And FASB is the authority that defines
GAAP accounting standards. And GAAP is an acronym for Generally Accepted Accounting Practices. I'm
sorry, Principles. Generally Accepted Accounting Principles are defined by a private group. And these
principles are used on EDGAR, which is the website that the SEC uses to present accounting. So, they're in
Norwalk, Connecticut, and they have their own website, and you can see how they define accounting
standards. I'm running out of time here.
I wanted to tell you about another government agency called SIPC. I'm just having too much fun telling you
about all of these. The SIPC is the Securities Investor Protection Corporation, created by the United States
Congress in 1970. And it's part of an effort to protect small investors. SIPC insures your brokerage
accounts against losses due to failure of your stockbroker. It corresponds to the FDIC. Did I mention this
before? Maybe, I mentioned it briefly. The FDIC is the company that insures your bank account. SIPC is
the company that insures your brokerage account, and it's a government corporation. It has limits on the
amount that it insures. It was actually created in 1970, in response--a lot of things happen in response to a
crisis--There was a brokerage firm called Goodbody that failed in 1970, just before SIPC was created. A lot
of people had their stocks in Goodbody, and they had accounts there, and it looked like they were going to
lose it. They held their stocks in street name, and I remember telling you about that. So, they thought they
owned shares, but really Goodbody owned the shares, or they thought Goodbody owned the shares. But
Goodbody went under, so they ran the risk of losing the shares they thought they owned. So, SIPC was
created in order to prevent that.
Chapter 8. Regulatory Pushes at Home and Abroad [01:04:25]
Continuing along on the national level. Regulation is getting stronger at the national level. I'll talk about
two examples in the U.S. And I'm going to talk about the European Union as if it were a nation. It sort of is
a nation. It's an assembly of nations, but it's kind of halfway between national and international. But I'll
start with the U.S. I mentioned that in the 1930's there was a big step up in regulation with the New Deal,
creating the Securities and Exchange Commission. The next big regulatory push in the United States
occurred last year, in 2010. We had the Dodd-Frank Act. Christopher Dodd is our own--was our own
senator from Connecticut. And Barney Frank is chair of the House Financial Services Committee. I'll just
give you a couple of things from the act. The act is really trying to push regulation more to the
macroprudential from the microprudential. All this thing about fraudulent activities that milk innocent
individuals, that was taken care of by previous legislation. Well, not all of it, some of it was.
But Dodd-Frank creates the Financial Stability Oversight Council, or FSOC. The Financial Stability
Oversight Council is designed to worry about ''too big to fail.'' They are the regulator that deals with
systemic risk. That is, risk that affects the whole system. They're regulating not just to protect the
individual from bad activities, or from being fooled, but also to protect the whole system. So that's part of
Dodd-Frank. The other part I was going to mention is the consumer--I see it two ways. Bureau of
Consumer Financial Protection, or Consumer Financial Protection Bureau, so I'm not sure how to write the
acronym. It hasn't actually taken form yet. I'll say Bureau of Consumer Financial Protection. This one is a
microprudential regulation. I mentioned her before, I think, Elizabeth Warren proposed it. She's a Harvard
Law professor. And what it's going to do is have a government agency that is focused on protecting small
investors, or borrowers in the mortgage market or the like.
Student: Shouldn't the last B be a P?
Professor Robert Shiller: Yes, that's right. I can't write always on the blackboard. Thank you. Bureau of
Consumer Financial Protection. Elizabeth Warren pointed out, and I said this before, that there's a lot of
abusive tactics. Now, other regulators weren't so focused on protecting, say, mortgage borrowers or credit
card borrowers. They were more focused on disclosure and other issues. So, the idea in Dodd-Frank is, let's
create an agency whose express purpose is protecting the consumer. The idea is, that you have to have an
agency focused on each problem, and this is a problem that hasn't been dealt with well.
I wanted to move to in Europe, because Europe has had similar legislation, also in 2010. So, we have the
European--OK, I'll write it out--European Supervisory Framework. And that's also in 2010. And it consists
of a number of things. One, the European Systemic Risk Board, which will be in Frankfurt, well, which is. I
think they're just getting started. European Systemic Risk Board is the European counterpart to FSOC. All
these things are brand new, and so we don't know too much about how they're going to function yet. But it's
supposed to worry about ''too big to fail,'' and about systems. It's about systems. How the whole European
economy could collapse if something goes wrong in the future. Then there's the European Banking
Authority. These are big steps for Europe, because regulation was more done by the individual countries.
And the European Banking Authority is in London, and it will impose Europe-wide banking regulations.
And then, we have ESMA, the European Securities Market Authority. And that's in Paris. And then there is
the European Insurance and Occupational Pension Authority, and that's in Frankfurt. They spread things
out across Europe. They don't want to centralize things. I don't know why Frankfurt got two of them, but
somehow that worked.
Finally, I want to do international. If I could just have five more minutes of your time. International
regulation is a problem, because people can leave the country that they're in and, you know, it's called
offshore. If you don't like the regulations in the United States, there's always the Bahamas, or there's the
Cayman Islands, and you can set up your financial organization with the regulator that you please. That's
why it's important for international cooperation and regulation, so that all the financial activity doesn't
migrate to the cheapest place, cheapest in terms of regulatory cost.
But I just wanted to give you a few more institutions that are important. One is the Bank for International
Settlements. That's in Basel. This is the oldest of my regulators. 1930. Actually, when we get on the
international front, they don't really have authority anymore. They can't impose on anyone, but they can
suggest things. So, the BIS is a bank that has as members heads of--I think it's 57 central banks. [correct]
And they meet regularly in Basel to discuss monetary policy. So, what comes out of these meetings is
suggestions about how to run a central bank. And it has real impact, even though it doesn't have the force of
law. Then, I wanted to mention the Basel Committee, also in the same city. You notice these are in
Switzerland. That's because by longstanding it's been a neutral country, and has such a long tradition of
neutrality, so it seems to be the place to set up a lot of international organizations. This was created in 1974,
and it issues suggested bank regulation. Basel I was in 1988. That was their first set of recommendations.
Basel II was in, sorry, in 2004. And obviously Basel II wasn't successful, because we had a huge banking
crisis. So we've had Basel III. I'll come back to these. Well, it's been going on for years. It was finally
approved, Basel III, in 2010.
Then, I wanted to talk about the G-6. And going back to the 1970's, the finance ministers in six major
countries met together. The countries were France, Germany, Italy, Japan, United States, U.K. In 1976,
they added Canada, and it became the G-7 countries. So, that's Canada, France, Germany, Italy, U.S., U.K.
Who am I missing? Japan. So, these seemed to be the most financially prominent countries at the time, and
their finance ministers got together and thought about, what the countries should do, and it coordinated
financial regulations somewhat. This expanded notably--I'm just about done now--in 2008. The world is
changing, and there was resentment that these countries represent overwhelmingly Europe and the U.S., or
the North America. We created the G-20 countries in 2008. And I don't have the whole list, but it notably
adds China and India, and adds other developing countries. It now represents most of the world. Again, it's
the finance ministers. Typically, what happens now is the finance ministers will meet, and after that the
heads of state will meet. And it's involved in financial regulation.
The current president of the G-20 is Nicolas Sarkozy from France [addition: in the year 2011], and he
intends to make it a stronger organization. He has proposed that they have a permanent secretariat. The G-
20 has created something called the FSB, the Financial Stability Board. And guess where it is. It's in Basel
again. Any of these things that are really--if it's European Union, they'll scatter it around the EU, but if it's
really international, it seems to go to Switzerland. Basel is a sleepy little town if you visit it, but somehow
it's the center for the world finance. So, the Financial Stability Board is making recommendations for
regulatory procedures for the whole world. And they report to the G-20, and then the G-20, they've already
agreed, to take FSB seriously.
So, what I'm seeing here as developing is, the financial regulation is becoming more and more large scale.
And it's something that covers the whole world. And it's very important, because we've just seen a
worldwide financial crisis, and it has to be dealt with by worldwide--I think, this is an inspiring moment for
financial regulation. The G-20 seems to be an effective body that is promoting good financial regulation. At
this point, this is a good time in history, where there's a lot of cooperation. And if it continues, and we see
this develop further, it will make for more successful world economy.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 13 - Banks [February 28, 2011]
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: OK. So, today we're going to talk about banks, banking. Before I start, I wanted
just to remind you that we have Hank Greenberg coming on Wednesday [addition: next lecture]. And we
talked about him in a previous lecture, but he is one of the most important capitalists, I think, in the world.
The firm, AIG, which was started by C.V. Starr, was converted into the biggest insurance company in the
world by Hank Greenberg. Over many years, the two of them ran AIG exclusively, first Starr and then
Greenberg. And Greenberg produced a very innovative insurance giant. It didn't end well, but I think he--I
talked to him the other day. He said he's going to talk about the end, what he learned from the experience.
Once again, no one can control everything that happens. And random shocks affect all of our lives. He
remains a very important--he's no longer at AIG--remains a very important force in our society. Now, he's
very much involved with philanthropy and doing things like lecturing young people, which he freely does
out of a sense of commitment. So, I think he's a committed person that has a moral purpose, that's why I
asked him to be one of our lecturers.
But today we're talking about banks. And I wanted to--the outline my lecture: I'm going to start with the
origins of banks, thousands of years ago. Then, I'll talk about the theory of banks, fractional reserves and
deposit insurance. Then, bank regulation, particularly in light of the world financial crisis, which has
changed the nature of regulation. Changes that will be with us for decades to come. I talk about shadow
banking, which is the new banking sector that emerged and escaped regulation until the crisis. And then, I'll
talk at the end a little bit about comparison of financial crises in the past in various places around the world,
to see how banks managed in those crises.
Chapter 2. Basic Principles of Banking [00:02:52]
So, the first thing I want to say is, this is a lecture about banks, OK, and that means traditional banks who
take deposits and lend money. It's not about investment banks. That's another lecture. An investment bank,
a pure investment bank, does not accept deposits. And its most characteristic thing is underwriting of
securities. So, that's a different lecture. And I'm not talking about central banks in this lecture. That's also--
well, the lecture on monetary policy. Central banks are the government organizations that manage the
money supply of a country.
So, we're talking here about banks, and I thought I should start out by defining a bank. The word bank, by
the way, means counter or tabletop where bankers used to do their business. That's the English word that
emerged in the 15th century. But banks, of course, precede that with other names. What is it that is the
characteristic activity of banks? I would say, maybe the most characteristic thing is that banks earn spread
income. That is, they borrow at a lower interest rate, and lend it out at a higher interest rate, and they make
the difference. Your deposit rate is lower than the rate at which they charge for the loans they make. So
that's the spread income or margin. So, that might be considered the core idea of a bank, that you borrow at
a lower rate than you lend. But I'm not sure that that summarizes it, either. There's other aspects of banks
that we'll talk about.
Another aspect of banks, traditionally, has been note issue. That is, they print paper money, and then it
circulates and goes--you have some of these in your pocket. They're currency. If you stopped a person on
the street a couple hundred years ago, and said, what is the essence of a bank? I suspect, the first thing they
would say is, oh, they print money. And that's the paper money that we use. But you don't think of it this
way. Probably not, because most of that function all over the world has been shifted to the government
banks, the central banks, in the various countries. And so, you don't think of private banks as issuing bank
notes. But they used to and it used to be prominent.
The private bank issuing of notes today in the world, I believe, is concentrated primarily in two countries.
One of them is the United Kingdom, and the other one is Hong Kong. Tell me if there's another country. I
don't know who else does it. In the United Kingdom there are eight banks that still print pound sterling
notes. And they're not very prominent. In Scotland, there are some. I actually once went through the
Chunnel from England to Scotland, oh, from Scotland to France [correction: from England to France], and I
tried to spend my Scottish sterling notes on the train, and the guy, who was French-speaking, stared at it
and said, what's this? And he wouldn't take it. So I said, this is pound sterling. This is official. It trades at
par with the Bank of England notes.
Hong Kong has three banks that issue their bank notes. Let's see, Hong Kong Shanghai Bank [correction:
Banking] Corporation, Standard Charter [correction: Chartered] Bank, and the Bank of China, Hong Kong.
Everywhere else, banks don't issue notes. And the reason they don't is, laws have been made to prevent
them, because these notes lost value so many times in financial crises that governments said, it's not
something that we'll allow private banks to do. So, it's generally gone.
If you look at your $1 bills in your pocket, it will give the name of a Federal Reserve bank. And there's 12
of them. Our Federal Reserve bank here is the Federal Reserve Bank of Boston. So, you can look at your
dollar bills and see which bank issued it. So, you're probably carrying a lot of Boston money, but since it's
all the government, you know, you don't even notice that, right? You don't notice. If this were 1750, and
you had Boston money in your pocket, you might--because we're in Connecticut--you might have a
problem. You'd have to go to a money dealer and have it exchanged, because they didn't know or trust the
Boston bank. That's all past. So, note issue is a matter of history.
So, there's other aspects of a bank I want to emphasize. One is liquidity. And this is essential element of
banking as well, and I'll come back to that when we talk about theory in a minute. But banks offer liquidity
by borrowing short and lending long. This is different from spread income. I'm saying the interest rate is
lower on the borrowing of the bank than the lending of the bank. There's another discrepancy. The maturity
is longer on the lending of the bank than the borrowing of the bank. So, banks are providers of liquidity.
That means, a business wants to borrow money, or let's say a homeowner wants to borrow money to buy a
home. Right? Let's take that example. That's more familiar. You're going to lock up the money for maybe
30 years. You don't want to pay the loan back tomorrow. What if the lender says, I need the money, give it
back. You can't give it back, or you don't want to give it back. So, what a bank does is, it takes deposits and
allows people to cash them in whenever they want. It lends the money out long on 30-year, or so, loans. So,
it generates liquidity. The borrower has what he or she wants, which is a 30-year loan. The lender has what
they want. They have an account they can get at any time. And so this is an important function of banks.
But the problem with it is, that there's a problem of crises. Because if everybody asks to pull their money
out at once, they can't do it. The banks, in normal circumstances, generate liquidity, but they create a
system that's vulnerable. And so, the banking industry has been plagued by frequent crises throughout
history.
Chapter 3. The Beginnings of Banking: Types of Banks [00:10:46]
So, I wanted to say something about the very beginnings of banking. Who did it first? By the way, I should
have written the words interest rate. When I'm talking about spread income or margin, I'm talking about the
difference between two interest rates. But more primitive is the idea of interest rate. So, where did that idea
come from? Well, I was reading some economic historians. Apparently, the word interest first appeared in
the Sumerian language. I guess the oldest records are about 2000 B.C. And they had a word which they
write as mas. I guess, that's pronounced mosh, which was their word for interest, but it also means lamb.
And so, one historian was wondering, why do the Sumerians use the same word for interest as they do for
an animal, a lamb. And he thought that maybe it was because the idea of lending money at interest grew out
of an earlier idea of renting land. So, you would have land that you weren't using in ancient Sumeria, and
you would rent it out to somebody who would then use it. And one of the things that the person would do
with it, is raise livestock, raise sheep, on the land. So, you would say, well, I need some produce from the
land to compensate me for letting you use it. So the guy would say, fine, I'll give you all the offspring of
our sheep, the lambs. That was an old tradition in Sumeria. So, they thought it's basically the same thing.
It's like giving over the lambs. If I lend you money, I'm giving you productive resources, and it's going to
produce something. We'll call it lambs. And I want that. And you're compensating me for it.
So, that's where the idea began. And so, you'll find it in the ancient world, in the near, non-oriental ancient
world. In ancient Greece and Rome, interest was well established. And some kind of banking. Now, I don't
know whether there were bankers in Sumeria, but there probably were, because all it takes is that you do
both sides. They actually didn't necessarily lend money in those days. They would lend barley or wheat,
and they would charge interest in terms of wheat. You don't need money to do banking. But I suspect that
somebody in ancient Sumeria was doing both sides. He was borrowing wheat, and lending it, and earning a
spread income. And so, there must have been banking in the world.
But anyway, what about these kinds of institutions that we call banks? Oh also, the first--apparently, if I've
got my history right, the first record of interest rates in China was Song Dynasty. And that was from the
year 960 to 1279. They were, at that point, inventing paper money and other financial institutions. I don't
know if they had institutions called banks. But, you know, it often would be a family business lending
money. If you were a prominent family, you would often take other people's money for safekeeping. And it
was also connected with religious temples in the past.
But the modern banks seem to appear in Italy in Renaissance times, where they actually had a banking
institution. And that's where the oldest bank in the world today exists. It's Banca Monte dei Paschi, in
Siena. And that means the bank of the mountain of sheep. [Correction: Mountain of Pastures] It's the same
analogy, I guess. I don't know if they called their interest lambs. And so, that bank was set up in 1472.
That's the oldest surviving bank in the world. I went there. You can go there if you visit Siena, and they
have a little museum on the first floor near the lobby. And it's actually the third largest bank in Italy. A very
old institution. It's interesting that this bank, which was founded in 1472, was founded as a philanthropic
institution to lend money to the poor. And wealthy donors in Italy gave money to set up this bank. It goes
beyond that now. It's not just lending to the poor. The other thing is in the 1600's, they gave it deposit
insurance. Believe it or not. The Duke of Siena said he would guarantee all deposits. So, deposit insurance
appears to have been invented in Italy as well.
But a lot of people emphasize, when they talk about the history of banking--I was reading, in preparing for
this, economic histories to see what they would say about banking. And professor Clive Day, a professor
here at Yale, wrote a book called, History of Commerce, in 1907. You can pick up his book, if you want to,
on Google Books. It's past its copyright. I had great fun reading it. He's long gone, professor at Yale. But
his history begins in England, with the so-called goldsmith bankers. What happened was, in England in the
maybe 1500's or 1600's, somewhere around that, goldsmiths who made gold jewelry had safes or good
places to store gold. And so, people would go to the goldsmith, and maybe they're having jewelry made,
but then they'd say, could you keep some of my gold in your vault? And so, the goldsmith banker would
say, all right, I'll do that. And I'll give you a note saying, I'll promise to pay you this amount of gold that's
in my vault. So, sometime when you were out shopping, the goldsmith banker's note would be in your
pocket still, and you'd want to buy something. So you'd say, well, I've got this--you talk to the merchant
and you say, I've got this gold. It's in the goldsmith. I've got his note here. So the merchant would say, all
right, I'll take that, but you got to endorse it over to me. Write a note on the note saying that this thing is
being transferred to me. And so, I can go to the goldsmith and get it out. That's how paper money got
started in England.
It started to circulate with many endorsements on it. And then finally, the goldsmith said, let's forget about
endorsing it to one person. Let's just say, to the bearer. And so, paper money started developing kind of
spontaneously. And then, the goldsmiths noticed, you know, they've got all this gold in their vault, they can
lend it out. Why not? Because nobody ever comes and asks for it, now that these paper notes are
circulating. Nobody asks for it, so I'll start lending it out. And they didn't have to pay any interest on the
notes, because people would hold them anyway just because they valued the safekeeping. I guess they were
paying interest in the sense that they were providing the safekeeping. So, that's how banking got started in
England, but it was really preceded in Italy.
What has happened is, because of repeated problems in the banking industry, which gradually grew through
time into something that's more and more important, governments all over the world regulate them. And
that means they define certain specific types of banks that differ a little bit from one country to another.
And you have to--when you decide to create a bank--you have to decide which type you are. So, I wanted
to start--and in your textbook, Fabozzi, talks a lot about types of banks. But let me just talk about the major
types. I'll talk in the U.S. The most important type of bank is called a commercial bank. And these are
banks that take deposits. You can put your money in the bank, and then it will pay you interest, and it will
also make loans of various kinds. But, most characteristically, business loans.
Commercial banks were even more prominent 100 or 200 years ago, because they didn't do mortgages and
consumer loans. It was all business loans, initially. So, this is kind of the historic important kind of bank.
And in 2010, the total assets of U.S.-located, commercial banks was 14.6 trillion. But actually, a lot of that
was foreign commercial banks operating in the United States. Of that 14.6 trillion, only 10.1 was U.S.-
chartered banks. So, bankers operate all over the world. So, we have banks like, I mentioned Hong Kong
and Shanghai Bank [correction: Banking] Corporation, or the various Swiss banks that have big operations,
or Deutsche Bank, big operations in the United States. So, they account for almost a third of our
commercial banks. But then, there are other kinds of banks, and they're smaller in terms of--this is assets of
the banks. It's not their market cap. Market cap would be much lower, because remember offsetting these
assets are liabilities they owe to the depositors.
But there's other kinds of banks. There are savings banks. In the U.S., savings banks had only 1.2 trillion.
These savings banks tend to be old institutions that have grown very large over time. They're the result of a
savings bank movement in the 19th century, which was a philanthropic movement to set up banks for
lower-income people. Because commercial banks traditionally wouldn't take deposits from small--you'd
have to have a minimum size. They didn't deal with ordinary people. So, they created savings banks to
encourage thrift and saving. Actually, it follows on a U.K. movement, a savings bank movement in the
U.K. And they're still with us, but they're not so big. And there's also credit unions. That's another social
movement. And they're only 0.9 trillion, or about 900 billion in assets. Credit unions are basically clubs of
people that belong together in some group. If you have a company, you can set up a credit union for the
employees of your company. Both savings banks and credit unions make a lot of mortgage loans. That's
kind of their characteristic business. In U.K., you have the same kinds of banks. The savings banks would
be called building societies, but it's the same idea. They make loans for buildings.
Chapter 4. Theory of Banks: Liquidity, Adverse Selection, Moral Hazard [00:24:00]
So, I said I would talk about the theory of banks. I've already given you some indication by describing what
is it that banks do. But I see I have a lot more to talk about. I have to consider my time here. There's so
much to say about banks. It's a whole fascinating subject. But I wanted to mention, the theory of banks was
laid out in the Diamond-Dybvig model in the Journal of Political Economy, 1988. They were both
colleagues of ours at Yale. They've moved on. So, I know them both. Doug Diamond and Phil Dybvig.
But what they described is a model--I'm not going to give you the model, just to tell you about it--the
theoretical model of banks as providers of liquidity. That liquidity is an economic good that you can
somehow get for nothing. It's just like portfolio diversification. We don't need to expend any resources to
get diversification, we just have to manage our portfolios right. Similarly, you set up a bank, and lo and
behold, liquidity appears. And it makes it possible for people to live their lives better. I mentioned that you
can live in a house for 30 years, or you can move whenever you want. But the problem with this is that
there are multiple equilibria. Their model has a good equilibrium and a bad equilibrium, and it depends on
expectations. If people think that the banking system is sound and it's going to work well, it works
splendidly. But the problem is, all it takes is for people to suddenly change their expectations, and then it
all falls apart because you have a run. You have a bank run.
So, what Diamond and Dybvig did is to provide an economic rationale for deposit insurance. Insuring
deposits against default of the bank helps prevent bad outcomes, keeps us in the right equilibrium. So, this
is an important paper. The problem is that banks runs can be triggered by random shocks to the model. And
so, what happened in the latest crisis is, there was a real estate bubble. It's not something that's represented
in Diamond and Dybvig. And the bubble, when it burst, when home prices started falling, and commercial
real estate prices started falling, the banking system started to fall apart. So, it's not entirely easy to keep
banks under good control. You see, Diamond and Dybvig emphasized that banks are an invention that
creates liquidity. And liquidity is a positive economic good that makes us run our lives better. So, it's an
important invention in the history of economics.
But there's other issues that banks do, problems they solve. One of them is an adverse selection problem
that plagues securities. I didn't mention the alternative to banks for raising money, if you're a business, is,
that you could issue bonds or commercial paper. You can borrow money directly from the public without
an intermediary, OK? They do this. I'm a company. I need money to, say, build a new factory. I go not to a
commercial bank. I go to an investment bank, and they help me issue some paper to the public. And we sell
it off in some market. The problem with issuing debt directly to the public is, that the public can't judge the
quality of the company easily. Most people who are investors are not good at estimating the value, the
security of a company. So, they need some kind of experts.
If the adverse selection would happen, see, the experts, the people who know, would buy all the good stuff,
and it would leave beyond--people would start to think, I'm not going to buy these securities, because why
are they being offered to me? I don't know anything. I'm a sucker. That's the idea. I'm not a sucker, I just
don't know. I may be smart, but I just don't know what the quality of this company is. If I just go in there
blindly and pick up whatever seems to be out there, I'm going to suffer an adverse selection. I'm going to
get the worst stuff, because I'm not looking--I can't look, they're going to dump the bad paper on me. So,
banks solve that by being in the community, knowing who is borrowing, and having a reputation, so that
instead of you suffering this adverse selection problem, the bank has people who know what's going on. So,
the thing about banks is they have local loan officers who serve in a particular community. And they know
all about that community. And they solve the adverse selection problem.
So, for example, if you are a loan officer in a bank, by tradition, you are someone who gets involved in the
community. You'll find them on the program at the symphony. They're one of the donors. They show up for
all kinds of things. They know what's going on. They play golf with local business people. They hear the
gossip. So, someone says, you know, this guy, the CEO of this company, I think he's an alcoholic. You
better watch this guy; I don't know what he's doing. You hear these things. And you know what happens?
The guy doesn't get a loan the next day. I hate to say it, but they kind of vouch for the character of people. I
mentioned this in a previous lecture, that there's all kinds of people out there. And you can't prove or judge
who's good. You can't write it down in some objective way, who's going to be a responsible business
person. But banks know that, so they solve the adverse selection problem.
There's also a moral hazard problem that banks solve. The moral hazard is that a company may borrow
money, and then take a big flyer and do some wild investment. Let's take this, for example: suppose we
owned a small company and it's not doing well. We have this great idea. Let's borrow $10 million, and let's
go to the racetrack and let's put it all on the least likely horse to win, all right. And, you know, our chance
of winning is only one of 10, but if we win, I got $100 million, OK? If we lose then, hey, we just go
bankrupt. We say, sorry. Of course, you really couldn't do it at the racetrack. I mean you'd be sued if you
did that. But you see what I'm saying. I could see--I wouldn't do that--but I could see wanting to do that,
right? Your company's going out of business anyway, you know, you don't have any prospects. But if we
can borrow $10 million, go and bet it on the racetrack, and one in ten we'll be super rich. We'll have $90
million, right? Pay off the debtors. Everything's fine. They won't complain if you win. They'll complain if
you lose, but then you say, sorry, you know, we're out of business. It's limited liability.
So, what banks do is, they help solve this problem by constant monitoring, and they make commercial
loans that are at effectively long-term, but in practice, officially short-term. They keep renewing them, and
they can cut you off, when they think you're doing something that reflects moral hazard. So, the constant
monitoring that banks provide solves the moral hazard problem, just as their information collection solves
the adverse selection problem.
Chapter 5. Bank Runs, Deposit Insurance and Maintaining Confidence [00:33:03]
I'm just trying to see, where I want to go next. So, I mentioned deposit insurance. I mentioned that it started
in Italy in the 1600's, but it has a long history of governments backing up deposits of banks in order to
prevent banks runs. Because bank runs happened too often. People would get a little scared, and they would
go to the back and try to pull all their money out. They'd hear a rumor, and then the whole banking system
could collapse. People in various governments at various times offered guarantees. But the problem is,
those guarantees can get really expensive. So sometimes, they had a limited guarantee, and so sometimes,
the deposit insurance scheme would fail. And so, the history of deposit insurance is a checkered one. So, in
the United States there were various state governments, local governments, that created deposit insurance
schemes before the FDIC, but a lot of them failed, and so, people said this is a crazy idea.
But the United States government in 19, I think it was '33, do I have this right? [1933 is correct.] Created--I
think that's right--the Federal Deposit Insurance Corporation as part of the New Deal under Franklin
Delano Roosevelt. And it has never failed to this date. Why didn't it fail? It's hard to know, exactly. We
never had a big back run since 1933. It seemed to create the psychology that people stopped worrying about
bank failures, because they believed they were insured. I guess they believed Franklin Delano Roosevelt.
And so, if you believe it, then it's one of those funny things, it's the multiple equilibria that Diamond-
Dybvig mentioned. As long as people believe the bank system is sound, it is sound.
We also created later, another deposit insurance, called the Federal Savings and Loan Insurance
Corporation [addition: abbreviated FSLIC], that was doing the savings and loan associations, which were a
type of savings bank. And that did fail. And so, we had a huge crisis in the United States, called the saving
and loan crisis, in the 1980's.
So, the S&L crisis in the 1980's was due to a widespread failure of saving and loan associations, and then,
kind of a run on the saving and loan, but it wasn't really a run, because the FSLIC was trusted. And what
ended up happening is, the FSLIC had reserves against a certain amount of losses from the banks, but they
went through them completely. And then they were bankrupt. So, the insurer went bankrupt. What then
happened is, the United States government picked up the tab. And the total tab was $150 billion. And that
restored confidence. I guess the government had to do that. And the FSLIC no longer exists. Savings and
loans are now insured by the Federal Deposit Insurance Corporation.
So, you know, these institutions really don't necessarily represent the real insurance. You have to always
see beyond institutions. The FSLIC was encouraging people to believe in the security of the banking
system, but it really wasn't the ultimate security. The ultimate security wasn't even written down. It was the
recognition by the U.S. government, that if we let FSLIC fail, and we let all these depositors in the savings
and loans lose their money, it's going to destroy the confidence that has kept us away from bank runs. And
the next thing, commercial banks, or who knows, what else will happen. So what always happens is, the
government stands behind these promises, even if they weren't made so clearly.
There's another example, I'll give you, which is more recent, of a bank run. And that occurred in United
Kingdom in 2007. The bank was called Northern Rock. And a rumor started--this was at the beginning of
the financial crisis--a rumor started that Northern Rock held a lot of subprime securities, and was going to
go bankrupt. So, people rushed to Northern Rock, and big lines formed outside of Northern Rock. People,
they wanted to get there first, because you thought, they're still handing out the money. I want to be there
first. And then, newspaper photographers photographed the crowd outside the bank, and people thought,
well, this is just like 1933 and the huge banking crisis. Now, actually, the U.K. government did have
deposit insurance, but the deposit insurance in the U.K. would insure fully all deposits up to GBP 3,000.
And then, it gave 90% insurance up to GBP 75,000. After that, you were out of luck, OK?
So, why was there a bank run on Northern Rock when there was deposit insurance? Well, I tell you. It was
people who had more than GBP 3,000 in the bank, very simple. And so, you know, they didn't really have
enough deposit insurance to stop a run. So Mervyn King, who's head of the Bank of England, just decided,
you know what, we'll bail everybody out. No questions. Forget our deposit insurance scheme. And that
stopped the run. So again, it happened the same way in the United Kingdom. The deposit insurance stopped
it, before it was any problem. So, the United Kingdom has never had a bank run failure since 1866. It's not
really because of any deposit insurance scheme. It's about the Bank of England, which is their central bank,
and what it does to maintain confidence.
Other countries handle it differently. I was going to mention, in Germany, IKB Deutsche Industriebank,
OK, in 2007. This is a German bank that German depositors put their money in. And it had invested a lot in
subprime securities. And it was in trouble, and there were starting to be worries of a run on them. The
German government didn't even wait for a bank run. They just bailed them out, and it cost them EUR 1.5
billion. But again, the governments know that they want to maintain confidence, and so they do it. They do
what they have to do.
Chapter 6. Bank Regulation: Risk-Weighted Assets and Basel Agreements [00:41:07]
Now, I want to go to bank regulation, more generally. If you are insuring banks, then you'd better regulate
them, because there's a moral hazard problem. I just described a moral hazard problem for a company that
borrows money from a bank, but there's moral hazard problems for banks as well. Namely, banks can do
the same trick. I said, go to the racetrack. Borrow money and go to the racetrack. Banks can do that, same
thing. Except, they wouldn't actually go to the racetrack. They would pick some really risky business
venture. And if it fails, then it all falls to the deposit insurer. This is a fundamental lesson of insurance,
whenever you insure something, you've got to regulate the person insured. Because once you've taken a risk
from their shoulders, you create moral hazard for them. And so, bank regulation is very important.
So, I was going to talk mostly here about the kind of bank regulation that has an international dimension.
And so, what I wanted to talk about is the Basel bank regulations that were generated by international
organization in Basel, Switzerland. After the saving and loan crisis was Basel I. Was an international
meeting that published a set of recommendations for all the countries of the world to regulate their banks.
The idea was that there should be some coherence across countries. If one country regulates its bank very
stiffly, that's going to drive business out of that country and into other countries. Also, there should be
some standardization. It helps the world economy, if everybody knows that all the banks of the world have
similar regulations. But Basel, the Basel Committee, as it's called, that created the recommendations, had
no legal authority. All it could do is recommend. But it did recommend bank regulations, and these were
widely adopted around the world. Each country could make modifications, whatever they want. You can't
order countries around, but they often followed the Basel recommendation.
In Basel II, they met again in the 2000's, and they issued recommendations in 2004. What they said in
Basel II was, the banking system was getting so much more complicated that they had to think more about
how to do it. Now, there's all these complicated derivatives and special purpose vehicles, and so they had to
update their regulation. Unfortunately, Basel II has suffered a reputation blow, because right after Basel II
we had the world financial crisis. So, they didn't do something right. They didn't really fix the system in
Basel II. So, that brought us to Basel III, which is the latest version. And they issued their report in 2010.
And also in 2010, the G-20 nations meeting in Seoul, Korea, expressed their support for Basel III. So, Basel
III is the current world regulation standard. But it's phased in gradually, and it won't be fully phased in until
2019. They didn't want to put it in all at once, because the world is in a financial crisis, and it would be too
stressful. So, it has a slow phase-in. And some of the details haven't even been worked out yet. The G-20
countries have agreed, in principle, that these regulations are where we'll go, but details have yet to be
worked out.
You know, bank regulation is a big business. We could have a whole semester on studying what these guys
do. So, I just wanted to give you kind of a caricature of what's in Basel. It's also in Fabozzi, the Fabozzi
textbook, which is copyright 2010. You'd think this would be in it, but it's not. Basel I and Basel II are in
Fabozzi et al. Basel III isn't, because it didn't come in until the end of 2010, and so it didn't make it in time
to appear in your book. But I wanted to just give you a simple account of all the Basel agreements, and
some sense of where we are with Basel III. They're all about banks having enough money. You know, not
taking on too much. Enough money for the risks they take.
Let me start with Basel I, because part of Basel I is enforced in all three of them. And there's a concept
called ''risk-weighted assets,'' which is in Basel I, and Basel II and Basel III, essentially the same. OK, so,
here's the idea. We're going to put capital requirements based on risk-weighted asset. What does that mean?
That means, that banks cannot take too many risks. They have to have enough money to back them up for
the risks they take. And we'll call that money capital. It's not money. It's not cash, but it's assets that they
can use to get them out of trouble, if the risky assets do badly. So, if we're going to have a requirement on
how much capital a bank holds, we have also to define their risks. And so, Basel I had a very simple
formula to compute risk-weighted assets. Well, it's very simple, until you get into all the details. And so,
you'll see the definition of risk-weighted assets. It's in table 3.3 in Fabozzi.
But basically, here it is. There's four categories of assets. The 0% weight, the 20% weight, the 50% weight,
and the 100% weight. The higher the weight, it means more risky, OK? So, where will I write these? I'll do
it up here. Now, we're talking about all three, Basel I, II, and III. 0% are national--well, I'll say OECD
government bonds, national government bonds. The OECD is the Organization for European Cooperation
and Development. And they represent advanced, stable European countries. And U.S. government bonds
are included among them. What else, OK? Yes, basically that's it. Now, there might be something else in
there, and I'm sure there is, but this is the simplest. 0% weight, because these have 0% risk. There's no risk,
OK? So, banks can hold all they want of these and they don't have to hold any capital.
Then, next up is 20% weight, and that's municipal bonds, or local bonds, that's not issued by the national
governments but issued by a city or a state. We're having a municipal bond crisis now. They're suddenly
showing their risk, and we're worried about defaults on them, so Basel I was right to give them some
weight. They gave them a 20% weight, because they thought, municipal bonds are pretty safe. They're not
as safe as national government bonds, because there's examples of default. But they also included, there's a
long list of what they include, but notably Fannie and Freddie--these are the two mortgage lenders in the
United States--were included for 20% weights. Because people thought, these guys are really safe, and
anyway, the U.S. government backs them up. Although the U.S. government said, it wouldn't back them
up. But you know, we all know, they're going to back them up, and indeed, they did back them up when
they failed. But Fannie and Freddie, prior to the crisis, started increasingly investing in subprime
mortgages. And they were issuing subprime mortgage securities that were really very risky and eventually
went kaput. Basel I didn't know that, or Basel II and Basel III still, they just gave them a 20% weight.
Theres a big mistake, that's where probably part of the banking crisis comes.
Then, there's 50% weight, and that's for mortgages, home mortgages. The Basel people thought, there could
be some big real estate crisis. You know, it's something to worry about, so there's more weight than that.
And then, we have 100% on everything else, but notably loans, like commercial loans to businesses, all
right? So, those are the weights.
And so, I just wanted to go through a simple example. Suppose you are a bank, and you have $400 million
in assets on your balance sheet, OK? These are things that you as a bank own. And let's say you have 100
in government bonds, federal government bonds. 100 in Fannie Mae, 100 million. And you have 100 in
mortgages that you own directly. And you have 100 in commercial loans. So, your total assets are 400
million. But you've got to know what your risk-weighted assets are. What are your risk-weighted assets?
Well I take the 100--Fabozzi goes through an example too, but this is very easy--I multiply the 100 by 0, I
get 0. I multiply this 100 by 20%, so that gives me 20 million, right? I multiply the mortgages by 50%, it
gives me 50 million, and I've got to throw all these in. So, what does that add up to? It's 170 million RWA,
risk-weighted assets, right? It's 0 plus 20, plus 50, plus 100, all right?
So, those are my risk-weighted assets, and then, the amount of capital that I have to hold is a percentage of
the risk-weighted assets. I could go through Basel I, Basel II, Basel III; they kept changing these
percentages, as they went along. So, I'm just going to talk about Basel III, because that's going forward, all
right? And Basel III is complicated, too.
Chapter 7. Common Equity Requirements and Its Critics [00:53:27]
I'm going to just talk to you about common equity requirements. So, Basel III says--it's an interesting and
creative construct--common equity must be 4.5% of RWA at all times. But I'll add to that. They have plus
2.5%, what they call a capital conservation buffer. And so, that adds up to you 7%, I'll explain. You
absolutely have to have 4.5% as common equity, but if you don't also have another 2.5%, you can't pay out
any dividends. That's not so good. So, in reality, you better keep 7%. So effectively, Basel III--this is Basel
III, it's not in your textbook, but it's coming all over the world, 7%, OK?
Now incidentally, the interesting thing about Basel III, they're thinking creatively, they added another
buffer, called a countercyclical buffer. Well, that's not added automatically. And that's another 2.5%, but
only if the regulators in the country choose to impose it. And here's the idea: We have to stop bubbles
before they burst, right? So, suppose you think that a bubble is building up in your country, then the
regulators are asked by Basel, if they make that judgment, to add another 2.5% to the capital requirement,
while it's booming. You don't wait until the crisis to do this, because then they'll all be in trouble, and if you
tighten up on banks then, they'll stop making loans, and will crash the whole economy. You have got to
tighten up when times are good. So, that adds up to 9.5%, OK? So, you'd have to hold capital equal to 9.5%
of your risk-weighted assets. But presumably, the normal number is 7%, OK?
So, let me just go through for this bank here, which has $400 million in assets. What is their requirement?
Well, we figured out that they have 170 million in risk-weighted assets. Multiply that by 7%, and that gives
you, I think it's $11.9 million that they have, right? So, your common equity must be 11.9 million.
So, you go to your balance sheet. We showed balance sheets in an earlier--
Student: It's common equity plus the first buffer, right?
Professor Robert Shiller: I'm sorry?
Student: The $ 11.9 million is --
Professor Robert Shiller: Oh, did I do with--yes, I'm sorry, that's 7% of 170 million. You don't actually
have to hold this buffer, but it limits you if you don't. And so practically, most banks will. So then, you go
to look on your balance sheet, and you see, hey, we're lucky, we have got 12.9 million. Let's say, I just
made that up, all right?
How do you get common equity? You take the total assets in your balance sheet, you subtract off all of the
liabilities, all the money you owed. And that gives you shareholders' equity, but that has two components,
common equity and preferred equity, so you've got to subtract off the preferred equity. But it's a sense of
how much extra resources you have. After you've paid off all your debts, you still have $12.9 million.
You say, hey, we're good. We've got an extra million dollars, OK? So then, you bring that up at the board
meeting and say, we're satisfying Basel III, isn't that great? But someone at the board might say, but wait a
minute, that means we have $1 million too much. It's just sitting there, we're not even using it. Let's lend it
out. I'm sorry, let's use it up, not lend it out.
How do you use it up? You've now got more than the amount of capital required. You've got another
million dollars. You could lend out $1 million, but think about it. You can borrow more and lend more. Or
you can borrow more and take other assets. And you can go beyond $1 million. Let's consider this. So, do
you understand the situation? That we've done our accounting. We have 170 million in risk-weighted
assets. We have a requirement, therefore, of 11.9 million in common equity. We have an extra million
dollars. Let's consider buying different kinds of assets. How about buying Fannie Mae bonds, all right?
How much more can you buy? Well, you've got $1 million. If you're going to buy more, you're going to
add both assets and liability. You're going to borrow money, and you're going to buy more. So, you're
going to add both assets and liabilities to your balance sheet.
How far can you go without violating the capital requirement? Well, the amount you can buy of Fannie and
Freddie bonds is $1,000,000/.2-.07.
And that's about $70 million worth of Fannie and Freddie bonds. Because you add that to this mix, then it
will raise your risk-weighted assets by exactly $1 million. So, you can buy $70 million of Fannie and
Freddie bonds according to this weighted asset calculation. You see that?
Well, how about making loans to small businesses in our community? Well, that's 100% risk-weighting. So
that means, I can make loans of $1,000,000/.07, and that's about 14 million. So, this is what you would tell.
You're at a board meeting and you're saying, let's consider that. We're going to stay within the
requirements, we can buy 70 million of Fannie bonds, or we can make 14 million more in loans. But at the
board meeting, someone might say, you know, 70 million sounds better than 14 million, I think we should
do Fannie bonds, and tell all the guys with small businesses coming by, tough luck. You know, we don't
have any money for you.
So, we see what it's doing. Its pushing people--the Basel requirements, and these are Basel II, or Basel I
requirements, we're pushing banks toward investing in subprime loans issued by Fannie Mae as against
lending to businesses. And people are starting to wonder about that now. But you have to say, isn't the
prosperity of the country determined by the businesses?
When you're making a subprime loan, what is a subprime loan? It's a loan to someone with bad credit,
whos bad employment history, to buy a house. So, we have created an incentive for banks to lend to those
people rather than to businesses. And so there are critics of Basel, all the Basel agreements, saying, it's
counterproductive. We shouldn't have done this. These weights were wrong. There shouldn't have been so
little risk-weighting on Fannie Mae. But then, the Basel people would say, look, we can't get it exactly
right. We thought Fannie and Freddie--and we're right, they haven't failed. Our job at Basel is to prevent a
run on the banks, so we want banks to be sound. And maybe you're right, maybe businesses should be
encouraged, but it's not our department. We're trying to prevent bank failure. So, these rules stick, and
they're still with us today under Basel III. If you want to subsidize small businesses, countries like in the
United States we have the Small Business Administration, that gives loans to small businesses. But Basel
III is not going to do that.
Chapter 8. Recent International Bank Crises [01:02:49]
So, I said I would talk about other financial crises, and let me talk briefly about a few, and then I'm going to
have to wrap up. The crisis that we have been through was a worldwide crisis, starting in 2007, peaking in
2008 and 2009. And it caused a worldwide recession. So, it's especially vivid in our memory. But I want to
just reflect that these crises--we've had banking crises so many times in history that it's not a unique event.
And I just wanted to remind ourselves of a few other crises.
I'm going to start with the Mexican crisis, our neighbor to the south, of 1994-5. Under President Salinas,
the government privatized Mexican banks. Salinas was a Harvard-educated economist who wanted to
modernize the Mexican economy. And they privatized the government banks, and turned it over to the free
market, and they forgot to regulate it. And so, it led to a bank-lending boom. In 1988, lending was 10% of
GDP. 1994, up to 40% of GDP. Salinas did not stop this. And it led to a boom in Mexico, because lending
was going wild, everything was happening really fast, and it led to a bubble and a boom in Mexico. And
there should have been a regulator who said, stop it, anyway. But there wasn't effective regulation, because
Mexico had deregulated but it hadn't set up the banking institution, the regulatory institution. So, it
developed an atmosphere in Mexico that, you know, I don't worry about the possible crisis, because the
Mexican government will bail everybody out.
And, you know, they couldn't bail everyone out, it turns out, there was a collapse. So, Salinas was replaced
by Yale-educated Ernesto Zedillo. I shouldn't put it that way. And the Mexican banking system was
destroyed by this crisis. And what ended up happening is that most Mexican banks were taken over by
foreign banks. And it was followed by an economy that was heavily damaged by a crisis. But Mexico
recovered. And 1994 and 1995 was unique to that country. It was a terrible recession that hit Mexico
briefly. That's one example. But again, it was a regulatory failure that did it. If you allow the moral hazard
to develop, if you allow people to think that, hey, let's make all these loans. I think it'll work out, but maybe
it won't, and if it doesn't, hey, we have friends in Mexico City, so we'll all be all right.
The next example is the Asian crisis of 1997. It's a very complicated crisis involving a number of Asian
countries, but it was heavily related to bank lending. And international banks had lent a lot of money to
Asian countries. And the countries then had loans that were--they were dependent on loans--that were
withdrawn when a sort of a bank run occurred. It was something like a bank run, because the international
investors suddenly wanted to withdraw their money from the Asian countries. And the Asian crisis started
in Thailand, and Korea, and Indonesia, and then it spread all over the world. It reached Russia as a
consequence, and it's called the Russian Debt Crisis. It was a contagion effect. And it got all the way down
to Brazil. You wonder, why was Brazil affected by an Asian crisis? Well, the world, it was and is
interlinked. So, it's experiences like this, that encourages the G-20 countries now to agree on bank
regulation, that will prevent this kind of collapse.
And the last example I have is, again, it's not--this one is not so international. The Argentine crisis of 2002.
This was, again, a complicated crisis. But it involved the Argentine government shutting down the banking
system in Argentina. And I don't have much time to talk about all this.
The examples that I gave of crises around the world, I went through them very quickly, but let me just
reiterate the themes that I started out with. And that is that banks fill a fundamental role in our economy.
They make things work. They solve moral hazard problems. They solve adverse selection problems. They
create liquidity, so that businesses can function and individuals can function. When the crisis develops, we
suddenly realize the importance of our banking system in its absence or in its poor behavior. And so, I think
there's an attitude among a lot of people that they don't like regulators, or they don't appreciate regulators.
But in fact regulators are people who are managing a very complicated system, which is really important to
our prosperity. If you look at causes of economic disruptions, it's failures in our banking system that seem
often to be responsible. There's other things, like, for example, an oil crisis can bring on a--it seems to be
completely independent of a banking crisis, but you take those two together and you explain most
economic crises. It's a very important thing to get banks regulated right.
Now what I didn't talk about in this lecture is--I'm going to come back to this--is the shadow banking
system. Let me just mention this in anticipation. And that refers to other kinds of companies, not officially
banks, that are doing business that resembles banking and is not regulated. So for example, Lehman
Brothers or Bear Stearns, which were major failures that led to this crisis, they were not banks. Well,
they're not commercial banks. They're not under Basel III. They are investment banks, which is different
animal and it's not regulated by Basel III.
Let me add innovation in finance. It's making the financial world harder and harder to understand. That's
why we keep having Basel I, Basel II, Basel III. There's going to be a Basel IV. Financial systems are so
much more complicated than they were, say, in the 19th century. There used to be a bank. You can see,
there's one downtown New Haven that looks like a Greek temple. You probably didn't even notice it. I
looked at the corner stone. It was 19th century. It's a beautiful old building. Banks were like that. They had
a nice granite edifice. You'd go in and there'd be a banker sitting there. And you could talk to a person, and
they'd make a loan. But now, we have all these complicated derivative contracts, and they trade all over the
world, it's so interconnected.
And shadow banking, which I'll come back to later, shadow banking is a consequence of--it's the kind of
thing that happens. Regulators can't keep up with all these innovations. But I don't think the answer is to
shut down innovation. We just have to allocate resources, and that's a trend that we are doing. And I think
that we will benefit, if we have effective and sound regulation that takes into account the subtleties of moral
hazard, adverse selection, the importance of liquidity. These are basic, important concepts that make for
better lives for people. And we have to expect that regulation is going to get complex. Basel III may look
complex. It's going to get even more complex, but we'll have computers managing the regulations
somewhat, so it'll all be doable. OK. I'll see you again. I hope you have a nice spring vacation.
[end of transcript]



ECON 252
Financial Markets (2011)
Lecture 14 - Guest Speaker Maurice "Hank" Greenberg [March 2, 2011]
Chapter 1. Introduction of Maurice "Hank" Greenberg [00:00:00]
Professor Robert Shiller: I'm very pleased that we have Hank Greenberg here today. We've already talked
about him and his career. Let me just reiterate it. It's a most amazing career. It starts when you landed on D-
Day, right? On Omaha Beach, amazing. At age 17? 18?
Maurice ''Hank'' Greenberg: A little over 18 then.
Professor Robert Shiller: And this goes way back. And then, participated in the liberation of Dachau at
the end of World War II. And then, not to be stopped, was involved in the Korean War as well. And then,
took over an insurance company, and made it into the most important insurance company in the world. And
experienced a number of vicissitudes inherited with that as well.
So, I was asking Mr. Greenberg, if he would talk about what he did, how he made this enormous success.
We're interested in finance here, so do something about how it was financed, but as we've been
emphasizing in this course, it's more than just mathematical CAPM modeling, it's about incentivizing
people, about finding people with the right character. And I think that you can tell us about your
experiences, and what you've learned over so many years.
So I'll turn it over to you. And then, we'll stop at around 10, and then, we have time for a few questions
from you.
Chapter 2. The Start of a Career in the Insurance Industry [00:01:56]
Maurice ''Hank'' Greenberg: That's fine. Good morning. Let me start, really, picking up where the
professor--I enlisted in the Army when I was 17. I hadn't finished high school. World War II was on. I felt I
wanted to do something, and I was bored. So, I was able to fix a birth certificate, so it said I was 18. And
they had no problem taking me, because they weren't looking too closely. I went to Europe, went to
England first. I got there in 1943, a year before the invasion. Spent the year training. Left England, went to
the continent, obviously, on D-Day.
Then, went all the way through Europe, linked up with the Russians in Linz, Austria. The war was then
over. Came back. I had to finish high school, which was a chore. Coming back after being in a war, and
going back to high school was one of the toughest times in my life, actually. But I did, went on to college,
and law school. Finished law school when Korean War broke out. I was a Reserve officer. I'd gotten
commissioned toward the end of the war. Spent the year in Korea, separated as a captain. Came close to
staying in the military, because I was fairly young and moved up pretty well in rank, and was offered--tried
to incentivize me to stay in the military, but I didn't. But Id finished law school, and came back. I was
married by then. I just married a girl that I met in college. And had to get a job. I didn't feel like practicing
law. I didn't think--I had a law degree--I didn't think I wanted to do that. I came back from Korea, and the
next day went down to visit some of my friends who I went to law school with, and it convinced me that I
didn't want to practice law. And as I left their office, I went by an insurance company, Continental Casualty
Company. And I thought, I'd see if they had a job opening. And I went in, went up to the personnel
director, and he was kind of nasty.
I had just come back from Korea, and I came back, I had orders to fly back, so I was really very untamed at
that moment. You know, just only about four days before that, I still had mud on my boots. And so, I went
down to the main floor, looked around the directory, and there was a resident vice president by the name of
[? Bob Braureid ?]. I just walked into his office and said, you have a--the word I used is not the word I use
now--you don't have a very good personnel director. And I was a little more excited than that, and I wound
up getting a job. And I started as a junior underwriter in the insurance business.
So, what is a junior underwriter? You analyze risks and decide whether the company wants to write those
risks or not. And I had to get a job, because I said I was married and had responsibilities. And I kind of
liked it. I was working in what they call the Special Risk Division, which was different kinds of risks
almost everyday. Some were sports risks. Some was accidental deathing for executives. It was a whole
range of different risks you had to analyze. I found it interesting. I became the youngest vice president in
the history of that company, and moved to Chicago where its head office was.
And about a couple of years later--it's a whole long story so I won't take you through--I met Starr, C.V.
Starr, who was the founder of the company that I chair today. Starr started his company in China in 1919.
Long time. And obviously during World War II, he had to leave, came back to the United States. And he
had a series of small insurance companies then. I was intrigued with his business, because it operated
outside the United States by and large.
He had one company in the United States called The American Home, which really was a failure. It was not
doing well, and he was embarrassed by that fact, that a company that was not doing well that he owned. His
other business, he represented American companies in doing business overseas. It was called the AIU,
American International Underwriters. It was one of a kind. And it operated mostly in Asia, one or two
European countries, but, by and large, its background was really Asian, having started in China, as I said,
1919.
So anyway, I joined Starr and took over The American Home in New York, which I said was not doing
well. It was a failure. Now, what was wrong with it? It did business through agents, and depending upon
the skill of a company, it would determine the quality of the agents that it had. And while it was an old
company, it had a very poor agency organization. And so, the quality of its business was very, very, very
poor. So, it was losing money year in and year out. And the job I had was to turn it around.
To cut to that short, I got rid of all the agents, and went toward the corporate brokerage business. Instead of
writing small businesses, we began writing large commercial risks. And we needed a lot of reinsurance. I
went to London, got Lloyd's to back that strategy. And up to then, most of the large risks were being
written in London at Lloyd's. Very few American companies had the skills to underwrite large, complicated
risk, whether it was large property risk, or casualty, or marine, aviation, very difficult risk.
And we assembled a group of quality underwriters, and we started doing that. We ultimately became the
largest brokerage underwriting company in the United States. We were going to run out of capital, we were
growing so rapidly and successfully. So, I looked around for a couple of other companies that had the same
problems that we had, before we turned it around. I found one called the National Union. We bought that,
got rid of all of its agents and agency business, and consolidated that into American Home. Kept its
identity, because it was a very old company. It was one of the oldest companies in the United States. And
then, subsequently, bought the New Hampshire Insurance Company, did the same thing.
Chapter 3. Creating AIG and Its Basic Principles of Operation [00:10:33]
By now it's 19--in the mid '60s. And by 1967, I created AIG, put a holding company on top of these three
companies, and AIG was born. In '67, I also became the head of C.V. Starr & Co., which was the owner, by
and large, of these insurance companies. Starr died in 1968, but he saw the beginning of AIG. It was
formed. We also owned a life insurance company, called American Life,that did business outside the
United States. And we consolidated that into AIG, so we had both a life and a non-life business. And we
were expanding internationally.
We ultimately did business in 130 countries. We opened markets around the world. We introduced new
types of insurance. One of the things that made us different was that we continued to evolve new products
that the business or individuals needed. For example, we were the first ones to introduce directors and
officers liability insurance in the United States. We introduced political risk insurance. American
companies doing business in very difficult environments, where their business might be nationalized or
confiscated, we insured against those risks. We introduced kidnap ransom insurance. American companies
doing business in the not-so-friendly countries, where some of the employees might be kidnapped and held
for ransom. We insured against that. And we put together a unit that helped find and get their release.
Sometimes on a friendly basis, sometimes not so friendly basis.
So, we were very creative in developing products that American business needed around the world. We
began to diversify, because the insurance business, the property casualty business, is a very volatile
business. You're subject to earthquakes. You're subject to hurricanes. You're subject to different economic
environments. And that affects the outcome of your business. And so, we wanted to diversify not just
within the property casualty business, but globally. That's why we entered so many countries around the
world, which gave us diversification. More diversification in your business provides greater stability, and
that became one of the things that was very important to us.
We also focused on, what the expense ratio should be. Most insurance companies are running an expense
ratio of about 30%. We ran our company with an expense ratio of 19%. And how'd we do that? Being the
most efficient, using reinsurance very, very properly. So, we did a much better job in both developing our
business and managing the business in a more efficient way than others would do.
And obviously, you have to have an organization. You have to surround yourself with people, who share
the same values, the same aspirations that you do. You have to have a team that works hand in glove, and
we did. The senior management of AIG was like a band of brothers. We saw things alike. We work well
together. I mean, there wasn't ever a palace revolution, anything like that. It was a great organization.
Chapter 4. The Connection between Foreign Policy and Business [00:14:37]
We added more diversification, because clearly diversification was essential. But in order to do business in
many countries, you had to open the market. Markets didn't welcome you in many countries. Take Japan,
for example, it was a very closed market. The Japanese were very reluctant to open their market to foreign
insurers, so we had to force the market open. And we did. The U.S. government was very much on our
side, and if the Japanese didn't open their market to us, we worked hard to keep some of their own
companies, whether it was insurance or otherwise, or other things, from doing business in the United
States. We didn't hesitate to use the U.S. government to support our desire to open markets around the
world.
When there was negotiation on trade, for example--most of the negotiation in the early years was on goods
and trade. Things, not financial services. Financial services were not negotiated at the world trade
negotiations, the WTO. We brought that into being. I served on the President's advisory board for trade
negotiations. They had never heard of negotiating financial services. And it took us a while to get that done,
but we did. We opened the market for financial services to be negotiated. And there are rules then that
came into existence, so that you can negotiate trade services.
It wasn't easy, even when the rules changed, countries dragged their feet. It took a long time to open us in
Japan and Korea. China, it took me from 1975, the first time I visited China, to 1992, to get the first life
insurance license ever granted to a foreign company. Moreover, while other foreign companies afterwards
could only get a license where they could only own 49%, we owned 100%. And to date, still, it's the only
foreign company in China, a life insurance company,that owns 100% of the company. It wasn't easy. As I
say, it took from '75 to '92. And I visited China every year, a couple of times a year, to make that happen.
But we did a lot of things for China. At the same time, we helped China. I lobbied very hard for China's
entry into WTO, which was very important for our country and for China, and really for the world.
So, we were very active, and you had to be in foreign policy matters. It was linked to our business. Since
we did business, I said, in ultimately 130 countries, it became essential that we were at the leading edge of
what the foreign policy issues were. We did business behind the Iron Curtain, before the Iron Curtain came
down, in Hungary, Poland and Romania. Moreover, I went to the Soviet Union in 1964, during the height
of the Cold War, and began a reinsurance relationship with them. And that lasted throughout the years,
even during the height of the Cold War we had a relationship going on. It wasn't easy. They thought I was
in the CIA, most of the time. It was a difficult thing, but we persisted. And when the Iron Curtain came
down, we had a head start against anybody else. Doing business in Romania, and Hungry, and Poland,
before the Curtain came down, was not easy, but we built relationships, so then, when it did happen, we
had a head start against anybody else.
We operated all through Latin America, the Middle East, parts of Africa. And all of those were a story in
themselves, because in each country it was a different environment, and you had to deal with different
personalities and governments. It was very difficult.
But we also had some basic principles. We would never, never be involved in a bribe. Anybody in our
company that got involved in anything like that would be fired instantly. We understood what the Foreign
Corrupt Practices Act meant, before they even had such a Corrupt Foreign Practices Act. So, we had a
reputation that you didn't tamper with us that way. And they knew also that we wouldn't hesitate to retaliate
through our government if necessary, if they tried to keep us out of their country. So, we were tough on that
basis. We wanted to open markets, and we did.
Chapter 5. AIG's Growth and the Expansion into Financial Services [00:20:09]
You go back, what kind of a structure did we have? And how do you bring a group of people together that
can work so harmoniously and enthusiastically together. It's critical. And to run a business like that, you
have to have an organization that, really, everybody's on the same track, and everybody is enthusiastic
about what they're doing.
Our overseas people, we had what we called an MOP, Mobile Overseas Personnel. It was like our own state
department. You can be working in Nigeria today as a manager, and then six months later you might be in
Singapore, or some other country. And so, you have to be mobile, and you have to be prepared to move,
and not be reluctant because of one thing or another. And becoming an MOP was a very high honor.
Everybody couldn't get that designation. You had to earn it. And it was a great group of people.
But how do you motivate people to do that? How do you get an organization that could be so effective?
AIG at its pinnacle, when I left in 2005, was the, by far, largest and most profitable insurance company in
history. I mean, think about that. From a dead stop. Now, we had a compensation structure that was unique
to the industry. I mentioned it briefly to the professor. C.V. Starr & Co., we considered to be the ultimate
company in the group. It spawned AIG, and so, within the organization, it was viewed as the top company
in the group. And since we spawned AIG, and put assets into AIG in exchange for AIG stock, so that C.V.
Starr and Starr International, the two companies, owned in the beginning, 100% of AIG.
As we grew, and we needed more capital, because we were growing so rapidly, we had to raise capital, and
therefore we got somewhat diluted. But even at the end, we controlled about 15% of AIG. The market cap
was close to $200 billion dollars from a dead stop of 300 million, when we first went public. From 300
million to $200 billion, one of the largest companies in the world. So, we weren't afraid of anybody taking
us over. Nobody was big enough to even attempt that.
But what we did, we had several principles. Nobody could earn more than $1 million in salary. I put that
rule in. Two, nobody would have a contract. You stayed in AIG because you loved it, and you didn't have
to have a contract. And I refused a contract any number of times. But you got bonuses based on
performance, and performance was fairly rigid. We tried to grow our business close to 15% a year, and for
many, many years we achieved that growth. The private companies that owned AIG stock were not owned
by AIG, but by the private companies.
We set up a structure, where the private companies would allocate some AIG shares to individuals based on
performance. At the end of every two years, if we hit the goals that we had established, they'd have a
certain number of AIG shares set aside for them that they would get at retirement. So, it was golden
handcuffs. If you left the company, you left behind the shares that were set-aside for you. And these were
worth an awful lot of money. Very few people left the company. I can assure you that it was a great
incentive to stay. The people we wanted to stay are the ones that got allocated shares obviously. It cost AIG
nothing. The public shareholders of AIG had no cost allocated to that, so the shareholders of AIG benefited
from that, and, obviously, the company overall benefited because they did so well. So, it was a great
organization.
So what happened? In 2000--in the meantime, we had further diversified. Our life insurance business grew
dramatically. We bought a company called SunAmerica, American General Life, and so we became a very
major life and non-life company.
And then we wanted to expand into financial services, which we did. We had consumer finance. We had a
thrift. All of which was done, because we could benefit from all the policyholders that we had, that we
cross-market from one to the other. And so, it was natural for us to do that. And we had close to $1 trillion
of assets to be invested, obviously. And so, we had the funds and the capital that we needed to finance these
new startups. And that was going quite well.
One day I had a call from Senator Ribicoff, who was a Connecticut senator at the time. And he wanted me
to meet a young fellow, who was running a financial services business. He had been with Drexel originally.
And he came--he was a very bright guy--he came to us. And we started something called AIG Financial
Products. It was a very successful company. Did derivative business. Everything was hedged. It was a very
successful operation. He got a little greedy at one point, and we separated. He left. We wanted him to leave.
And we put somebody else in, who was a very, very good man. Most of these people were all Ph.D.'s in
math. They were a special breed. They were different, and in order to ensure that we knew what they were
doing, we had a mirror of all the computer systems that they used for some of the things that they were
doing. We got one off-site that mirrored every transaction that was being undertaken.
We also had in the company what they call an enterprise risk management system, which means we
monitored both market risk and credit risk throughout our organization, because insurance is a risk business
to begin with, and you have to monitor risk. So, that was part of our nature. We understood risk. And knew
how to balance it and how to manage it in the insurance business and the financial business as well. After
all, we had to invest $1 trillion of assets every year and growing, so clearly we had to know what we were
doing. And I said it was a very successful company.
Chapter 6. Eliot Spitzer and Greenberg's Parting from AIG [00:28:30]
In 2000 and--I guess it was 2004, the end of 2004, we were reporting our earnings on a conference call with
analysts, and one of the analysts asked me, what the regulatory environment was like today. And I said, it's
like a foot fault is like a murder charge, because things had changed dramatically after Enron in the United
States. The regulatory system became very, very difficult, and anything at all really was being exaggerated
beyond what you can just believe.
The next day we got a subpoena from Eliot Spitzer, who then was the Attorney General in New York. And
I should say a word about this, because there was a major change in the regulatory environment after
Enron, and in some states, in New York particularly, the Attorney General's office has been used as a
platform to run for governor. It became a politicized office. And Spitzer had gone after me. He went after
my son, Jeff, who was running Marsh & Mclennan, the largest insurance brokerage firm in the United
States. He went after Sandy Weill, who was running Citigroup. He went after Merrill Lynch, all to promote
himself as an attorney general who was helping the people, quote, unquote.
He destroyed several hundred billion dollars of value, is what he did. He got elected governor, and you
know the outcome of that. It was a very short tenure. He got caught with prostitutes and had to resign. But
he left behind a lot of broken companies. I was forced to leave, because he threatened the board of directors
of AIG, that, if I didn't leave the company, he was going to indict the company. He went on national TV,
and accused me of accounting fraud in the company. Just before Thanksgiving, he dropped all those
charges, because nobody reads the newspapers the night before Thanksgiving. He was a bad actor.
So, I left the company in 2005. The outcome was that--the plan actually had been that I would step down as
CEO in May of that year at the annual meeting, and remain as chairman, and see how the successor team
would work. At that point, we had 92,000 employees, not a small company. To make sure that the new
management team would be able to handle the diverse businesses that we were in. These were all
experienced people. There was nobody new in that role. I believe that we wanted it to have the new team
come from within the company, not from outside. Because they had to understand what we were.
Chapter 7. AIG Shortly before and during the Financial Crisis [00:32:31]
And we had a culture in the organization that was quite unique, and you can't just change the culture of a
company instantly. You build a culture over many, many years. In any event, I was out. A new chap came
in, Martin Sullivan, who had been a senior man in the organization for years. He attended every senior staff
meeting that we had for years. We had several different--I won't go through all of that--but several senior
management meetings that were critical to knowing, what was going on throughout the organization on a
real-time basis. We'd meet every Monday morning. About 15 people represented the entire organization.
They'd be reporting on everything that was happening on a real-time basis. We did the second meeting,
held on a Wednesday every morning,that dealt with hedging full-time, and risk management. And those
two subjects were on a real-time basis weekly. And, of course, there were people working on that on a daily
basis. But anything that was out of the ordinary would be surfaced at these meetings.
For some reason or other, he discontinued those meetings. I can't understand why, but he did. And what's
very disturbing is that the audit committee of AIG's board knew that and did nothing about it. The outcome
of that was then, that AIG Financial Products loaded up on credit default swaps. They did more credit
default swaps in the nine months after I left the company than we had done in seven years.
Now, let me say something about credit default swaps, because I think it is important. A credit default swap
originally was created, so that, if a security--in this case CDOs [Collaterized Debt Obligations], which was
really a product that was mostly real estate put together, and packaged and sold as a CDO--originally, those
instruments had to have a default before a CDS, a credit default swap, would respond to that instrument
that defaulted. Someplace along the line, that was changed, so that you didn't have to--the instrument didn't
have to default, it simply had to lose value. And you had to put up collateral, the one who issued the credit
default swap had to put up collateral equal to what the loss of value--even though it wasn't realized, on
what the CDO had lost in value.
That change played a major role in what happened in the recession that we've just been going through,
particularly on Wall Street. Putting up more collateral meant you had to have a lot of cash on hand. No
matter how big you were, it became a very important issue, as to the ultimate demise of several companies,
including the problems that AIG ran into. They were called on for billions and billions of dollars of
collateral, which ultimately--I don't care how big you are, you run out of cash, which they did.
One of the problems was in trying to determine what is the value of a CDO, since there was no price
discovery, because there was no exchange in what you traded the CDOs on. That was, strangely enough,
during the Clinton administration, the Treasury Department, then run by Bob Rubin, turned down the
question of having an exchange and regulating credit default swaps. So, you had a situation where every
broker dealer had a different price for a CDO. And how much collateral did you really need to put up, if
you couldn't tell what the price of one was. In this instance, Goldman Sachs had the lowest price of any
CDOs that were being called on for collateral. And since AIG Financial Products did a great deal of
business with Goldman Sachs, they were being called on for more and more collateral. They ran out of
cash.
Now, the insurance companies were all very, very solvent. It's state-regulated. You can't just take their
capital for something else. They were protected, all the policyholders were protected, under the fact that
there was state law and not federal law that governed the insurance companies. But AIG ran into
difficulties. I was not in the company. I would have handled it much differently had I been there. I would
not have responded to the call for collateral, when you couldn't tell what the price discovery really was. I
would have said, you know--
And one other thing, AIG was a AAA rated company when I was there. The day I left the company, it lost
its AAA rating. So, if you were AAA rated, you did not have to post collateral. If you were not AAA rated,
you had to post collateral. So, AIG ran out of cash. So, they turned to the Fed for help.
You got to remember, this was now in a time, when Bear Stearns first got in trouble. And they found a
buyer in J.P. Morgan, which really, J.P. Morgan got Bear Stearns for nothing, practically. It was six months
in between Bear Stearns and Lehman Brothers. What did they do during that six months, the government
that is, to prepare for any kind of financial upheaval? There was no plan to deal with what was about to
descend in the financial markets in the United States.
So, Lehman Brothers, who could have been saved by the Fed, was let to go down. And that caused a run on
virtually all the banks. The loss of confidence that ensued, when Lehman Brothers was let go into
bankruptcy, startled the financial world. And everybody that had any money in any of the investment
banks, or banks, was pulling money out. And so, there was a--you couldn't borrow any money. The markets
froze. And so, there was an ad hoc approach to doing things.
So, Goldman Sachs and Morgan Stanley, both of which were going to have a problem, were given a bank
holding company license. That gave them access to the Fed window, and they could borrow money at
virtually no costs at all, practically. The Hartford Insurance Company, here in Hartford, a medium-sized
company, was also given a bank holding company license. And AIG was denied one. So, AIG was left to
really find a solution. So, they went to the Fed, the New York Fed, which I had chaired, incidentally, for
about seven years before. So, I knew the people in the Fed quite well.
They borrowed $85 billion from the New York Fed at 14.5% interest. And the Fed took 79.9% of the
equity of the company. So, they essentially nationalized the company. Now, the money that AIG got, the
$85 billion, at these terms, which is outrageous, they then had to pay the CDOs that you couldn't tell what
the real price was, because there was no price discovery. You could have negotiated the value of those at
about 40 to 60 cents on the dollar, but the Fed made them pay 100 cents on the dollar.
So, AIG borrowed the money, paid Goldman Sachs and others 100 cents on the dollar, and had to pay that
money back to the Fed. So, things began to unravel very quickly after that. They obviously lost credibility
in the marketplace. They were losing business left and right. They had to pay back the government. So, one
thing led to another.
The Treasury put in a man by the name of Ed Liddy to run the company. He'd be on nobody's list to
succeed running AIG. He hadn't got a clue how to do that. And they began to sell off assets of AIG, really
at prices that were just outrageous. So, the outcome is, that AIG is a shadow of what it had been. The
government now owns 92% of AIG. They want to sell that 92%. It'll take at least, in my view, three to four
years, because it's an overhang. If they sell 10%, everybody knows there's another 80% to be sold, and so
the stock will go no place. So, do I feel bitter about it? Yes I do. I feel very bitter about it.
So, what am I doing? I'm running C.V. Starr & Co., Starr International. We're building it back into a major
organization. When I left AIG, C.V. Starr & Co. had 300 people. We're about 1000 right now, so we're
adding employment to the country. And that's coming along. We've formed three new insurance
companies. We're doing business in probably about 30 countries right now. We have a big Lloyd's
operation. We operate throughout the European market. I'm going to China next week. We'll have a joint
venture in China by the end of April. We'll be in Southeast Asian countries, all of which we know for years
and years. And we have a big investment operation.
I'm giving you a shorthand version of what really is happening. How much time do I got?
Professor Robert Shiller: Nine or ten minutes.
Chapter 8. Assessment of the Causes of the Financial Crisis [00:44:45]
Maurice ''Hank'' Greenberg: All right. So, I think there's a lot to think about. Why did we get into this
trouble in the country? What's this about? How could a country as wise as we are, and financially literate as
we are, do what we did? And I have my own thoughts about that, but let me just rattle some of the reasons
off their thing. There was a desire in this country, during the Clinton Administration, that housing should
be an opportunity for everybody. Everybody should have the right to own a home. There wasn't much
differentiation, whether you can afford one or not.
Historically, in our country, mortgages were granted by local banks, who knew the individual, and would
work with that individual, if they got into any trouble. When the Clinton administration decided to expand
housing, Fannie Mae and Freddie Mac were buying mortgages from these local banks. And local banks
only serviced the mortgage, but they really didn't have any financial involvement after the mortgage was
sold. And clearly many people got mortgages in homes that couldn't afford it. So, that was one thing, that
was going to lead up to, ultimately, a problem.
Second, investment banks in the United States were leveraging their capital 30 and 40 times. It was
outrageous. Going from, say, five and six times, or seven times your capital to 40 and 50 and 30 times your
capital, was obviously a risk that shouldn't have been taken. The SEC [addition: Securities and Exchange
Commission] just ignored that fact. Why? It's hard to understand. But it was clear that it was setting in
motion some conditions that would be very difficult to live with on a real-time basis. And, of course, it was
going to cause problems.
Then, some of these investment banks said, look, our job is to be creative and create products. So, they took
some of these mortgages that were being now written for people, who didn't have, really, the right to own a
home. They just didn't have the financial needs. They didn't have the financial background for it. And they
packaged these mortgages into a product. They took mortgages, they said, from the east to the west to the
south, and the northeast, put them all together. They said, the diversification is terrific, and that means, it'll
be marked AAA.
They went to the rating agencies, and sold the rating agencies, Moody's and the rest, that this
diversification--they deserve a AAA rating. And the rating agencies accommodated them, didn't do very
much analysis of their own, and they were marked AAA. And they sold these mortgages then, these
products, these CDOs, to every client and customer they could find all around the world. And, of course,
they weren't AAA.
And then, as I said earlier, these credit default swaps, that would respond to a normally a default, had been
changed, so that you responded to just a reduction in value. It blew up in everybody's face. The same time
they were doing all of this, the Accounting Principles Board [Addition: now called the Financial
Accounting Standards Board], located here in Connecticut, came out with mark-to-market accounting.
Couldn't have picked a worse time to do that. And that marked balance sheets, that you normally would
carry, say, at cost, or held to maturity, where you keep the value--you had to mark it down to a market
value. And that destroyed capital artificially in many instances. That never should have happened.
The SEC, who oversees that, kept silent. So, you had all of these things come together, at the same time,
that led to the destruction that took place. There are other things that happened. I could go through a list of
them, but I don't think the real story, on what truly occurred in our country, has been fully recognized yet.
Jelling will take a while. There have been a lot of books written, but jelling on parts of it, not the entire
issue. I testified before a couple of congressional committees on this, particularly on the AIG issue. For
example, by what right did the government have to take, essentially, 92% of AIG? To me, it was an
unlawful taking.
What should have been done, and if you look at the other companies that they aided--they aided Citigroup
and they got about 30% of the equity. That's different than 92%. And they aided several other companies
the same way. So, why was AIG set aside and used the way it was? AIG was a national asset. We have no
insurance company that operates globally in 130 countries. When I tell you it was a national asset, I know
what I'm talking about, because we did many things that were beneficial to our country and our
government. It was totally destroyed. They saved Goldman--AIG was used to save many, including
Goldman Sachs. But that story will come out. It's been alleged already in the newspapers, and in articles,
and magazines, and you have it.
But anyway, I think I'll stop right here and take questions.
[SIDE CONVERSATION]
Chapter 9. Questions & Answers [00:52:16]
Student: So, when you were talking about the culture of your organization, you mentioned that you do not
prefer having contracts with your employees. And I'm wondering what that means not to have contracts,
and why do you do it?
Maurice ''Hank'' Greenberg: I didn't quite understand.
Professor Robert Shiller: About your contracts.
Maurice ''Hank'' Greenberg: Yeah. I didn't think that you ought to hold and have a contract, that you
stay if you weren't doing the job. But you have to start someplace and it started with me. I refused a
contract. I thought that, if I wasn't doing the job, I shouldn't be forced to stay in the company. They should
have the right to have a new CEO, so I turned it down.
Professor Robert Shiller: Is that because the contract couldn't be explicit?
Maurice ''Hank'' Greenberg: Well, no. Say, that, if you have a five-year contract, at the end of three
years, if the company's not doing well, why should the company be forced to keep you for two more years?
If you don't ask me a question, I'll ask you some questions.
Student: I guess, this is more of a personal question. I was wondering what--so, we're all in school, and we
don't have jobs yet. And so, in thinking about careers, it's an important decision, so, I wondering what made
you really enjoy your job. Was it the success you had? Was it the day-to-day activities? Was it the impact
you made on being part of AIG?
Maurice ''Hank'' Greenberg: Well, I think it's many things. You have to love what you do, to begin with.
And I love building. And I loved working with the group of people that we had. It was a very close group.
And it's a lot of fun opening new markets, and beating our competitors. It was a very satisfying experience.
And you have to love it. The other thing I would say, you need a lot of energy. You have to want--you
know, work should not be viewed as, say, from nine to five. You work as long as you have to because you
love doing it.
Student: It also kind of reminds me of Bear Stearns, and another very experienced chairman, Ace
Greenberg, kind of warning his board--
Maurice ''Hank'' Greenberg: I'm not hearing you.
Student: This is on? Like, AIG, the story of AIG really reminds me of Bear Stearns' fall. And of a really
experienced board member pointing out that what the company was doing wasn't great. So, can you talk to,
I guess, the idea of having experience in this field, and the fact that companies were kind of--boards weren't
working, was also a core problem of the financial crisis. So, can you tell me a little bit more about that and
how you felt afterwards?
Maurice ''Hank'' Greenberg: I didn't quite hear that. Did you hear?
Professor Robert Shiller: Boards were not working properly.
Maurice ''Hank'' Greenberg: Boards were not working properly is absolutely right. There was a lead
director in the company--if you go back through the history of AIG, we had some outstanding people on the
board. Over a period of time, some retire, some die. But we had a pretty good board. Carla Hills, for
example, was on the board, and she was an outstanding director. She had been in the cabinet of George
Bush, the first. She was a terrific director. Bill Cohen, who had been secretary of defense, was a director.
Dick Holbrooke, recently died, was a director. So, we have had some good directors.
On the other hand, when Spitzer threatened the company, many of them just folded. Not Carla Hills and not
Bill Cohen, but many others. And you don't know, how people are going to respond until they're confronted
with an issue. But there's no question that the board failed, in my judgment, to recognize what was
happening after I left.
Student: So, China has recently been experiencing rapid growth. How do you think their growth, the
change toward a consumption model, will change the insurance industry in China?
Professor Robert Shiller: China, you're saying, has been growing rapidly.
Maurice ''Hank'' Greenberg: What is?
Student: How will that change the insurance industry in China?
Professor Robert Shiller: The insurance industry in China, how is it changing with their rapid growth?
Maurice ''Hank'' Greenberg: It's changed dramatically. The largest insurance company in the world
today, by market value, is China Life. Amazing growth in China, and you expect it. China has passed the
United States in the number of automobiles being sold a year. They all have to be insured. So, the growth in
the insurance industry in China is very rapid. Very immature in many ways in understanding risk, but that'll
change. They've come a long ways.
When I first went to China, and we entered our life company, the life insurance industry in China was very
small. And they didn't have agents selling life insurance. They had their employees selling life insurance.
So, if an employee sold something, he would get paid, and he'd get paid whether he sold or not. So, they
had a fixed expense. We introduced an agency system in China, and recruited thousands of agents. And
they got commissions, if they sold something. If they didn't sell, they didn't get a commission. The Chinese
companies quickly adapted to our system. So, you can say that we created millions and millions of jobs in
China.
Student: Thank you. I'm just wondering what you do you think of Chartis and SunAmerica, currently sub-
businesses, and how you would evaluate Robert Benmosche as the current CEO.
Maurice ''Hank'' Greenberg: Look, I've known Bob Benmosche for 15, 20 years, and he's a decent man.
He's a good man. And he's, I think, a pretty good leader. He has very little experience internationally, and
his experience has been in the life insurance sector, not in the non-life sector. One of the largest
components of AIG is the non-life sector, so he's got a hard job in front of him. Also, the most valuable
assets have been sold. The AIA, which is the company that's entered in China, that AIG owns 100% of,
they sold that, which I wouldn't have done. And they sold American Life to Metropolitan Life. That
company does business in 55 countries around the world. You can't replicate that. I wouldn't have sold that.
So, AIG is a shadow of what it was before. Benmosche's got a tough job. He doesn't know the non-life
business very well. And the culture of the company is gone. Most of the people who worked there, who
were some of the better people, have left. Many have come to me, are working in C.V. Starr & Co., and in
our agencies and our insurance companies. It's going to be a tough job, but he's a good man. I like him.
Student: Good morning. During your speech, you get to the destructive power of credit default swaps. And
what I find interesting is, different countries have taken a very different approach. Some European
countries have absolutely banned credit default swaps. China, most notably, introduced them in the market
recently, but put a cap on the value with the underlying amount. So my question really is, what sort of
regulation do you think would work well, both at a national level and, possibly, the international level?
Maurice ''Hank'' Greenberg: That's a good question. I would do at least two things. First, I would go
back to where a credit default swap would only respond if the underlying instrument, that it is supposedly
insuring, defaults. In other words, I would not respond to just a reduction in value, because if you look at
all those CDOs, that the credit default swaps were covering, most of those have recovered in value. OK, so
that there was a temporary reduction in value, but they didn't default. And so, what it led to was
unnecessary chaos in the market.
The second thing, I would have is an exchange, where you get price discovery. Without price discovery,
you're back where you were, and so you have to have that. And you'd have to put up reserves. If I was
going to issue credit default swaps, you ought to reserve it. If it's going to be an insurance instrument, treat
it like an insurance instrument. And make the underlying company, who's issuing them, put up reserves.
Student: It can be a bit intimidating sometimes to hear, or learn, or read about the insurance industry
because of the regulation, and the billions and billions of dollars that are always involved, et cetera, as a
student. But I'm wondering, in addition to what you're doing yourself now, with C.V. Starr, what
opportunities do you see for entrepreneurship in the insurance industry today, if any.
Maurice ''Hank'' Greenberg: Well, I think there's tremendous opportunity for being an entrepreneur. You
know, you're living in a changing world, changing economies, new products are being invented and
developed every day. And investments are going on in different parts of the world. All of that needs
insurance. And so, there's great opportunity to be creative in the insurance industry, and differentiate
yourself from everybody else. I'm about to do a joint venture insurance company in China. The one we're
doing a joint venture with, a very traditional company. We will change that in less than a year into
something different. And that's exciting to do that. So, I'm looking forward to it.
Student: Hi. Do you think that--I mean, with the recent financial crisis, we've seen a lot of government
intervention and interaction through the private world. And I was wondering, do you think that the
government should have any role, other than just keeping things fair? Do you think they should intervene,
when these companies are having big issues, like what happened to AIG?
Maurice ''Hank'' Greenberg: Do I think government should intervene? I think that--the least amount
that's necessary. I think, if you're asking the question of ''too big to fail'', I think there are some institutions,
that probably would cause chaos if they failed. But I would make that very, very few and far between.
What troubles me is, what happened in this recession in government intervention. They picked and chose
who they wanted to save and who they didn't. It wasn't even-handed. It was done with the intent to save
some and not others.
The real story of what happened has not been printed yet. After all, it's very common knowledge that
Paulson, who was then Treasury Secretary, was surrounded by Goldman Sachs people. I'm not making that
up. That happens to be a fact. And so, how objective were they in what they were deciding to do and not
to? I think that there are times government has to intervene, but I happen to believe in the private sector, in
the ability of Americans to create jobs and businesses. And government should be small. Government
created jobs and not the best jobs. Private sector jobs are the best jobs, in my judgment.
Student: Thank you. What role do you think that banks should play in the future to avoid a similar crisis?
And do you think that there needs to be a different sense of what risk is?
Maurice "Hank" Greenberg: What was the last part?
Student: What kind of role should banks play in the future? And do you think that there needs to be a
different definition of what risk is?
Maurice ''Hank'' Greenberg: Of what risk is?
Student: Risk.
Maurice ''Hank'' Greenberg: Yeah, OK. When you say banks, you have to differentiate between
commercial banks and investment banks. Look, I think that the Dodd-Frank bill, that has been passed,
comes up with a whole new set of regulations. Let me touch on that in a minute. And will banks use their
own capital to do transactions that puts the whole institution at risk? Probably will not be the way it was. I
think the Volcker Rule, which would limit the amount of individual transactions that might endanger the
bank, are going to be limited. It'd have to use an off-balance sheet approach, so that that doesn't pollute the
rest of the bank. Investment banks, for example, that may have done transactions, that bet against their own
clients, I think should be outlawed. If an investment bank is selling me, say, invest in the XYZ CDOs, and
then they take a position against that, it seems to me that that's immoral. And should not be permitted.
Now, the Dodd-Frank bill was enacted, before they even had any of the response of all the investigations
that were going on. It seems to me, they should have waited and heard what the investigators had come up
with, before they passed a new law. Now, the Congress has to provide for the financing of all these new
regulators that are going to be created under the Dodd-Frank bill. And I'm not sure that's going to happen.
I'm not so sure that all of them are necessary. What we need are better regulators, not more regulation. We
had plenty of regulation. If they had enforced the regulations that were in existence, we would have
avoided a great deal, if not all, of what took place.
Student: Hi. You mentioned earlier about how AIG attracted and retained the best people in the business,
and that's how they grew, because of the strong culture there. But if you're starting a new company, or even
entering in a management position at a current company, how do you go about building that type of culture
that just fosters growth?
Professor Robert Shiller: How do you build the culture that you have talked about?
Maurice ''Hank'' Greenberg: The culture starts at the top, OK? It's got to start with the individual
running the company. The same thing, as I say, in risk management. The CEO is the top risk manager in
the company. You have other people involved, but you're the risk manager. You decide, how much risk you
really want to take. And the same thing is true in culture. You build a culture based upon your performance,
what you stand for, what you believe in, and you surround yourself with people who share those beliefs. If
they don't, they'll feel out of step.
Professor Robert Shiller: All right. Thank you very much.
[APPLAUSE]
Professor Robert Shiller: That was great.
Maurice ''Hank'' Greenberg: Do you want to get rid of all this stuff? Do we get rid of all these now?
Professor Robert Shiller: Yes, why don't we just put them up here?
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 15 - Forward and Futures Markets [March 21, 2011]
Chapter 1. Forwards vs. Futures Contracts; Speculation in Derivative Markets [00:00:00]
Professor Robert Shiller: OK, good morning. Well, today I want to talk about what, to me, is a very
interesting topic, and that is futures markets. Not very interesting to most people. Most people have no idea
what they are. But I think that, well, futures markets, what we're really talking about is--
There are different ways of viewing it. Futures markets for things like agricultural commodities, or interest
rates, or financial securities, are markets about the future. They're markets that, in some sense, predict the
future. And future matters, right? We live a life. We have a long horizon. I said before, I think that your
planning horizon must be at least a century, because you'll probably live that long anyway, with modern
medicine. And you care about other people, too.
So, the beauty of futures markets is that we have prices for the future. We talked already about forward
markets. We talked about forward interest rates. And that is related to what we're talking about. Forwards
and futures are similar concepts. Futures is the more precise concept, or the more developed concept. And
I'll explain the difference between forwards and futures. But just in a nutshell, futures markets are
organized markets, like the stock market, that trade standardized contracts, representing things that will
happen at future dates. And because they're standardized, they're worldwide. Everybody looks at them and
uses them. Whereas forward markets are more specialized markets that, typically, are not as easy to
interpret or as clear.
So, futures markets are, in some sense, more fundamental and important. I have a particular interest--I've
been interested in futures markets myself for many years. And wondering, why they're not even bigger and
more important. So, in 1993, I wrote a book called Macro Markets, about let's make our markets bigger and
more important, and more pervasive. And I've been trying to do that.
Notably, in 2006, I was working with the Chicago Mercantile Exchange, which is the biggest futures
market in the world. And we created home price futures. And they've been trading now for five years. But
I'm not really going to talk about them, because they have so far disappointed. They're not important, at
least not yet. But I'm going to talk about some important futures markets.
First, I want to put just a couple of definitions up. Futures, that's what we're going to talk about most in this
lecture, and it has a special meaning in finance. And I was contrasting that to forwards. But both of these
together are derivatives. And that means that the price in these markets derives from a price in some other
market. There's a primary or underlying market, which has its own price. And then there's a derivative
market that has a futures price or a forward price.
I guess I'm speaking in kind of abstract terms. Well, let me just start--I want to give you an example, and
we'll see better what I'm talking about.
But let me just first comment just on this word, derivatives. To people in finance, derivatives are an
exciting development of financial markets. We start out with a simple market and we develop derivative
markets, that add more detail and information than was in the underlying or primary market. That's
exciting. I find it exciting. However--I don't know how often you hear this word, derivatives--it's become a
four-letter word. It's become an ugly word.
Why is that? I think it's, because people blame the current financial crisis on derivatives, whether rightly or
wrongly. And it's because, I think, there's a public anger about derivatives that is largely due to
misunderstanding. I mentioned before that I think that finance tends to attract sociopaths. I mentioned that,
I defined that for you. People who want to manipulate, and fool, and deceive people. But I don't think the
financial community is particularly populated by sociopaths. You might think so, reading some accounts.
But I think, it's not true. And I think, it's not true, because the financial community knows about this
problem and ejects such people. They get caught. And you can't make a career in finance if you're a
sociopath.
So, if you think you have this problem, that you have sociopathic tendencies, I would advise you not to go
into finance, because you will get caught and ejected. So, save yourself the trouble. Don't go into finance.
Pick some field where you can't hurt anybody. And that would be a smart thing to do, if you have such a
problem.
So, I think we need to regulate derivatives markets, and that's what I'm talking about. And we need self-
regulation of the markets themselves, but we need government regulation as well. But there's nothing evil
about derivatives. And in fact, derivatives are fundamental to the way I think a modern economy works.
So, I had you read an article--I put it on an earlier section of the reading list--by Charles Conant, who wrote
a book in 1904 called Wall Street and the Country. And you should have read that by how. He starts out by
saying, it's just amazing, how public opinion thinks that speculation is evil. And they don't understand that
speculation is just business. I mean business decisions involve guesses about the future. And so, when you
have well-developed markets, these guesses become market prices. And so, the prices go into the
calculations that everyone makes. And the calculations are just done better.
Somehow, there's just a failure for most people to understand it. And I'm hoping in this lecture to try to give
some more understanding of these markets. I think they're fascinating. Most people apparently don't,
because you don't hear them brought up very much. I want to just say a little bit more about hostility toward
derivative markets and futures markets, and speculation in general. In 1991, that was 20 years ago, I wrote
a joint paper with a--I don't remember whether I mentioned this, probably not--with a Russian, a young
man from Russia that I met when I was visiting the Soviet Union, just before the end of the Soviet Union.
[Addition: Maxim Boycko, with Vladimir Korobov]
And we were talking about how antagonistic Russians are toward capitalism. And he said this is a big
problem. Russia just can't embrace capitalism. These people hate it. They hate the profit makers and the
financiers. And I said to him, well, you know, it's the same in the U.S. How do you know it's any worse in
Russia?
And so, we decided to do a questionnaire survey. And I was going to read one of the questions, comparing
people in Moscow and people in New York, to see, which one understands capitalism better. So, one of the
questions that we had was the following. We wrote these questions and translated them into Russian. And
we tried to make them exactly the same questions between Russian and English, all right? So, here's the
question we asked in both cities: ''Grain traders in capitalist countries sometimes hold grain without selling
it, putting it in temporary storage in anticipation of higher prices later. Do you think this speculation will
cause more frequent shortages of flour, bread and other grain products? Or will it cause such shortages to
become rarer?''
What do you think, people said? Does the process of speculating in grain cause problems or solve
problems? Well, we found that, in the USA, 66% said, it will make shortages more common. But in the
Soviet Union, in Moscow, only 45% thought it would make shortages more common. Both of them were
wrong. A lot of them were wrong, but the Russians were better, closer to the truth than the Americans.
Living in the financial capital of the USA, most people think that speculating in grain creates problems. But
wait a minute, what is speculation in grain? That means holding it off, expecting higher prices later, right?
Isn't that what you have to do if you are managing a grain market?
Now, think of it this way--and I'm coming now to agricultural futures. In the simplest world, there's one
harvest of wheat every year, OK? And that harvest comes in a certain time of the year, every year. Once a
year. And it has to be held in storage over the year, right? Because people don't eat it all at once. You eat it
over the whole year. So, somebody is storing grain. This is a fundamental problem, OK? That's a business.
So, you have to know that somewhere there's some warehouse holding the grain that you will be consuming
in six months time. And that warehouse is run by some professionals who do that.
If they think prices are higher later, they'll keep it longer in the warehouse. And what does that do? That
evens out the price. It doesn't make it worse. If they think there's going to be a shortage of grain, they hold
it back now and the price of grain goes up. And so, everyone starts consuming a little less because of the
higher price, and it smoothes things out and it works better. And this is elementary economics, but it's not
understood, I think, by most people.
Chapter 2. The First Futures Market and the Role of Standardization [00:12:46]
And the futures markets are just sophisticated markets that help that process. So, I'm going to start with
agricultural futures in talking about this. And I want to start also with a very homely--it's not homely--it's a
very elementary example, because it's the first futures market. So, where do you think futures markets
started? You would think, it started in New York, or Chicago, or London, or Paris. It actually started in
Japan in a place called Dojima, which is in the city of Osaka. And they started in the 1600s.
So, let's go back. If we can go back to the year 1673, in Osaka in Japan. Japan was heavily dependent on
rice, OK? And the rice farmers would farm all over Japan, but there was a rice market in Dojima, which
was the national rice market. And I have data here. According to a study, there were 91 rice warehouses in
Dojima in 1673. That's a long time ago, isn't it? So, it was a big storage place for rice, and they were storing
it all year. And people would come, people who were merchants for rice, and they would come to Dojima
and they would sign contracts to get rice. I live in some town 20 miles from here; I'm a rice merchant. I
need a regular supply of rice from your warehouse. Can you supply it to me? And the guy would give you a
terms, and that would be a forward contract, OK?
And this is what was happening before the futures market. Forward contracts precede futures contracts. So,
do you see what it is? You're a rice merchant. You make a deal. You sign a contract that I will pay you so
much in currency at every month, and you'll give me so much rice. And you'll deliver it here, and I'll take
it, and I'll sell it in my town. Problems developed in the forward market that led to the development of a
futures market. And the problem is, one of the problems is that there's counterparty risk. You are a rice
merchant. You make a deal with a warehouse. That's one person dealing with one person, right? What if
one of the guys reneges on the deal?
So, for example, what if the price of rice falls? Then you, the merchant, will say, I'm not going to go back
and buy according to this contract, because it's cheaper now, right? I'll buy it somewhere else. So, I just
don't show up, and then the warehouse is saying, what happened to our contract? And you're nowhere to be
found, OK? Or if it goes the other way, if rice goes up, the warehouse might renege. They'd say, we signed
this contract but there's something wrong with it, and we're not going to honor it. So, it messes up. It is also
possible that one of the two counterparties is just a sociopath or something, or is an alcoholic, or something
is wrong. So, the market doesn't work well.
So, what they invented in Japan was the first true futures market. And the market worked like this. There
was a trading floor in Dojima, and rice traders would come there, and there were certain hours of the day,
when you would trade contracts for future delivery. But they were standardized contracts, mediated by the
exchange, so that there would be no problem with the contract. And then every day, there would be a
trading time, and you could buy and sell contracts for future delivery.
Moreover, they enforced trading hours. And this is something that's kind of an interesting invention. They
didn't have--I guess they didn't have clocks. I don't know what they had. But they had a certain time, when
trading would stop, and they wanted to stop all the trading at the same time. They didn't want people
dribbling out. They wanted it to be a good market. So, they would light a fuse, and it would be a bright
light in the middle of the trading floor. And you'd see the fuse burning down, and when it burned out, all
trading stopped. So, they had trading hours. Moreover, they had a problem that some of the traders wouldn't
stop trading. So, this is something that they did in Dojima, they had men called watermen, who came out
with buckets of water. And they would throw the buckets of water on anyone who was still trading. So that
worked. It stopped trading.
They also had hand signals. This was big. This is big time. You were trading rice for all of Japan. And you
may think the 16- or 1700s are long ago, but a lot of rice was traded and it got really noisy and difficult.
They found that it was so many people trading on the floor, that you couldn't hear anyone talk. And there'd
be shouting and noisy, and so, they devised a system of hand signals. And the Dojima hand signals were, I
don't know exactly, but something like this. If your hand was out, you put your hand out, that means sell.
You put your hand this way, it meant buy. And if you put three fingers up, it means selling three contracts.
That kind of thing. I don't know the whole system, but that's where it started. That whole concept was
copied all over the world in subsequent centuries.
So, what is it that happened? And the other thing is, what were the contracts that you bought and sold? The
problem with the forward market is that the contracts are all different. One guy made a contract with one
guy, and he said, I want my delivery here. And I don't like this kind of rice. I want this kind. And better
make sure that there's not a single insect in it, or I'm going to reject the whole thing. But that's all different.
So, you don't know what--these contracts, you don't even know what the price of rice is. If someone said, I
paid so much to get rice in the--but you have to say, well, under what circumstances? And what kind of
rice? And where? And what are the terms for possible failure? You know, there's so many terms in the
contract, so you don't even know what the price of rice is.
But at the futures market, they standardized the contract. So, it may not be exactly what you want, but it's
standardized. So, you deliver rice--I don't know all the details of Dojima, but I'm talking about futures
markets, as they evolve. In a modern futures market, agricultural futures market, you deliver your--the
contract is to deliver some commodity like rice at a specified future date, at a specified future warehouse,
which would be run by the exchange.
And there's inspectors at the warehouse who are expert on grain. And they verify, because they know rice.
They know it really well. And they know that some rice has bugs in it. They know how to find out. They
have a standard. Of course, there can always be some bugs in it, but they have a standard and they have a
way of measuring, and they get it right.
And so, all those contracts are exactly the same. And so, they become the price. It turns out, funny thing,
the futures market almost becomes the real market, because they're all standardized. The futures price--You
know where it's delivered. You know what's delivered, exactly. The futures market becomes the market, in
a sense. The fact that it's in the future is, in effect, a help, because since it's a comfortable time in the future,
it's well defined. Whereas the spot market--the spot market is the market for rice, or whatever it is, today as
it's traded, OK? The spot market is inscrutable. It's hard to understand.
So, let's think about a farmer today, who grows rice, or wheat, or soybeans, or something. If you drive
through farming countries, listen to the radio, regularly they'll give prices. Soybeans, wheat, rice, et cetera.
Why do they give that? Because farmers care. They're raising this stuff. It's their whole livelihood, whether
they make a profit or not, depends on it. What prices do they quote? They quote the futures prices, even
though they're in the future. But they quote them, because they mean something and they're standardized.
So, that's why the futures market becomes the central market.
I want to just say something about future--Japan started the futures markets in the 1600s, and they were the
world leader in rice futures until 1939. And then, at World War II, the Japanese government shut the
futures market down. And to this day since, there is no rice futures market in Japan. Believe it or not. The
inventors, they're talking now of starting it up again. Where do they trade rice futures? Well, its the USA is
the main market, even though you don't think of the U.S. as a market for rice. But the point is, that markets
have to be centralized. And that people want the centralized market, and if it happens to be in Chicago, so
be it. So, it becomes a huge international rice market.
Chapter 3. Rice Futures and Contango vs. Backwardation [00:23:03]
And so, I looked up--this is called Rough Rice Futures, and this is the futures curve as of last Friday
[addition: March 18, 2011]. So, what we have is different delivery months. This is May of this year. And
then, there's other delivery months, and then there's next year. It goes out about a year, different delivery
dates. And this is cents per 100 weight. 100 weight is 100 pounds of rice. And since this is USA, we mean
100 U.S. pounds of rice. But anyone in the world can figure this out and trade in this market. And it's in
dollars, because it's what we're trading in the USA. So, someone in Japan, who wants to trade in the futures
market, has to come to the USA, change their yen into dollars, and do this.
Now, you see that the futures price is going up. This was all quoted last Friday [addition: March 18, 2011],
OK? This is the market, essentially, right now. But you see, it's a futures market, because it's giving prices
of rice at dates in the future, OK? These prices way out here, next year, are not so reliable, because there's
not much trade. The trade tends to dominate at the front months. So, here's where most of the trade is.
They're trading May, and maybe this is July. I forgot exactly. Is that clear, what this means? It's going up.
And it's going up pretty fast, isn't it? From about less than 13 cents to 15 cents.
What this means is that, in effect, the market is expecting huge increases in the price of rice, all right? So,
that's interesting. Anyone who's doing business in rice looks at this and says, look, there's price increases
anticipated. Now, I just want to talk about the world at this point in history, and try to interpret this curve
right. You must have heard that there is a food shortage in the world developing. And it's a source of crisis.
It's developing in the Middle East.
One reason why that's been given for the revolutions that have happened in the Middle East are, that people
are hungry. There's dissatisfaction when the price of food goes up. A lot of people are living much more at
the margin than you'd imagine. So, this increase in rice prices matters a lot.
So, it's very interesting that it's showing this steep increase in the price of rice. But the first thing you want
to think of as a financier is how much is this going up? I didn't actually do the calculation. It goes up from
14--under 13.75 to 15.5. That's quite an increase in six months, right? So, it sounds like there's a profit
opportunity here, right? Buy rice today and sell it on the futures market. This is a good time to sell it. I'll
sell it in 2012. And that's my futures profit. I can lock in this price today, because that's what the futures
market does. The contract is a contract to deliver rice as of that future date, and this would be in Chicago,
OK? And so, I could make a profit.
This is a very professional market with real expertise. You talk to the rice traders or the wheat traders; they
know what they're doing. Believe me, they know what they're doing. We're looking at this for the first time.
People who trade this all their lives. And if you ask, why is it? Look how much it's going up, this is a big
profit opportunity. They'll tell you, why it isn't. Why it isn't such an opportunity as you think. There must
be some reason, why I can't make huge money by trading in rice, because otherwise other people would do
it. This is such a liquid market, open to everybody in the world. So, somebody's going to take advantage of
this.
You understand, this is futures prices quoted as of a single date, for various horizons in the future. Don't get
confused by it. This is not a plot through time. This is now. This is what's quoted now. And so, when you
have an upward slope in futures curve like that, we call that contango. And that is what we usually see,
maybe not upward sloping so much as this. The opposite is called backwardation, if futures prices are
declining through time. That happens, and I'll show you that in a minute. But it's not happening in rice. So,
not happening now in rice.
It must be that there's something that prevents you from just making a killing by buying rice, selling it on
the futures market. Do you understand, this is riskless? If I sign a contract to sell rice in Chicago on the
futures market, that is riskless [addition: only if I own the underlying commodity]. And so, why don't I just
do that? I think that there must be some, in some level, there must be some storage cost problem. In order
to actually do this, you'd have to buy the rice and store it for six months. And I'm thinking, that must
explain it. It must be that at this point in time, storage costs are, in some sense, too high for this to be a real
profit opportunity.
So, this is what happens now in the real world. There are people who store rice. There has to be, right? I
think, rice comes in more than one harvest, because there's different kinds, but there's no more than a few
harvests in the year. And some of them are bigger than others. And so, it's got to be stored. And this really,
really matters, because if it's not stored, some people are going to starve to death. So, it really matters.
And you have professional warehouse operators, who--they sure do know what this curve says. And they're
thinking, right now, I'm sure lots of people looked at this curve yesterday, and they thought, look at that
contango, wow. I'm going to see if I can get some other warehouse. Can I get another one? There's an
empty building on the south side of Chicago, maybe I can fill it up with rice. And so, I have to look up, and
I have to get inspections, and sanity checks--sanitation checks. And think about insurance. And they're
thinking about that. But, you know, they find out that it's not going to work, and they're trying. This
generates, when you have a lot of contango in the market, it generates enthusiastic efforts by smart people
to try to store more rice. And you see, what that's doing. It's helping prevent a famine.
And this goes back to--I know, I'm putting it in dramatic terms--but this goes back to Adam Smith, who in
his Wealth of Nations in 1776, has a famous passage, which I can't quote exactly, but it was something to
the effect that, you know, there's a lot of people who express benevolent impulses. They give to charity.
They go to church regularly, and they talk about 'love thy neighbor.' But they're not doing a single thing to
prevent the next famine. They're not thinking about it. The people who are really effective are these quiet
guys dealing in the markets. And they see a contango, and they see something coming. And so, they get in
the business of storing. And it's purely out of self interest. So, the famous quote that is quoted a million
times from Adam Smith is, these people operating in their own self interest seem to be more important in
promoting human welfare than all the benevolent people combined. I'm quoting him roughly. Well, there
has to be an element of truth to that.
You know, people who do these storages of grains do not get much respect. And at dinner conversations,
nobody cares what they do. They're really good at what they do, and they know this market. And, you
know, they're not saints, either, right? They're speculators. They're trying to make a profit.
Chapter 4. Counterparty Risk and Margin Accounts [00:31:47]
Now, one thing I wanted to say about futures also, which I didn't really clear--in forward markets, which
are markets between a pair of counterparties, there's always counterparty risk. I'll write that. That means
you've got a contract. You had a lawyer. A lawyer wrote up the terms. You can take this guy to bankruptcy
court or something, but that's all a nuisance and it costs money. You never know. Futures markets get rid of
counterparty risk, or essentially get rid of it. And how do they do that?
The system is a standardized retail market that anyone can play in, but you have to post margin--and that's
the idea, margin, when you either buy or sell futures. OK, so this is what happened. This is what a futures
contract looks like. You can do this. I don't know what would happen, if you called up a broker at your age,
but essentially you can do this. I know, Jeremy Siegel, my friend, said, he would actually lend money to
students and let them play the markets. His own money. I have never done that; so don't ask me to do that.
But you can basically call up a broker and say, I'm interested in rice futures. It sounds like fun to me. I'd
like to play that game. So, the broker would say, fine, I'll open a margin account. How much money are you
going to put in? All right. The first question is, money, OK? He doesn't know who you are, but money
talks, OK? So, you say, all right--you have to come up with some money to do this. Let's say, I'll put in
$5,000 into a futures account at your brokerage. And he would then say, OK. Now, you have $5,000. And
the margin requirement for rice futures, I don't remember what it is; say it's something like 3% or 5%. You
can buy or sell up to the limits imposed by your margin. Your margin has to be whatever percent of the
contract that you sign, OK?
You're only putting up $5,000, I'll let you buy and sell $100,000 worth of rice. So, this would happen. You
say, OK, I want to buy--what do I want? What do I want to do? I'm going to store rice, and then I want to
sell it. So, I want to sell futures. It doesn't matter, whether you buy or sell. Either way, you've got to put up
money. Lets say, I'm going to do this rice storage business. I can do it. It's open to anybody in the world. I
can find a warehouse. I can buy some rice. I can store it. And I can sell it at that price. So, I want to sell
futures, OK? I can sell $100,000, even though I've only got $5,000 put up.
But then, you know what happens. Every day, they look at the change--the futures price is the price on that
contract today, but it's not a price that you pay today. You would pay it at the end, effectively, when the
contract comes due. Or in the case of selling, you'd be receiving it. So, if I sell futures for, say, May of
2012, then I am promising to deliver rice to the warehouse in Chicago on that date in 2012, and take the
price, OK?
OK, but now, the futures price today is the price that the market has today. Tomorrow, the futures price will
be different. And so, what they have in the futures markets is daily settlement. And that means that if I sold
futures--I'm storing rice and selling futures. If the price goes down--I'm sorry, if the price goes up--it works
against me, because I've locked in the lower price. So, the broker debits my margin account by the daily,
every day they change my margin account. So, if I've sold futures and the price goes up, they take it out of
my margin account. If the price goes down, they put it into my margin account.
And I can quickly deplete my $5,000, right? The post price keeps going up. Then I say, gee, I wish I hadn't
signed that contract, because I could have waited a few days and gotten a better price. Meanwhile, the
broker calls you on the phone and says, I'm sorry, your margin account is almost depleted. Do you want to
put up more margin?
And this is where you get the reality of futures trading. Because there's no counterparty risk. That means,
that if you don't put up more margin, the broker closes you out and says, here's your money. Do you
understand how this works now? So, there's no counterparty risk, because it doesn't matter, whether you're
a drunk or a sociopath, the broker has you trading. And it doesn't matter at all what you do. Once you put
up the money, and if you just don't answer the phone--if you, say you don't answer the phone, the broker
will close you out, when the margin is depleted. So, the broker takes no risk.
The counterparty is not even given to you. You don't even know who's on the other side of that contract,
because the other side is making--you're both making a contract with the exchange. And so, you don't care
about counterparty risk, and there's no risk to this contract. That means, these prices are pure prices, and
they don't have any counterparty risk.
Chapter 5. Wheat Futures and the Fair Value Formula for Futures Pricing [00:37:50]
I wanted to show you another futures contract. This is Soft Red Winter Wheat, which is a major crop in the
U.S. Winter wheat, you plant in the fall. Believe it or not, some people are surprised to hear this. You plant
it in the fall, and then it stays in the ground over all the winter, and it comes up really early in the spring.
And then, it's harvested in early summer, OK? And the Soft Red Winter Wheat is very good for biscuits,
and cold cereal, and cakes, but not so good for bread. So, it's a particular kind of wheat that is grown.
So, this is the futures curve, as of Friday [addition: March 18, 2011], for this. And this is in cents per
bushel. So, this is the front month future, and it's--looks like it's 723 cents, $7.23 a bushel. And now, we see
this sharp contango again, and the right prices are going up really rapidly through time. Again, this is all
prices quoted last Friday. This is futures contracts and different maturities. And then, you see sometime
around summer of 2012, it loses contango, and it becomes, actually, declining. And then, this market goes
out to 2013, and stops. That's as far out as they trade futures.
So, why is it declining in 2012? Well, there's probably a million factors in it. You need to talk to a futures
expert. But I think, one thing that comes to my mind, is the harvest, right? And so, they harvest grain
sometime around that time. You know, you shouldn't be storing grain at the harvest. This contango is a
compensation for the cost of storage, right? So, you shouldn't be storing grain in the harvest time, right?
You should be clearing out your warehouses, and sweeping them out, and cleaning them up, and waiting
for the new harvest to come in. So, you don't expect contango to continue then. There's a seasonal--it's not
so clear here. It's not dropping very much. I don't know, there's many factors that determine these prices.
But I wanted to just give a little bit of simple mathematics about futures pricing. The basic formula is that--
you have to think of futures markets as storage markets. And the basic equation is, that the price of any
futures contract, p
f
, is the futures price on one of those dates, is equal to (1+r+s), times the spot price, OK?
Where the spot price, p
s
--I'll write it out, p
spot
, is the price today, OK?
Now, this is kind of theoretical, because I just told you, nobody ever knows what the price today is anyway,
because the only way you ever know prices is through futures markets. But let's just think a little bit
abstractly. Say, there's a cash market for wheat, that it's bought and sold with. And we know what the price
is on that market. So, this is the interest rate between now--it's not the annual interest rate. It's the total
interest as a percent between now and the maturity of the contract, OK? So, if it's one year and the interest
rate is 5%, then r is 0.05. But if it's one and a half years, it's going to be more like 0.075, because the total
interest between now and one and a half years in the future is 7.5%. And s is the storage cost, OK?
So, this is called fair value, and what it means is, normally you think futures prices should behave like that,
OK? So, the normal situation in futures markets is contango, which means that prices are normally going
up through time, because the longer in the future we're looking at, the longer time that we're losing interest
and storage. See what this really is, this fair value equation, is just the equation that defines, when it is that
there's just no profit to storing grain, right? There's only a normal profit, right? If people who do it--this
equation can't hold exactly. Or if it held exactly, then no one would store grain, but it has to be
approximately valuable, OK?
So, do you see? How else do I say this? It shows that normally the futures price is above the spot price.
And as time goes on--I don't mean time in this sense, I mean calendar time--the futures price will converge
on the spot price, because the interest rate, the horizon for the interest rate and the storage costs--this is in
percent, and this is in percent--goes down.
So, let me just clarify that. Let's talk about a perfect world, where there's no harvest uncertainty, nothing
happens except the crop is normally produced, OK? And it's wheat, OK? And let's say--I'm going to do a
plot. And this is time. This is calendar time, not maturity time like on this plot. And this is the price of--I'm
going to plot the price of wheat. Now, what does wheat do over the year? It has a seasonal. I'm going to do
an abstract form of seasonal. This is what the price of wheat does. And this is a year. This is year 1, this is
year 2, this is year 3, year 4, all right? This is the price of wheat in each of these years.
It falls every harvest time, right? It has to be rising until harvest, because somebody has to be storing grain,
and the price has to go up, because they're facing storage costs. And then, every spring, every harvest time,
it collapses. And it does it again every year. No uncertainty. What do futures prices do? Well, let's consider
a futures market that's--a futures contract that has a maturity right here at the peak, just before the harvest,
OK? But if there were no uncertainty, the futures price would just be constant throughout that whole time,
right? It would always equal the expected spot price on that future date.
And again, it would repeat the next year. Futures contracts have no expected price change in this perfect
world. Do you see what I'm saying? This equation always holds, because, as this contract matures, the time
to the expiration date goes down. And so, this r goes down, and s goes down. And eventually, it hits 0 on
the expiration date. And the futures price equals the spot price on the expiration date. But in reality, we
don't see such a nice and perfect match.
I want to talk about another futures market, which is maybe the most important futures market of all. I've
been talking just about agricultural futures. Agricultural futures are the origins of futures market. And I like
to talk about them, because I like to imagine--well, our ancestors all lived on farms, once in the past. And it
just seems like such a family story that we all should know about farming, right? It's our history.
Chapter 6. Oil Futures [00:47:00]
But now let's move forward into other--we can have futures markets for oil as well. So, this is last Friday's
[addition: March 18, 2011] futures curve for Light Sweet Crude Oil. This used to be at the New York
Mercantile Exchange, but the Chicago Mercantile Exchange has been buying everybody up. And now, it's
the CME. They call it the CME Group, actually, Chicago Mercantile Exchange Group. And this is the price
of oil. Look, what's happening here. Isn't this something, this curve?
The price of oil as of last Friday, on the nearest month future, was selling at $101 a barrel. It's gone up a lot.
This is part of the crisis now around the world. People need food and they need oil. Incidentally, the two
markets are related, because we can turn fuel--we can create fuel from food by using grains to produce
ethanol, and that substitutes for oil. So, it's not independent. These two markets are not independent.
Now, oil is so important. It's the energy that drives the world economy. And any events, like the recent
earthquake in Japan and the nuclear disaster in Japan, it affects this market. Everyone's thinking, what does
it mean for oil? Maybe, we won't have so many nuclear plants anymore, so that's going to mean, oil's going
to go up. People are thinking. The other thing that's happening is, at this point in history, there's a crisis in
the Middle East, and it's cutting off the flow of oil. So, people are trying to predict it, and those predictions
come into this market.
So, here's what we see. We see right now, the market is predicting increases of oil until December, and
then, a collapse of oil prices, bottoming out in January of 2015. This market goes all the way out to almost
2020. That's a long time. That's because it's such an important commodity. So, this futures curve matters
for--the total value of oil in the ground in the world is probably over $100 trillion. It's bigger than the GDP
of just about any country. It's huge and important. And people who are thinking of extracting their oil,
they're looking at--everyone's looking at this curve.
So, why does it peak in December 2011, and then collapse? I'm guessing that has something to do with the
crisis in the Middle East, that the people who trade in these markets are thinking, that the crisis will be over
by then and prices will start coming down. So, we're seeing contango here, and backwardation here. I'm
using a simple definition of contango and backwardation. There's more subtle definitions, but we'll keep it
simple. We're seeing an increase, expected in oil prices, and then it decreases. And then, it has it going up
again.
Is this right? Well, if it isn't right, there's a profit opportunity for you. If you know better, you can get in and
you can do it with, I think, all you need is something like $5,000. I'm not trying to entice you to trade this,
but I'm just trying to give the idea of what these markets really mean.
That the oil, it means survival for people. I mean, oil and food are what keeps people going and alive. And
there's not enough. There's not enough for everybody. And so, this market is all about extracting oil at a
good rate, thinking about when to sell it, so that it, ultimately, I think, serves the purpose of humanity.
Now, incidentally, what's happening here? When you see the curve falling, how can that be? I just wrote
this equation here, saying that p

So, the futures price has to be greater than the spot price. I just wrote that, right?
But you can see that this futures price, this is essentially the spot price. This is the front month future, it's
about to expire, so it's converging. And this is what we call the price of oil. When you hear oil prices
quoted on TV or in magazines, they're quoting the front month futures. Let me be clear about that. Oil is
mostly sold on long-term contracts.
So, just like our rice merchant, buyers of oil are typically--who buys crude oil? It's some refinery. They've
got a big operation and they refine oil. And they care about, what kind of oil do I get? And when is it going
to be delivered? And what are you going to do for me, if it's not delivered on time? They have complicated
delivery contracts. Almost all oil is sold through that. So, what is the price of oil? You can't figure it out.
There's just too many contracts and they're all different.
There is a spot market for oil, but that's just overflow. You know what happens? There'll be some mistake.
Someone delivered too much oil to the New Haven harbor, or someone reneged on a contract, now I've got
this extra oil. It goes on to the spot market, but that market is tiny and is not reliable. You don't know what
kind of oil it was, you know, it's all different--what the issues are. So, when you hear oil prices, you're
hearing futures prices.
So what's happening? How can it be that the futures price in 2015 is lower than the price today? Well, there
is something funny going on. I'll tell you one thing that it does mean to me, is that nobody is planning to
store oil between now and 2015, at least not as a storage business. Because I'm going to lose money, right?
I'm going to be selling at less, unless I have negative storage costs, OK? I'm not going to store oil between
now and then. I'll store it for now. So, that means that people are kind of trying to store a lot of it now,
because the contango is there, but it's going to end in December, and then they're going to empty their
storage tanks. That must be what storers are thinking.
So, this thing doesn't always hold. This only holds when there's commodity in storage. Or you could say,
well, it still holds even when you have backwardation, because, in some sense, storage costs can get
negative, OK? And so let me just talk about, there's a term that they use called convenience yield. When the
futures curve is in backwardation, somebody is still going to be storing oil, right? So, suppose I have a
factory, and my factory depends on oil, because I use it to burn, to produce whatever we make. Am I going
to let my warehouse, my storage tank of oil go dry? No, I'm going to need some, just because we might
need more than we think. We might have a buffer stock. So, that means, I actually have negative storage
costs. I always want oil. I don't want ever to let my tanks go dry.
So, the only people who are storing oil, when you have a backwardated futures market, are the people who
want convenience yield. Now, I'm omitting some subtleties here. I'm sorry, but I'm trying to make the basic
point, that this equation holds when the commodity underlying is in storage. But it doesn't always hold.
Chapter 7. The History of the Oil Market [00:55:04]
So, now I wanted to talk about oil a little bit more, because it's so important. I have here the price of oil. I
like history. I like to give you long history. I wanted to give you the price of oil back to 1871. And this is,
well, U.S. oil price in U.S. dollars. But I've corrected for inflation, so it's real oil prices from 1871 until just
a short while ago, last week [addition: data ends on March 18, 2011]. And now, in recent years this is the
front month oil contract. The oil futures market started in the 1970s, so this is all the front month futures
contract. Before that, this is someone's guess as to what the price of oil was, because there weren't such
well-developed markets. We didn't have oil futures until the 1970s.
So, I wanted to think about what was happening at these various dates. These early swings in the 1870s
were due to discoveries of oil, and discoveries of uses for oil. Pennsylvania oil was discovered somewhere
around this time [around 1860] in the United States. Texas oil was discovered somewhere around this time
[around 1900] in the United States. Our economy wasn't so dependent on petroleum. Actually, if you look
up ''oil'' on ProQuest, back in 1870 they didn't even call it oil. They called it petroleum, because what was
oil? What did they think oil was in 1870? Whale oil, OK. It was different, different world.
So, we see a lot of jumping around of oil prices. But we see a big surge going into the 1890s. And there
was a big scandal about Standard Oil. Remember that? And the government eventually busted up Standard
Oil as a monopoly. So, they were starting to get concerned about oil.
But then, if you go forward in time, you see this interesting pattern here. What was going on here? The
price of oil became very stable, until, bang, there was this huge upswing in oil. Well, what was happening
in this interval of time? In the '40s to 60's, the U.S. was a big producer of oil. It kind of got started here, oil
production, with Drake's invention of the oil rig. And the U.S. was the biggest producer of oil. And during
this period, when you see oil prices were very stable, the oil prices were actually stabilized by the--it was
produced mostly in Texas--Texas Railroad Commission. It says railroad, but it was a government agency in
the state of Texas, which worked to stabilize oil prices. But during this period of time, the U.S. was
depleting its oil, and other oil discoveries were coming in.
And so, this whole period--this is before there were any futures markets, because there was no reason for a
futures market. Oil prices were very stable. And then, you see, here, a sudden jump up in oil prices. And
this point right here is called the first oil crisis. So, the first oil crisis, it kind of stands out on a diagram,
right? Looking at the whole history, if you exclude those early fluctuations in oil that you see in the 1870s,
which were not really so important, because people werent really so dependent on oil. So, the first oil
crisis was 1973, '74. And this prompted the creation of the futures market [in 1978]. Because what
happened was--it was actually coincided with the Yom Kippur War in Israel. And it was created by a
blockade against oil in oil-producing countries.
The U.S. was no longer, by this time, the major producer of oil. We had something called OPEC, which is
the Organization of Petroleum Exporting Countries. It actually goes back to 1961 with Qatar. 1962, Libya,
Indonesia. And then, we added the Abu Dhabi in '67, the United Arab Emirates, '74, Algeria in 1969,
Nigeria in 1971, Ecuador in 1973, Gabon in 1975. So what happened was, although the U.S. broke the
Standard Oil monopoly around the turn of the century, a new monopoly developed, and it was outside the
U.S. And so, there was no trustbusters to break this monopoly.
And so, what happened was, the oil exporting countries who belonged to OPEC, who wanted to use oil
prices as a strategy to deal with Israel, they restricted their supply of oil. And it caused the first oil crisis
right here.
I was going to mention another historical fact that, I think, precedes this, but it's part of the story. And that
is nationalizations of oil. It used to be that big oil companies went around the world and found oil deposits.
And then, they would buy the land, and they wouldn't tell anybody what they were doing. They'd buy the
land that had the oil under it. So, the oil companies were very rich. But there was discontent in the less
developed countries, who sold them the land and thought, why did we get gypped like that?
And so, they started a process. It started with Mexico in 1938. So, oil used to be owned by the oil
companies. Mexico said, no, not any longer. It's our national heritage. We never should have sold it to you.
We're just taking it back. This was considered outrageous at the time. No country should violate property
rights like that. But it was kind of a leftist--the word nationalization was a new word. It was kind of like the
people expressing their heritage. It started to take. Then, Iran in 1951. And then, other countries followed.
So, oil got taken away from international companies and put under government control of less developed
countries. And then, there was a monopoly called OPEC, and that produced this crisis right here.
There was a second oil crisis in 1979-80. And this one, again, was associated with trouble in the Middle
East. So, in '79, 80, we had the Iranian revolution, which again disrupted oil supply. So, 1979, 80 is the
second oil crisis. And that is due to the fall of the Shah of Iran, and the arrival of the Ayatollah Khomeini,
and the Iran-Iraq War. And so, you can see the huge increase in oil prices.
These were real panic situations at the time, because people were not used to these--people were used to the
stable oil prices, and it was just something taken for granted. But this put the world in a state of shock,
because oil price really jumped up almost sixfold, about sixfold, in a matter of--how many years is that?--
six, seven years. So, this left a lot of interest and enthusiasm for oil futures, and it became a major market
of the kind we know about today.
You know, what happened here? This mark. This is another--this is the second Iraq War, when Saddam
Hussein was overthrown [in 2003]. And U.S. and other countries were involved in that. But what it did is, it
cut off the supply of oil briefly, because the Persian Gulf was shut down because of a war. You can bet that
the futures market was heavily backwardated right then, for oil. Because everyone knew that the oil prices
were not--we weren't running out of oil, we couldn't get at it because of the war. And so, this was another
oil-induced spike.
Every one of these spikes produced a major worldwide recession, because the world wasn't ready for these
spikes enough. So, we see this huge spike in oil in '73, and a worldwide recession. Again, another
worldwide recession [after 1979-80]. This one was called The Great Recession, people forgot that they
called it that, and they use that term again more recently. And then there was another worldwide recession
[in 1990-91]--every one of these did it. And so, you can see the fundamental importance of oil, and of oil
futures, because oil futures is managing the risk.
If you bought an oil futures contract, you weren't impacted by this. If you bought a contract just before this,
then the oil crisis doesn't mean anything to me. It's not my problem, because I've already locked in my
price. And it's really safe, because the way the futures markets work, they've got this daily settlement
process. So, you don't have to worry about your counterparty reneging. It's very civilized. It's a tough world
out there, where they're fighting wars, but in Chicago, where the futures markets are--or it was in New
York back then--it's a very civilized market.
And so, look here, we have the latest spike. It's even bigger. So, oil got to--I can't even reach up there--oil
got up to over $140 a barrel in 2008. That's just a short time ago. Now, what did that? That is kind of a
puzzle. It has something to do with the world financial crisis. But it's not as well understood as a reaction to
any military situation. So, it seems like there's some speculative element that took place. See ultimately, oil
is stored in the ground, and it's owned by people, and they have to decide how to develop it and how fast to
produce it and sell it. And there were some quick changes of thinking around then, that surprised everyone,
I think.
And oil is, again, up above $100 a barrel right now. Just we saw in the futures curve. So, actually the
futures curve that we saw would look kind of unimpressive on this diagram, right? It would be just going
up a little more and a little down, not big swings that are predicted.
Chapter 8. Financial Futures and the Difficulty of Forecasting [01:08:16]
I just want to finally conclude with financial futures, which I didn't emphasize in this lecture. But we also
have futures markets in financial commodities, and I'm just going to tell you about one of them. It's called
the S&P 500 futures market, index futures.
And now, in effect, you have to deliver not oil, or rice, or wheat, but you have to deliver the S&P 500
index. How do you do that, by the way? How do I deliver 500 stocks? Well, there's a procedure, and it's
called cash settlement. It's different. Instead of showing up at a warehouse with your trucks full of wheat,
you only show up with the money, because they don't expect you to do that with stocks.
What is the storage cost for stocks? Well, you know, it's actually negative. It doesn't cost me anything to
buy. If I buy a share in a company and store it, it doesn't cost--it's a negative cost, because they pay a
dividend. So, the fair value, and this is what you'll see quoted all the time on CNBC, or any of these
business, Bloomberg, these business networks is: p

Same formula. This is the interest rate. And this is the dividend yield. So now, whether the futures price is
above or below the spot price, is less clear here, because it depends on whether the interest rate is higher
than the dividend rate or lower. At this point in history, for short time horizons, the interest rate is less than
the dividend rate. We have about a 2% dividend yield on stocks, and we have essentially a 0% interest rate.
So, for short horizons, we'd expect to see the futures price less than the spot price in stock index futures.
But at longer horizons, I think that would be reversed. But this market is very clear. The fair value
relationship is highly predictive of futures prices in the S&P 500 index futures, because there's always
storage of stocks. We never deplete the warehouses of stocks, so they're always there. And so, that means
that the futures curve is less interesting for stocks than it is for oil. All it does is reflect fair value. And so,
it's not like oil, where the storage situation is very complicated, and it's constantly changing. So in a sense,
the S&P 500 index futures is not so much about the future. The futures curve is not so much about the
future of the stock market.
So, don't make the mistake of looking at the futures curve for the S&P 500, and thinking I'm going to
forecast the market using this curve. You can't. Basically, the S&P 500 is very hard to forecast. And the
futures curve doesn't do you anything, because all it reflects is fair value. So, some futures markets, like
gold futures is like this also, there's always gold in storage, it never gets depleted to zero. It's always being
stored, so the gold futures curve is not so interesting, either.
Next, after the midterm exam, which you have coming up on Wednesday, we will come to options pricing.
And that's another fascinating market that we'll talk about.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 16 - Guest Speaker Laura Cha [March 28, 2011]
Chapter 1. The Private and the Public Sector of Financial Markets [00:00:00]
Professor Robert Shiller: OK. Oh, there, OK. Hi, Laura, do you see me?
Laura Cha: Hi. Hello. Finally. Finally.
Professor Robert Shiller: Thank you for--thank you for staying up late to talk to us, I know it's 9 pm now,
in Hong Kong.
Laura Cha: Right, yes.
Professor Robert Shiller: So are we on, is that--
[SIDE CONVERSATION]
Professor Robert Shiller: OK. All right, I'm very pleased to have today Laura Cha, who is connected to us
electronically, live from Hong Kong. It's 9 pm in Hong Kong. Well, we've already talked about Laura, she's
one of the most distinguished executives in Asia. She is on the Executive Council of Hong Kong. She's a
director at HSBC, she's served on the China Securities Regulatory Commission, and recently at the
National People's Congress of China, which is a remarkable set of achievements for someone, for any one
person. And I understand, the first Hong Kong citizen to serve in the government of the People's Republic.
But I guess, the really big thing that comes to my mind is, that HSBC is one of the most important and
biggest banks in the world. And I looked it up and I found that five branch offices of HSBC are within a
few miles of right here.
Anyway, Laura--I'm looking at you there--why don't you, you could introduce yourself, talk about what
you do, and what your thoughts are about the financial situation are and then we will turn it over to
questions.
Laura Cha: OK. First of all, good morning to you all. Thank you, Bob, for inviting me here, via
electronically. It is my honor too have the opportunity to talk to you. When I was invited to give this talk, I
went on the internet and see that your course's syllabus is very comprehensive, and I would imagine that at
the end of the course you would have covered or will cover just about every aspect of the financial markets.
And you will have a good idea of the function of the markets and how it works.
What I want to do in the next 20 minutes or so, is really to give you an overview of what it is like to work
in the financial markets, to have a job in the financial market, and perhaps, eventually, you may want to
have a career in financial services. And then, after that I would be happy to answer any questions that Bob,
you, or anyone of you want to raise with me. I think, when one talk about a career or job in the financial
services, one tends to think about the private sector. The banks, the investment banks, the fund
management companies, and, of course, the trading, the traders, both in terms of stocks, futures, options. Of
course, in the last decade, hedge funds, private equity.
There's no question that the private sector is very exciting. There's no question that a job or career in
financial services in the private sector is, by the most of any standard, is very financially rewarding. But
what I really want to talk to you about, is the other side of the financial markets, which is the public sector
side, and I want to share with you my own experience in the public sector. When one talks about financial
services, as I mentioned, we talk about the banks--the intermediaries, what we call the intermediaries--the
practitioners, people who practice in the financial market. If you are a college graduate, typically, if you go
to one of these firms, you start out as a research assistant. You do research. If you are in a bank you will
learn to read, how to interpret balance sheets. How to decide, when people come to you for loans, how you
evaluate them, and what is the creditworthiness of the potential client, whether you should or should not
lend money.
If you go to work for a private equity firm, you do the same kind of research, except that it's for companies.
You will help the firm decide whether a particular transaction is worthy to take on. And in between, of
course, there are all kinds of financial mechanisms, or tools, products, as one would say, that you devise,
that the markets devise to facilitate these financial services. And those have been covered in your course, I
can see that.
But, as I mentioned, the other side of the financial service, the other side of the financial market, is really
the regulators. The public sector side, the policy makers, the standard-setters, bodies such as the Financial
Accounting Standards Board. And all of these are the other part of the equation, which help to make the
financial market function well. And it is important for the public sector to have equally bright students. I
think, some of us get a little worried. In the last decade, a lot of the bright students, who want to go into
financial services, all go into the private sector.
The public sector is important, because the regulators and policy setters help ensure that the market
function in an orderly fashion. We want to make clear as regulators and policy setters, we want to make
sure that the market not only functions properly, that the playing field is level, that the rules are clear, so
that financial service, and finance, can indeed perform its function in society. And that's where, in the U.S.,
when we have the SEC, the CFTC, the Fed, and of course the exchanges, and, not to mention, the
Department of Justice, the State Attorney General's Office, et cetera, et cetera.
What the public sector do, is really to make sure that people on the private sector, in the banks, in the
investment banks, in the fund management, and so on, they behave properly, so that the investors are
treated fairly and equally. So that everyone is entitled or given in the same kind of information, so that no
one particular group has an advantage over the other group. And that's where investor protection comes in,
corporate governance comes in.
Chapter 2. China's Public Sector and Opportunities in Other Emerging Markets [00:07:20]
And I myself, my career has largely been in the public sector side. Although I started out as a lawyer, I was
trained as a lawyer and I practiced as a lawyer for seven, eight years in Foreign Direct Investment into
China in the '80s. And I dealt with a lot of multinationals on the corporate side, in the finance side.
My foray into the public sector as a regulator came out of the blue. I was headhunted to join the newly
founded Securities and Futures Commission in Hong Kong. That was 1990. And I thought, I will do it for a
couple years, learn to broaden my horizon, and see what it is like to be in the public sector. And I enjoyed
what I did, and I stayed 10 years. And then, I was made an offer by the central government, and I went to
work for the Chinese regulator for almost four years, and became the first person outside of Mainland
China to join the Chinese government.
So, I had a total 14 years of experience as a regulator. And I have to say that it has been hugely gratifying,
because as a regulator and a policy setter I was able to facilitate the development of markets in Hong Kong.
In the early days, Hong Kong was a--in the early days, I mean in the '70s and the '80s--Hong Kong was
largely local market. The international players like Goldman Sachs and Morgan Stanley, they came and
they went, they took a look and decided the Hong Kong market was too small for them. All that took a
change in 1992, when the Chinese government decided that they want to use the Hong Kong market as a
way to help transform or reform the state-owned enterprises.
And by that time, I was already at the Securities and Futures Commission in Hong Kong and because of my
experience working in the Chinese market in the '80s, I became the only person who was the familiar
enough with the Chinese market to take on that responsibility of really designing a structure for state-
owned enterprises in China to become listed companies in Hong Kong. And it was groundbreaking work.
At the time, we knew that it was very important. We didn't know how important it would become later on.
Some 20 years later, the Hong Kong market now is a totally international market. All the big players are
here, and more than half of our market capitalization came from Chinese enterprises. More than half of the
turnover on our stock exchange are from Chinese related companies, Chinese companies directly or what
we call ''red chips.'' So, the coming of the Chinese enterprises to Hong Kong really transformed not only to
state-owned enterprises in China, but also the nature and stature of the Hong Kong market.
I think today most people will recognize that Hong Kong is an important financial center. And I would say
that, without the Chinese enterprises, we would still have been a very local market, because our economy
itself, Hong Kong's economy, has not been that big. It really is what had happened in China that has
propelled our change. And as a regulator, I was fortunate to have that opportunity and to help structure the
market and spearhead changes.
The other thing that I did as a regulator in Hong Kong was, in the late '90s, '98, '99, and 2000, there was a
wave of demutualization of stock exchanges throughout the world. And I helped demutualize the stock and
futures exchange in Hong Kong, merged them together, together with our clearinghouse, and we became--
the Stock Exchange of Hong Kong became a listed company. Today, as an exchange, it has the largest
market cap in the world, more than the New York Stock Exchange and the London Stock Exchange. And
when I went to China, the market was in the nascent state, bearing in mind that it was a socialist,
communist-socialist, country. Capitalism was the new thing and stock market was an even newer thing in
1991.
So, I kind of witnessed, and then later on was fortunate enough, when I went to work in the Chinese
government, to participate in that grow of the Chinese market. And what I did in my almost four years as a
Chinese regulator was to promote corporate governance. I introduced quarterly reporting, the requirement
of independence of executive directors, and it was exciting times.
What I want to say, really, is the public sector work that would--at least for me, I felt that I was making a
difference. I was able to help the market change, and if things were not right, I felt that I had the ability to
make things right, to make things correct. Not always successful, I have to say.
But what I want to really impress upon you all is that, while the private sector work in the financial services
is extremely financially rewarding, in the public sector it's less so, but on a different level, I think the
policymakers do perform a social good. And the good thing about the United States is, there is a lot of
interchange between the public and private sectors. People do move from the private sector to the public
sector, and back again. I think that's what make the U.S. market vibrant, among other things. And I think, it
is a tradition that many other countries and jurisdictions want to emulate. Namely, the people, who have
been in the private sector, who has the market experience needed in the public sector. In other words, you
cannot have regulators, who have very little knowledge of how the market works. At the same time, those
people, who have been in the public sector, have kind of instilled on them the discipline of an orderly
market, doing the right thing for the market. And that, when you have it transplanted or being brought back
into the private sector, it is also a good thing for the, and healthy, for the market as well.
The other thing that I want to really talk about, other than the public sector work, and as a career choice or
a job choice in the financial services, is really the globalized nature of the markets these days. I think, in my
days, when I was going to college and law school in the United States, the U.S. was, and I don't mean to
say that it is no longer, everybody looked to the U.S. to be the center of the world. Particularly in financial
services, everything happened in the U.S., and to a large extent it still does, but I think the world outside the
U.S. has undergone a lot of changes.
A globalized market means, that today young people will find equally interesting and exciting work
opportunity in financial services outside of the United States. I think in my days, in the '80s, certainly
people, when they say they want to work outside the U.S., it would be in a mature market like Europe, the
U.K. or Japan. I think, increasingly more so in the last decade, opportunities in Asia and Latin America in
financial services have become very exciting for young graduates anywhere. And I would say, if you are
equipped as a young graduate and you wanted a career in financial services, I think you should not rule out
the possibility of working in a foreign country, in the emerging market in particular. I think, in an emerging
market you will learn, in a way, faster, because you would be given more opportunities, more
responsibility, at an early age. Your learning curve will be steeper.
And it is also interesting, as well as frustrating, I have to say, working in a developing market. There are
things that you think that you can do, and then, there are things, that the rules are not as clear, and the
environment and the people around you are not as sophisticated or educated as you are. But I think, in
today's world, the globalized market means that the opportunities are everywhere, and I think particularly
the emerging markets will offer a lot of opportunities.
Chapter 3. Motivations to Work in the Public Sector [00:17:50]
Bob, I don't know whether this is enough as an introduction for us to carry on discussion, or how do you
think about that?
Professor Robert Shiller: Yes, very good. I'll turn and face the class. I can't see you very well, but I
thought it was very interesting hearing your comments. What particularly struck me was your emphasis on
the public sector and about regulators. And it reminds me--I visited the SEC once, recently, in the U.S., and
I had lunch with people there, in Washington. And I found that a lot of them had worked in the private
sector in the past, and I was starting to wonder they must've taken a big pay cut. Why are you here at the
SEC? It crossed my mind, maybe they're losers, maybe they didn't make it in Wall Street, they can't--but
when I talked with them, I got a different idea. Maybe they're here, because they find all aspects of finance
exciting, and maybe the purpose of life isn't to make a huge amount of money.
So, I wonder if you agree with my assessment. I mean, why do people work in the public sector anyway, if
pay is lower? And that's a very open and big question, maybe you have a response to that.
Laura Cha: I think, there are a couple of reasons for that. I think, one, that a career in public sector need
not be permanent. You can work in the public sector for a number of years, and then go out into the private
sectors. And your public sector experience is hugely marketable, if we could use that term. I know that,
particularly in the U.S., if you had experience with the CFTC and the SEC or the Fed you are very--I mean,
provided that you're not really just in the technical aspect and you are in the broad policy aspect. I think that
you have a very marketable skill that people in the private sector don't necessarily have. If you change job
in the private sector, one bank and another, one private equity and another hedge fund, they will be more or
less the same, but I think in the public sector that's where the difference is. That's one.
The practical aspect is, of course, it is more steady work. The financial--how should I say? Yes, the
financial reward is huge in the private sector but also it is subject to a cyclical--when the market is down,
there are massive layoffs. And the public sector is a little more steady. So, I think it could be a different
phase in one's career. A certain phase you might want to have a more steady--or you want to accumulate
enough experience before you go out into the private sector, or vice versa. And I have seen, among my
friends, among the regulators, some people felt that they have made enough money, enough is a relative
term, they make enough in the private sector and they want to go in the public sector for a few years. I
think that's also one of the reasons.
Professor Robert Shiller: Listening to what you said, it seems to me, in some sense, working in the public
sector is an opportunity but also maybe a mission. When I'm thinking of what you helped achieve for
China, I think it's a really important mission in that you are getting the financial markets working right.
And the things you talked about, like independent directors on Chinese companies, is a way of combating
the problem of corruption--you didn't use the word corruption, or maybe that's too strong of a word. But
when things aren't up an up. And I thought that part of the motivation that maybe--I'm sure you have, and
maybe you can confirm this, it's just a sense of being part of history and part of making things right.
Laura Cha: Yes. I think, absolutely. When I became a regulator, I thought it was just going to be two,
three years. I was going to broaden my horizon, and it would help my career in the law, and then just one
thing led to the other, and I found that it was extremely--how should I say? It was very gratifying for me to
be in a position, where I feel that I was really participating in the development of a market. I'm sure,
colleagues in the SEC and CFTC feel the same way in a different manner, because obviously the U.S.
market is at a different stage. And even among the regulators, there are the people, who are in enforcement,
where they try to catch the bad guys, the insider dealing cases that we see nowadays. Those on the
enforcement--and of course the Department of Justice, the State Attorney General's Office--those people
also feel that there is a mission.
I think that's also a very important aspect of financial market. I just don't want young people nowadays to
think of financial services purely in the private sector.
Chapter 4. The Interplay between the Western Business World and Emerging Markets [00:23:26]
Professor Robert Shiller: Another of our outside speakers in this course this semester was Hank
Greenberg, who actually succeeded C.V. Starr as the founder of what was then the world's biggest
insurance company AIG. And one of the things that he told us was, how did AIG get so successful? Part of
it was because it embraced the emerging world, even when it wasn't popular to do so. AIG was founded in--
I think it was Beijing or Shanghai maybe, a long time ago. And I thought that maybe he and you have a
similar--it seems like the emerging world is obviously more and more a part of our economy and will
continue to be. And that business being connected--we are getting more and more international, as you
were saying. It kind of makes for a different life. One thing that AIG--and Hank Greenberg emphasized to
us is, that he has a life of diplomacy in some sense. He became a diplomat, or like an ambassador from the
business community, because to work with all these different countries requires a certain sense of mission
and purpose and skills. And I don't know if this is a well-framed question, but it seems like what you were
saying implies an interesting career, involving in the emerging world and a career that involves a broad
scope of skills, not just narrow finance skills. Does that prompt you?
Laura Cha: Yes. I very much agree with Hank Greenberg's view. I think, when you work in an emerging
market or you work in emerging markets, you develop a different set of skills. And I think, in today's
globalized world there are more and more multicultural, global professionals. I think, we're talking about
20, 30 years ago, U.S. expatriates, for that matter, any other expatriates from the U.K., for example, go out
to the emerging market. And people kind of use it as a stint, you work for five, six years, and you go back
to your homeland, and your roots will be in your homeland. Which is perfectly fine. And that's what most
people do.
But I think in the last decade, I have seen and I have come across more and more young professionals who-
-because of the education, because of the background what I would call global professionals. They're
multicultural, many of them are multilingual, and they will move job to job in the overseas market. And
people look upon it as life's adventure. You live in a country for five, six years, and then you move on, and
the skills that you acquire along the way really enrich yourself. Enrich oneself, and eventually, if you do go
back or not go back to your homeland, it is some skill that will stay with you and change your perspective.
And I think that kind of skill becoming increasingly important, when we have more and more cross-border
transactions, and globalized markets, where, when something happens in one market, it has an effect way
beyond the borders. And that's what we're seeing more and more nowadays.
Chapter 5. A Brief History of the Hong Kong Shanghai Banking Corporation (HSBC) [00:27:22]
Professor Robert Shiller: I was going to ask the class for questions. While you're thinking for a moment,
let me ask one more question of you.
Laura Cha: Sure.
Professor Robert Shiller: I just wondered about HSBC, which is another bank, like AIG, it originated in
Hong Kong and Shanghai, but it has become such a world force. And I kind of wondered, when did that
happen, how did that happen? Can you give us a nutshell, because it doesn't happen to every Asian bank.
Laura Cha: HSBC started in Hong Kong in 1865, and within a few months the Shanghai branch was set
up the same year. So, we've been here 160 years or so. Originally it was trading--dealing with trade finance
and so on. And it became the largest bank in Hong Kong over many decades. And the international push
really started in the early '90s, when HSBC started acquiring different banks. It acquired the Marine
Midland Bank in the U.S., and it acquired the Midland Bank in the U.K. And from a bank, from a financial
institution, which was largely local in Hong Kong with businesses in Asia, it became an international
organization by acquisition. So, the head office moved from Hong Kong to London, I think, around '92, '93,
when HSBC acquired the Midland Bank in the U.K., and the Bank of England required the HSBC to have
the domicile in London to be regulated by the Bank of England.
Since the '90s, the HSBC had acquired one of the largest banks in France called CCF, it's now called HSBC
France. It has acquired Bank of Bermuda in Bermuda, and it has made a lot of acquisitions. Of course, the
most famous, or infamous, acquisition in the U.S. was Household Finance about 10 years--less than 10
years ago. So, HSBC became an international financial institution really in the last, I would say, 15 to 20
years.
Now, today, 1/3 of our profit comes from Hong Kong, 1/3 comes from the rest of Asia, 25% or so from
U.K. and Europe, the U.S. about 6% and Latin America is about 9% roughly. So, Asia is a hugely
important market for HSBC, and the acronym is Hong Kong and Shanghai Banking Corporation, which
was the original name when we were set up in 1865.
So, we do not have a controlling shareholder, we are truly diversified in our shareholder base. A larger
shareholder holds no more than 3% to 4%. It's an institutional investor, so they represent many smaller
investors. So, it is really run by the management, professional management, and it has done a, I would have
to say, a very good job in the last two decades.
Chapter 6. The Role and the Enforcement of Regulation in China [00:31:19]
Professor Robert Shiller: OK, any other--
Student: Hi, thank you for coming. I was just curious, a lot of people have mentioned that the lack of
regulation and enforcement of contracts is a main barrier to foreign investment in Asian bond markets.
How do you think China will address this, and what are the primary differences in the regulation between
China and the United States?
Laura Cha: Can you say your question again? I didn't catch it. I only hear regulation, can you tell me your
question again?
Student: Yes. Many people have mentioned that the lack of regulation and enforcement of contracts is a
main barrier to foreign investment in Asian bond markets. How do you think China will address this?
Laura Cha: How do I think what?
Student: How will China address this issue? The lack of regulation.
Laura Cha: Right, I think China does not have a lack of regulation. There are lots of regulations in China.
What I would say is, that there has to be better application and enforcement of regulations, rather than
periodic and not consistent regulation. I think one of the most important things for the market in terms of
regulation is, that they have to be clear, they have to be consistently applied, and they have to be fair. It is
not a lack of regulation that is the major problem. I think, as in many emerging markets, China is still trying
to cope with the issue of stringent enforcement. And I think, the regulators in China recognize that there is
a lot that they need to do better in terms of enforcement. And the problem that I see in China is, that it is
developing so fast, the market is way ahead, developing faster and quicker and bigger than the government
and the regulator have anticipated.
If we put ourselves back in the U.S in, let's say the crash of the late '20s, and when the SEC was set up in
1934, I would say, China is probably slightly better than the U.S. in those days. But if we compare with the
development of the U.S. market in the last five decades or so, of course, the U.S. has developed a lot more,
and China does not have the luxury to wait 50 years for its rules and enforcement culture to develop. And it
is catching up. Whether the lack of regulation is therefore an impediment to foreign investment, I think
you'll have to look at it from several angles. China to date is the largest recipient of foreign direct
investments, so, in a way, if the conditions in China are so bad, it would not have attracted so much foreign
direct investment. I'm not saying that the environment in China is really top notch, compared with the
developed markets, but there are probably enough opportunities, and people do make enough money, so
that it is by statistics the largest recipient of foreign direct investment. And that is a fact compiled by
international agencies.
So, I don't think that it has been an impediment, it is an impediment when we talk about individual cases, it
is far from satisfactory.
Professor Robert Shiller: Can I just interject a question there? Some people say that the SEC in the
United States could use much more resources. Does China give enough resources to enforcement? It seems
to me that there is a problem in emerging countries, everywhere, that it's expensive. And the country has a
budget, right, which is still attracted to other things. So, do you think that China devotes enough resources
to enforcement?
Laura Cha: I think that every regulator would tell you, that they need more resources as far as
enforcement is concerned. I think China could certainly do with more. I think one aspect is that you have to
have enough people to carry out enforcement. And it is trying to catch up. And, as I said, because the
market is developing so fast, that the regulators are always trying to play catch up, and that is not ideal. I
think the SEC could do with more resources, I would absolutely agree with that. Any regulators you go to,
they always felt that the under-resourced aspect is the enforcement.
Chapter 7. State-Owned Enterprises and Support for Start-Up Companies in China [00:36:40]
Professor Robert Shiller: Other questions? Right here.
Student: I was wondering, if you think that there are any impediments to development in the Chinese or
Hong Kong markets based on the government of China. You mentioned earlier that there was a communist
tradition--that a lot of the businesses that you worked with were state-oriented or state-owned. So, I was
wondering, if you think that that will have to change in the future, or if the market will change or in some
way adapt to allow those to continue to operate as they do now?
Laura Cha: Do you mean the state-owned enterprises? When you say impediment, what you mean by
that?
Student: You mentioned that there was a tradition of communism and state-owned enterprises, that a lot of
the businesses were a little bit wary of a capitalist system, and that you played a pivotal role in introducing
that idea and really implementing it. Do you think that type of change will continue?
Laura Cha: Very much so. I think capitalism has taken deep root in China already. If you go to China
nowadays, the state-owned enterprises very much operate as any other enterprises. The difference is that
the controlling shareholder is the state, is some sort of government entity. But it operates, if you look at
some of the larger state-owned enterprises, like China Mobile, Petrol China, China Telecom--they are still
state-owned enterprises, no question, because their majority shareholder, their controlling shareholder, is
the state, but it operates in a commercial way. Of course, some people would say that there are policy
preferences, advantages, to being state-owned enterprises. But I think, by and large, now the state-owned
enterprises, particularly those that are listed on the exchange and some of those are listed in the U.S. market
as well, they do have to operate in a completely commercial manner. They have shareholders to answer to
other than the state. They have minority shareholders, who are public shareholders, and I think that's where
the discipline comes in, the market discipline comes in. So, when you say, whether any change will take
place, change has already taken place and will continue to take place.
Professor Robert Shiller: Is there another--Let me just add something. It occurs to me that, at least in the
U.S., there has been a policy going back to the 1930s of trying to encourage little, start-up companies. We
created the Small Business Administration, which subsidizes--the idea has been that big things grow out of
small beginnings. I wonder if you could comment on China. Does China support young start-ups
adequately?
Laura Cha: It does. It has been now two years, since the Growth Enterprise Board has been set up in the
Shenzhen Stock Exchange, what we call the ''gem board.'' And it has lower listing criteria, and that is more
or less a ''buyers beware'' market. I mean, it is like any other ''buyers beware'' market, it is fraught with a
number of high profile, high PE companies, which may or may not develop into something more concrete.
But I think the idea is to use the capital market to nurture the small business, that's the growth enterprise
market. Shenzhen Stock Exchange, which is across the border from Hong Kong, also have a--part of it's
board is called Small-Medium Enterprise Board. So, if you are not a growth company but you are a small-
or medium-sized company, then you are listed on this other board. So, there are two specific boards
addressing exactly the question you raised, namely to nurture the smaller companies.
Student: Hi, could you give a couple of examples, maybe, of the skills you learned in the public sector that
helped you, now working at HSBC, or maybe a situation, where, because of what you learned in the public
sector, you had a better decision making?
Laura Cha: That's a good question. I think, what I took away most from my years as a regulator is really
to look at an issue from the macro level. I think in the private sector, when you are given a problem, when
you are, let's say, in a private firm, in a bank, or a law firm, or any professional firm, you're given a set of
problems, perhaps a client has a certain problem, and your role is to help solve that problem. And the
context of that client alone, and in the confined of that problem. And most of the time, you help the client
to overcome some either legal issues or other commercial issues, so that the client can get to where he
wants to go. Whether it's acquisition or merger or disposal, et cetera. In the public sector as a regulator, you
learn to look at the issue that is presented to you from a more macro level in the sense that, how does this
particular issue impact on the market as a whole?
I'll give you an example: A group of companies in Hong Kong came to the regulator in Hong Kong and
asked for certain exemptions. The reasons that they put forward are quite cogent and not unreasonable from
the client's point of view, from the company's point of view. Now, if I were in my role as a lawyer, I would
fight very hard for the client to get that exemption, but as a regulator I have to look at what does this--if I
give the exemption what kind of knock-on effect will it have? It will set a precedent? And is it a good
precedent? Or is it not a good precedent? If it is a good precedent, then it should not be just given to this
one particular company. Then, perhaps rules should be amended in such a way, that what this client, what
this particular group of company wants, should be given to everyone who wants to apply for it. But if it is
not, and if it is just purely for the benefit of this one particular group of company, then you really should
not give in to that exemption.
And you do have to recognize that there are different considerations, such as the size of the group, the
impact that it may have on the market, et cetera. So, the skills that one learn as a regulator is really to look
at the problem presented to you from a more--at a higher level, you look at the entire scenario and how this
piece would fit into a bigger picture, where in the private sector you don't need to. And how it's helpful to
me now, in my current position, is that I am able, I think, to interpret policy and to anticipate policy,
because I could see that certain things are happening a certain way that as a regulator, those are the issues
that the regulators are likely to address. And therefore, from the private sector we should be prepared for
the changes that will take place. So, that's in a very abstract way. I can't quote you exact examples for
obvious reasons, but that is--in a nutshell, I certainly find it helped me as a person to look at matters from a
broader point of view.
Chapter 8. Mergers of Stock Exchanges [00:45:45]
Student: Hi, thank you. You spoke about the demutualization of stock exchanges. And one of the
outcomes you're seeing of that is the mergers and acquisitions of stock exchanges themselves. And I think,
in the last one year itself we've seen a whole bunch of very interesting deals, Singapore, Australia, New
York and Deutsche, et cetera. And one of the one's that really caught my attention was the Shanghai-Brazil
link-up. So, perhaps I want to hear your views on, do you think this wave of tie-ups is going to carry on,
and if so, what form do you think it will take in the coming years?
Laura Cha: I think in the last decade, the exchanges around the world have really taken on--or more than a
decade now, the landscape has completely changed. It used to be, an exchange is kind of like a national
symbol. Each nation has its own exchange, and that is almost like a national--how should I say? It's a utility
that cannot be taken over by a foreign country. We saw that went by the wayside, when the New York
Stock Exchange acquired Euronext, and of course NASDAQ have alliances, and just different ways. And
now we are into a second phase, where these already consolidated and aligned exchanges are forming even
more consolidation. That may or may not happen, there's a lot of talk about it. And I think, what drives this
latest wave of exchange acquisitions and alliances are really the easy end, electronic networks, that are
driving the cost of trading down, that leave the larger exchanges like the NYSE--a lot of the volume has
gone to the easy end, and they really have to align with others to get the business up.
The other is products. I think the merger of exchanges would only make sense when there are mutually
complimentary products. And geography also makes sense. And how will I see the outcome? I think, many
markets still look upon their exchange as a national symbol and they do not necessarily want--it's more a
matter of the local politicians' sentiment, rather than looking at the commercial side and looking at the
political side.
Someone once told me about this Singapore and Australian stock exchange--the pending merger that has
been announced--I don't have the latest, I don't know whether it's going to go through. Somebody in
Australia told me, well, it is almost like Qantas being taken over by Singapore Airlines. In the commercial
world, well, if that makes sense, why not? But I think, there is still a lot of sentiment that a stock exchange
is something very national.
So, I don't know how that will play out, because all these mergers are subject to the votes of the local
politicians. And so, they may have different considerations than just purely the commercial side.
Chapter 9. Overseas Registration of Chinese Companies and the International Board in Shanghai
[00:49:25]
Student: Hello. Hi. Thank you for your time. I have sort of a two-part questions. The first part, in regards
to all these Chinese companies that are registered overseas, that sort of complicates the regulations, so I
was wondering, if you could talk about how Chinese companies being registered overseas and being listed
in overseas exchanges. And the second part, the question is, I've heard, at least I've read that there's a new
international board that's being set up in China to encourage these companies to come back to mainland
China or Hong Kong. So, I was wondering if you could talk a little bit about how it's going to be shaped,
some of it's challenges, and what do you think would be most important for success?
Laura Cha: OK. The first part of your question, Chinese companies that are registered overseas and listed
overseas. There is no rule that forbids Chinese companies to be registered anywhere. I think, let's say a
company in China, they can elect to register themself in Hong Kong, in Bermuda, Cayman Islands,
wherever, U.S., Delaware. And the matter of listing is really up to the issuer itself, if they decided that a
listing in the U.S., whether it's NASDAQ or the NYSE, makes sense, that's where they would list. And
once they are listed, they are subject to the rules and regulations of the SEC just like anybody else, just like
any of the other foreign companies. So, I think the place of listing really determines the kind of rules that
would be applied to that company. Once a company is listed, let's say on the New York Stock Exchange,
then the U.S. rules will come in, and whether it is a Chinese company is kind of irrelevant. It will have to
be complying with the U.S. rules just like everybody else. So, that's the first part of your question, I don't
know whether that answers it.
The second part of your question, about the international board in Shanghai. Yes, there has been a lot of
talk about the Shanghai Stock Exchange setting up an international board. Meaning that a board, where
companies registered outside of China such as the red chips, which are not listed in China, would return to
the Shanghai Stock Exchange. Because they are not registered in China, they are therefore not a Chinese
company, they are therefore kind of like a foreign company, because they registered in Hong Kong or
Bermuda or wherever.
The idea of the international board is to attract not only these types of Chinese company that have been
registered outside, but for companies, that are multinationals, that are already listed in the outside market,
to be inside China. And the major reason that I can discern is, one, to give the Chinese investor a wider
variety of products. Because the renminbi is still a non-convertible currency, the vast majority of Chinese
investors can only invest in the domestic market, only in the Chinese companies that are listed there. They
cannot easily invest in, let's say Microsoft, HSBC, IBM, General Motors, et cetera. So, I think the Chinese
government has thought, well, maybe we can bring some of the companies to China, for these companies to
raise capital and issue shares in China, so that the Chinese investors will be able to asses it.
The second part is really to raise the profile and the standard of the Shanghai Stock Exchange. The
Shanghai Stock Exchange has ambition to be an international financial center. Domestic documents have
said that they should be developed into an international financial center by the year 2020. And one of roots
of reaching that goal is to have an international board for international companies. And that is, what, I
think, the Shanghai government and the Shanghai Stock Exchange are setting out to do. But to date, the
rules have not yet been promulgated. We don't know when it will. I was a delegate to the National People's
Congress, and we met in March [addition: 2011], earlier this month, and there's no discussion or timetable
that has been set. Many people think, it would be a good thing. Some people inside China think that it will
not be such a good thing, because it will divert the savings to foreign companies, but I think most people
think that it will be a good thing for China.
So, I don't know whether that answers your question. Do you have a second part to the second question? I
might have missed it.
Student: No, I think that really answered my question. But the first part, actually the reason why I asked
the first part of the questions was, because a lot of the recent frauds that came up happened or were
discovered, because a lot of Chinese companies were registering with the New York Stock Exchange had a
filing with the SEC, whereas they also have a filing for their own government, the Chinese government.
And then these filings for their annual reports, their numbers, would not match. And I just thought, there
would be some kind of complications in terms of regulation, when the government's regulating these
companies.
Laura Cha: I think that, whenever a company is listed on a foreign market, it is subject to the full rules and
regulations of that market. There are no if's and but's. I think, the U.S. authority would take action against
any fraud or misstatement.
Professor Robert Shiller: OK, right here.
Student: What type of law did you study, and how difficult did you find the transition from the legal world
to the business world?
Laura Cha: In law school, I took a lot of courses in corporate law, tax, corporate finance. I think the
business world always interested me. The transition from law to--I think it was a two-step thing. I was a
lawyer, and then I was a regulator, and then I am completely in the private sector now. So, the transition
from a lawyer to a regulator wasn't that difficult. I remember distinctly that, when I moved over to the
Securities and Futures Commission, what I wasn't used to was, I always want to correct every document
that came before me, I want to improve it. I mean, it was just the lawyer in me. I wanted to make it written
better, clearer, et cetera. And then, I had to kind of restrain myself, because I wasn't there to correct and
make a presentable document, but to really solve the problems.
And then, having been a regulator and mostly really regulating the corporate world, I became quite familiar
with the corporate finance side. And when I was at the Securities and Futures Commission in Hong Kong, I
was the head of the corporate finance division for five years, and during that five years I came across all
kinds of corporate transactions. Mergers and acquisitions, takeovers, and of course the IPOs, so that kind of
helped me in where I am today. I wouldn't really call me a banker per se, because I'm not in the operation
side, I'm on the board, and I provide advisory service to HSBC, but I'm not really operating as a banker per
se.
So, I would say it wasn't difficult, it was an evolution type of--throughout my career from one thing to the
next.
[SIDE CONVERSATION]
Chapter 10. The Regulatory Impact of Basel III [00:58:27]
Student: Hi, I was wondering, having worked on the regulation side and, now working for the private
sector, I think that puts you in a unique position to determine what the impact of internationalization of
regulation will have on the financial services sector. So more specifically, what do you think the regulatory
impact of Basel III will be? Because a lot of private sector individuals have come out and said that some of
the requirements, in terms of the capital adequacy requirements and so on, have been very harsh. So, first
of all, I guess, how do you think it'll be phased in and, second of all, do you think it's the appropriate level
of regulation?
Laura Cha: Basel III, I think, it is very costly to implement. I think, the banks have largely accepted that
more stringent regulations will have to come our way because of the financial crisis of the last two years.
But not all banks are alike, and certainly at HSBC we felt that we have been thrown in with the rest of
them, whereas we had not taken any government money and we have done reasonably well, we have
weathered the crisis reasonably well. But having said that, I think one has to accept that, whenever there's a
crisis, regulation will come in more stringently, and the pendulum will tend to swing too far one way. And
then gradually, the pendulum will come--in the boom market, then the pendulum will swing back, and then
it would be too lax, and then another crisis will happen, and then more rules will come in. It has always
been like that, if you look at the history of any market, they always swung to the extreme.
Sarbanes-Oxley, I think, is a good example. Sarbanes-Oxley came about, I don't need to tell you, as a result
of the Enron crisis. And of course the last crisis, which was the subprime crisis, was nothing like Enron.
When I was a regulator, we always said, we're always correcting yesterday's problems. When a scandal
happens, when a crisis happens, we think of rules to address what had gone wrong, but the next time
something happens it's not going to happen the same way. You are preventing the old problem from
repeating itself, but the new problem will be entirely different. So, that's just the way things are.
And that's the other reason, why I think some of the young and bright students should not always be in the
private sector. The public sector needs a balance of that.
And then, as far as international regulations are concerned, the regulators have talked for a long time about
harmonization of standards. I don't think it will happen, because different regulators, different national
regulators, have their own priorities, and they don't always have the same priorities. And the best example
is really the Financial Stability Board, which came out of the last Asian financial crisis. It was called
Financial Stability Forum, it is now a Financial Stability Board, and the idea is to ensure that there's
financial stability globally, but that takes a lot of work. I think, the G-20 is trying very hard, and of course
the regulatory agencies as well as all the central bankers are now, hopefully, in a better cooperative mood,
but I think to have one set of international and harmonized standards is very hard.
Professor Robert Shiller: OK, I think we're out of time. Laura, I just want to thank you. I think this was
very good. Hearing the details of your career, and hearing all the different things you've done in both the
public and private sector reminds me of--we're going through a period of development of the world and
expansion, and somebody has to get the details right. And I'm very impressed that you are one of those
people who's making things work. So, I'm glad that you were able to convey these thoughts to our students
here today, and thank you very much.
[APPLAUSE]
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 17 - Options Markets [March 30, 2011]
Chapter 1. Examples of Options Markets and Core Terms [00:00:00]
Professor Robert Shiller: All right. Good morning. The subject of today's lecture is options. And I think,
maybe I'd better first define what an option is, before I move to say anything about them. Because some of
you may not have encountered them, because they're not part of everyday life for most people, although
they are, in a sense. I'll get back to that. Let me just define terms here.
[side conversation]
Professor Robert Shiller: So there's two kinds of options. There's a call and a put, OK? A call option is an
option to buy something at a specified price, and the price is called the ''exercise price'' or ''strike price.''
Those are synonyms.
And a put option is the right to sell something at the specified exercise price. And it has another term it has
to be specified, and that's the exercise date. [addition: The exercise date applies to both call and put
options.] OK.
Options go back thousands of years. It must have happened before we have any recorded records. If you're
thinking of buying something from someone, but you don't want to put up the money today, you go to some
lawyer, and say, write up a contract. I want to buy an option to buy this thing.
So, for example, if you are thinking of building a building on land that is owned now by a farmer, but
you're not ready to do it. You may be thinking about it. You can go to the farmer and say, I'd like to buy
that corner of that acre there. I'd like to have the right to buy it. I'll pay you now for the right. And you get a
lawyer and you write up a contract. And that's an option. You have an option to buy at the exercise price
until the exercise date.
Now, in modern terminology, we have two kinds [addition: two kinds of options], American and European.
It doesn't refer to geography, those two terms. The terms refer, instead, to when you can exercise.
So, the American option is better than the European option for the buyer, because the American option can
be exercised at any time until the exercise date. Whereas the European option can be exercised only on the
exercise date. But you see the American option has to be better, or not worse than--I don't know if it's
strictly better--but not worse than the European option because you have more options. [addition: The latter
''options'' is used in the sense of flexibility.]
I think, we've defined what they are. Do you understand well enough what they are? They occur naturally
in life. I remember, Avinash Dixit was writing about options and he said, well, when you're dating someone
and you know the person will marry you, you have an option that you can exercise at any time by agreeing
to marry.
Now, one of the theorems in option theory is, you usually don't want to exercise a call option early.
[addition: This theorem abstracts from dividend-payments of the underlying asset.] And so, Dixit would
say, well, maybe that's why a lot of people have trouble getting married. They don't want to exercise their
option early.
What we'll see is that options have option value. They give you a choice, and so there's something there.
When you exercise an option, that is, when you actually buy the thing, or in the case of a put, sell the thing,
then you're losing the choice. So, you've given up something. Of course, you have to also exercise
eventually, if things are going to make sense.
Usually, when we talk about options, we're talking now about options to buy a share of stock, or 100 shares
of stock, and that's the usual example. But they occur all over the place.
Let me mention some other examples of options. The usual story is the stock option. You go to your broker
and you say, I'd like to buy an option to buy 100 shares of Microsoft. I don't want to buy Microsoft, I want
to buy an option to buy Microsoft, which happens to be cheaper, by the way, usually. Usually, it costs more
money to actually buy the thing than to buy the right to buy the thing at another price. We'll get back to
that.
But in a sense, let's think about this, stocks themselves are options in a sense, with a zero exercise price.
Maybe, I'll have to get back and explain, but what I mean is--let me get back and explain that in a minute.
But let me go ahead to other examples, mortgages. An ordinary home mortgage has an option characteristic
to it, in the sense that, if the price of your home drops a lot, you can just walk away from the mortgage, and
say, I'm out of here. It's like not exercising an option. It's analogous. Or I can choose to prepay a mortgage
early, and that's like exercising an option. So, option pricing gets into all sorts of things. OK.
Chapter 2. Purposes of Option Contracts [00:07:11]
I thought I should say something about the purposes of options, before I move on to try to discuss what
their properties and pricing are, which is the main subject of this lecture. I can give two different
justifications for options.
Why do we have options? Some people cynically think that options are just gambling vehicles. It's another
way to gamble. You can go to the casino, you can play poker, or you can buy options. Well, I think for
some people that's just what it is, theyre volatile risky investments that can make you a lot of money.
But I think, they have a basic purpose, or purposes. First of all, theoretical. If we were trying to design the
ideal financial system, what would we do? Some people thought of ideal economic systems without
reference to finance, like Karl Marx--I come back to him--the great communist, thought that we would
have an ideal communist state and there'd be no financial markets. When they actually tried it and they tried
to do it, I think they gradually realized that not having any financial markets makes our entrepreneurship,
our management of enterprises, kind of blind. We can't see where we're going because there's no prices. We
don't know what anything is worth. There was an old joke that the communist countries survived only
because they had prices from capitalist countries to rely on. Otherwise, they don't know anything about
values or profits, right?
So, we need prices. Many people have written about this, but I mentioned, in 1964, Kenneth Arrow, who is
an economic theorist, wrote a classic paper, in which he argued that, unless we have prices for all states of
nature, there's a sense in which the economic system is inefficient. You really need the price of everything,
including the price of some possibility. In a sense, that's what options are giving you, the existence of
options is giving you.
So, Steven Ross, who used to teach here at Yale, a friend of mine, lives here in New Haven, in 1976, in The
Quarterly Journal of Economics, wrote a classic paper about options, showing that, in a sense, they
complete the state space. They create prices for everything that affects decision-making. I'm not going to
get into the technicalities of the paper, but I wanted to start with a theoretical justification for options, so
you'll see why we're doing this.
I don't want this to come across as a lecture, how you can gamble in the options market. This is about
making things work right for the economic system, improving human welfare. But a lot of people don't get
that. That's why Karl Marx was so successful. It seems too abstract. What does this options market do for
us?
Let me just go back to the example I started out with. You're a construction firm, and you're thinking of
building something, a new supermarket, where people can buy their food. And you note that there's a pair
of expressways crossing somewhere, and you think, that's the perfect place to build a mega supermarket,
because everyone can get there by car. And there's a lot of land, I can build a big parking lot, perfect. But
before you think further, you go to buy an option on the land, right? So, you knock on the door at the
farmhouse, and there's a farmer with all these acres, and you say, I'm thinking of building a mega
supermarket here. I'd like to buy an option on your farm.
You learn something at that moment. You might learn that the farmer says, I've already sold an option, so I
can't do it. You could try to talk to the person I sold it to, and see if you can buy it from him. Or the farmer
might say, I've had three other offers, and I'm raising my price to some millions of millions of dollars.
Then, you have second thoughts about doing it.
You see what I'm saying, that the price discovery is in there? It's making things happen differently. You're
learning something. The farmer is learning something. You are learning something from the options
market, and ultimately it decides where that supermarket will go. So, that's the theoretical purpose of
option.
I wanted to talk, also, about a behavioral purpose of options. It's a little fuzzier about the actual benefits of
options from this standpoint. The behavioral theory of options says that--very many different aspects of
human behavior tie into options, but I would say it has something to do with attention anomalies and
salience.
Psychologists talk about this, that people make mistakes very commonly in what they pay attention to, what
strikes the fancy of their imagination. Salience is something psychologists also talk about. Salient events
are events that tend to attract attention, tend to be remembered.
Now, when you think of options, a lot of options are what are called incentive options, OK? And when you
get your first job, you may discover this. They'll give you options to buy shares in the company you work
for. Why do they do that? I think it's because of certain human behavioral traits that I mention here, your
attention and your salience.
It's not necessarily very expensive for a company to give you options to buy shares in the company, but it
puts you in a situation, where you start to pay attention to the value of the company. It becomes salient for
you, and you start hoping that the price of the company will go up, because you have options to buy it, at a
strike price. You hope that the company's price per share goes above your strike price, because then your
options are worth something. They're in the money. So, it may change your motivation and your morale at
work, or sense of identity with the company. All these sorts of things figure in. That's why we have
incentive options. They can also give you peace of mind.
Insurance is actually related to options in the sense that, when you buy insurance on your house, it's like
buying a put option on your house, although it may be not directly connected to the home's value, right?
When you buy an insurance policy in your house, and the house burns down, you collect on the insurance
policy. Well, the price of your house fell to zero. If you had bought a put option on the house, it would do
the same thing, right? You would have an option to sell it at a high price on something that's now
worthless. So, insurance is like options, and insurance gives you peace of mind.
So, people think in certain repetitive patterns, and one of them is, that I would like to not worry about
something. So, I can get peace of mind, if I have a put option on something that I might otherwise worry
about. All right, maybe that's enough of an introduction, but Ive given you both theoretical reasons for
options and behavioral reasons. I think of them as basically inevitable. You may have people advising you
not to bother with options markets. That might be right for you, in a sense, but I think that they're always
going to be with us, and so it's something that we have to understand.
Chapter 3. Quoted Prices of Options and the Role of Derivatives Markets [00:17:11]
I have a newspaper clipping that I cut out. I've been teaching this course for over 20 years, so sometimes I
don't update my newspaper clippings. I have a newspaper clipping from the options page that I made in
2002, OK? So, that's nine years ago. But I can't update it anymore, because newspapers don't print option
prices anymore. So, I could go on some electronic trade account and get an updated option page. But why
don't we just stick with The Wall Street Journal? This is a clipping from The Wall Street Journal, April
2002, when they used to have an options page, OK?
I just picked America Online. I don't know why. It's an interesting company. You remember America
Online, a web presence? It used to be bigger than it is now. And actually, in 2000, America Online merged
with Time Warner, OK? So, we actually have two different rows corresponding--Forget Ace Limited, the
second row says AOL.TW. That's America Online Time Warner, the merged company, and then below
that, they have America Online itself. These were options that were issued before the merger, and they
apparently are being exercised in terms of the same AOL Time Warner stock.
AOL, by the way, was spun off by Time Warner last year, so they had a divorce. They were married in
2000. They were divorced in 2010. So you can get back to it, AOL options, now.
So, anyway, it shows the price of the share at $21.85 a share. So, you take any of these rows, and it shows
you, for various strike prices, what the options prices are. So, let's go to the top row. A strike price of 20,
expiring in May of 2002, which is one month into the future. Remember, it's April 2002 right now. The
volume is the number of options that were traded yesterday, and the $2.55 up there is the price of a call
option, the last price of the option to be traded yesterday. This is the morning paper. It's reporting on
yesterday morning's prices [correction: yesterday's prices at closing]. And then, there's put options traded.
A lot more puts were traded on that day. There were 2000 put options traded on that day in April 2002, and
the last price of the put option was $0.85. For $0.85, you could buy the right to sell a share of AOL Time
Warner at 20, OK? And similarly, you could buy the right to buy it at $20.00 for $2.55. So, these are
different strike prices and different exercise dates. This one--I can reach it--is to buy it at, if it's a call,
$25.00 strike price, costs you $0.45 to buy that. But if you want to buy a put, it costs you $3.60.
And we want to try to understand these prices, OK? That's the purpose here. So, let me say one thing more
before I get into that. This is presented for the potential buyer, OK? These are options prices. There's also
the seller of the option. They're called the writer of the option. I gave you an example before, when I talked
about the farmer and you thinking of building a supermarket. So, you are the buyer of the option and the
farmer is the writer of the option. The farmer is writing the option to you.
You could also consider buying an option from someone else, who's not even the farmer, right? It could be
some speculator. You don't have to go to the farmer. You can go to somebody else and say, I'd like to buy
an option on that farm over there. And someone would say, sure, I'll sell you an option on it. And then I'm
good for it. That means I have to go and buy it at whatever price from the farmer [addition: in case that the
option is exercised]. Maybe that's not such a good idea. He might sense my urgency to buy it.
But if it's a stock, someone can write an option, who doesn't even own the stock. And so, that's called a
naked seller of an option, OK? Neither the buyer nor the seller ever have to trade in the stock. This is a
market by itself. You could buy an option, and then you could sell it as an option without ever exercising it.
The writer could write an option, and then buy an option to cancel it out later, and then, essentially, get out
of that contract.
So, the option becomes a market of its own, where prices of options start to look like an independent
market, and this is called a derivatives market. There's an underlying stock price, but this is a derivative of
the stock price.
The first options exchange was the Chicago Board Options Exchange, which came in in 1973. Before that,
options were traded, but they were traded through brokers and they didn't have the same presence. You
didn't see all these options prices in newspapers. It's when they opened the market for options, that the
options trading became a big thing.
So, options markets are relatively new, if you consider '73 new. You weren't born then. It's not really that
long ago. Since then, there are many more options exchanges, but CBOE is the first one. They're now all
over the world.
And we also have options on futures. And so, futures exchanges now routinely trade options on their
futures contracts. So, that's a derivative on a derivative, but it's done.
Chapter 4. Call and Put Options and the Put-Call Parity [00:24:54]
So, let me draw a simple picture of option pricing. So, this is the stock price and this is the option price,
OK? And I'm going to mark here, the exercise price. Let's look at the exercise date, the last day. The option
is about to expire, and this is your last chance to buy the stock. Then, it doesn't matter, on that day, whether
it's an American or European option. They're both the same on the last day.
What is the price of the option as a function of the stock price? Well, if the stock price is less than the
exercise price, the option is worthless, right? It will not be exercised. You won't exercise an option to buy it
for more than you could just buy it on the market, right?
Student: You have to say ''call''.
Professor Robert Shiller: Did I not say call? Yes, I'll put it up here. We're talking about call options.
Thank you.
But if it's above the exercise price, this is a 45 angle, that's a line with the slope of one, the option prices
rises with the stock. In fact, it just equals the stock price minus the exercise price, right? So, this region, we
say, is ''out of the money.'' The option is out of the money, when its prices [clarification: the stock price],
for a call, is less than the exercise price.
Here, it's ''in the money.'' I'll put it up here, in the money. And then, on the exercise date, it will always
equal the stock price minus the exercise price. So, it's very simple.
Now, one confusion that's often made: I gave the example of building a shopping center or a supermarket
on a farm. Now, someone might think that you buy an option on it, so that you can think about it and make
up your mind later. Well, in a sense, you could do that. But the thing is, you will exercise the option
whether or not you build the shopping mall or this supermarket, if it's in the money, right? Suppose, you
changed your mind, and I don't want to build the supermarket. But I'm sitting on an option that I bought, to
buy his land for a price, which is less than the market price for it. Of course, I'll buy it. So, you're going to
buy it, whether you build the shopping center or not.
You always exercise the option, if it's in the money on the last day. That's the assumption. I mean you
could not, I suppose, if you like the farmer and you want to be a nice guy. I don't know. But usually, what it
is, is a non-linear relation between the stock price and the derivative. So, the derivative is a broken straight
line function of the stock price. Whereas all the portfolios we construct, are linear. They're straight lines.
They don't have a break in them. So, the option creates a break in the stock--and this is why Ross
emphasized that options price something very different, that's not priced in the regular--no portfolio shows
you this broken straight line relation.
Now, I wanted to then talk about a put. What is a put? Let me erase, where it says in and out of the money.
I'll show it. I'll do this with a dashed line, so that you'll see which one is which--I'm leaving the call line up.
With a put, a put is out of the money up here--I can't really show it too well--if the stock price is above the
exercise price, because you're selling now. And it's in the money, if the stock price is less than the exercise
price--I didn't draw that very well. That's supposed to be a 45 line. That's 45 angle, has a slope of -1,
right? On the exercise date.
Now, it's interesting that there's a pretty simple pattern here between puts and calls. What if I buy one call
and I short one put, all right? Or write a put, writing a put and shorting a put are the same thing, all right?
What does that portfolio look like? Well, if I put that portfolio together, I want to have plus one call minus
one put, all right? [addition: Both options have the same strike price and the same maturity date.] My
portfolio relation to the stock price is going to look like that, right? It's just going to be a straight line.
So, the value of my portfolio is equal to the stock price minus the exercise price. Simple as that. And my
portfolio can be negative now, because I've shorted something. I can have a negative portfolio value. That's
very simple, can you see that?
This leads us to the put-call parity equation. If a put minus a call [correction: a call minus a put] is the same
thing as the stock minus the exercise price, then the prices should add up too, right? So, put-call parity--
there's different ways of writing this. But it says that the stock price equals the call price minus put price
plus exercise price on the last day, on the exercise day, right? [clarification: The two options involved have
to have the same exercise price and the same maturity date.] It's simple. This is put-call parity on the
exercise date.
Now, let's think about some day before the exercise date. [addition: The following argument only applies to
European options.] Well, you know this is going to happen on the exercise date. So, at any day before the
exercise date, the same thing should hold, except that we've got to make this the present value. Present
discounted value of the exercise price. And also we have to add in, in case there is any dividends paid
between now and the exercise date, plus the present discounted value of dividends paid between now and
the exercise date. Because the stock gets that, and the option holders don't, OK? So, that's called the put-
call parity relation.
And now I can cross out ''exercise date.'' This should hold on all dates. Because if it didn't hold, there would
be an arbitrage, profit opportunity.
So, it should hold on this page, except for minor failures to hold. It should hold approximately on this page.
And let me give you one example. See, if it holds. Let's consider the one that I can reach. OK, oh, this is the
stock price. So, what do I have? The biggest thing here is the strike price, exercise price. So, we want to do-
-we'll do this line, $25.00 + $0.45 - $3.60, and I'm assuming there's no dividend paid between now and
May. It comes out very close to $21.85. I can't do the arithmetic in my head. It may not hold exactly,
because these prices may not all have been quoted at exactly the same time, and there's some transactional
costs that limit this. Do you see that?
So, because of the put-call parity relation, The Wall Street Journal didn't even need bother to put the put
prices in, because you can get one from the other. But they do put them in, just because people like to see
them, and some people might be trying to profit from the put-call parity arbitrage. But for our purposes, we
only have to do call pricing. Once we've got call pricing, we've got put prices. So, I just use the put-call
parity relation and I get put prices.
Chapter 5. Boundaries on the Price of a Call Option [00:34:56]
So, now let's think about how you would price puts [correction: calls]. The price of a put [correction: call],
we know what it is on the exercise date, right? I'm going to forget the dashed lines. There's no dashed lines
here anymore. We're just talking about call prices. All right, so this shows the price of a put on the last day-
-of a call on the last day.
Now, what about an earlier day? [clarification: The following argument about price bounds solely applies
to call options. It also abstracts from dividend payments of the underlying stock.] Well, the price of a call
can never be negative, right? So, the call price has to be above this line. It can never be worth less than the
stock price minus the exercise price, even before the date. And also, it can't be worth more than the stock
price itself. I'll draw a 45 line from the origin. That's supposed to be parallels of that.
It's obvious that the call price has to be above this broken straight line, but not too far above it. Above this
broken straight line, representing the price as a function of the stock price on the last day. And the closer
you get to the last day, the closer the options price will get to that curve.
So, on some day before the exercise date, the call option price will probably look something like that, right?
It's above the broken straight line because of option value. So, think of it this way, suppose an option is out
of the money today--well, you can see out of the money options. For a call, this is out of the money, right?
Because its stock price is $21.85, but I've got an option to buy it for $25.00. All right, that's going to be
worthless, unless the option price [correction: stock price] goes up before it expires.
So, it's only worth something, because there's a chance that it will be worth something on the exercise date.
And what are people paying for that chance? $0.45, not much. Why are they paying so little? Well, you can
say intuitively, it's because it's pretty far. $21.85 is pretty far from $25.00, and this option only has a month
to go. What's the chances that the price will go up that much? Well, there is a chance, but it's not that big.
So, I'm only willing to pay $0.45 to buy an option like that. So, we're somewhere like here on that row that
I've shown you.
The reason you don't want to exercise an option early is, because, if you exercise it early, your value drops
down to the broken straight line, right? It's always worth more than the broken straight line indicates before
the exercise date. So, if you want to get your money out, sell the option. Don't exercise it early.
So, that's why the distinction between European and American options is not as big or as important as you
might think, at first. [clarification: American call options should indeed not be exercised early. However,
there are circumstances under which it is optimal to exercise an American put option early.] So, we can just
price European options, and then we can infer what other options would be, what put options would be
worth.
Chapter 6. Pricing Options with the Binomial Asset Pricing Model [00:39:07]
Let's now talk about pricing of options. And the main pricing equation that we're going to use is the Black-
Scholes Option Pricing equation. But, before that, I wanted to just give you a simple story of options
pricing, just to give you some idea, how it works. And then I'm going to not actually derive the Black-
Scholes formula, but I'm going to show it to you.
I'm going to tell you a simple story, just to give some intuitive feel about pricing of options. And to
simplify the story, I'm going to tell a story about a world, in which there's only two possible prices for the
underlying stock. That makes it binomial. There's only two things that can happen, and you can either be
high or low, all right?
So, let me get my notation. I'm going to use S as the stock price, all right? I'm going to assume that the
stock price, that's today--this is also a simple world in that there's only one day. The option expires
tomorrow. There's only one more price we're going to see. So, the stock is either going to go up or down.
So, u is equal to one plus the fraction up that it goes up. u stands for up. And d is down, is one plus the
fraction down. So, that means that stock price either becomes Su, which means it goes up by a fraction,
multiple u, or is Sd, which means it goes down by a multiple d. And that's all we know, OK?
But now we have a call option. Call C the price of the call. We're going to try to derive what that is. But we
know, from our broken straight line analysis, we know what C
u
is, the price if the stock goes up. And we
know what C
d
is, it's the price if down, OK? So, suppose the option has exercise price E, all right. Do you
understand this world? Simple story.
Now, what I want to do is consider a portfolio of both the stock and the option, that is riskless. I'm going to
buy a number of options equal to H. H is the hedge ratio, which is the number of shares purchased per
option sold. I'm going to sell a call option to hedge the stock price, to reduce the risk of the stock price,
OK? And so, hedge ratio is shares purchased over options. Each option is to buy one share, OK? So, what
I'm going to do is, write one call and buy H shares. So, let me erase this and start over again. I'm on my
way to deriving the options price for you--a little bit of math.
So, I'm going to write one call and buy H shares, OK. If the stock goes up, if we discover we're in an up
world next period, my portfolio is worth uHS minus C
u
, right? Because the share price goes from S to uS,
and I've got H shares, and I've written a call, so I have to pay C
u
. If it's down, then my portfolio is dHS
minus C
d
, OK? This is simple enough?
Now, what I want to do is eliminate all risk. So, that means I want to choose H, so that these two numbers
are the same. And if I do that, I've got a riskless investment, all right? So, set these equal to each other. And
that implies something about H. We can drive what H is, if I just put these two equal to each other and
solve for H. And I get H=C
u
-C
d
/(u-d)S.
So, I've been able to put together a portfolio of the stock and the option that has zero risk. If I do this, if I
hold this amount of shares in my portfolio, I've got a riskless portfolio. So, that means that the riskless
portfolio has to earn the riskless rate, right? It's the same thing as a riskless rate [correction: same thing as a
riskless investment], so it has to earn that [clarification: earn the riskless rate]. If I can erase this now, I'm
almost there, through option pricing.
The option pricing then says that, since I've derived what H is, the portfolio has to be worth (1+r) times
what I put in, which is HS minus C. And that has to equal the value of the portfolio at the end, which is
either uHS minus C
u
, or dHS minus C
d
, the same thing, OK?
So, I've already derived what H is, and I substituted into that, and I solved for C. So, substitute H in and
solve for C, and we get the call price, OK? It's a little bit complicated, but C=[(1+r-d/u-d)x(C
u
/1+r)]+[(u-1-
r/u-d)x(C
d
/1+r)].
And I'll put a box around that because that's our option price formula, OK? Did you follow all that?
This is derived--this option price formula was derived from a no arbitrage condition. Arbitrage, in finance,
means riskless profit opportunity. And the no arbitrage condition says, it's never possible to make more
than the riskless rate risklessly, all right?
If I could, suppose I had some way--suppose the riskless rate is 5%, and I can make 6% risklessly, then I
will borrow at the riskless rate and put it into the 6% opportunity. And I'll do that till kingdom come.
There's no limit to how much I'll do that. I'll do it forever. It's too much of a profit opportunity to ever
happen. One of the most powerful insights of theoretical finance is, that the no arbitrage condition should
hold.
It's like saying, there are no $10 bills on the pavement. When you walk down the street and you see a $10
bill lying there on the street, your first thought ought to be, are my eyes deceiving me? Because somebody
else would have picked it up if it were there. How can it be there?
I once actually had that experience. I was walking down the street in New York. It was actually a $5 bill. It
was just lying there in the street. And so, I reached down to pick it up, and then, suddenly, it disappeared.
And it was people on one of the stoops of one of these New York townhouses playing a game. They'd tied a
string to a $5 bill. And they would leave it on the street, and watch people reach for it, and they'd snatch it
away. That's the only time in my life I ever saw a $5 bill on the pavement. And so, it's a pretty good
assumption that, if you see one, it isn't real.
And that's all this is saying, that if the option price didn't follow this formula, something would be wrong.
And so, it had better follow this formula. Now, that is the basic core option theory.
Now, the interesting thing about this theory is, I didn't use the probability of up and the probability of
down. So somebody says, wait a minute, my whole intuition about options is: I'd buy an option, because it
might be in the money. When I was just describing here, this is $0.45, I said, that's not much, because it
probably won't exceed $25.00. It's so far below it. So, it seems like the options should really be
fundamentally tied to the probability of success. But it's not here at all. There's no probability in it. You saw
me derive it. Was I tricking you? Well, I wasn't. I don't play tricks. This is absolutely right. You don't need
to know the probability that it's in the money to price an option, because you can price it out of pure no-
arbitrage conditions.
Chapter 7. The Black-Scholes Option Pricing Formula [00:51:02]
So, that leads me then to the famous formula for options pricing, the Black-Scholes Option Pricing formula,
which looks completely different from that. But it's a kindred, because it relies on the same theory. And
there it is. This was derived in the late 70's, or maybe early 70's, by Fisher Black, who was at MIT at the
time, I think, but later went to Goldman Sachs, and Myron Scholes, who is now in San Francisco, doing
very well. I see him at our Chicago Mercantile Exchange meetings. Fisher Black passed away.
It doesn't have the probability that the option is in the money, either, but it looks totally different from the
formula that I wrote over there. The call price is equal to S
where S is the share price, r the interest rate, T time to maturity, E the exercise price, and d
1
as well as d
2

are given on the slide:
d
1
=[ln(S/E)+rT+#
d
2
=[ln(S/E)+rT-#
And the N function is the cumulative normal distribution function.
I'm not going to derive all that, because it involves what's called the calculus of variations. I don't think
most of you have learned that. In ordinary calculus, we have what's called differentials, dy, dx, et cetera.
Those are fixed numbers in ordinary calculus. In the mid 20th century, mathematicians, notably the
Japanese mathematician Ito, developed a random version of calculus, where dx and dy are random
variables. That's called the stochastic calculus. But I'm not going to use that. I'm not going to derive this.
But you can see how to price an option using Black-Scholes. But Black-Scholes is derived, again, by the
no-arbitrage condition and it doesn't have the probability. Oh, the other variable that's significant here is
sigma, which is the standard deviation of the change in the stock price.
So, once we put that in, someone could say, well, probabilities are getting in through the back door,
because this is really a probability weighted sum of the changes in stock prices. Well, probability is not
really in here at all, but maybe there's something like standard deviation, even in this equation. Because we
had C
u
and C
d
, and thatd give you some sense of the variability. [clarification: In the binomial asset pricing
model, u and d give you some sense of the variability of the underlying stock price, analogous to sigma in
the Black-Scholes formula.]
I'm going to leave this equation just for you to look at. But what it does do is, it shows the option price as a
nice curvilinear relationship, just like the one I drew by hand. Which then, as time to exercise goes down,
as we get close to the exercise date, that curve eventually coincides with the broken straight line.
Now, I wanted to tell you about implied volatility. This equation can be used either of two ways. The most
normal way to do it, to use this equation, is to get the price that you think is the right price for an option, to
decide whether I'm paying too much or too little for an option.
So with this formula, I can plug in all the numbers. To use this formula, I have to know what the stock price
is. That's S. I have to know what the exercise price is. And I have to know what the time to maturity--these
are all specified by the stock price and the contract. I have to know with the interest rate is. And if I also
have some idea of the standard deviation of the change in the stock price, then I can get an option price.
Chapter 8. Implied Volatility - The VIX Index in Comparison to Actual Market Volatility [00:55:49]
But I can also turn it around. If I already know what the option is selling for in the market, I can infer what
the implied sigma is, right? Because all the other numbers in the Black-Scholes formula are clear. They're
in the newspaper, or they're in the option contract. There's this one hard to pin down variable, what is the
variability of the stock price?
And so, what people often use the Black-Scholes formula to is, to invert it and calculate the implied
volatility of stock prices. So, when call option prices are high, why are they high relative to other times?
Well, it must be that people think--I'm going back to the old interpretation, that the probability of exercise
is high, right? If an out of the money call is valuable, it must be people think that sigma is high.
So, let's actually solve for how high that is. I can't actually solve this equation. I have to do it numerically.
But I can calculate, for any call price, given the stock price, exercise price, time to maturity, and interest
rate. I can calculate what volatility would imply that stock price. And so, that's where we are with Black-
Scholes.
So, implied volatility is the options market's opinion as to how variable the stock market will be between
now and the exercise date. So, one thing we can do is compute implied volatility. And I have that here on
this chart here. What I have here, from 1986 to the present, with the blue line, is the VIX, V-I-X, which is
computed now by the Chicago Board Options Exchange. When the CBOE was founded, they didn't know
how to do this. Black and Scholes invented their equation in response to the founding of the CBOE. And
now, the CBOE publishes the VIX. You can get it on their website, and that's where I got this, off their
website cboe.com. [Clarification: The VIX is computed from a different formula involving more than one
options price.]
And so, they have computed, based on the front month, the near options, what the options market thought
the volatility of the stock market was. That's the blue line. And you can see, it had a lot of changes through
time. That means that options prices were revealing something about the volatility of the stock market.
Now, the blue line is from the Chicago Board Options Exchange. What I did, and I calculated this myself,
the orange line is the standard deviation of actual stock prices over the preceding year, of monthly changes,
annualized. That's actual volatility. But it's actual past volatility.
Let's make it clear, what this is. What the VIX is, is [essentially, not exactly] the sigma in the Black-
Scholes equation. But it is, in effect, the market's expected standard deviation of stock prices. And to get it
more precise, it's the standard deviation of the S&P 500 Stock Price Index for one month, multiplied by the
square root of 12, because they want to annualize it. It's for the next month.
Why do they multiply it by $12? Well, that's because, remember the square root rule. These stock prices are
essentially independent of each other month to month, so the standard deviation of the sum of 12 months is
going to be $12 times a standard deviation of one month.
And this is in percent per year. So, that means that the implied volatility in 1986 was 20%. And then, it shot
way up to 60%, unimaginably quick. That might be the record high, I can't quite tell from here. Remember,
I told you the story of the 1987 stock market crash? The stock market fell over 22% in one day. Well,
actually, on the S&P, it was only 20%, but a lot in one day.
It really spooked the options markets. So, the call option prices went way up, thinking that there's some big
volatility here. We don't know which way it'll be next. Maybe it will be up, maybe it will be down. It
pushed the implied volatility, temporarily, up to a huge level. It came right back down.
My actual volatility, I calculated this for each date as the volatility of the market over the preceding year.
Well, since I put October 1987 in my formula, I got a jump up in actual volatility, but not at all as big as the
options market did.
See, the option market is looking ahead and I have no way to look ahead, other than to look at the options
market. So, to get my actual volatility, I was obliged to look at volatility in the past, and it went up because
of the 1987 volatility, but not so much. So what this means is, that, in 1987, people really panicked. They
thought something is really going on in the stock market. They didn't know what it was and they were
really worried, and that's why we see this spike in implied volatility.
There's a couple other spikes that I've noted, the Asian financial crisis occurred in the mid 1990's. Now,
that is something that was primarily Asian, but it got people anxious over here as well. You know, Korea,
Taiwan, Indonesia, Hong Kong, these countries had huge turmoil. But it came over here in the form of a
sudden spike in expected volatility. People thought, things could really happen here. So, all the option
prices got more valuable.
And then there's this spike. This is the one that you remember. This is the financial crisis that occurred in
the last few years. Notably, it peaks in the fall of 2008, which was the real crisis, when Lehman Brothers
collapsed, and it created a crisis all over the world. There was a sharp and sudden terrible event. And you
can see that actual volatility shot up to the highest since 1986, as well, at that time.
So, implied volatility, you can't ask easily from this chart, whether it was right or wrong. People were
responding to information, and the response felt its way into options prices. There's no way to find out, ex
post, whether they were right to be worried about that. But they were worried about these events, and it led
to big jumps in options prices.
Now, I wanted to show the same chart going back even further, but I can't do it with options prices, because
I can show volatility earlier, but I can't show implied volatility before around 1986, because the options
markets weren't developed yet.
But I computed an actual S&P Composite volatility. Well, in my chart title, I said S&P 500. The Standard
and Poor 500 Stock Price Index technically starts in 1957, but I've got what they call the Standard and Poor
Composite back to 1871.
And so, these are the actual moving standard deviations of stock prices, all the way back to the beginnings
of the stock market in the U.S. Well, not the very beginnings, but the earliest that we can get consistent data
for, on a monthly basis. And you can see, this goes back further than the other chart. You can see that the
actual volatility of stock prices, except for one big event, called the Great Depression of the 1930s, has
been remarkably stable, right? The volatility in the late 20th century, early 21st century, is just about
exactly the same as the volatility in the 19th century. It's interesting, how stable these patterns are.
There was this one really anomalous event that just sticks out, and that is the Great Depression. 1929
precedes it, it's somewhere in here. But somehow people got really rattled by the 1929 stock market crash.
And not just in the U.S. This is U.S. data, but you'll find this all over the world. It led to a full decade of
tremendous stock market volatility around the world, that has never been repeated since.
The recent financial crisis has the second highest volatility after the Great Depression. This isn't long ago.
This is well within your memories. Just a few years ago, we had another huge impact on volatility. And as
you saw on the preceding slide, it had a big impact on implied volatility as well. So, I think that we had a
near miss of another depression. It's really scary what happened in this crisis.
Also shown here is the first oil crisis, which we talked about, in 1974, when oil prices had been locked into
a pattern because of the stabilization done by the Texas Railroad Commission. But when that broke, and
OPEC first flexed its muscles, it created a sense of new reality. And it caused fear, and it caused a big spike
up in volatility of the stock market, but not quite as big as the current financial crisis.
So, this is an interesting chart to me. A lot of things I learned from this chart, and let me conclude with
some thoughts about this. But what I learned from this chart is that, somehow, financial markets are very
stable for a long time.
So, it would seem like it wouldn't be that much of an extrapolation--when are you people going to retire?
Youve pick a retirement date yet? Well, let's say a half century from now, ok? So, that would be 2060? So,
you're going to retire out here, all right? Your whole life is in here. What do you think volatility is going to
do over that whole period? Well, judging from the plot, it's probably pretty similar, right? That's not much
more history compared to what we've already seen. Probably just going to keep doing this. But there's this
risk of something like this happening again. And we saw a near miss here, but this plot encourages me to
think that maybe outliers, or fat tails, or black swan events, are the big disruptors to economic theory.
Black-Scholes is not a black swan theory. It assumes normality of distributions, and so, it's not always
reliable. So, this leads me to think that option pricing theory--I presented a theory. The Black-Scholes
theory is very elegant and a very useful tool, especially useful when things behave normally. But, I think,
one always has to keep in the back of one's mind, the risk of sudden major changes like we've seen here.
Chapter 9. The Potential for Options in the Housing Market [01:09:33]
So, let me just you give us some final thoughts about options. I launched this lecture by saying, they're very
important. And they affect our lives in many ways. I've been trying to campaign for the expansion of our
financial markets.
Working with my colleagues and the Chicago Mercantile Exchange, we launched options, in 2006, on
single-family homes in the United States. We were hoping that people would buy put options to protect
themselves against home price declines, but the market never took off. We have, since, seen huge human
suffering because of the failure of people to protect themselves against home price declines.
There were various noises that were made by people in power, that suggested that maybe something could
be done. President Obama proposed something called Home Price Protection Program, and it sounded like
an option, a put option program. But, actually, it was a much more subtle program than that. It was a
program to incentivize mortgage originators to do workouts on mortgages, if the mortgages would default--
if home prices were to fall. And nothing really happened with it. The President can't get things started,
either, always.
I've been proposing that mortgages should have put options on the house attached to them. When you buy a
house, get a mortgage, you should automatically get a put option. I've got a new paper on that.
But these are kind of futuristic things at the moment. I'm just saying this at the end, just to try to impress on
you, what I think is the real importance of options markets. People don't manage risks well in the present
world. Having options or insurance-like contracts of an expanded nature will help people manage their
risks better, and it will make for a better world.
OK. I'll see you on Monday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 18 - Monetary Policy [April 4, 2011]
Chapter 1. The Origins of Central Banking: The Bank of England [00:00:00]
Professor Robert Shiller: Today's lecture is on central banks. We already had a lecture, a few lectures
ago, about banks, so what are central banks? Well, today they're very special government banks that are
responsible for the currency, the money. And so, every country in the world has a paper money that has the
name of their central bank on it. But I wanted to take the--as you know, I like to understand origins of
things--and I wanted to take it back to the beginnings of central banking, so we'll understand better what the
institution is.
I wanted to bring up first the theme of this course, which is that financial innovation or invention is an
important process that is not unlike engineering invention. When somebody gets an idea, and it's proven to
work, it gets copied all over the world. That's the way the human species is. We all have the same kind of
cars, we all have the same kind of airplanes. Why? Not because we're copycats, but because someone has
figured out something that works, and of course, everyone copies it. And I think the same thing is true with
central banks.
So, I wanted to get to the history of central banks and to go back first to the first central bank. Then, I'll
bring it all the way up to the modern times, where the recent financial crisis--the actions during the crisis,
the actions of the world's central banks was extremely important in preventing what might have been
another Great Depression. So, these institutions have become of fundamental importance.
Remember the story I told you in our banking lecture, about how banks got started in the U.K. They'd
already been seen earlier in other places, but the really modern banking institution is traced to the
goldsmith bankers, OK? So, people used to--there were goldsmiths who made gold jewelry, and people
found that, since they had a safe or they had a way of protecting things, they would leave their gold on
deposit at the goldsmith banker. And the goldsmith banker would give you a little piece of paper, indicating
that you could, any time, come back to the goldsmith and claim this amount of gold. And then, the pieces
of paper started circulating as paper money, and that's how it all started--unregulated, nothing to do with the
government. It was just private businesses.
And that system, paper money backed by gold, lasted until the 1970s. Amazing. Well, it wasn't always
gold. It was bimetallic. There would be gold and silver, and things--or all silver--it's a long story, but we
were effectively on the gold standard until just a few decades ago.
But there were problems right from the beginning. And the problem was, that sometimes the goldsmith
bankers wouldn't make good on their pledge to redeem in gold. You'd come with your piece of paper, and
they'd say, I've gotten too many requests. I don't have any gold anymore. So, that was the problem.
So, I wanted to start with the Bank of England, which was founded in 1694. And it was just a bank, but it
had a special charter from the parliament, from the British government, that gave it a monopoly on joint
stock banking, to start with. It would be the only bank in the United Kingdom that was allowed to issue
shares and sell shares to a large number of people. There were other banks, but they were partnerships and
had only a limited number of partners, so they didn't get as big. So, the Bank of England became the
dominant bank in the United Kingdom.
It started a practice--and this is very important, historically--it realized it had a lot of power, because it was
the gorilla bank and there were a lot of little banks. And they realized soon that they could put any bank
they wanted out of business, whenever they felt like it. How? Well, because Bank of England was so big,
they got a lot of notes issued by these other banks, so anytime they wanted to, they could just present them
all for payment, and no bank could withstand that. They didn't have enough gold on hand. So, they could
drive any bank to bankruptcy.
But the Bank of England began to assume its role as essentially a government bank, without being
officially government, by using a ''let's live and let live'' policy under one condition: if you are another bank
in the U.K., you have to keep a deposit with us, OK? And the Bank of England would tell you how much.
If you didn't do that, you could be destroyed. But that created a stability to the system, because the Bank of
England had money to bail them out whenever--you know, they had a deposit with the Bank of England.
The Bank of England required that. And so, whenever a bank got in trouble, they could always take their
money out of the Bank of England. So, the Bank of England than would help these banks in return for their
keeping a deposit, sometimes even lend more money to them. So, that created a stable banking system over
the centuries.
So, that was the model for all of the central banks of the world. They're all copies of the Bank of England.
The Bank of England, by the way, was not an independent--it became a government bank. I don't know the
whole history, but it wasn't really independent of the government until 1997, when the United Kingdom
made it formally independent. But nonetheless, it was a model for central banking, and it was observed
over much of the world.
Chapter 2. The Suffolk System and the National Banking Era in the U.S. [00:06:27]
Notably, in the United States there was a bank called the Suffolk Bank. This is much later. It was founded
in 1819 in Boston, and it was a private bank. And on its own, it just decided to do the same thing that the
Bank of England did. It required that all of the New England banks kept a deposit with it. And it did the
same thing, and it stabilized New England from bank runs. The Suffolk System lasted until 1860.
So, you can see how central banks are inventions of people. They weren't government inventions at all.
This Suffolk Bank just did this. It became a big and influential bank.
The United States in the first half of the 19th century had repeated banking crises, and there were repeated
problems with the currency. It used to be that, if you went to a store and you wanted to buy something,
they'd say, let's see your money. You'd take out all of your money, you'd lay it down, and they'd look at it,
and they'd say, well, this is Boston money, this is New Haven money, this is Hartford money. And they
would pull out a book called the Bank Note Reporter, and they'd say, well, our money dealers are now
doing a 20% discount on Hartford money, so I'll give you $0.80 on the dollar for the Hartford money.
Boston money, we're down 30% on that. What a messy system.
I shouldn't mention Boston, because Boston had a good record because of the Suffolk Bank. It was worse in
other states, further you got from Boston. So, the Suffolk Bank became held up as a model of a banking
system.
But the U.S. also had two banks, one called The Bank of the United States, which was founded in--I'm
forgetting the year, it's not in my notes. Anyone tell me? When was the Bank of the United States founded?
1789, I think. [Correction: 1791] And we had a Second Bank of the United States, but they weren't really
functioning like the Bank of England. They were maybe somewhat like them, but the Banks of the United
States were not really central banks, and they were not renewed. They disappeared in 1836.
But the big movement in the United States. Because the United States didn't want the government involved
in private business, they were reluctant to set up a central bank for a long time. In 1863, the U.S. passed the
National Banking Act. Actually, there was a revision of it in 1864, and they tried to get some of the
advantages of these central banks without actually founding one. So, what they did then is, they said, there's
a new kind of bank called a national bank, and the national bank would have a name like the First National
Bank of New Haven. Every city created a bank in 1863, which was called the ''first national bank of
something.''
And the government required that they keep on deposit with the Treasury capital to back their currency. So,
they were called National Bank Notes that were issued by the banks--printed by the government--but they
all looked the same, except they had a different name of the different bank on them. And they had capital
requirements, so the banks had to put deposits with the Treasury backing their currency.
That was a success. The United States never again had a problem with its paper money. There was never a
problem of discounts anymore. All the national banks would honor each other's notes at par, and so that's
when the United States had a paper money for the first time.
But it didn't create a system of stable currency. There were still banking crises, but they had a different
form. It wasn't a failure of the bank notes. We fixed the bank note problem in 1863, but the problem was,
there were still runs on banks, and there were still credit expansions and contractions, that led eventually to
people in the United States thinking, we've got to eventually copy the Bank of England and do the same
thing here.
There was a terrible banking crisis in 1893, for example, when everybody thought the banks were going to
fail. Somehow they didn't worry about the currency. The National Bank Notes were thought to be perfectly
safe, but they thought the banks weren't safe, and so there was a crisis, and it led to the depression of the
1890s. Then, there was another one in 1907 that was really bad.
Chapter 3. The Founding of the Federal Reserve System [00:12:08]
And so, people wanted to fix somehow the system, and so, that led to our current system, which has been
around almost 100 years. And I call it a copy of the Bank of England, but it might not be described that
way by everyone. It's called the Federal Reserve System, all right? And that was created by an act of
Congress in 1913, and it opened its doors in 1914.
But the U.S., again, we always feel that we're different. We have to make it look different. We can't just
copy the Bank of England. We've got to do something different. So they said, why don't we create 12
banks, that sounds more American, and have them all over the country. And so, we didn't create a central
bank, we have a banking system with 12 Federal Reserve Banks. But of course, they decided to have a
headquarters in Washington, DC, called the Federal Reserve Board, or the Board of Governors of the
Federal Reserve System. It's an agency in Washington that oversees the 12 regional banks.
Do you know what region--the country is divided up. What region are we in? It's Boston. This is the Boston
region. So, most of the money in your pocket is Boston money. It only says so now on the $1 bills, I think,
but you can look and see where your money came from, which of the 12 banks your currency--but the
Federal Reserve System, as founded in 1913, required, just like the Bank of England, that banks have
deposits. Either currency in their vaults or deposits with their Federal Reserve Bank to back up their
currency. And once again, if they got into trouble, they could draw on their deposits with the Federal
Reserve. Or even beyond that, the Federal Reserve could come to their rescue. They've been good banks,
they've kept their deposits--just like under the Suffolk System--they've kept their deposits with the Federal
Reserve. The Federal Reserve will then help them a little bit more. And so, it became known as the lender
of last resort.
And the system also operated something called the ''discount window.'' Why do they call it a window? You
people never go into a bank anymore, right? Or do you go into banks? Remember, they used to have a
teller, and the teller would be sitting at a table, and there was a little something. He's talking to you through
a window. I guess, they wanted to keep you separate from the money. So, there was a window, where a
teller would talk to you.
The discount window was a special window at the Federal Reserve Bank for banks to come. This is the
metaphor, anyway. I don't know if they ever had such a window. And so, the bank that was in trouble could
go to the discount window, and has to bring something, though. They have to bring some securities as
collateral. And so, the teller behind the discount window would discount the collateral brought by the bank,
and lend money. It's called a discount window, because you couldn't just borrow money, you had to bring
some asset as collateral for the loan.
So, in 1913, when the Federal Reserve was founded, President Wilson--whos the president who signed the
bill--was almost ecstatic. I have a quote from that. I don't remember exactly, but something like, we have
put banking crises behind us forever, and this will lead to a system of prosperity and--I can't think of all the
nice words he used. People thought that now that we have adopted the British system, it ought to be smooth
just like in Britain. There shouldn't be a problem anymore.
And so, we still live with that system today. I think Wilson was right. It was a big step forward. Again, it
was a copying of other people's successes. Nobody knows exactly, how the banking system works. There's
a theory of money in banking, but it has worked in practice.
So, central bankers start to become very important in modern society, because they are really the keepers of
the gate of sensible lending. There is a tendency for banking systems to over-lend. They create booms, and
create a false prosperity for a while, and then it crashes, and we have a banking panic and a recession or a
depression.
That means, then, that the banking system has to be the source of stability and good sense. We tend to
recruit as central bankers people, who are moral and stable in their lives. One of our Federal Reserve chairs,
William McChesney Martin, summed it up very nicely: the job of the central banker is to take away the
punch bowl as soon as the party gets going, OK? It's like a parent, right? You can have one drink, but we're
going to stop. So, that's what the central bank controls the system through reserve requirements. That is, by
telling the banks, who are members of the system, how much they have to hold in reserves, which are
deposits at the central bank or currency. If they hold currency in their vaults, if it's right there, then they're
OK.
This term, reserve requirement, actually goes back to before the Federal Reserve. Because we had state--in
the United States--we had state banking regulators that were already imposing reserve requirements. I
haven't tracked down exactly, when it began, but I think, probably around 1900 in the United States, during
the Progressive Era.
There are also capital requirements. And I'll come back to making a distinction between the two. Capital
requirements and reserve requirements, both of those terms began to flourish around 1900, even before the
Federal Reserve, with state banking regulators, who were requiring both capital and reserves in the United
States. I don't know the history of every other country. But after the Federal Reserve was set up in 1913, it
began to take over both of these functions of setting reserve requirements and setting capital requirements.
Let me go a little forward in history. The system appeared great. Now, every country of the world, not just
the U.S. and U.K., virtually every country of the world had a central bank. Even communist countries, I
think, had central banks. But the system broke down in 1933. Well actually, before '33. After 1929, banks
started to fail. And the Federal Reserve could have bailed out the banks--in the United States they started to
fail, not the United Kingdom. There was a banking crisis after 1929, and it reached its peak in 1933.
So just before President Roosevelt took office, the banks were in total disarray. And the first thing
Roosevelt did as president was to shut down the entire banking system of the United States. It was called
the banking holiday. Because everyone was running to the bank, it was a catastrophic bank run. Everyone
was failing at once. And it was quite a scary situation, because nobody could get their money. The banks
were all closed, all of them. And people started to run out of money.
I remember that--was it the Harvard Crimson?--did a poll of its students asking them, how much money do
you have in your pocket? And it got down to, like, $0.10 and $0.05. They just spent all their money. What
do you do? I mean, how can you get lunch? Well, I assume they had a cafeteria. Somehow, you could still
do it. You couldn't go anywhere and spend any money, if you didn't have it, because it was all tied up. So,
people started changing IOUs, and it was just a mess.
So, the Federal Reserve didn't stop that crisis, but the Roosevelt administration did other things to prevent
crises like this, notably set up the Federal Deposit Insurance Corporation. Now this was a--deposit
insurance had preceded the FDIC in 1933, but it had never been a success. It had been tried in a number of
places. The U.S., I think, set the example for deposit insurance. And that began to augment central banking.
The U.S. had not had another banking crisis since 1933 until 2007, just recently. Well, I should say, there
was the Savings and Loan Crisis [in the late 1980s], but not a big banking crisis. And that is testimony to, I
think, the importance of deposit insurance.
But the Federal Reserve began to see its role as not so much preventing banking crisis--that was always in
the background--but as stabilizing the economy. And so, the Fed began to think of itself as preventing the
recurrence of recessions. So, when the economy was over-heating, the inflation was building up, the Fed
would raise interest rates, and the higher interest rates would cool down the economy. And when the
economy got too soft, when the unemployment rate went up, the Fed would cut interest rates, and that
would encourage borrowing, encourage spending, and boost the economy.
Actually, that function of the Fed goes back even before 1933. There's an economist, Charles Amos Dice,
who wrote in the 1920s, that the Federal Reserve is like the regulator on a steam engine. Do you know
anything about steam engines? They have this thing that whirls around with two little weights, and if the
steam engine gets too fast, the weights spin out by centrifugal force, and it cuts off the steam, so that it
doesn't overheat, the engine doesn't get going too fast. And so Dice said, the Federal Reserve is an
invention, it's the regulator for the whole economy. And I think he was right, although it's not as accurate as
a regulator on a steam engine, but it works out somewhat well.
Chapter 4. The Move to Make Central Banks Independent [00:25:46]
I wanted to mention that every country now has a central bank, but I just wanted to mention the European
Central Bank, because it's quite new. It's quite new, and it's maybe the biggest central bank now in the
sense that it--well, I shouldn't say that. It might be the biggest central bank by some standard. There was a
treaty signed at Maastricht in 1992, which led to the creation of the European Union from the European
Communities, and it also created a plan for a new currency called the euro, which is a European currency.
And the euro did not actually start until 1999, and the currency, actual currency, was not issued until 2002.
So, that is a relatively recent invention.
The European Central Bank, or ECB, was founded in 1998--that's before the euro currency started. They
created a list of countries that wanted to participate in the euro zone. Not all European Union countries
decided to participate in the euro, notably the United Kingdom had a referendum and voted against it. And
to this day, they are not members of the euro. Also [addition: as of April 2011] Sweden, Lithuania, Latvia,
Estonia, Poland, Czech Republic, Hungary, Romania, Bulgaria, and Malta are not in the euro zone.
[addition: All these countries are members of the European Union (EU).] [correction: Malta officially
adopted the euro in 2008, and Estonia in 2011] Some of these countries, that are not officially in the euro
zone, use the euro unofficially. It's not their currency, but there's no law against your coming in and
spending euros, so the euro seems more distributed than that.
So anyway, that's the most recent central bank, but it's the same general structure as--every European
country has it's own central bank, like the Banca d'Italia or the Deutsche Bundesbank. But their original
purpose is kind of gone, because they no longer maintain a currency. There are no more Deutsche Marks or
Italian Lire. They're all using the euro. So, the real central bank is the European Central Bank in Frankfurt,
led by Jean-Claude Trichet right now [addition: as of April 2011].
Bank of Japan, by the way, became independent in 1997. Bank of Japan, another very important central
bank. There's been a movement in the last few decades to make central banks independent. This was
something that our own Federal Reserve had from the beginning. It was designed to be separate from the
government. The reason was, they thought that a government might want to inflate the currency. Political
pressures might at certain times cause them to try to influence the central bank. And so, the Federal
Reserve was set up, so that the members of the Board of Governors had 14-year terms. They couldn't be
kicked out, except for impeachment offenses, and so the government couldn't control the central bank.
The independent central bank has been very important. What tends to happen is, you bring people in,
who've had long careers in banking, who have a reputation for integrity. And you tell them, that you are the
custodian of the currency. You bring in people, who believe in the importance of a stable currency, and
then you give them a 14-year term. And they're there. It's like the Supreme Court, almost. You can't kick
them out.
Some people think, that's why the U.S. has had such a stable price level, because of our independent central
bank. So many countries have fallen into inflation that has undermined the currency, but the U.S. hasn't. I
think, that's why there has been a move to copy the independent central bank.
Chapter 5. U.S. Monetary Policy: Federal Funds Rate and Reserve Requirements [00:30:49]
I wanted to talk now about specifics of what the central bank does. Notably, the Federal Reserve System
has a committee called the Federal Open Market Committee, FOMC, Federal Open Market Committee, that
meets around once a month. And they issue a statement every time they meet, and as it is now--actually,
FOMC doesn't go back to 1913--but I'm talking about the Federal Reserve as it is now.
This committee decides on a range for an interest rate called the Federal Funds Rate. And the federal funds
rate is an overnight interest rate that is charged on loans between banks and some other financial
institutions. You generally would not have access to the federal funds rate. Now, you probably don't need
it, because you don't need an overnight loan, anyway. Most of us would borrow money for more than one
night, but banks, for various reasons, do this lending and borrowing every day, at least under normal
circumstances.
So, we have an overnight interest rate, OK? There's also a longer federal funds, but we're emphasizing the
overnight rate. And it's unsecured. This is just an unsecured--there's no collateral--it's an unsecured loan
between banks. So, the interest rate reflects some risk. Negligible risk, usually, because banks trust each
other, at least overnight, right? They know pretty much, they're going to get paid back. And the current
federal funds rate in the United States is 0.13%, as of last Friday [addition: April 1, 2011]. That's 13 basis
points, so it's virtually zero.
This is a policy decision of the Federal Open Market Committee. They have decided that the range for the
federal funds rate will be between zero and 25 basis points, so as of last Friday [addition: April 1, 2011], it
was exactly in the middle of their range. The FOMC uses its decisions to set the federal funds rate as a way
of stabilizing the economy. This is the regulator that Dice talked about.
Right now, they've set it virtually at zero, because the economy is so weak. The unemployment rate last
week was 8.8% [addition: as of April 1, 2011], extremely high. And so, the Federal Reserve is not worried
about inflation now, it's worried about high unemployment. And it's pushed it about as close to zero as it
can get it. It can't go below zero, because you can't have negative interest rates--no one would lend at a
negative interest rate. So, that's where we are.
Now, I wanted to just tell you about an interesting development that came in just, well, just in 2008. I
mentioned that banks hold reserve accounts at the Federal Reserve. Traditionally, those accounts were not
interest-paying. Banks had to either hold money or an account at the Federal Reserve for their reserves, and
neither of them pay interest, right? If you hold money, you don't get any interest. If you actually have
currency in your vault, you don't get interest. And until recently, banks didn't get interest on their deposits
at the Federal Reserve, but that all changed in 2008 with the Emergency Economic Stabilization Act, that
President George Bush signed. EESA, as it's called. And EESA allowed the Federal Reserve to pay interest
on the reserves, held in accounts at the Federal Reserve, OK?
So, the Fed has a policy now of paying interest on reserve balances. Do you see what I'm saying? I don't
know what the Suffolk Bank did, or the Bank of England did, but I know what the Fed is doing now. If a
member bank puts money in deposit with the Federal Reserve, they will get an interest rate. And you can
find out what the interest rate is by going to the Federal Reserve website, and right now [addition: as of
April 1, 2011] it is 0.25%. So, that's an important policy change, because now it encourages the holding of
reserves.
Some people look at this, and ask this question: Here's the federal funds rate--why isn't it the same as the
interest on reserves? Interesting question. Why would any bank invest in the federal funds market, if they
can get a higher interest rate by just holding a reserve at the Federal Reserve? There's been a lot of
discussion of why that is now. It's a new phenomenon, because the interest on reserves goes back only less
than three years. I think the simplest answer to the question is, that member banks of the Federal Reserve
System have stopped lending on federal funds market, basically. They just leave it in reserves, because
that's a higher interest rate.
So, who is lending at this? It turns out that there are some people, notably the government-sponsored
enterprises like Fannie and Freddie, that are not eligible for interest on reserves. So, they have taken over
the federal funds market.
The reason the Fed added interest on reserves is to create another tool of monetary policy. There's a lot of
concern that, after this crisis is over, there'll be a sudden surge of inflation. Let me come back to that.
Basically, what the Fed has a new tool is, if that happens, to raise the interest on reserves, and that will help
contract the economy instantly, very rapidly.
The way the Fed controls the federal funds rate, and has been doing for years, is by buying and selling
Treasury bills on the open market, by affecting the supply and demand for short-term credit. And that
indirectly--they don't actually deal in the federal funds market, they deal in the Treasury bill market, but
since those markets are interlinked, they indirectly target the federal funds rate.
So, that's the old way of trading in the federal funds--not in the federal funds market--trading in the short-
term Treasury market through the New York Fed. But now, they have a new tool. So, we're entering a
whole new regime of monetary policy.
So, I wanted to talk to about reserve requirements a little bit more and what those are. So, the Federal
Reserve has the authority to set the amount of reserves that a bank holds. I wanted to make clear the
distinction between reserve requirements and capital requirements. The Federal Reserve has what's called
Regulation D, which specifies how much banks have to hold as a function of their liabilities. And as of
right now [addition: April 2011], the reserve requirements are 10% of transaction accounts. That means,
that a bank has to total up all of the transaction accounts, and that consists of checking accounts, NOW
accounts, and ATS accounts.
Their transactions accounts are accounts like checks that--people have a deposit in the bank, that they'll use
for spending, and those are instantly withdrawable. In contrast, there's something called ''time deposits.''
Those are savings accounts, and the bank does not have to give you the money immediately. In other
words, if you go to your checking account [addition: checking account institution], and say, I want my
money--it's a transaction account--they have to give it to you instantly. That's the rule. But if you go to your
saving account, they can stall. You might not have noticed it, but it's in the fine print somewhere. This is a
time deposit. So, the Fed is not worried about time deposits.
Here, we're talking about reserve requirements. Reserve requirements are still based on the old theory that
we're trying to prevent bank run, OK? We don't want there to be a run on banks, where people panic and try
to withdraw their money all at once. So, we want to make sure the banks have enough reserves, and the Fed
currently thinks, 10% ought to be enough.
For time deposits, it's zero. You don't have to put any money on reserve for time deposit. Why does the Fed
think that? Because you've got 60, 90 days, or a year to pay the person back, so they can't run on you. So,
we don't require any reserve requirements against time deposits. But it's 10% for transaction accounts,
which is substantial, because they're still worried about this. OK. So, this is the situation.
We used to emphasize in lectures about central banking the so-called money multiplier. The money
multiplier, well, it's complicated, but the simplest thing is, it might be one over the reserve requirement. It's
not exactly that, but if the reserve requirement is 10%, then the total amount of deposits, that banks can
issue, is going to be 10 times the amount of currency and deposits they have at the Federal Reserve. So, that
means the reserve requirements would fix the money supply under the old theory, because the high-
powered money is the currency plus deposits at the Federal Reserve--that's reserves--and if the reserve
requirement is 10%, and banks want to just meet that requirement and nothing more, they're going to have
10 times as much deposits as there are reserves.
I'm over-simplifying the money multiplier, but I'm telling you that, at the moment in history, it's irrelevant
because banks are holding excess reserves. The world has changed. Just a few years ago, before this
financial crisis, banks didn't want to hold excess reserves, and so there were hardly any excess reserves.
Why? Because they don't get any interest on them. And so, banks didn't hold excess reserves. So, the
money multiplier theory would work, because the amount of reserve was just about exactly equal to 10% of
transactions. I'm over-simplifying, but something like that was true. But now they're paying 25 basis points
on reserves, so that's a lot more than you can get investing in the federal funds market, so banks are just
perfectly happy to hold excess reserves.
So, the excess reserves now are over--I think it's $1.2 trillion. [That was the correct value for February
2011.] It's huge, because of interest on reserves. I don't have the exact number. But something has
fundamentally changed in just the last few years. So, reserve requirements, they must hold for some banks,
but for most banks, they don't even look at reserve requirements anymore. What do I care? I'm so happy the
hold reserves, I'll hold way more than they require. So, reserve requirements are non-binding for most
banks now, so it's a different world.
Chapter 6. Capital Requirements, Basel III and Rating Agencies [00:45:23]
This brings us, then, to capital requirements. So, in the world--history has always changed--the world, as of
a few years ago, everyone emphasized reserve requirements, and those were the requirements that had as its
motive preventing bank runs. But we're not going to have a bank run now, when these banks have over a
trillion dollars just sitting there. They're holding so much, that it's not an issue right now. So, something
else has taken the center stage, and that is capital requirements, which we talked about last time [correction:
in the lecture about banks].
So, capital requirements are different from reserve requirements. I just defined--reserve requirements were
a fraction of the transaction accounts. They were defined by a liability of the bank. A transaction account is
like a checking account. It's money that the bank owes to other people, and we have this requirement, that
10% of that is the reserve requirement.
But capital requirements are different, and they're more likely to be binding these days. And these were
emphasized in Basel III, which we talked about before. Basel III is not yet in force. It's going to take a long
time. Basel III has a phase-in period that is going to take until, I think it's 2019. [correct] But there's a lot of
talk now about trying to get Basel III phased in.
Remember, we talked about risk-weighted assets? Now, it is, banks have to hold capital as a fraction of
their risk-weighted assets. So, right now, the countries of the world, they've agreed, the G-20 countries have
agreed on Basel III. But each country has to decide on the implementation of Basel III.
The United States, in particular, is having problems with Basel III, because Basel III refers to credit ratings
in many places. But Dodd-Frank, the Dodd-Frank Act of 2010 abolishes credit ratings. The government
will no longer make any use, in any regulation, of credit ratings. Remember what credit ratings are.
Moody's and Standard & Poor are the two best-known credit rating agencies.
The government, the SEC, starting in 1975 defined what they called NRSROs. That's Nationally
Recognized Statistical Rating Organization, all right? And that included Moody's, which was founded
about 1900 [John Moody & Co. was founded in 1900], and Standard & Poor's, which was result of the
merger of Standard Statistical Association [correction, Standard Statistics Bureau, sometimes called
Standard Statistics Company] and Poor's [H. V. & H. W. Poor & Co., also called Poors Financial Service,
Poors Rating Service] a little bit after 1900 [Correction: actual merger was in 1941].
They're venerable old institutions that give a risk rating for securities. For example, Moody's will give its
best securities a AAA rating, OK? That means, Moody's thinks they'll never default. Yale University is
rated AAA by Moody's, for example. But if they don't like you quite as much, they'll down-rate you to AA.
Or if they don't like you even more, you're only A. And then God forbid, you go down into the Bs.
In fact, Moody, John Moody, in this book, acknowledges that he took the same grading system that he got
in college. It's a little different. You don't get a AAA grade here, do you? I've never given a AAA. But
that's, how Moody saw it, so it survived. It's like letter grades to securities.
But Moody did that in 1900. If you read his autobiography, people said, you're crazy. How can you give a
grade to a security? It seemed like a wild idea, but he stuck with it, and over the years, people began to
believe in them more and more. So, it led to the idea that we fully understand the risk of securities, and so,
a complacency set in, and the government started to recognize these NRSROs as if they were proclaimers
of God's truth. And they started all kinds of regulations, said what your capital had to be depending on the
rating of various assets you hold.
But the whole thing collapsed in the recent financial crisis, because some AAA securities lost almost
everything. So, the rating agencies made a big problem, issue, and so Congress has now said, nobody can
make any regulation based on ratings of the NRSROs.
But Basel III people didn't get the message. Theyre not America, they're international, and they still
believe in them. I think it's a little bit difficult to know how to handle risk. This is the fundamental problem.
And it would be nice, if Moody's and S&P could tell us, but the problem is that they missed this whole
crisis. They didn't see it coming. And why didn't they? Well, that's a deep issue, but that's what people are
wrestling with right now.
So, the U.S. has to figure out what to do to reinterpret the Basel III recommendations for the United States
without using any reference to Moody's and S&P. What will probably happen, I think, is, that the banks
will have to have their own risk committees, and they will have to come up with their own assessments of
risk, and they'll be responsible for those. But what will really happen is, they'll just look at the Moody's and
S&P ratings. It'll be rubber-stamping them. So, I don't think that--there's a whole question whether Dodd-
Frank will be effective in reducing our requirement.
Chapter 7. Capital Requirements and Reserve Requirements in the Context of a Simple Example
[00:52:34]
But I wanted to go over the capital requirements once again, because now they're increasingly important.
And I wanted to go through just a simple example of capital requirements, so that you'll understand them.
And I don't think, the general public understands them very well at all. This is old accounting, or old
finance. These requirements go back 100 years. I'm going to talk in very simple terms about them, over-
simplifying. Basel III is a complicated new agreement. It has a lot of ins and outs, but I'm just going to
over-simplify it and talk about the Basel III common equity requirements.
I'm going to tell a little story about founding a bank, OK? Now that's just to understand how capital
requirements work. So, imagine that you decided to found a bank, OK? In developed countries of the world
today, you can do this. You can set up your own bank. The only problem you have, you have to get a
charter, you have to apply for a charter. You have to decide, whether you're a national bank in the United
States or some other kind of bank, but you get a charter and you open your doors. Now you've got to start
complying with capital requirements.
But let's say you do that, all right? You find that there's an empty bank building downtown, all right? You
rent the building, you go through the paperwork, and you set up your bank, and you open the doors. And
now, we have one of those windows with a teller, and are inviting deposit, OK? So, I'm going to tell a
story, which is over-simplified maybe a little bit.
Let's say, that you open your doors, and someone walks in with $100 and deposits it, all right? So, this is
your bank, or I'll say my bank. OK. Now, I think regulators would require you to come up with some
capital first, but it seems to be a nicer story--you start out with deposit. Assume your regulators allowed
you to start. So, somebody walks in and deposits, and here's your assets, and here's your liabilities, OK?
Left side is assets, right side is liability.
So, someone deposits $100 in cash to your bank, all right?? So, you've got an asset now of $100, OK? And
you have a liability now of $100. If that's a savings account, you don't have any reserve requirements. If it's
a transactions account, you have to hold $10. I've got it, right? I've got $100 sitting in my vault, because the
guy just gave me $100, so I'm satisfying both my reserve requirements and--now, am I satisfying my
capital requirements? Well, I have to calculate risk-weighted assets, all right? Remember, every kind of
asset has its risk. What about cash? Well, cash has a zero risk, so it has a zero risk-weighting. So right now,
my risk-weighted asset equals zero, OK?
OK, I've got to satisfy all the regulations that are on me. I'm satisfying my reserve requirements, right? I've
got my reserve, I've got $100. This is cash in my safe, and this is a liability. I owe $100 in the form of a,
let's say it's a transaction account. Whenever this person comes back, I've got to pay $100, OK? So, my
reserve requirements are satisfied, because I've got more than 10% of my transactions account.
My risk-weighted assets are zero. Now, Basel III says that you have to hold 4.5% of your risk-weighted
assets as capital. But now, wait a minute. I have a problem, OK? What is my capital here? I don't have any
capital. I've just opened my doors, and I've got $100 in assets, $100 in liabilities. Everything looks okay
reserve requirement, but there's no capital.
So, what is capital? I have to issue shares to come up with capital, and I'm going to need--Basel III says,
4.5% common equity requirement. And they also have something called a capital conservation buffer,
which is another 2.5%. Plus 2.5%, which you don't absolutely have to hold, but if you don't hold it, you're
subject to restrictions, so I'm going to add these. This is the capital conservation buffer. I've got to hold 7%
under Basel III. And I don't have any capital here, all right?
So, what do I do? I'm not in compliance. So, I've got to raise capital. So, what I can do is I can issues
shares. I have to sell shares in the business. So, all I need to do is sell seven--OK, what would it be? Let's
say, I issue $20 in shares, OK? And then, that means someone gives me more cash, because someone paid
for the shares. So, I've now got $120. Well, I add another plus 20, so it's a total of assets of 120, all held in
cash. Now, this is a different kind of liability. This is common equity.
And the regulators make a big distinction between this kind of liability, the transactions account, and this
kind of liability, the $20. Why do they make a big distinction? Because this guy can come to the window
any time, and you've got to give him $100, whenever this person asks. The shareholders have no demand
on you at all. They own a share of the company. They can't come to the window and demand anything. You
can just send them away. The only deal you have with shareholders is, that all shareholders will receive an
equal dividend, if the board of directors decides to vote dividends--they're shareholders in the company.
But they can't run the bank. The shareholders can't show up at the window, so there's no risk of bank runs
for them. And there's no risk of problems, because if anything goes bad, you just tell the common equity
guys, you're out, you lost.
So now, what are my risk-weighted assets? They're still zero. I've got $120 in cash. Zero--I don't have any--
7% times zero is zero. So now, I'm in great shape. I've satisfied both my reserve requirements and I've
satisfied my Basel III capital requirements.
So, what do we do next? We've created a bank, and there's no interest paid on these checking accounts, and
we're not earning any interest. We've got a bank and we're satisfying the requirements, but nobody's
making any money, so we've got to do something to make money.
So what I'm going to do is, I'm going to--let's say we get our board of directors meeting--a board of
directors elected by the common equity shareholder--and we decide, let's make some corporate loans. So,
why don't we lend out all of this $100, that was cash, and lend it to some business as a corporate loan, and
we'll charge them interest? Now, we're going to start making money. So, this is no longer cash in safe, this
is corporate loans. Loans to corporations to do business, all right?
So, there we are. Our balance sheet balances, everything looks fine. But what are our risk-weighted asset
now? Well, you remember, corporate loans get 100% risk-weight, because under Basel--going back to
Basel I, they always thought corporate loans are risky assets. So, my risk-weighted assets are now $100,
OK? And 7% of $100 is $7. So, hey, I'm doing fine. Now, we're capitalized enough, we're in business.
We're satisfying both our reserve requirements--reserve requirements being 10%--and that's only $12
[correction: $10], we've got it in cash--and we're satisfying our Basel III capital requirements. So,
everything is fine. Everything is fine and we're in business. And we're not done yet, because our risk-
weighted assets--our $7 is the capital requirement, and we've got $20 in common equity. OK. So,
everything is great. This is fine.
But now, let's go on. Now, there's a crisis. Business gets bad. So, the next thing that happens is 20% of my
corporate loans default, OK? And so, we then--it becomes clear, we have another board meeting, and
someone says, I have bad news. We made $100 in corporate loans, but these guys--$20 is never going to
get paid back. The borrower is out of business. So, I suggest, we do a write-off of our corporate loans, and
lets reduce them to $80, OK?
So, what happens? Now, assets have to equal liabilities. $100 is our assets now, not $120, right, because we
just lost $20. Our liabilities can't be $120, because they have to equal our assets. What gives? Well, it's the
shareholders that give, so we mark down common equity to zero. And now, assets and liabilities match.
So now, let's look at our requirements. What about our reserve requirements? Reserve requirements are
fine. We're holding excess reserves. We've only have to hold $10, and we've got $20 in cash. But we're no
longer satisfying our capital requirements. So, our bank regulator is going to shut us down, unless we do
something to raise capital.
So, how do we raise capital? That's the next step. Well, one thing we could do is, we could sell some of our
corporate loans. We could find a buyer for our corporate bonds, and we could sell, say, $20 worth of them,
bring this down to 60, and this would go up to 40, all right? Our risk-weighted assets would now--let me
see. No, that wouldn't do it. Sorry, that wouldn't do it, would it? We'd still have--I'm sorry, I misspoke. We
still don't have any common equity.
In this case, if we don't have any common equity, we can't get out of this by selling our loans. We could
have, if it didn't reduce it to zero. If the common equity went down to $10, then I could sell some of my
corporate loans to get out of this mess, right? But I made it zero, so the only way out that I can do, is to
issue more shares.
So, I've got to go to my friends again and say, well, we started this bank, but we goofed up. We made bad
loans, and so we've exhausted our common actually. I've got to raise more capital now. And so, what you
could do is, get more friends to come in. Now, they might not want to do it, because the previous friends
got wiped out. They lost everything, right? But you're coming in as new shareholders on top of the old, and
you could then go back to where you were before by just issuing more shares.
Chapter 8. Capital Requirements to Stabilize the Financial System in Crisis Times [01:05:30]
So, this is the system. I think I've pretty much summarized it. It's simple. Now, the issue is, however, that,
what motivated Basel III was that--this system of requiring banks to hold capital is supposed to stabilize the
system. If they've got enough common equity, the bank won't go bankrupt, even if they lose some of their
corporate loans. It would be a big disaster to drive them to insolvency. But the problem is that the system
they set up has banks responding to a crisis by selling corporate loans or issuing new shares. The problem
is, both of those are hard to do in a crisis.
In a crisis, when everything is falling apart, you go out saying, I want to issue new shares in my bank that
just lost everything, the investors are going to say, you have got to be kidding. I'm not going to invest in
you right now. So, you can't raise new equity. OK, what about selling loans? Well, the problem is, in a big
national or international crisis, every bank on the planet is trying to sell its loans at the same time. So, it
creates a collapse in the system. And this is what happened in the financial crisis.
This story repeated a million times. Banks were trying to raise capital and they were trying to sell assets
either by issuing--they were trying to raise capital either by issuing shares or by selling assets. And
everyone doing it at the same time created a crunch, and the whole system would have collapsed, if it
weren't for the central banks. The central banks of the world responded quickly by loans to companies, to
banks and other companies. So, the lender of last resort saved the whole system from collapsing. That's the
story of the financial crisis.
The remaining story is, the Basel III people in Switzerland said, let's analyze how we got into this situation.
How did it get so bad? And they thought, you know, it's kind of a funny system, because we're requiring
banks to raise capital at the worst time, and that can't be the right system. They looked around and tried to
decide what to do better. Most countries of the world were following this kind of system. There were some-
-some people were impressed by the government of Spain having a better system, but the Spanish banking
system collapsed anyway, so it didn't solve the problem.
So, Basel III came up with a solution, which was to allow the central regulators to add another buffer of
2.5%, if they think, there's a bubble going on. They would do this before the crisis, and that raises the
common equity requirement to 9.5%. So, the idea is, this is going to be a problem--raising capital at a time
of difficulty is always going to be a problem. And we can always rely again on our central banks, but
maybe we can't, maybe we shouldn't. And so the idea is, let's take bank regulators and make it their
obligation to raise capital requirements in advance, when they see a bubble coming.
Now, another thing that happened in the United States is the Dodd-Frank Act of 2010. Because of intense
public reaction to all the bailouts, said that the Federal Reserve can no longer use discretion in deciding
who to bail out. They can operate a discount window, but it has to be completely fair and even for
everyone. They can't decide, we're going to bail out Bear Sterns, and we're going to let Lehman Brothers
fail. All they can do is operate a consistent discount window. So, they've constrained--the Dodd-Frank Act
constrained the central bank in the United States from exercising the kind of judgment that saved us from
the crisis. And we're going to have to rely on some different things, like better capital standards, like Basel
III, to fix the situation.
Whether we're there or not, is going to be a big question. This is a complicated system, and we put a lot of
the best minds into trying to figure out how to prevent the kind of instability that we're seeing in this
example, where everyone is short on capital at the same time, everyone is selling loans at the same time,
and the whole system collapses. We've come up with different solutions, but they have to be implemented
yet, and there are problems of implementation. The role of central banks and of regulatory authorities are
evolving and changing, and it'll be a period of many years, before we know where the system is actually
going.
All right. I will stop here. Next lecture is on investment banking, and we have a former ECON 252 student,
Jon Fougner, who is back after nine years, and he will tell us about his experiences as an investment
banker, and also a Facebook executive.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 19 - Investment Banks [April 6, 2011]
Chapter 1. Key Elements of Investment Banking [00:00:00]
Professor Robert Shiller: All right. Now, are we in order? OK. All right.
Today, we want to talk about investment banking, which is different from commercial banking. And today
we have a guest, Jon Fougner, who took this course almost 10 years ago and has been working in
investment banking since. I'll introduce him in a few minutes, but I wanted to start with just the elements of
investment banking, and then I wanted to talk about changes in it that came about after the financial crisis
of 2007 through 2009. OK.
The topic is investment banking. And that is a term, a 20th-century term, that first became big and
important, I'd say, in the 1930s, but preceded that by some years. And it refers to a business of helping
other businesses create securities. If someone wants to issue stock, they go to an investment banker to help
them. Or if you want issue bonds, you go to an investment banker. It can be a corporation that goes to the--
for-profit, it can be a non-profit corporation, it can be a government. I suppose even an individual, who is
incorporated, can go to an investment bank. That's the investment banking business.
Now it differs--it shares something with the consulting business, because investment bankers serve often as
consultants. A company will come to an investment banker with a problem, and they want to raise money
by issuing new shares, for example, to solve that problem. But if it's a good investment bank, they will do
more than just issue shares for them. They'll talk about their whole corporate strategy. So, in that sense, an
investment bank looks like a consulting firm, but they don't do pure consulting. That makes the distinction.
Maybe, they're in many ways a favored consultant, because they bring money, all right? You can talk to a
consultant, who will bring you no money, and another consultant, who has his hands on money somewhere.
And that helps a lot. The advice and the money together help a lot.
So, investment bankers are different from traders, because usually they deal with creating something--about
making a corporation or a government--making it work, enabling them to do something that they want to
do. And then, being realistic about it, and coming up with the money to do it. And so, that's how investment
banking differs from consulting [correction: trading].
And it differs from commercial banking in that a pure investment bank does not accept deposits. You can't
go to your investment bank and say, I'd like to open a savings account. They don't do it, OK? I'm talking
about a pure investment bank.
But let me just give you something about this business. I'm going to come in a moment to point out that
most investment banking businesses are not pure investment banks. But let's talk about what a pure
investment bank does.
It does underwriting of securities. That means--suppose you're a company and you want to issue shares.
You need someone to go to bat for you, someone who knows the kind of people who might buy your
shares, and can vouch for you. So in some sense, it's a reputation thing. The investment bank has contacts
among people who make big investments, and they manage the issuance of your new shares, and that's
called an underwriting.
If it's the first time youve issued shares, it's called an IPO, or initial public offering. So, you're a private
company, it's just you and a few friends own the company, but now you want to go public, you would
generally go to an investment bank, and talk to them about how to do it. And the investment bank would
solve that problem for you by doing an underwriting.
So, traditionally there's two kinds of underwriting. Also, there's also something called a seasoned offering,
and that means, for a company that has already gone public, and it already has shares traded, so that the
shares are seasoned, but you want to issue more shares. So, you can go to an investment bank to do that, as
well. OK.
There's two kinds of deals. There's a bought deal, and then there's a best efforts. With a bought deal, the
investment bank buys your shares. They go in and say, you know, we know that we can get market for your
shares. We will buy them ourselves and resell them on the market. A best efforts offering is one where the
investment bank doesn't buy it and doesn't promise anything. They say, we'll make our best efforts to place
this offering, OK? So, those are the basic things that they do.
The methods that they use are regulated by the Securities and Exchange Commission in order to make--the
SEC in the United States, and regulated similarly in other countries. So, that's the basic investment banking
business.
So, if you're thinking of where to place yourself, I think investment banking suits very well people who are-
-it's not good for autistic people. If you're autistic, be a trader, OK? Then, you just get on the phone, and
you buy and sell all day, and you can be rude, and you can have coffee stains on your shirt, and you don't
have to know anything about classical music. OK? But investment bankers are a different--I see Jon is
laughing. Tell me, what you know about classical music. I assume that was a part of your training at
Goldman. He says no.
It's a whole different industry. So, if you go to the symphony and look around, you'll see lots of investment
bankers there. But you won't see any traders. You nod on that [POINTING AT JON FOUGNER], maybe.
We talked about moral hazard. I think that an important part of what investment banks do is, solve a moral
hazard problem. And that problem is, that companies, who issue shares, don't have a reputation. And so,
what do I care, I'll issue shares, right before we're going to go bankrupt, OK? We know inside that we're
going to go bankrupt, so hey, let's just see, if we can milk this company, before the public knows it, and
issue shares. That's a moral hazard. And the investment bank is in business to prevent that moral hazard.
They do the due diligence, they check you out, and then after that, people are more trusting of you. So, I
think investment banking is built around trust, it's establishing trust.
So, that's how it differs from a lot of--that's why it's important that these people be cultivated and
impressive. They tend to be well-spoken. I can ask Jon, whether he agrees on all this, but it's my
impression, you can tell when the investment bankers walk in the room. They dress differently, they look
differently. I don't know what it is. It's something about reputation, it's what it's built around.
Chapter 2. Principles and Culture of Investment Banking [00:09:50]
The investment banking industry--let me just--since I'm talking about the nature of investment banking and
since we have a Goldman Sachs representative here. I put on your reading list a book as an optional reading
by Charles Ellis called The Partnership, and it's a history of Goldman Sachs. Goldman Sachs was an
investment bank until just very recently, and we'll talk about that. They're still in the investment banking
business, but now they're officially a commercial bank.
It's an old, venerable firm, and Goldman Sachs emerged in the early 21st century as, I think, the most
highly respected and esteemed investment bank in the world. Amazingly successful, and amazingly well-
respected.
Ellis wrote a book just a few years--Ellis is on the Yale Corporation. He's a distinguished businessmen and
author himself, and he wrote a book about Goldman Sachs, which is largely admiring. Like, how did this
happen? How did this phenomenon of Goldman Sachs come about? And I suggested--I didn't assign--I
suggested, you read one chapter, was called Principles. And it says something about Goldman Sachs, and it
refers to, in that chapter, the chairman of Goldman Sachs, John Whitehead, in the 1970s wrote down a list
of principles that guide Goldman Sachs. And Ellis seems admiring of these principles. Not everyone would
agree. It's a matter of taste, I guess, if anything.
Whitehead is now--I just looked it up--he's 88 years old, and is retired from Goldman, must have retired
some years ago. What kind of an organization? Ellis says, that the thing that struck him about the
organization is loyalty. But that's not alone, that people feel a strong loyalty toward their company. That's
not on Whitehead's list.
So, Whitehead's list. What is his first principle of Goldman Sachs? "Our client's interests always come
first." These sound a little bit like bromides. I'm sorry, but I read them thinking, it is the most successful
investment bank in the world, so maybe there's something beyond--I think, there is something beyond
platitudes here. Second, "our assets are people, capital, and reputation." That's a coincident with what I
said. "Uncompromising determination to achieve excellence." Well, everybody says that, so maybe
discount that. "We stress creativity and imagination." Well, those are sort of bromides, maybe. Then,
Whitehead issued some guidelines--this is also in that chapter later--for Goldman Sachs employees, and
these seem to be a little bit more candid. ''The boss usually decides, not the assistant treasurer. Do you
know the boss?'' That's sort of something I've learned from my own interaction with people--the boss really
does decide, and Goldman Sachs goes for the top. And maybe this is obnoxious, I don't know--they don't
want to talk with underlings.''You never learn anything when you're talking.'' That means, be a good
listener. ''The respect of one person is worth more than the acquaintance with 100.'' ''There's nothing worse
than an unhappy client.'' The one thing that--I don't if it's on Whitehead's list--but I think it really says
something about investment banking, and that Ellis says, is that they shun publicity. They don't want to be
in the newspaper, they want to be known by the president. They want to be known by a few prominent
people. They're kind of social climbers, in a way. But it's all built around some basic principles of service,
and they want to be talking to the top guy, and they don't want to be in the newspaper.
I'm going to quote Ellis on this. Now I'm quoting Charlie Ellis. I call him Charlie. I know him. He's a friend
of mine. "Making money, always and no exceptions, was a principle of Goldman Sachs. Nothing was ever
done for prestige. In fact, the most prestigious clients were often charged the most. Absolute loyalty to the
firm and to the partnership was expected. Personal anonymity was almost a core value. The real culture of
Goldman Sachs was a unique blend of drive for making money and the characteristics of family, in ways
that the Chinese, Arabs, and old Europeans would well understand.''
So, I'm giving you a flavor of what an investment bank is. You might be repelled by it. You know, is
making money so important? And if you are repelled by it, you probably don't want to work for Goldman
Sachs. On the other hand, they're kind of respecting some economic principles, right? Working for a firm
like this, you can make huge amounts of money, and then at the end, you can give it all away to charity.
And that's the new capitalism, right? So, what's wrong with that? What are you going to do with all this? If
you make $100 million, what are you going to do with it? You're going to give it away, right?
I mentioned at the beginning, I mentioned Andrew Carnegie's book, The Gospel of Wealth. Maybe that's
what this is all about. On the other hand, some of them don't give it away, and some of them live lavishly.
Different people have different impressions of this business. But I want to make sure I have time for our
guest and I'm sort of running out of time.
Chapter 3. Regulation of Investment Banking [00:16:54]
I wanted to talk about what has happened in the crisis. There's so much to say about this topic. Maybe, I
should talk first about the first crisis. In 1933, the U.S. Congress passed the Glass-Stegall Act, which forced
investment banks--it prevented investment banks from doing commercial banking, or commercial banks
from doing investment banking. It split them in two, and it said you have to decide, are you a commercial
back, or are you an investment bank? The Glass-Steagall Act was the act that created the FDIC, the Federal
Deposit Insurance Corporation, the first successful national deposit insurance act in the world. And part of
it--it makes sense--if you're going to insure the commercial banks, you better watch what they're doing and
prevent them from doing dangerous business. So, the dangerous business was investment banking, and they
forced companies to decide.
So, J.P. Morgan, which was doing both investment banking and commercial banking in 1933 had to decide.
What is it? Investment banking or commercial banking? So, they picked commercial banking, and that
means they fired all their investment bankers. So, these guys regrouped and they formed an investment
bank, called Morgan Stanley. [Harold] Stanley was a Yale graduate and [Henry S.] Morgan was, I think--
not J.P. Morgan, it was his grandson. Morgan died around 1911 [Correction: 1913]. And so, those were two
separate one. J.P. Morgan, commercial bank. Morgan Stanley, investment bank.
But since then, we've repealed the Glass-Steagall Act, and that occurred with the Gramm-Leach Act
[correction: Gramm-Leach-Bliley Act] of--what was that--1999. Well, Gramm-Leach[-Bliley] repealed
Glass-Steagall, and now these businesses, they generally do the same business, both commercial and--yes,
Gramm-Leach[-Bliley] was 1999. OK.
Since then, as you recall, we've had a financial crisis. And in that financial crisis, Glass-Steagall got
brought up again, because it seemed that the crisis was related to a number of shenanigans that firms were
undertaking. And the government had to bail out commercial banks. We talked about this, and it's very
controversial. So, the question is, did these banks get in trouble because we repealed Glass-Steagall? A lot
of people came on saying that. These banks were doing all kinds of screwy things that were dangerous, and
we're insuring them, so it can't be. So, a lot of people said, we have to go back. There was some inherent
wisdom in Glass-Steagall that we've lost. And this was debated.
Now incidentally--I didn't mention this--Glass-Steagall was somehow confined to the United States.
Outside of the United States, I don't know if there was any country, but as far as I know, U.S. was the only
one that did it. So, outside of the United States they had what was called universal banking. And these
banks outside of the U.S. were doing both investment banking and commercial banking. They sailed right
through the whole century without being divided up. So, the reason why we got Gramm-Leach[-Bliley]
was, that people started to say, you know, we're at a competitive disadvantage. We Americans are at a
competitive disadvantage to Europe, because we can't do both, and they have more freedom than we. And
so eventually, in 1999, we said, they could do both, so that U.S. also became a universal banking country.
But then problems arose. And the problems were--Paul Volcker, who was chairman of the Federal Reserve
Board in the late '70s, early '80s, proposed something called the Volcker Rule. And the Volcker Rule was
not a full return to Glass-Steagall, but--and this is now in the Dodd-Frank Act. It's Section 619. It doesn't
say Volcker Rule there, but that's what it is, and it prohibits proprietary trading at commercial banks. And it
also says, that commercial banks can't own hedge funds or private equity [addition: private equity funds].
So, that was the Volcker Rule that was put in.
There was also another rule added, which is analogous to the Dodd-Frank Act [correction: analogous to the
Volcker Rule], also. And this is in the Dodd-Frank Act of 2010. There was a senator. Her name was
Blanche Lincoln, a Democrat from Arkansas, who proposed the Lincoln Rule. Unrelated to Abraham
Lincoln, as far as I know. And the Lincoln Rule was--Lincoln Amendment, and that is Section 716 of
Dodd-Frank. It says that--doesn't prohibit banks dealing in swaps, but it said swap dealers barred access to
Fed window, discount window. And so effectively, it prevents banks from dealing in swaps anymore.
As a result of this, Goldman Sachs has got to shut down--or it appears that--the Volcker Rule says banks
have until October 2011 to comply. So, it means that Goldman Sachs has to shut down--Goldman Sachs
had to become a commercial bank, too, so it's no longer--it's an official commercial bank now. And because
of the Volcker Rule, it appears that it has to shut down its proprietary trading, which was a huge part of its
profits. And Goldman Sachs will never be the same again, apparently. But it's not clear what will happen. It
depends all on how Dodd-Frank is enforced.
I think that the people that are in the banking industry are going to try to claim, that some of the activity
that was done by their proprietary traders--that is, people who were trading the market on--true investment
banking shouldn't involve the investment banker buying and selling securities trying to make a profit.
That's not underwriting of securities, that's proprietary trading. Volcker Rule says that you pretty much
can't do it anymore, unless you're a pure investment bank, but if you're a commercial bank, you can't do it
anymore, and they're kind of forced to become a commercial bank. But they're going to try to steer around
these rules, and I think that maybe they can. They'll re-define something that looks something like
proprietary trading, and then continue to do what they're doing. We'll have to see. These things are long and
arduous.
You know, one thing that strikes me about finance is, that it's so rules-based. There are so many laws, there
are so many lawyers, that nobody can grasp the magnitude of the regulations that these people live under.
And you see these landmark bills, but none of us understands them, because the real content of them is
involved in hundreds of pages of legal documents, that never cease to amaze me with their complexity.
Chapter 4. Shadow Banking and the Repo Market [00:27:21]
Let me tell you something about shadow banking, which is relevant here. The term shadow banking, I think
of that as coming from a term that I first heard from people at Pimco just within the last five years or so. Or
maybe it goes back further than that. It refers to a new kind of semi-banking system. What are shadow
banks? These are companies that are acting like commercial banks, but they're technically not. So, they're
not regulated as commercial banks. And in many cases, the investment banks were shadow banks.
I'll give you an example of Lehman Brothers, which was a pure investment bank. It's now bankrupt, it's
gone. It was a pure investment bank, so it wasn't regulated as a commercial bank. This was before the
Volcker rule, before Dodd-Frank, and they went bankrupt in 2008, and it was the worst moment in the
financial crisis.
Why did they go bankrupt? Well, there's a reading I have on your reading list by Professor Gary Gorton
here at Yale, who argues that Lehman, like many other investment banks, was financing a lot of proprietary
investments by issuing repos, or by dealing in repos. What is a repo? That's short for repurchase agreement.
The banking crisis, that we saw in 2008, was substantially a run on the repo.
So, here's what happened, according to Gorton and others who agree with him. Investment banks, like
Lehman Brothers, were not regulated like commercial banks, and as long as they didn't accept deposits,
they didn't have to be regulated as commercial banks. So, they could do what they want, and they were
considered underwriters, so fine, do whatever you want. Well, not quite, but they weren't heavily regulated,
the way commercial banks were. And what Lehman Brothers started to do is, to make heavy investments in
subprime securities and other securities by effectively borrowing through the repo market.
What is the repo market? It's a market, in which a company effectively borrows money by effectively
selling some securities it owns with an agreement to repurchase the security at a later date. They're short-
term loans, in fact, collateralized by some security that they own. What it was, it almost the same as a
deposit. They were short-term loans that someone could withdraw at any time. The someone wouldn't be
some mother and father with their small savings account. It would be some bigger, probably institutional
investor.
But these were acting like banks, like commercial banks, because there could be a run on these banks the
same way there's a run on a commercial banks. If anyone starts fearing that Lehman Brothers is going to
fail, they all want to take their money out, which means, they don't renew their repos. And so Lehman
Brothers failed, when the housing market declined, the value of its subprime securities declined. People
who were lending it money through repos, got wind of this, and they stopped wanting to do it, so it was like
a run on Lehman Brothers. And Lehman Brothers could not be saved, if it weren't for a bailout. The
government had already bailed out Bear Sterns, and it had helped Merrill Lynch, which was failing as well,
and they decided not to bail everybody out, so they let Lehman Brothers fail.
So now, the reaction to that is, that we can't let shadow banking go unregulated, and Dodd-Frank is part of
that reaction. So now, investment banking is substantially altered by these laws. And still, of course, it's a
very important business. The United States has traditionally been the most important country in investment
banking, but it continues that Europe and Asia are also important, very important participants in investment
banking. Growing, I think. The financial crisis has put something of a damper on the business for a while,
but I think, it seems to be coming back. The latest news is, that the investment banking business is starting
to look more stable and prosperous.
Chapter 5. Founger: From ECON 252 to Wall Street [00:33:04]
So, what I want to do now is invite--let me just do a brief introduction. So, Jon Fougner took this class, I
think it was 2002, and then he served as my research assistant for a book I was writing, called The New
Financial Order, so I got to know him better. The important thing for this lecture is, that you worked for
Goldman Sachs, and got to know people there, and now is working for Facebook. You've heard of this
company, right?
I thought it would be interesting to have him back to give his impressions of what life was like after ECON
252, of what Goldman Sachs was like--at least the old Goldman Sachs. And I think, it's interesting to hear
about Facebook, too, because it's a different kind of culture, and I'm interested in culture. It's more of a tech
business. I'm interested to hear, if they have anything like the Goldman Sachs principles, or they enunciate
them the same way.
So, I'll bring Jon up, and I'll let him continue.
Jon Fougner: Very well. Thank you Professor Shiller. And Professor Shiller has promised, that I'll be
well-spoken, and well-dressed, and a bunch of other things, good, bad, or otherwise. I'm not sure, if I'll live
up to any of those expectations, but hopefully can share a little bit about this business.
How many of you are considering going into investment banking? Maybe about 30%, or so. OK. And how
many of you are on Facebook? OK. And how many of you are considering working at Facebook? OK, so
maybe we'll add a few more to that by the end of this.
Goal for the next half hour is really to help you think about, whether banking might be the right next step
for you after college, and for those of you who say yes, to share a few tips on how to think about getting
into the business. I'll give a little bit of my background, kind of a context for my reflections on the industry,
so you can take them with a grain of salt, share some anecdotes from banking during the debt boom, and
then also give a few tips, or steps that you could take today, if you're interested in it.
So, a little bit on my background. Junior summer, I went to work for a large investment bank, as Professor
Shiller mentioned, and I really enjoyed the work, knew that I wanted to go back to it. But I had never lived
abroad, because, as you all know, your junior year here at Yale, there's a lot going on with extracurriculars,
and so many people don't go abroad. I went to see Charles Hill--now how many folks are familiar with
Charles Hill? Fabulous negotiator. And I said, Professor Hill, how can I negotiate to go back to this job a
year later, so I can do a Fulbright in the meantime? So, he taught me all this jiu-jitsu, and it ended up
working out, and I did a year in Norway, and then came back full time to banking.
Now, as you probably know, a lot of analysts go into banking, they do it for two years, maybe do private
equity, hedge fund, maybe do an MBA afterwards, and something like 15% might stay on, get promoted,
and become career-track bankers. When I was working on Wall Street, this was the peak of the most recent
private equity boom and the associated debt boom. And so, recruiting to private equity had reached such a
fever pitch, that literally 16 months before the start date for these jobs, analysts were getting calls from
recruiters, doing interviews, and actually making commitments to joining companies.
And I knew I was interested in tech, and so I became very close to signing with a technology private equity
fund, that I admire still very much to this day, but I actually decided that I wanted to work in tech itself, and
so the last three and a half years, as you mentioned, I've been working at Facebook working on our social
advertisement strategy.
So, a little bit about inside the banking role. It may sound a little bit funny to talk about the investment
banking division of an investment bank, but that's what we'll do for the next 15 minutes. And by that, I
really mean, just the part of the business that Professor Shiller mentioned, giving advice to CEOs and CFOs
about financing, and mergers and acquisitions.
So if you see this logo--and that makes you smile--I see a few smiles, maybe a couple grimaces--if it makes
you smile, it's a good sign that banking may be for you. You think about two, three, four--
Professor Robert Shiller: They don't understand that. That's an Excel logo.
Jon Fougner: That's an Excel logo.
Professor Robert Shiller: What are you driving at?
Jon Fougner: That's an Excel logo, and these are Excel models, and they go on and on.
Professor Robert Shiller: You mean, they're going to be a nerd. Is that what you're saying?
Jon Fougner: Yes, if by that you mean you want to feel comfortable with the technical aspect of the role,
yes, absolutely. Especially at the junior level, where--you mentioned some of the relationship aspects of
banking, but at the junior level, really your core responsibility is building out these models. So, if you think
about working on that until 4 in the morning maybe two nights in a row, maybe 20 nights in a row, and
that's exciting to you, that's a good sign.
So, how many of you have gone online to Open Yale to see Stephen Schwarzman's talk from this class
from three years ago? One, two. Two enterprising users of the Internet. I would strongly encourage
everyone to do that. One of the things, that he talks about is that in banking, there's not a ton of flexibility
for getting the numbers wrong. As the analyst, you really need to nail the details. And primarily, what we're
talking about there, is building operating transaction and valuation models that describe your clients, and
other companies, and their industry. And then, the information from those models, along with research you
find by hook and by crook on the internet, from your colleagues, wherever you can, kind of comes together
into presentations, polished pitch books to help win a piece of business.
So, that could be an IPO, a merger advisory, as you mentioned, and once you've won that piece of business,
then you as the analyst really are the organizing principal for getting this deal across the finish line. Dealing
with the accountants, working with the lawyers, other bankers, even competitors who might also be
working on the deal, and then, of course, your client, and whichever counter-party your client is selling to
or buying from. So, it's a fair amount of responsibility.
Typical investment banking deal team, the core team is pretty lean. Maybe one each of an analyst, associate
VP, and MD, and if you decide to and are given the opportunity to continue working in investment banking
on a career basis, then you will gain a little bit more control over your week to week and month to month
schedule as you become more senior. But even at a senior level, investment banking is really considered an
always on-call client service profession.
Now, one of the advantages of this very lean deal team is, that there's plenty of responsibility to go around.
So, if you raise your hand and say, yes, I can take on some of this work, that might by default fall to some
of my associate, and you do it without making mistakes, you're going to be able to get more and more
responsibility, learn more and more on the job. One of my favorite projects that I worked on was a
proposed venture capital transaction, where we were looking at investing in eight different operating
companies, and because the team was that lean, I was actually able to basically take on leading the due
diligence on these eight different companies.
Professor Robert Shiller: Before you go ahead, why do the managing directors have zero grey hairs?
Jon Fougner: Well, I'm just assuming it's all gone by then. That's a median, the mean might be a little bit
higher. High variance. So, I would--was that the nerdy comment you were looking for?
So, I might encourage you to think about these roles as an investment in your career, where what you put
in, of course, is long hours--maybe 100 hours a week for a couple of years--and what you get out, is a
number of things, including a skill set that's really valued and respected, not just in finance, but around the
business world, exposures to CFOs and how they think about problems. If you decide to continue on as a
career banker, participation and success that you'll help create for your company. And then, of course, a
network of very smart, eager peers, like the folks in this room, who then fan out across the finance industry.
So, as I mentioned, I was in banking during the debt boom, and there was such a peak in transaction that
people started calling it Merger Monday, this expectation that before the bell at the beginning of the week,
there'd be a 20 billion, or 30 billion, $40 billion transaction that would be announced. And there was so
much enthusiasm for this sort of transaction that even financial institutions, which, conventional wisdom
told us, couldn't be LBO'ed [clarification: LBO stands for leveraged buyout], because their balance sheets
were already so levered, actually became considered targets for leveraged buyouts. And arguably the peak
of this was, when Blackstone themselves, one of the fathers of the buyout industry, filed an S1, and in fact
became a publicly traded company, which they are to this day.
Your final task as a banking analyst is to create a deal toy, when you successfully created a transaction.
Now, this particular one used to have water in it and glittering fish, and at the time I thought it was very
pretty, but I would just invite you maybe, when you create your deals toys, don't picture your client
swimming with the fishes. Not the best idea. And then, this is a safe for a bank, which, of course, is logical,
safes are in a bank. But this is actually an especially fun toy, because you pull this handle here, and then
actually this one opens up. That was my idea of fun when I was a banker, so you again should take it with a
grain of salt.
This is a snow globe--you shake it upside down, which is a lot of fun, as well. But again, just in terms of
the metaphor, and I have only myself blame--maybe I was sleep deprived--I guess, maybe don't show your
client's capital structure literally underwater, when you design your deal toys.
Professor Robert Shiller: Are you saying that investment bankers have a childish side? You say, deal
toys. I was presenting them as going to the symphony. What are you presenting them as?
Jon Fougner: I can't claim, I ever made it to the symphony, when I was an analyst, but a number of my
colleagues were on the boards, involved philanthropically with those organizations. But yes, I think that we
have this creative energy and creative spirit. I think, there's a lot of creativity in finance that, as Stephen
Schwarzman mentioned in his talk, at the senior levels, when you're dreaming how to combine companies,
how to finance companies, how to deal with new regulation, as you mentioned. But at the analyst level,
maybe not quite as much. So maybe, there is that creative spark, that's just trying to find its way out, one
mischievous way or another.
But anyway, this was the landscape, when I left banking. That was September 2007. And then six months
after that, as Professor Shiller mentioned, Bear Sterns sold in a fire sale to J.P. Morgan, and then six
months after that, September 2008, we saw Merrill Lynch narrowly avert liquidation, become the asset
management brand of Bank of America, which it still is today. That same week, Lehman Brothers
collapsed under the weight of those mortgages, suffered a bank run, and was not bailed out, was liquidated,
some of their investment banking capital markets assets sold to Barclays in bankruptcy. A week after that,
what a lot of people thought would never happen, did happen, and Goldman Sachs and Morgan Stanley
went to the Federal Reserve, asked to become commercial banks, which technically they still are today, as
Professor Shiller mentioned.
Now, that having been said, if you take Charles Gasparino's account of this era, this was the end of an era
for Wall Street. That having been said, investment banking continued at firms all around the world, some of
these diversified conglomerates, and also at a burgeoning slate of so-called independent advisory shops. So,
these are folks like Evercore, Lazard, Greenhill. And if you're interested in learning about finance,
investment banking is not the only way to get into it. There are also, for example, the so-called alternative
asset managers, private equity hedge funds. Folks like KKR, Carlyle, Bridgewater, who I believe still
recruits here on campus. And then, out where I live in California, you have the heart of the venture capital
industry, especially around the information technology industry. So, folks like Kleiner, Sequoia,
Benchmark. They may not be recruiting on campus, and they may not even be open to hiring
undergraduates, but some of their competitors are.
Chapter 6. Fougner: Steps to Take Today to Work on Wall Street [00:46:24]
So, if that's interesting to you, maybe we'll just touch on a few steps that you can take today. Obviously,
you're already doing plenty of this, without anyone having to remind you. Things like taking the right
classes, doing well in them, researching the firms you want to apply to. Just three that I'll touch on. Taking
advantage of the incredible resource you have in the professors here today, which you really don't want to
take for granted. Learning a little bit about yourself--and I know that sounds touchy-feely, but I'll give a
couple specifics around that. And then, of course, there's no substitute for trying this hands-on to see
whether it suits you.
So, this is pretty much exactly as I remember John Geanakoplos--genius mad scientist. You can find him
on Open Yale now, and if you have not yet taken his class, and it's offered next year, I would strongly
recommend that you do so.
David Swensen, I understand you've had the distinct pleasure of hearing from already, the most successful
endowment manager ever, the reason that we get to have nice things here at Yale. And I just keep coming
back time and again to Pioneering Portfolio Management, the bedrock of core investing principles that he
articulates in that book. Even if you never become an institutional investor and are only thinking as a retail
investor, it's still incredibly useful stuff. And he does teach a senior seminar.
And then, in addition to this class, as you probably know, Professor Shiller has a graduate seminar, which I
think you have promised to let students apply to, to get into to.
Professor Robert Shiller: Yes, I had about eight last semester.
Jon Fougner: OK. And how did they do?
Professor Robert Shiller: That's an embarrassing thing. They did pretty well, against our graduate
students. I won't rank them. Embarrassing to our graduate students.
Jon Fougner: But flattering to all of you.
As Professor Shiller mentioned, I got to work a little bit on The New Financial Order as an undergraduate,
and I just still consider it such a rewarding experience, because the tenets that you talk about in this book,
around how finance can be a technology for societal innovation, everything from the micro level of
personal income insurance to encourage people to take more risks early on in their careers, to the macro
level of GDP insurance are some really visionary ideas. I, of course, remain dismayed that some of them
have not been put into practice yet, but that really is an opportunity for all of you who are interested in
Finance for Idealists [clarification: This is an alternative title for Professor Shiller's book Finance and the
Good Society whose preliminary version is assigned as a reading for the course.] to think about that as a
potential career option.
Other useful courses, of course, anything with math, probabilities, stats, econometrics, Excel modeling,
especially using the three financial statements, computer science, computer programming is going to serve
you well, not just in investment banking, which we're talking about this morning, but also in those other
aspects of financial services like trading.
Now, kind of switching gears a little bit. How many you have either done Myers-Briggs or Strengths
Finder? A few. Maybe 20--maybe 30% or so. So, these are tools that I think have become a little bit more
popular in recent years, which are basically psychological inventories where you spend an hour answering
multiple choice questions, then they literally spit out a profile of how you like to work. Obviously, there's
no right or wrong answers, they're really just preferences. It's a pretty modest investment of your time--
maybe an hour each--to gain insight not just into what you're good at, but also to helping you articulate to
potential employers really what you can bring to the table.
And then, of course, where the rubber meets the road, is actually applying for that internship or that job,
and getting your foot in the door. Career Services on campus are a fabulous resource, but because of that
they are very scarce resource, because almost everyone is using them. So, if you want to find jobs that don't
get 200 other Yale resumes coming in their front door, you want to look a little further afield. So, you've
got things like lists of investment management firms, from Institutional Investors, American Banker, Hedge
Fund Research. There are plenty of these lists. And I'd say, don't be shy about cold calling, cold emailing,
just kind of be persistent.
We touched on professors here. I am incredibly grateful to Professor Shiller, Ray Fair, David Swensen,
folks who have helped me in my career, even at this extremely early stage in my career, and it was really
just because I asked. And Id encourage you to do the same thing, because once you've left campus, it gets
a lot harder to get that help.
And then the alumni directory--how many folks have been using the alumni directory to reach out for jobs?
Maybe 15%. I'd encourage you to do so, and all I would add to that is, think about what you share in
common with the people you're reaching out to, think about whether you can reciprocate the help that
you're asking for, even if that might not be obvious now, because they're established in their career and
you're starting out. I had a student in this class reach out to me three weeks ago interested in advice, and I
was happy to share that. And actually, he ended up being really helpful, helping me understand where you
all are in your decision making process and your career right now. So, there are always ways that you can
help, and you'll find a much more welcome hand if you're about to do that.
And then lastly, recruiters. These large, so-called two and 20 funds, the alternative asset managers,
typically use third party recruiters to find the talent that they want to interview. And they are typically
targeting current banking analysts and associates, but there's nothing to say that if you have a strong finance
and technical background as an undergraduate, that you couldn't actually get on their radar and try to use
them for a placement. The only caveat I would add to that is, that you want to be really clear and confident
when you speak to them about what is that you're looking for. Because if you go in there waffling, asking
them to sort of be your mentor and your career coach, they're really not going to get that sense of
confidence for you, and they're not going to want to put you in front of one of their clients, who are the
asset management firms.
Professor Robert Shiller: We're having questions in just a minute.
Jon Fougner: Oh, great. Yes.
[SIDE CONVERSATION]
Professor Robert Shiller: We're going to open it up for questions in a minute, but go ahead and interpose.
Student: It could probably also come at the end, I was just wondering, who is Keith Ferrazzi?
Jon Fougner: How many folks are familiar with Keith Ferrazzi in the room? Some people are--their arms
are getting tired. Maybe 20%. So, Keith was the youngest ever Fortune 500 CMO. And he's a fellow Yalie,
New York Times best-selling author, written a lot about the role that relationships play in business.
And you hear this word networking, which, I think, all of us now get sort of a sort of unctuous feel around.
It seems very, sort of, superficial and self-serving, and what he's really helped elucidate is how the basic
tenets of psychology--and in this respect, he reminds me of Professor Shiller--applying the basic tenets of
psychology to how you actually build real, meaningful business relationships, and breaking down this
artificial barrier between relationships and business. Because business is relationships. As Professor Shiller
mentioned, one of the things that investment bankers try to do is, establish senior level relationships,
because it's ultimately individuals, not entire companies, who are making decisions.
Chapter 7. Fougner: From Wall Street to Silicon Valley, Experiences at Facebook [00:53:49]
So, just to share a couple of anecdotes about my transition from banking, after banking, as I said, I knew I
wanted to work in tech, and I very fortuitously got a phone call from a lifelong friend of mine around that
time, who was an engineer who had started working at Facebook. And what he convinced me was, that I
could help him and his colleagues change how people communicate.
I was pretty sort of anxious about this, pretty intimidated by the prospect of being a business guy doing
engineering. And what he told me, and I ultimately think this proved true, is that you don't have to be an
engineer in Silicon Valley to have an impact, you just have to be able to think rigorously like an engineer
does. I think the training, that you're doing here at Yale, and then the potential training of investment
banking, both have the potential to serve you well in that respect.
So, what we're trying to do at Facebook is get people the power to share and make the world more open and
connected. Pretty simple, in principle. And our strategy for doing this is mapping out what we call the
social graph. Now, we didn't create this. This exists out in the world, all we're trying to do is draw a
mathematical representation of it, and that's basically who likes whom, and who likes what? And then, we
push information as efficiently as possible along the edges of that ground.
So, this is kind of where I spend most of my day, not just over here in FarmVille, but also over here in ads-
land. And what my role is called is ''local inbound product marketing.'' So, to kind of parse that out, what
we mean is basically, I go and talk to local businesses, restaurants, plumbers, understand what their pain
points are, what other advertising products they use, what they're trying to accomplish as a local business
owner, and then basically synthesize that with data analysis, and ultimately present it to the engineers as a
case for what we should build next. So, these are questions like, what do the ads that you see on Facebook
look like? How should they interact with the rest of the product? How can we target them to make them
more relevant? Whole bunch more.
The real guiding precept here is that, it's basically what Henry Ford said, right? He didn't want to build the
faster horse, even if that's what his clients might have asked for, he wanted to build something that was
dramatically more useful, and for him that was a car, and for us it's something that we call social
advertising. I am happy to chat a little bit more about that during questions, if folks are interested.
So finally, just to kind of compare these two roles, and how one might have prepared me for the other, I
think the three things from banking that have served me best working on internet products are: One, this
cross function of process management, which is a ubiquitous part of the business world. Two, building
polished presentations, this one notwithstanding. And three, being resourceful about tracking down data
points to help make the right decision.
On the other hand, there's some parts of the job that were totally new. Thinking from the mindset of the
CMO, the chief marketing officer, rather than the CFO, the chief financial officer, just the pace of the
environment, banking is fast-paced, but the rate at which products evolve in the internet is dramatically
faster. And the fundamental job itself, which is basically creating new products, building the business case
for them, validating that case with data, trying to actually mock them up--and I assure you, I'm not good in
Photoshop--and then actually use those mocks and that case to inspire engineers and product managers to
want to build them.
So, it's an environment that is much more ambiguous. The yardsticks for whether or not you're going in the
right direction, especially in the short term, are not nearly as clear. But if that's actually something that's
appealing to you, then I strongly encourage you to check out jobs around Silicon Valley, and especially at
Facebook. So, you can actually go to facebook.com/careers--quick plug--to check out about the internships
and the full time jobs that we have available.
Chapter 8. Fougner: Question and Answer Session [00:57:56]
So, Professor Shiller, did you want to use the rest of the time for questions.
Professor Robert Shiller: Well, yes. I'm opening it up to all of you for questions. OK, you have a question
back there.
Student: Before you did your junior summer in investment banking, how did you even know you wanted
to--
Jon Fougner: I caught some of that, and then the screen caught some of it, so just bear with us for one
second, and then I'll be right with you. You said, before I did my junior summer, what did I do?
Student: Before you did your junior summer. Or how did you figure out that investment banking was the
field you wanted to be in?
Jon Fougner: Well, you know, I knew that some of the stuff on the right hand column of the ROI chart
was stuff I was interested in. I was interested in the technical side of the work, working on math, basically,
but also interested in the relationship side of it, the strategic side, thinking about basically how you help
these companies vet the company decisions. And during the first week of training, one of the partners of the
firm came in--and we use this term partner kind of as a term of art, because, as the professor mentioned, it's
no longer a partnership--but he came in and said, when our clients want to do really important things, they
come to us. And when they want to think about important things, they come to fill-in-the-blank name of top
tier consulting company. And that kind of action, and actually physically seeing the results that you create
in the world was really appealing to me. And I hadn't done Strengths Finder yet at the time, but I did it
subsequently, and found, not surprisingly, that that's where my psychological reward structure was kind of
geared towards.
Professor Robert Shiller: Yes?
Student: So, Peter Thiel, who was the first investor in Facebook, and is currently on their board, is now
offering 20 people under the age of 20 each $100,000 to drop out of school for two years and start their
own companies. And since you actually work for Facebook, I was wondering what you thought of that.
Jon Fougner: Yes, I think that's fascinating. And obviously, I don't work with Peter Thiel. Look, I think,
whatever we can do to promote innovation is great. Now, if you're sitting here in this room and you're
saying, well, do I want to take this risk of sacrificing this signaling device of this college degree, and also
potentially sacrificing some structured classroom experience, in order to rapidly accelerate, how quickly I
got into entrepreneurship, I don't know. That's a personal decision that is for you to make, and I don't really
have any opinion on it. Ultimately, for me it'll come down to, do these companies actually end up doing
really cool things and building really cool stuff?
Professor Robert Shiller: And I'd add, it isn't as risky as you might think, because Yale will take you
back, if it fails in a couple of years.
Jon Fougner: One of our very early employees was a Yalie, who had had an undergraduate experience
somewhat like you're describing, where, I think, he had actually taken some time off to work on startups. I
think he came back, finished his degree, and is now a partner at Benchmark, one of the firms that I had on
that slide.
Professor Robert Shiller: Well, while they're thinking, can I ask you--I emphasized the core values at
Goldman Sachs, and it strikes me that Facebook is totally different. Or maybe I'm wrong. Can you tell me,
what are the core values at Facebook? If I were to read that list that I just gave you from Goldman Sachs,
how would it sound to the Facebook people?
Jon Fougner: Yes, so I think there are similarities and differences. I think, each of us has a core
constituency, who we wake up thinking about them, go to bed thinking about them, probably dream about
them, and know that whether or not we serve that constituency will determine the success or failure of the
company. And at Goldman that was the clients. And at Facebook, our number one focus is the users and the
user experience. And we care a lot about our partners, we care a lot about our advertisers, we care a lot
about everyone in the ecosystem, but ultimately we know we have to serve the user as well. So, each
company, I think, has almost a maniacal focus on serving one core constituency, albeit they're different.
Now, in terms of the day-to-day experience, I do think they're quite different. I think that what I'm doing
now is quite a bit more creative.
Professor Robert Shiller: You're not doing spreadsheets.
Jon Fougner: A little bit, but--
Professor Robert Shiller: You're doing it, still.
Jon Fougner: Yes, not as much. And I really love the creative side of the work. If you think back to
Stephen Schwarzman's lecture, where he mentions that there's no flexibility for getting the numbers wrong,
I mean certainly we feel the same way, all the analysis needs to be correct, but there's almost an ominous
tone, when he says that, whereas the way that we operate is knowing that we have to move really fast in
order to continue to innovate, continue to stay relevant.
And so, that means that sometimes you make mistakes, and it's no secret that we've made mistakes, and
some of them have been big mistakes. And we just try to minimize the number of times that happens, try to
fix them as soon as they do happen, and just be honest about them, and admit them when we make them.
Professor Robert Shiller: Can I ask a question of the class? You set the example. How many in this class
are engineering majors? Not many. Like 5% maybe. What about science majors? That looks like 10%. See,
you're kind of in an engineering company, right? I mean, I don't know exactly what Facebook is, but is
there some kind of division here? Why aren't there more engineers in this class?
Jon Fougner: That sounds like a question for the class.
Professor Robert Shiller: Well, I can't ask them, because they're not here.
Jon Fougner: All the engineers, who are not in the room, why are you not in the room?
Professor Robert Shiller: But I mean, is there a big cultural difference? I mean, are engineers prejudiced
against us finance people? You're there, so--
Jon Fougner: Look, I think that product design and software engineering is at the heart of the company,
but as I mentioned, I was pretty intimidated going in and saying, huh, I'm going to be a business guy here.
Am I not really going to be able to have an impact? And I think the things that are important for the
business people are: one, to remember what the core mission of the company is, which for us is really all
about the users; two, to have a sense of what is feasible. So, you don't actually have to know how to write
the code, or even necessarily how to mock up the product, but if you're making recommendations that we
should build things that are simply technologically not feasible, you're going to waste people's time and
lose credibility pretty quickly. And then, three, I think, when you do the analysis, engineers are going to
want to see as rigorous analysis as possible, quantitative analysis when that's relevant, when that's possible,
and to the extent that you can bring that to the table, I think that's helpful.
If you think about the business world at large, one of the things, that's just going to be increasingly
important, is the ability to design, conduct, and interpret statistically significant, valid experiments. And
this sounds like a pretty straightforward thing, that you might learn by maybe second or third year of
college, and yet you get out into the business world, and you'll find that many of your colleagues, whether
they're coming from MBAs or other backgrounds, may not actually have that background. So, being able to
bring that sort of rigor to the table, whether it's at a consumer internet company or an industrial company,
anything else, I think is very helpful.
Professor Robert Shiller: You know, I'm thinking, maybe I should change the name of this course to
Financial Engineering. That would bring in the others. Because to me, engineering and finance have a
certain connection. They're both designing devices.
I think, we have another question.
Student: Have you thought of going back to graduate school, and how do you see that playing into a career
like investment banking?
Jon Fougner: Yes, I have thought about going back to graduate school. I think that all of us want to be
lifelong learners throughout our career. There's a number of ways you can do that. Graduate school is one
of them. Another is, going into industries where you're just confident that everyone you're working with is
really smart, and they're going to push you hard, and not settle for mediocrity, so you just know you're
going to learn by that pressure and that osmosis.
And then, I think, there's some kind of simple, structured things that you can do, as well. I threw a slide up
of a couple that you can do in the comfort of your own living room--the Meyers-Briggs and Strengths
Finder. But then also, you can leverage having a workplace to do things like peer coaching, career
coaching, executive coaching.
So, I kind of take a somewhat agnostic point of view as to which of these tools I'm going to use at any
given time. I just know, that I constantly want to be challenging myself and constantly want to be learning
more.
Professor Robert Shiller: OK.
Student: I've heard a lot about issues with click-through rates on various social networking sites, so if you
could talk about, what you think the putative value of Facebook should be, and whether the current
valuation is appropriate.
Jon Fougner: Yes, so, I'm happy to share a little bit about click-through rates. I'll probably defer on the
question of how much the company should be valued at.
Is everyone familiar with what a click-through rate is? No, not everyone. OK. So, this is just a simple ratio.
Let's say, you show an ad some number of times to users on the internet. It's the ratio of the number of
times the user clicks on that ad to the total number of times you showed it. So, if you show an ad 100 times,
and you get one click, you have a 1% click-through rate.
And if you think about, well, why are people advertising? In marketing there's kind of this concept of this
marketing funnel, which is a little bit silly, but it actually conveys a useful concept. Up here is everyone in
the world, and then here is the people we can actually make aware of our product. And then here is the
people who we can actually make have an affinity for our product. And here is the people who we can
actually make consider purchasing our product. And then people who actually buy it, and then repeat, loyal
customers who buy it more and more. So, we get to a narrower and narrower pool.
And what marketers are constantly trying to do is, push people through this funnel, so they can actually
start with someone who may not know about the product at all, and then actually get them to buy it again
and again. So, marketers use a variety of different tools. Online advertising is one, but that represents
maybe 15% of the market, but it's a relatively new one, and there's plenty of others that go back decades or
centuries. Things like television, radio, print.
These different media play different roles in getting people through this marketing funnel. And if you think
about where online advertising originally grew up, it was really towards the very bottom of this funnel. Of,
OK, I am looking for a blue iPod at the best price, that I can either order online or that it's within five miles
of my home. So, I search that on a search engine, I see a list of vendors, and in that case, it's really
important whether I click through, because that's basically determinant of whether or not we get them
through the next stage in the marketing funnel.
If you think about Facebook advertising, that is one of the roles that it can play, but it can also actually play
throughout this entire marketing funnel, where we have a reach of 500 million people, and then you can
target within that. And then you can use things like social context, telling you that your friend might really
love a product, to help build your affinity for it, on through this whole funnel.
So, for some of it, click-through rate is relevant, for other of it, click-through rate really isn't relevant, and
you need to think about other sorts of measurement. Things like companies like Nielsen do. Like polling
people and asking them, OK, you saw this media, did it increase your likelihood to buy this product? Or did
it make you aware of the message, that the brands trying to convey, that you weren't aware of before? I
think, it's one of a number of metrics that go into assessing the health of the business as a whole.
Professor Robert Shiller: I think we're essentially out of time, but let me just say, click-through rates and
marketing sound profit-oriented, but it seems to me they have a social purpose--one thing is that capitalism
is being transformed by this kind of thing, because it gets people to buy things that they really need. It's like
your Strengths Finder or Needs Finder. And I have to applaud Facebook and other companies.
Finally, I'm going to invite you back in another 10 years. This was great.
Jon Fougner: Thanks.
[APPLAUSE]
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 20 - Professional Money Managers and Their Influence [April 11,
2011]
Chapter 1. Assets and Liabilities of U.S. Households and Nonprofit Organizations [00:00:00]
Professor Robert Shiller: All right. Well, we're talking about institutional investors today. I don't know, if
that sounds like an enticing topic to you. ''Institutional'' sounds boring, but I'm actually talking about
people, who control much of the wealth of the world, and they have a lot of influence and importance. So, I
think it's worth considering them, and considering it's really part of the governance of the world. How do
things happen? Who decides what is going to happen? What's going to be done? Increasingly, it is
professional institutional investors. They're kind of unseen, mostly. They don't make movies about them,
not that I've ever seen. Someone tell me, if there is one. But they're very important.
So, I thought I would start by just talking about the importance of--in this lecture I'm going to include both
people, who manage money for institutional portfolios, and also financial advisors and financial planners.
They're a very big and important part of the world economy. But I wanted to start by just giving some
perspective on them, by looking at what it is that we own, and what they manage.
So, I thought I would start for the United States, and show a list of everything, everything that's owned,
OK? And I got this from--this is from Table B-100 of the Balance Sheet for the American Economy
[addition: as of the fourth quarter of 2010], produced by the Federal Reserve Board in Washington. So, it's
really a sum of everything, everything that people own in the United States. And the point I'm going to
make from this is that institutional investors are quite prominent on this list, as managers of it.
But let's just first look at the total. This is 70,740 billion, or let's say, $70 trillion is it. It's everything that
anyone owns in terms of assets that the Fed can measure. Of course, there's all these priceless things that
we all own. Theyre not on this list.
So, what are they? Well, number one is real estate. This is owned by households. Actually, they lump in
nonprofits, unfortunately, because nonprofit organizations are like people, because nobody owns them. So,
this is the sum of everything that ultimate owners own, so it's everything. But nonprofits are a small part of
the total. So, real estate is 18 trillion. That's real estate owned directly by households and nonprofits. It
doesn't include commercial real estate that are owned by some of these other things. But that's not held by
institutions, that's held directly by households.
But the next item on this thing is pension funds, and that's 13 trillion. Almost as big as real estate. And
what are pension funds? These are plans, that either businesses create for their employees, or that people
invest in themselves for retirement. It's planning for old age.
Then, there's equity in non-corporate business. Non-corporate business means family businesses. Well, not
necessarily family, but partnerships and family businesses. You know, the corner store is a business, it's
worth something. The Fed has estimated the total value of all of these non-corporate businesses, and
estimates them at $6 trillion. Again, that's not institutionally held, that's held by families and people. So far,
we've got more family than institutional.
But then, if you keep going down the list, deposits are deposits at banks. $8 trillion. That's savings deposits,
time deposits. Now, that's institutional investors managing that.
Corporate equities, now this is shares in corporations, owned by households. That's $8 trillion. Now, we're
back to households owning them directly.
But then, we have mutual funds. Mutual funds are investment funds for the general public, that invest in
equities and sometimes bonds and other things. And that's almost $5 trillion.
Consumer durables. We're going kind of--seems like half and half or maybe a little bit less than half are
institutional, but it's a big share so far. Consumer durables, about 5 trillion. That's your cars, your clothes
that you're wearing, whatever else is in your house. It's estimated at 5 trillion.
Treasury securities are--now, that's government bonds. It might surprise you that it's only 1 trillion. That
includes both savings bonds, which your grandmother gave you, right? I don't know if you got that--you
got a $100 saving bonds--maybe you did. But that's only $100, doesn't add up to much. There are big-time
treasury securities that are treasury bonds, treasury notes, but they generally are held by institutions, not--
households just generally don't buy them.
The total national debt is now--in the United States it's 14 trillion [addition: approximately, as of April 11,
2011], but only 1 trillion, that's only 1/14 of it, is held by households. So, the institutions hold the rest.
Well, foreigners hold some of the rest, too, but we're not counting foreigners here.
Corporate bonds held directly by households, 2 trillion. Municipal bonds held by households, 1 trillion. But
I'll come to this--the total municipal bonds outstanding are more like 3 trillion. So, households don't hold
them generally, except indirectly through institutions. Life insurance. These are reserves at life insurance
institutions. That would be institutional investors again.
So, it seems like less than half, but close to half of all of the assets in this country are held by institutional
investors. This is a change from 100 years ago. 100 years ago, virtually none of it would be held by
institutional investors, so our society is becoming more institutionalized, more and more things are being
done by professionals.
And a related thing I wanted to mention again is that, as society gets more modern, the importance of the
family is diminished and the importance of government and business are increased. So for example,
pension funds are taking over what used to be a family responsibility. When Grandma and Grandpa get old,
they move into your house and you take care of them. That's an extra-financial thing that has gone on from
time immemorial.
But now, it works differently. Grandpa and Grandma commit to a pension fund, contribute to it. When they
get old, they move to an assisted living facility, which is a place where maybe they're happier. I don't know.
At least they can choose. They don't have just the single choice of living with you, which they might not
like. They might like it, they might not. It's working more institutionally.
So, this is really--I wanted to talk about thoughts, about where our society is going, and seeing the
increasing professionalization of it.
I thought to complete this list I should--remember, the previous slide--this 70 trillion is assets owned by the
households, OK? But I just wanted to get you in the right perspective on this. What about liabilities, OK?
So, the Federal Reserve Board computes that, too. [addition: The data is as of the fourth quarter of 2010.]
Those assets are owned, but it's not net worth of households, because households owe money, too.
So, the biggest debt that households owe is, in the United States, $10 trillion of home mortgages, all right?
We saw they have $18 trillion of real estate, but they owe $10 trillion, so that they have a net worth in real
estate of only 8 trillion.
But moreover, consumer credit is 2.4 trillion. That's credit card debt and some other revolving debt like
department store cards, or when you buy something--when you buy a car on time, it would go into that
total.
So, the total liabilities are 13.9 trillion. And then, so household net worth is the 70 trillion assets minus the
almost 14 trillion liabilities. So, it's 56.8 trillion is the total assets. And in per capita terms, that's $184,000.
That would mean that the average family of four has about $800,000--I'm just multiplying it, 184 by 4.
That's almost $800,000, so we're a country of millionaires, I guess. Or soon to be. But the problem is it's
not--it's only on average. This is unequally distributed.
But I should also add, the U.S. government has a debt of, as of this morning [addition: April 11, 2011]--I
looked it up on a national debt clock--14.286 trillion. And that's not counted as a liability of households.
But it should be, because we have to pay it, and we're going to pay it through our taxes, eventually. So, you
might subtract off another 14 trillion from the 56 trillion. And then, let's not forget, there's state and local
government debt, which is another 3 trillion [addition: approximately, as of April 11, 2011].
So, what does that bring us down to? Something like 40 trillion or less. I wanted to do that just to get
perspective on what our assets and liabilities look like.
Chapter 2. Human Capital and Modern Societal Changes [00:11:30]
The other thing is--I'm trying to put things in complete perspective, so I wanted to talk also about
something that's not on any of this, and that's human capital. Human capital is the value of our people, and
what people can do and produce. And if you want to develop total national wealth, you would want to
include human capital as well, right?
So, what is the national wealth for the United States, if we include everything, OK? Well, the way I figured
that is, right now the national income, U.S. national income is 13 trillion a year [addition: as of 2010]. And
I want to capitalize that, to value their present value with that. If you assume 3% growth in real terms and a
5% discount rate, that would make wealth equal to 13 trillion--I'm using the Gordon formula--divided by
0.05 minus 0.03, or 260 trillion.
That's also just for perspective, because I just wanted to put this $40 or $50 trillion in perspective. I'm kind
of diminishing my lecture. I'm telling you institutional investors are important, but as a fraction of the total
national wealth, it's not that important. And I think the family is still very important, as a manager of our
wealth. This is not managed by institutional investors.
One more calculation that will diminish the importance of institutional investors even more. What do you
think the world is worth? If we were to take the total national income of the whole world, and take the
present value of that, well, according to the International Monetary Fund in Washington, which estimates
for the world, world national income in 2010, well, world income--actually, this is world GDP, I believe,
but I'll use that as a proxy for income--is $62 trillion. And if I use the same discount rate and assumed
growth rates, you know what I get for the value of the world? The World wealth? It's $1.2 quadrillion.
Again, put things in perspective, we are going through an enormous transition in the world. I'm only
assuming a 3% growth rate for the world, and many countries are growing at 7% to 9% now, so maybe this
is conservative.
But I think that, as the world matures, as we become more and more modern and capitalist, the importance
of the family will remain. It will remain important, but it will diminish in relative importance. So, as time
goes on, we're going to see something like a quadrillion dollars increasingly managed by institutional
investors. So that's, what I want to talk about today.
As I was saying, in modern society we do things differently. We don't expect young people to take their
parents in, to care for them. I mentioned that as an example. Is that, because we don't care about our parents
as much as we used to? Interesting question. There's a lot of discussion about that, but my general take on it
is that most elderly people like to have choices. They love their children, but they don't want to move in
with them. They want to have a savings, some kind of pension, they want to be able to choose, how they
live, with whom they live with.
Similarly, our health care, we used to depend on our families to provide health care, but it didn't work very
well. People weren't getting very good health care. And now, we have it all institutionalized through trust
funds for health plans, and benefits and the like. This means that it's more and more run by investment
managers.
Chapter 3. The Fiduciary Duty of Investment Managers [00:17:04]
And investment managers are trained in modern finance and understand risk management. So, there's a
professionalism to all this. The family is of limited--even if it were smart, even if they were brilliant as
investment managers, they're a small unit. And unless they were to engage in some kind of risk sharing
agreement, they can't manage risks well. The whole family is too small a unit to manage risk. But
increasingly, investment managers are running risk management for families, that allows risk sharing
around the world.
We have growing pains with this. The recent financial crisis shows that investment managers mess up
sometimes, and their attempt to share risks around the world--like, for example, the subprime crisis was
caused by the failure to manage mortgage risk appropriately. But nonetheless, I think they're getting more
professional and more important. So, right now we have professional risk managers that are, I think,
increasingly important in our very lives.
Now, they have a fiduciary duty. If you are managing other people's money--that's a quote--''other people's
money,'' then you might be negligent. It's not my money, what do I care? So, the law prescribes that you, as
an investment manager, have a duty to act in the interest of the person you're managing for, or of the group
of people you're managing for. And the law has been trying to prescribe what this duty is. There's
something called the prudent person rule, which is a rule that investment managers have to behave as a
prudent person would.
I'll read one definition of it. ERISA, which was an act of Congress in 1974, defined--they called it ''prudent
man rule'' back then, because our language was still sexist in 1974--they said that ''investment managers
running pension funds must manage with the care, skill, prudence, and diligence under the circumstances
then prevailing, that a prudent man acting in a like capacity and familiar with such matters would use in the
conduct of an enterprise of a like character and with like aims."
They're trying to legislate what it is to be a good fiduciary. And it seems sensible. You should ask--if
someone is managing a pension fund for elderly people, they shouldn't do wild and crazy investments,
right? They shouldn't invest in racehorses or something like that. It should be prudent. But then, how do
you define it? If you read the act, it says, they would be acting like a prudent man ''in a like capacity in a
conduct in an enterprise of a like character and was like aims." OK?
The problem is, with the 1974 act, that it's hard to legislate duty, define what it is. So, what the law said,
and it has said it in many places, is that you have to--as a fiduciary, as an investment manager--you have to
act as a prudent person would act. And what is a prudent person? I guess, it's somebody else. Somebody
else, who is of a kind of a standard of ordinary type. I don't know what it is. I mean, I could say that
investing in racehorses is the smartest thing for me to do, but I can't claim that that's a prudent person act.
So, the law has required institutional investors to some extent to behave, not as they would behave, but as
they think other people would behave. It was legislating a requirement, that you don't do what you think is
smart, you do what you think other people think is smart. And this has been a problem, because what it has
done is, it has created a class of institutional investors, who live in fear of laws that could come down on
them, if they, with the best of intentions, invest on behalf of their clients in a unconventional way, and
therefore could be punished for violating the prudent person rule.
Thus, for example, because of the prudent person rule, university endowments, which are an example of
institutional investments, for much of the 20th century were invested in bonds, government bonds, because
they thought, well, that's prudent. No one can tell me that we're not prudent. The government bond is safe.
But some investment portfolios, notably the one that--we had David Swensen come and speak to us earlier-
-took a more aggressive interpretation of the prudent person rule, and developed an investment strategy that
looked imprudent.
So for example, Yale University was investing in startup dot-com firms during the dot-com explosion--
managed to sell out just at the peak. Is that being a prudent person? Well, the interpretation of prudent
person rule has changed, and this is part of the phenomenon that drove the bubble. Institutional investors,
led by people like David Swensen--it lead to a more benign interpretation of the prudent person rule, and
allowed them to take chances. And I think that, that general sense that one could be more aggressive in
investing, was part of the bubble that led to the financial crisis. I'm not saying it's a bad thing in itself, but
I'm telling you it was part of the factors that led to this bubble.
I looked through Dodd-Frank. The Dodd-Frank Act of 2010 is the most important piece of financial
legislation in the United States since the Great Depression. And I did a search for prudent person--it
appears nowhere. But I found that the word prudential standards appeared 34 times in the Dodd-Frank Act.
So, it seems like the financial crisis is changing things a little bit. It's bringing our society to want
regulators, government regulators, to be making the ultimate decisions about what kind of risks institutional
investors will take on. They're still letting households do what they want, but in terms of institutional
investors, the Dodd-Frank Act talks extensively about regulators going in and regulating what institutional
investors--what kinds of risks they can take.
The same thing is true in other countries. I think, this is a world phenomenon. The problem is that the
prudent person rule didn't seem to work, didn't seem to work well enough. It started out, when it was first
imposed, as encouraging a very conservative investment, but then people thought, as time went on, that that
didn't make sense, they got more loose, and it let to a financial crisis.
So, Dodd-Frank is creating something called the FSOC, the Financial Stability Oversight Commission,
which has to enforce. Well, it doesn't enforce, but it makes recommendations on prudential standards,
particularly regarding--well, I wouldn't say particularly--but including leverage. Leverage--we talked about
it--it's a measure of the risk that you've imposed on your portfolio by borrowing to buy assets. The
economy became increasingly leveraged up until the financial crisis, when it began around 2007. And
people were concerned about that. Well, were institutions following the prudent person rule? Well,
somehow, as time went on, their mind allowed more and more leverage to be considered acceptable.
So, now what we have in the Dodd-Frank Act is, that the Financial Services Oversight Commission is
supposed to recommend standards of leverage and prudential standards for financial corporation, and to put
financial corporations under increasing regulatory authority to meet those standards. So, in some sense, it's
shifted to the government. We had seen a historic shift of power over investments from individual investors
to institutional investors, and to some extent, at least, it's shifting to the government. And I think--I'm
talking mostly about the U.S., but I think this is a currently worldwide trend.
It's exemplified also--I mentioned before, that we had private organizations, the securities rating agencies
such as Moody's and Standard & Poor's and Fitch, but the governments are trusting them less, and they're
putting standards more on government regulators now.
Chapter 4. Financial Advisors, Financial Planners, and Mortgage Brokers [00:28:23]
I said I would talk about financial advisors. Financial advisors are people who don't directly manage
portfolios, they're not institutional investors, but they give advice to those who do. And the financial
advisors are regulated by governments in most countries. So in the U.S., for example, the SEC, the
Securities and Exchange Commission, requires advisors to be approved by FINRA, to win FINRA
approval, where FINRA is the successor to the National Association of Securities Dealers. It's a non-
government organization that administers an examination and education program for advisors. And so, you
effectively have to go through FINRA to get licensed to be a financial advisor.
I'll give you an example of an organization of financial advisors. NAPFA is the National Association of
Personal Financial Advisors, that manages the relation between financial advisors and the public. These
people will typically charge between $75 and $300 an hour, and you can get one tomorrow. Just make a
phone call, get on to a website, NAPFA website, and hire one. And they have a code of standards. They
have to be licensed through the SEC, and they have to have an oath of loyalty to the client that they
undertake. This is a big business. I mention it, because in one of my first lectures I gave you a count of how
many people there are. But I'm just trying to--
There's also something else called a financial planner. Financial planners. Now that sounds like the same
thing to me, but somehow, if you call yourself a financial planner, you don't have to go through this
licensing. And in the Dodd-Frank Act, I didn't find much new legislation regarding them. The Dodd-Frank
Act is calling for a study of financial planners.
The question is, how does the government get involved in making these people give good advice? The
problem is, that the financial crisis seem to be led by a lot of bad advice given out. A lot of people were
encouraged to leverage up their ownership in their home, to borrow heavily to buy second homes. I'm sure,
that financial advisors were not uniformly advising that, or financial planners, but there's a concern now
about what kind of advice people were given. So in 1996, Congress passed a bill in the United States,
saying that financial advisors cannot be convicted felons, among other things. But there hadn't been, until
then, such a law.
We have something else called mortgage brokers. It's a little different. These are people, who give advice
on getting a home mortgage. There was no licensing of them until the financial crisis. Because mortgage
brokers could be anything. They could even be a convicted felon, until just a few years ago, until after the
crisis. Here's the fundamental problem, that people are getting--they're confronted by an increasingly
complicated financial structure. Living is less family, and it's more investing and getting involved in
financial markets, and most people don't know how to do it. And that the people who give them advice are
often, are not giving them the best advice. What can we do about that? Well, the government is trying, but
it's imperfect.
I think that, as the world develops, I think we'll probably see--I think there is a trend toward increasing the
professionalization of these groups. And although it's not a simple matter to straighten out some of the
irregularities, we're moving, as the world gets better and better, to even stronger such institutions.
Chapter 5. Comparison of Mutual Funds between the U.S. and Europe [00:33:53]
Now, I wanted to go through some kinds of institutional investing. The mutual fund is--I've talked about
this before--is an investment company that is owned mutually by the participants. It will invest typically in
stocks, and it distributes everything to the owners of the stock [correction: owners of the fund]. The first
mutual fund was the Massachusetts Investor Trust. That's not the university. Massachusetts--I'm sorry--
Investment Trust, which was founded in the 1920s. And it was very open and direct with its investors. It
published its portfolio. It promised--it was completely open about what it did--and it promised nothing
more than it would divide up all of the returns among the participants. There were no senior members, who
got more of the money than anyone else. So, MIT became a model for an investment fund for the public.
In the 1920s, there were many investment funds that were exploitative of the public. They had two classes
of investors, and the first class of investors ran off with the money, at the expense of everyone else. So, it
took a while after the 1929 crash, but the Investment Company Act of 1940 set the stage for the growth of
mutual funds. And so, mutual funds are designed for individuals, and they are--this is U.S.--they are a very
successful institution. So, you know exactly what--they have regular reports--you know exactly what
they're doing, and there's no rich person benefiting excessively from what happens.
In Europe, they have an analogous institution, UCITS. It refers to a European Union directive, called the
Undertaking for Collective Investment and Transferable Securities, which is an EU directive, 1985
[clarification: In 1985, it was still the European Communities, and not yet the EU, which was not
established until 1993.], and then they had revisions in 2001, that creates a standard investment fund like a
mutual fund for Europe. It used to be that every European country had its own securities law, and it made it
difficult, because there's so many European countries. So, they standardized, and they developed a sort of
European version of the mutual fund.
The key difference, I think, between a mutual fund in the U.S. and a UCITS in Europe is--it's technical--it's
how they're taxed. The mutual fund in the United States--if you own shares in a mutual fund and you just
hold them, you will still get capital gains taxes every year, even if you didn't sell it. Because other people in
the mutual fund sell some of their shares, generating a capital gains, and that capital gains is then
distributed to all of the participants in the mutual fund. With a UCITS in Europe, you don't pay capital
gains taxes, unless you yourself sell.
So, I think the UCITS form is gaining on the mutual fund form. And some people, notably Robert Pozen at
Harvard Business School is advocating that the U.S. switch to the European standard.
Chapter 6. Trusts - Providing the Opportunity to Care for Your Children [00:37:58]
I wanted to talk about trusts. What is a trust? It is money held on behalf of another individual. Well,
particularly a personal trust is something, that you can set up on behalf of another person or a cause, so that
an institutional investor will manage money on behalf of that person or cause. And a company that does
trust is called a trust company, and trust companies have often been combined with banks, but they're not
necessarily part of a bank. You see many institutions, the title will be Bank and Trust Company. Well, you
know what a bank does. It takes deposits and makes loans. What does a trust company do? It creates trusts
on behalf of some person and manages the money for them.
The classic example of a trust is, imagine that you have a child, who is handicapped in some way and
unable to manage his or her own affairs. And you, as a parent, know that your child will outlive you, and so
how do you provide for the child after you are gone? Well, you create a trust for the child. And you can go
to a trust company and say, I want an income for my child, managed for the rest of my child's life, and the
bank will outlive you--or the trust company will outlive you--and can do that.
So, this is very important, because it allows people to create situations that outlive them. But particularly in
common law countries, it doesn't have to be a company. You can set up a trust, you can take a young
relative of yours, who will outlive you, and say, I want you to be the trust manager for my child. And if you
become ill, can you appoint a successor? You can do that, too. U.S. trust law recognizes the importance of
trusts, and so that person--suppose that person that you appoint as a trustee for your child, suppose that
person goes bankrupt, and then other people are taking, seizing, that person's assets. They could not take
the assets in the trust, because the law recognizes the importance of trusts.
There are different kinds of trusts. But I thought, I should tell you about a particular kind that may be
relevant to some of you in your future. There's a certain kind of trust called a ''spendthrift trust,'' which is a
trust that your parents may be setting up for you now. I don't know. What is a spendthrift? A spendthrift is
someone who spends money to freely, all right? Can't be trusted to manage money.
Suppose, you have a child, who's like that, and you're getting on in years, and you're thinking that you
could leave a will to your child. But the child might just blow it. So, what you do is, you go to a trust
company, and you say, I'd like to set up a spendthrift trust for my child, and after I die, the trust will pay my
child an income, and the child cannot get at the assets, only the income. And so, you manage it, and the
child comes to you and says, I want the money, and you say, sorry. Your parents set up a spendthrift trust.
That's all you can get.
There's various reasons why they do this. One of them is, that in a divorce, if your child gets divorced, if
you gave money to the children, the divorce court might give half of the money to the awful spouse your
child married. But if it's a spendthrift trust, they can't get at it. It's income to the child. So, there's all kinds
of reasons why people set up trusts.
But I think trusts are a really an important invention in our society, and they're not talked about very much.
But I mean, it solves a real problem. This handicapped child problem is an extreme case, but it's very real.
You can have assurance, the law makes it clear that that money is managed by a professional for the child.
These are real and important institutions that help people get on with their lives, and I think our financial
system does a lot to make these things work well.
Chapter 7. Pension Funds and Defined Contribution Plans [00:43:14]
I wanted to talk about pensions because--I've already talked about them, but people do get old and they
can't keep working. And if you look at the history of the world, the fate of elderly people is highly variable.
Many of them, if they have good and dutiful children, will do all right--who take care of them. But in the
past, you would find a lot of elderly people out on the streets begging, because they didn't have children, or
the children died, or the children lost their income. It's a problem that we've worked substantially to solve,
and again, it's an example of progress of our civilization. We take it for granted, that people are living as
comfortably as well as they are, but it's substantially a product of invention.
So, the idea of a pension is actually a relatively new idea. The first U.S. pension plan was 1875. American
Express Company set up a pension plan for its employees. There's actually an earlier example in the U.K., I
think, but I don't have the name of it here. But only something like 20 years earlier. So, until then, there
was never a pension plan. So, American Express set up a plan, and it said employees, who had worked at--
this, by the way, is not the credit card company, this was a delivery company. They had stagecoaches. This
is a long time ago. And if you worked there for 20 years, past age 60, and were disabled, you would get
50% of the average of the last 10 years pay for life. This was the model--50% of average of the last 10
years pay on retirement. Because it was tied to how much income. They thought, you could live on half the
income that you earned when you were working.
In 1901, Carnegie Steel--that's Andrew Carnegie, the same Andrew Carnegie, who wrote The Gospel of
Wealth that we've been talking about--gave what was the first large industrial pension fund. And it covered
a substantial number of people, it was a milestone that suggested many more such pension funds.
Unions, in the early 20th century, started setting up pension funds. For example, the Pattern Makers in
1900, the Granite Cutters and Cigar Makers in 1905, et cetera. The union pension funds became popular in
the early 20th century, but there was a collapse of pensions after 1929. Many people were promised
pensions in the first three decades of the 20th century, and then the companies just went out of business and
didn't--moreover, the unions' pension funds failed especially disastrously. They didn't manage their money
well, or the institutional investors were not very astute. You know, it's like the world was very amateurish
about how they handled these things. Obviously, it's very important that people have money to retire on,
but many of them got wiped out in 1929, so it lead to further thinking about pensions.
The General Motors pension plan was a landmark pension plan in 1950. And in 1950, GM chairman
Charles Wilson proposed a fully funded pension plan. This was a new idea. That is, General Motors, in
promising to pay you in your retirement, would set aside and invest now enough money, so that they would
have that. In other words, they created a trust for the employees. So, it's just like the parent for the
handicapped child. If General Motors dies, doesn't matter, because there's a trust managing their pension
fund.
You know, it's kind of a funny idea. Why didn't anyone do that before? Why didn't the unions, who were
looking out for the union employees, demand that they fund their pension funds? You know, it seems like
financial history shows a lot of stupidity. I don't quite understand, how it could be. It seems obvious,
doesn't it, that if a company is going to promise you for a pension, that they should set aside money?
Because companies fail all the time. There may have been some union complicity, that the unions were not
really always working on behalf of their members. They thought, well, the members don't think about this
problem, so we're not going to think about it, either. It's going to come years down the road, we're not going
to worry.
So, General Motors, in 1950, set an example for funding the pension funds. It's very important. And more
and more firms started to do that after 1950.
But the next thing I want to give is Studebaker. Do you remember Studebaker? They were one of the major
automobile manufacturers. You maybe don't remember them, because they went bankrupt in 1963. That's a
long time ago for you, but they were around. Well, they had a pension plan that was partly funded, but
inadequately funded, and, when they went out of business, their employees lost. So, this led to arguments
about--and their labor union, again, the United Autoworkers, supposedly standing up for the employees,
didn't do the job.
So, the whole idea of labor management negotiating, protecting the workers seemed flawed, and so the
government got involved, and it led to ERISA, which I mentioned before. 1974. ERISA stands for
Employment Retirement Income Security Act. This was an act to clean up pension funds, and make them
work well, make them work better. The government wanted to make sure, not only that pension plans said
they were funded, but that they were really funded, so that another bankruptcy wouldn't cause pension
plans to fail.
So, ERISA set up a new government agency, called the Pension Benefits Guarantee Corporation. That's
PBGC. The Pension Benefits Guarantee Corporation is a government organization that insures the funding
of pension plans, OK? So, pension plans not only have to undergo scrutiny by the PBGC that they are fully
funded, but they also have to pay an insurance premium to the PBGC. And if it turns out that they're not
fully funded, then the PBGC would come in and replace the lost income.
You see, over the century we're trying to come up with financial structures that solve basic human
problems.
The PBGC, by the way, is still here, and it hasn't gone bankrupt, despite this financial crisis. Though people
are worried about it, it has managed to survive.
After 1974--shortly after this--after 1974, a new kind of pension plan became popular. So, ERISA was
written in an age of defined benefit pension plans, like the original American Express pension plan. What
did American Express pension plan in 1875 promise you? It promised you half of your average income for
the last 10 years, all right? And if you're going to fund the pension plan, you're presenting a problem to the
managers of the pension money. They have to hit that target. They're told, the pension plan has an
obligation to fund the payments equal to whatever percent of last year's income. And that's kind of a tricky
problem, if you're a manager. How do I do that? How do I hit that target? How do I know, how much
money to set aside? Well, it's getting now into government regulators, and prudent person rules, and it's
tricky. But the point is that in 1974, almost all pension plans were like that. They defined the benefit that
you would receive when you retired.
But afterwards, in the 1980s, companies started offering a new kind of pension plan, called a defined
contribution. The idea was, it's hard for us to hit that target, of say 50% of your average income for the last
10 years. How do you expect us to do that? We don't know how much these investments will pay out. We
don't even know how much money you'll be paid in your last 10 years. So, it's asking us to do the
impossible. Well, it's not impossible, but difficult.
So, many companies decided, instead of requiring a defined amount to be paid, they would just define the
contribution they'll make to your portfolio. They give you a portfolio as an employee, and you get whatever
income that portfolio generates when you retire. The most famous example of that is a 401(k) plan in the
United States. But ever since, shortly after ERISA, the world has been moving towards defined
contribution pension plans, where a defined contribution pension plan doesn't promise what you'll get in
retirement.
So then, a portfolio manager for a defined contribution pension plan doesn't have to worry about hitting
targets. And in fact, the way defined contribution plans are usually set up, they give the individual
employee the choice of the main portfolio allocation between stocks and bonds and real estate, or whatever.
But you have investment managers managing within one of those asset classes. So, theyll be someone
managing an equity fund, another one managing a bond fund, and they try to do as well as they can as
investors, subject to the restriction of what they invest in, and it's left to the client to choose the allocation.
Defined contribution plans are going through growing pains, too. We still don't have the perfect system.
The problem with defined contribution plans--one problem is, that you don't have to sign up for them, the
way they've been set up. It used to be, under the old days, defined benefit plans, it was just automatically,
every employee would get the pension plan. But with a defined contribution plan, typical rule was, that the
company would ask you to make contributions out of your paycheck to the plan, and the company with
then match them, typically, with additional contributions. But something like a quarter of the people would
choose not to participate--that's, because they're not thinking, they're not thinking ahead--and so, when they
come to retire, they don't have any pension plan. Moreover, some of them take the most risky investment
offered. They might put it all in the stock market, and if the stock market does badly, they might end up
poor in retirement.
And companies generally would not give any advice to the people who were employees, because they
didn't want to be liable for giving bad advice. So, it led to kind of an amateur investing for pension plans.
So, there has been work to try to fix that, and I think federal legislation has made it easier for companies to
give advice to employees. They've also allowed, recently, in the last few years, for companies to
automatically enroll employees in a pension plan, and allow them to make allocations, if they didn't hear
anything from the employees. In other words, they'll put you into a prudent allocation, and then you're
actually there. You're in it, because you've said nothing. That's working towards solving the problem. We
still don't have, I think, the ideal solution to any of these things.
Chapter 8. History of Endowment Investing [00:58:23]
So, I've talked about pension plans. Let me move on to endowments. Endowment managers, of which
David Swensen is one. So, an endowment manages a portfolio for some cause or some purpose, like a
university. And the history of endowments is one of great--it's just amazing to me, how many serious
mistakes were made in history, but we're gradually becoming more professional.
So, I give you an example of a mistake. This is in Swensen's book. In 1825, Yale University put its entire
endowment in an investment in the Eagle Bank of New Haven. You know what happened? It went to zero.
It ended up with nothing. So, Yale had no endowment after 1825. So, Elihu Yale may have given us
money, and we should have turned it into a pretty tidy sum, compound interest from 1700 to 1825, but we
blew it completely. This is the first thing you learn, in a portfolio you don't put all of your money in one
investment. But Yale University did that.
By the way, I was looking it up, 1825 was the year that Yale College introduced the economics
requirement, or they called it political economy. Before that there were no economics courses at Yale. But
maybe it was this experience that made them do that in 1825.
So, I'm going to give you another example. Boston University--this is much more recent--under John
Silber, invested not the whole endowment of the university, but $90 million in one company called
Seragen, which was a genetic engineering company. And just John Silber decided to do this, and he lost
Boston University 90% of $90 million.
University of Bridgeport, not far from here, blew its whole endowment, and ended up having to join the
Unification Church to survive. I think that somehow that's been undone since then. I'm not sure of the
details. It may not have been what they would have done, if they had had an endowment.
See, what Swenson thinks is, what he's doing is protecting the ability of a university to undergo its financial
mission. And so, because Swenson was not overly constrained by prudent person rules, because he was free
to invest in a high intellectual standard, he's made it possible for Yale to pursue its educational objectives.
Right now at Yale University, like other successful endowment universities, graduate students get their
whole tuition paid, plus a living allowance. It's like a job, coming to be a graduate student. The university
pays--you should know this, if you're thinking of getting a PhD. Come to one of these universities, and
they'll pay you something like $25,000 a year, something like that to--that's pretty good deal. It's not a deal,
it's a gift. It's the generosity of the alumni, and it's the success of the investment strategy that makes that
possible.
Chapter 9. Family Offices and Family Foundations [01:02:34]
And then, I wanted to talk about another kind of institutional investor, and this will bring me back to my
discussion of the family. I started out by saying that the family is the fundamental unit of our society. Its
demise has been predicted. Remember that in the Communist Manifesto, Karl Marx said we're going to end
the family as an economic unit? Something like that. Didn't happen. It's too ingrained in our genes or our
long history.
So, I thought, I should come back and talk about family offices and family foundations, although these
apply only to the more wealthy people in our society. What is a family office? These are--people who have
$100 million or more typically set these up. Maybe even less. Maybe, with 20 million in assets. But if you
have $100 million in assets, 5% income is $5 million a year, right? It would be sensible to take on some
full-time employees to manage your family portfolio, and so that's called a family office.
I recently spoke at a family office forum, down in Florida. They seemed to be very numerous. There's an
awful lot of families. The families come to these conventions, and they hear people like me speak.
Although I'm different than most of them, because most of the people speaking there wanted to sell
products, and I wasn't there to sell anything.
So, they typically have two or three or five people working full-time, managing their portfolio and planning
things like trusts for the children.
And then, there's something else called a family foundation. The family office is for the family, and there's
something else called a family foundation. And this is different from a family office, but they could be
interrelated, and I think most wealthy families have both. A family foundation is a charitable organization,
created by a family with the name of the family typically on the foundation.
I think that most wealthy families--or actually, I don't know. A large number of wealthy families, at least in
the United States, now set up family foundations. And the reason they do that--well, why do they do that? I
think it's partly, because, when you're wealthy, you realize that you can't spend it all on yourself. And you
reflect on yourself as a member of society. As people get older, they think, what am I going to do with this
money? So increasingly, people are setting up family foundations.
I learned, that, as of 2006, there were 36,000 family foundations in the United States, and it's growing
rapidly. This seems to be a trend toward that, I think, reflecting our increasing affluence, but, I think also,
reflecting maybe changing values.
So, the typical family foundation is not huge. It might be one or two million. So, you can set something like
that up, eventually--not right d now--I want you to think about doing that. So, whatever it is you believe in,
you set up a family foundation to do that, while you're still young, and you get it going, and it will then
outlive you. And you endow it, you give it enough--say, you give it a couple million dollars. That would be
a small family foundation, but you can do that. And then, there's some named cause, like it could be
improving neighborhoods in our city or the like.
And family foundations, I think there's an important tax advantage. You don't want to think about this yet,
but you should start thinking about it. When you start making money, assuming that happens, what do you
do with it, OK? Now, you're pulling in a million dollars a year, OK? That's something that you might well
do. And so, I can just put in the bank and not think about it? One problem is, the government will tax you
on it. And you get a charitable deduction from your tax, which encourages you to give to charities.
All right. So, you're now 30 years old, and you're making a million dollars a year. And what do I do with all
this money? I'm paying taxes on it. If I give it away, I get a tax break. So, there's an incentive to give it
away. You're getting all these phone calls at night from--they found out that you exist--from United Fund
or different charitable organization. But you stopped answering the phone, because you're annoyed by all
these phone calls, and you're thinking, I don't want to just give it away to someone that called me up on the
phone. I want to think about what I'm--I want to do something for the world.
The idea is that, while you're still young, you set up a family foundation, and you give the money to the
foundation irrevocably. All right? It has a cause written in its charter or something. And then, you don't
have to spend it now. You're too busy thinking about what you're doing, so you start contributing to the
family foundation, and it accumulates. And meanwhile, you're getting the tax deduction. So, that's why
36,000 families have done this in the United States, and I think it's growing, again, over all the world.
Sometimes, family foundations are plans for children, too, because then your children can then run the
foundation. It becomes an ongoing thing for the family that unites them in a cause, as time goes by. I think
this is really important to recognize this channel--although it's only 36,000, that's still a lot of them--as we
think about the growing inequality in the United States and in other places around the world, and think
about a policy toward that. I think, we should do something about inequality, but I think encouraging this
kind of a family foundation activity is a good cause.
I wanted to just think about--I'm almost done here--there's a recent book by a Wall Street Journal writer,
Robert Frank, called Richistan. And he talks about rich people in America and what they do. And the book-
-this is Frank, Robert Frank--the book talks about excess that some people do. Some rich people spend
money lavishly, and it disgusts people, who think, what is going on in our society? But on the other side of
it, there is also this philanthropic trend that Frank talks about.
So, I'll give you an example. Robert Frank talks, for example, about Paul Allen. Remember him? I guess,
he was the number two man at Microsoft. So, is he a good person? Well, I'll give you two sides to that
story, and this I got from Richistan. Paul Allen wanted to have the biggest yacht in the world, and so he
went to a yacht company, and had a 400-foot yacht. It turned out, they said--it created problems for him,
because he couldn't dock it at any yacht club. He had to go to industrial docks for major cargo ships. So,
that's a big yacht, and he called it The Octopus, OK?
Paul Allen has a new book that just came out, or it's just coming out now, called Idea Man. In his own
recount of himself, he had brutal battles and arguments with Bill Gates. It was a revealing thing. They were
really in this for the money, OK? So, he's starting to look like a bad guy, right? Because here he is showing
off with the biggest yacht in the world--and actually, he's been topped, somebody else. Who was it? Larry
Ellison got a 450-foot yacht.
But on the other side of it is, there is something called the--it's the Paul G. Allen Family Foundation, which
he has set up already. And it turns out, he has already donated over a billion dollars through this foundation
and otherwise to charity. So, that's much bigger than the 450-foot octopus. What does it cost to buy a 450-
foot yacht? I don't know, it's not going to be a billion dollars, right? This is one of the ironies that you face
in living, that someone like Paul Allen, he's a tough businessman, an aggressive guy, he sometimes does
extravagant expenditures, but on the other side, there's this charitable side, so I think we have to reserve
judgment about most people. Anyway, what he has working for him is a great understanding, apparently, of
financial arrangements, of endowments, and he's setting these up, and you got to give him credit for that,
and I think we have to consider that as important.
Institutional investing is an important trend in our society that can and does work for important and good
purposes. I'll see you on Wednesday.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 21 - Exchanges, Brokers, Dealers, Clearinghouses [April 13, 2011]
Chapter 1. Exchange as the Key Component of Economic Activity [00:00:00]
Professor Robert Shiller: Well, today I wanted to talk about exchanges and clearinghouses, primarily
stock exchanges. So, these are places, where shares in corporations are traded. And I think, it's good to
devote a whole session to them, because exchange is central to economics.
In fact, I was struck recently. I was re-reading the presidential address of my old teacher. When I was an
undergraduate at University of Michigan, I took a course by Professor Kenneth Boulding. I suppose, I'm
influenced by him. When he was elected president of the American Economic Association, he gave a talk
about economics.
And he had an interesting definition of economics. What is economics? There's a lot of definitions given
for the field, but one definition is the theory of the allocation of scarce resources. That's, by some
definition, what the essence of economics is. But Boulding said, that doesn't sound right to him, because
political science is about the allocation of scarce resources, and so is--even the family is an instrument of
scarce resources. So, Boulding said in--it was his 1969 presidential address--that economics is the study of
exchange. Obviously, it's prices and quantities that economics emphasizes, and those are parameters of an
exchange. So let's say, that equals economics.
I'm reminded of another book. I'm talking in very general terms first, and then I'm going to focus in on
stock exchanges. But I'm reminded of another really important book, which I read so many years ago, by
Karl Polanyi called The Great Transformation. And that was written in 1944. What is the great
transformation? Well, for Polanyi, it's the invention of exchange. He said, what is the most important
invention of man? Maybe, it's exchange.
According to his history of humankind, this was a relatively recent invention, Neolithic or more recent than
that. He argues that in primitive societies, there is really no arm's length exchange. An arm's length
exchange is one, where you just quote a price and a quantity, and you don't have any other business. The
price and the quantity sum it up. It's a business transaction. But Polanyi argued, that until just something on
the order of 10,000 years ago, there were no business transactions. There was only gift exchange. There
were relationships people had. And you would solidify a relationship by making a gift to someone else, and
then that person would later reciprocate, but there's no price, there's no exchange.
So, he claims that the development of our civilization is really the result of the development of the idea of
exchange, and then, an amplification of the idea as it became more and more pervasive.
By the way, I've since learned--I thought Polanyi was very impressive--but some anthropologists question,
whether there wasn't exchange more than 10,000 years ago. And they cite evidence. One kind of evidence
that's found of this is that certain commodities, even in the Paleolithic times, certain commodities are found
far from where they were mined. Like flint to make stone tools, or ochre to make body paint. And they
figured out where--you can do a chemical analysis and you can figure out where it was mined. And then, if
you find that it arrived somewhere 1,000 miles away, there must have been exchange, right? The cave--no?
Student: Couldn't they have just killed someone?
Professor Robert Shiller: OK. It could have been, that they just killed someone, right. So, I guess nobody
knows.
But anyway, some anthropologists argue that there was exchange. Maybe, it was too pervasive. Of course,
people did kill a lot of people in those days, too, anthropologists report.
So, maybe Polanyi had it exactly right. But I think, he had it at least approximately right, that exchange has
become a bigger and bigger part of our lives, and that's modern civilization.
Chapter 2. Brokers vs. Dealers [00:05:50]
I'm going to talk mostly about financial exchange. That's the subject of this course. But I can be a little bit
more general. I wanted to start by distinguishing a broker and a dealer. What's the difference? It's a
fundamental thing. A broker--actually, I've got this almost as a slogan--a broker acts on behalf of others as
an agent to earn a commission. So, it's for others, trades for others as an agent for a commission. A
commission is a fee. What is a dealer? A dealer trades for himself or herself, acting as a principal, not an
agent, and profits from a markup.
So, I can give you an example of each. When you buy or sell a house, do you get a real estate broker or a
real estate dealer? That's almost obvious, right? Because you heard the term real estate broker so many
times. When you buy or sell a house, you commission a broker, and you agree on a contract that pays the
real estate broker a certain sum of money--maybe 6% of the value of the house--if a buyer is found. And
then, the broker doesn't buy your house, right? So, the broker is an agent. And the 6% is the commission
that the broker gets, if he or she is successful in finding the other side of the deal.
What's an example of a dealer? An antique dealer, right? Suppose, you're buying a chest of drawers for
your apartment. You go to an antique store, and there's someone there--your antique dealer--who has
furniture, that he now owns, having bought it, and makes a profit by selling it to you at a higher price,
namely with a markup. He marks up the price that he paid for the item.
But let me just ask you, why is it that way? Why are antiques sold by dealers and real estate by brokers? I
recently had a discussion with Guillermo Ordoez, who is an assistant professor here, and we were
wondering, maybe there are real estate dealers. Oliver helped us and found, actually, in Germany, a couple
of real estate dealers. But only like a couple, and we couldn't find any in the U.S. And we had searched
around in many other countries, and there was just virtually none, no real estate dealers.
Anyone have any idea why? I'm asking you to think. It's a little--or does anyone come from a country,
where they have real estate dealers? And that would end it, if you--I bet not, right?
Well, what about antique brokers? Why not that? Have you ever heard of an antique broker? Maybe, there
are.
But it's an interesting question. It seems like some markets are naturally dealer markets, and some are
broker markets. We thought of one explanation, why there aren't real estate dealers, at least in the United
States. We learned that a dealer has to pay income tax on the profits from a deal, and that is at a higher rate
than a capital gains tax, and so that closes people out. You wouldn't want to be a real estate dealer, because
you end up paying a higher tax.
The other thing is, I wonder if there's something about information, that someone who deals in real estate--
it's just too hard to know what to pay for a house. It's so subjective. You could make big mistakes, if you're
going to buy houses, and then resell them at a markup, because the market is just so variable, and it
ultimately changes quickly. Maybe it's too risky. I don't know. I'm trying to think. But of course, there are
real estate dealers, just very rare.
So, we're going to talk about stock markets. Which do you think stock markets are? Are they dealer
markets or broker markets? Well, the answer is both. And now it's not as clear, and I'll come back to this.
The New York Stock Exchange, New York Stock Exchange in New York is a broker market. Or they
would say, an auction market. It's a continuous double auction market, where a broker facilitates the trades.
The NASDAQ market is a dealer market. So, you pay commissions to your broker at the New York Stock
Exchange, you pay a markup to your dealer at the NASDAQ.
[SIDE CONVERSATION]
Chapter 3. History of Stock Exchanges around the World [00:12:25]
Professor Robert Shiller: I thought I will start by talking about stock exchanges, and historically--and I
have a lot to say. I can't cover it all, I was going to start with ancient Rome, I think I mentioned that before.
But the--I'm getting there in my notes--the ancient Roman stock exchange is the first stock exchange, that, I
think, anyone knows about. But traders--I'm relying on the research of Ulrike Malmendier, who has studied
the ancient Roman stock exchanges much as can be studied. There's not that much evidence about it.
But the traders met outdoors on the Roman Forum at the Temple of Castor. That's where you went to buy
and sell shares. The shares in Latin were called partes--I don't know if I covered this or not--and the
companies were called publicani. The peculiar nature of the ancient Roman corporations is that they sold--
their customers were the government. And so, they did services for the government, like provide horses for
the army, or they would feed the geese on the Roman forum, on the Roman capital. They always fed the
geese there, because the geese were hallowed in Ancient Rome, because they once warned of an invasion
by cackling. So, there was a publicanus that was in charge of feeding the geese. And also, they would talk
about share prices. It's known, that they would go up and down, even then, but there's no data on their share
prices.
It seemed that there was a long gap for stock exchanges after the fall of the Roman Empire, and the
publicani disappeared. And there was a wide variety of financial arrangements, some of them resembling
corporations. But the advent of the rebirth of the stock exchange didn't occur until 1602 in Amsterdam,
when the--I mentioned this before--when the Dutch East India Company started trading.
And then, Jonathan's Coffee House--I like that story--in London. Lots of people would get together and talk
there, and coffee houses became a big thing in the late 1600s. And somebody started posting stock prices
on the wall at Jonathan's Coffee House by--what was the date--1698. And so, the London Stock Exchange
grew out of Jonathan's Coffee House.
And then, moving forward in time, now we're going to get lots of countries, but I'll mention the New York
Stock Exchange. The traders of shares in the United States met outside, in 1792, under a buttonwood tree.
I'll put buttonwood, its a curious name. I think that's just a common tree that we still have around. And
they signed the agreement to form the New York Stock Exchange.
What else? Next, in my little history. India. By the 1850s, there were in Mumbai--or then called Bombay--
there were traders under a famous banyan tree. Theyre all outdoors. In Bombay. Banyan trees are more
impressive than buttonwood trees. But it was by 1875, the Bombay Stock Exchange was founded. So, that's
the BFC. So, that's been around for over 100 years.
But things have happened more recently. One thing that's been shaking things up--these are very venerable
old institutions--what's been shaking things up is the advent of electronic trading. And these were kind of
old-fashioned, venerable institution. Do you know what happens at the New York Stock Exchange, what
happened then and still happens today? There's a floor called the trading floor, and the various brokers meet
there, just like in Jonathan's Coffee House. They actually physically come to the floor and they stand
around, and there are posts for each stock. And if today you think, you have a customer who wants to buy
IBM stock, then you go over to the IBM crowd, and there's a crowd of brokers there who are trading. And
you just do it, verbally. You talk to them and you make a trade. That's really old-fashioned. There is
something more electronic and more modern about the New York Stock Exchange, but that specialist post
behavior still persists.
Most of the world is switching over to electronic trading, and so things happen that--so, for example, in
India they developed another stock exchange called the National Stock Exchange, and that was in 1992.
And the National Stock Exchange was all-electronic, and so it was the modern version. It's rapidly gaining
on the Bombay Stock Exchange.
So, let me go a little bit more forward. China, because of the communist government, did not have a stock
exchange until 1990. And there were two stock exchanges founded in China in 1990--Shanghai, Shenzhen.
And at least the Shanghai Stock Exchange is owned by the Chinese government, and that's why Laura Cha,
when she talked to us about that--she was on the China Securities Regulatory Commission, which actually
owned the Shanghai Stock Exchange.
Oh, Latin America. Sao Paolo Stock Exchange, 1890. Mexico has only one stock exchange, but it was
founded in 1894. So, we seem to have like two different kinds of exchanges. We have the old exchanges,
which are at least 100 years old, and we have the new electronic exchanges. Things have really sped up
with the advent of electronic exchanges.
So, I mentioned the New York Stock Exchange, which started on the street outdoors and is an old-
fashioned exchange that has been slow to update. But more recently, we have--I mentioned it already--
NASDAQ. It stands for, originally, National Association of Securities Dealers Automatic Quotation
System, which was created in the 1970s.
The interesting story about NASDAQ. In the '70s, the New York Stock Exchange with highly prestigious.
It was the big board, the place. And a critical element of as stock exchange is, that, in order to get your
stocks traded on the exchange, you have to satisfy listing requirements. So, the New York Stock Exchange
would examine any corporation that wanted to be listed on the exchange, and it was the prestigious, big
exchange, so it had high standards. So, the company had to have a history of earnings, it had to have the
right kind of management structure and board. A lot of things were checked out by the exchange, and as a
result, the way it would work in the 1970s, a startup company could never get traded on the New York
Stock Exchange. It would be traded, instead, by brokers off-exchange, or over-the-counter. So, OTC means
over-the-counter, that means not on an exchange.
So, in the 1970s and earlier, the over-the-counter brokers would deal with each other, informally with
telephone call, or actually out on the street. Meet each other out on the sidewalk originally, and then they
got telephones. And they had some record, which they called pink sheets, because they were traditionally
printed on pink paper. These were lists of dealers' buy and sell quotes on prices of over-the-counter stocks.
The National Association of Securities Dealers, then, was an organization of these over-the-counter traders.
And in the early '70s, they set up the first computerized system. They decided that everyone's telephoning
everybody--let's create a system that really works and that gets us the information. And so, that was the
NASDAQ system, the first computer based system, which has now increasingly taken over much of the
world.
I shouldn't imply that the New York Stock Exchange was entirely a laggard on this. Electronics played a
role in stocks going back very early. The New York Stock Exchange used telegraph in the 19th century to
convey prices, and they invented ticker tape machines. A ticker tape machine is an electronic printer that
would print out stock prices. And in fact, Thomas Edison, the inventor, his first invention was actually a
ticker tape machine. That was in, I think, the 1870s. It printed stock prices. But all it was, was a record of
what had traded recently. It wasn't a system that helped you trade. You just reported what had happened, it
was historical.
Chapter 4. Market Orders, Limit Orders, and Stop Orders [00:24:28]
So, I wanted to show you, what NASDAQ created in the '70s, and it's a order book, that would be visible to
everyone who trades on it. Prior to discussing that, I want to tell you about different kinds of orders. If you
buy and sell stock, and you call up a broker and you say, I want to buy and sell, the simplest kind of order
is a market order. And you would specify the quantity. You would say, I want to buy--and the name of the
company, of course--I want to buy 100 shares of General Motors, or I want to sell 100 shares. But you don't
name a price. You'll find out, whatever the price was.
The broker will get you the best price--if he or she is a good broker, will try to get you the best price--but
it'll still be unknown to you, because you didn't specify it. You might be unhappy with the price, OK? The
price might be too high [addition: if you want to buy shares]. And then, the broker will say to you, well, if
you're unhappy, you should've told me. You could have told me not to pay more than a certain amount for a
buy, or not to take less than a certain amount for a sell.
So, the alternative is a limit order. And so, with a limit order you give both quantity and price. So, if it's a
buy, I want to buy so many shares but I don't want to pay more than such-and-such a price. Then, the
broker will keep that on his or her books, until--well, whatever the agreement between you and broker is. It
might expire after the day is over, or you could ask to have it kept on the book. And when the price
becomes available, which is no higher than your specified price, then the order will be executed. Otherwise,
it won't be executed. And then, for a sell order, it would be the same thing. You specify both the quantity
and a price, and the order will be filled or partly filled. Might not be able to get all of your quantity, but
they'll fill as much as they can of it at that price or lower.
And there's another kind of order, called a stop order. With a stop order, you also specify quantity and
price, but it's different. With a limit order, say it's a buy limit--well, let's talk about sell. If it's a sell limit
order, you would sell the quantity at such-and-such a price or higher. With a stop order, you would sell that
quantity at such-and-such a price or lower. Let's make that clear. A stop order, also called a stop loss order,
is an order that you can place with a broker to indicate that I'm worried that this stock might really collapse.
I'm holding it, but I want you to sell it, if the price starts falling a lot. So, suppose the price is 100 today, I
could put in a stop loss order at 80, and then, at least I know I can't lose more than 20% of my investment,
because the broker will immediately sell it when the price of that stock falls below 80.
There's also a buy stop order, and that would be something that someone would rationally do, if that person
had shorted a stock. So, if you had shorted a stock, and you were worried that the price would go up and
ruin you, you can leave with your broker a buy stop order to sell it--I mean, to buy the stock, whenever the
price exceeds a certain amount. And you would do that to prevent yourself from having unlimited losses on
your short position. There's other kinds of orders, but those are the main kinds of orders.
Now, I wanted talk quickly about limit orders--that's the most important kind. A lot of advisors say, never
place a market order. Why should you ever do a market order? There's always some price that you'd be
unhappy with. You might as well say that. And so, some exchanges don't even allow market orders.
So, let's talk about limit orders. And what I wanted to show you was, what a NASDAQ level II customer
sees. NASDAQ is an organization--now it's a firm traded on its own stock exchange, it's called NASDAQ
OMX--but if you want to subscribe to NASDAQ, it's very expensive, I understand. So, you can subscribe at
level I or level II, which is more expensive. I was going to show you an example of what you would see on
your computer screen, if you subscribe to NASDAQ level II, for a particular stock.
So, this is a hypothetical limit order book for Microsoft. What it shows--this is not live, but it would be live
on your screen, and these numbers would be changing before your eyes, flashing back and forth before
your eyes. And so, I've just frozen it at a moment in time. So, what do we have? We have six columns here.
This first column is the shares that people want to buy. So, the first three columns correspond to those. So,
''bid'' is the price there, bidding to buy these shares, OK?
Remember, NASDAQ is a dealer market. So, these dealers are making these bids, or people are making
them through a dealer, and MPID is the marketplace ID, where these bids and offers are being made.
So, the first one shown, someone is offering to buy 100 shares of Microsoft at a price of $25.23, and that is
listed on ARCX. ARCX, there's an interesting--I didn't mention that exchange. It's now part of the New
York Stock Exchange. Maybe, I'll come back to that in a minute, but let me just continue to explain this
slide.
Now, you note that the bid prices are arranged in declining order, right? They go down as you move down.
The computer has sorted all the orders. These are all the unfilled orders. Someone called their broker and
said, I want to buy 100 shares, and the broker entered the bid through ARCX, and it's now on the NASDAQ
screen. Someone else had a much bigger buy order, wants to buy 9,430 shares, and this came in directly to
NASDAQ, but it's a penny less, $25.22. So, you can just see what's going down.
Now, the other side--is that clear what we're seeing here? The other side of the screen is the buy
[correction: sell] orders, and it's exactly the same, except that here the numbers go up as you move down
the screen, because the computer has sorted them in the reverse order. So, that represents what various
people are willing to buy [correction: sell]. So, somebody is willing to buy [correction: sell] 2,400 shares at
$25.24. Actually, there's two different customers. This one placed the order first, so I think that's the
priority, it's by the one who placed it first. Somebody else at the Cincinnati Exchange--I guess that's what
that means--offered to buy 8,200 shares at the very same price, but it's listed as a separate order, and so on.
So, now you're sitting here looking at the screen now, and you notice that this ask price here, it's higher
than the bid price there. So, what does that mean to you? It means there's no trade, right? Because someone
is offering to sell at $25.24, and somebody's offering to buy at $25.23. It's no trade, until somebody
changes their price. That's no surprise, because these orders would be filled very quickly, if there's a
crossing. These two lines don't cross, so it's like, if you plotted these curves, they're supply and demand
curves, right? We could plot the amount at various prices.
Well, you can see, I'd have curves, a supply and demand curve, that don't cross. Normally, they have to
cross somewhere, and then, there's a market-clearing price. These things normally don't cross, because, if
they did cross, would immediately disappear from the screen. Someone would finish the order and itd sell.
But you, sitting at the screen, now have a pretty good idea what the price is.
A NASDAQ level II is better than a NASDAQ level I, because level I just gives you the first row. It's
cheaper to subscribe to that. What NASDAQ level I gives you is the inside spread. It would tell you that
there is a 100 shares bid at $25.23 and ask at $25.24, and if you want to hit that order, you could take either
side of that. But it doesn't tell you the whole picture. If you know NASDAQ level II, you know a lot more
about the market, and if you're going to play the game of trading, you want to know this. So for example,
you know that it might be hard for a price to fall rapidly below $25.22, because there's a big buyer down
there, and so it's going to be hard for the price to fall below that.
If you saw this screen in real life, these numbers would be just blinking, changing rapidly before you. And
trades that were there 20 seconds ago would be gone in a flash. So, you've got to move fast to execute these
trades.
Chapter 5. The Growing Importance of Electronic Trading [00:36:15]
On a fully automated system, the trades would be executed automatically, and this is becoming--electronic
trading is taking over the world. And the orders can be executed by computers that make it instant, so that
the number doesn't even appear on the screen long enough for you to see it.
So, one development that's coming in now is, what's called high frequency trading, or HFT, which is
trading that is done by computers. Once you have a system like this--when you have to trade through a
floor broker on the New York Stock Exchange, it has to proceed at human pace, right? The way it works is
you make a telephone call to your broker, your broker makes another telephone call to the representative on
the floor of the New York Stock exchange, that person walks over to the crowd, and then discusses it, and
indicates what--it's like a poker game. You don't want to reveal your hand, but you kind of feel people out,
and then after a little discussion you reach a trade. But when you have something that you can hit on a
computer, it just goes instantly. So, people start programming trading, and that's been an important
phenomenon, because you see these moving faster than you can--these prices disappear and reappear so
fast that you can't quite know, you can't act fast enough.
So, we have algorithmic trading, or program trading. So, that goes back practically to the 1970s. Certainly
by the '80s, program trading was becoming a big and important phenomenon, and it's becoming
increasingly important now. High frequency trading now--brokers will invoke what are called ''millisecond
strategies.'' You can actually flash an order on some of the exchanges that lasts a thousandth of a second.
You can put a buy order or a sell order, and retract it in a millisecond. This could be a trading strategy,
which you might employ. You could do that to discourage people from trading. If you want to trade only
with the computers, if you think people are too smart for me, I don't want to trade with people, I want to rip
off the computers, then you write a millisecond trading strategy, and then you can sort into who trades with
you.
Now, the interesting thing about millisecond trading is that it's favoring the electronic exchanges. As time
goes on, people are getting more and more sophisticated about high frequency trading, and so they want to
trade on exchanges that are fully electronic, so they can play all of these games. And that means that the
floor exchanges are dying out over most of the world.
By the way, the New York Stock Exchange--I was going to give you a history of this--the New York Stock
Exchange has been slow to adapt to these technologies. Let me just give you a little history of--electronic
trading is an exciting thing for many people, but, I think, it started--or the really interesting electronic
trading started with the ECNs, electronic communication networks, that were allowed by the Securities and
Exchange Commission as alternatives to stock exchanges. Stock exchanges are highly regulated by
governments around the world, but in the 1990s, the Securities and Exchange Commission allowed more
sophisticated electronic trading, at least as an experiment. So, they didn't call these things exchanges, they
called them ECNs.
One of the most important ECNs was a company called Archipelago. Another one was called Island. And
these were actually just websites, where you could trade, and they were open to the public. They had a
different culture. They had more of a web culture. The web culture is, we're not going to charge you to see
the order book, we'll just put it out to everybody. The web doesn't charge you for a lot of things. And so,
they became popular trading sites for the general public.
They grew up the way the personal computer grew, so the New York Stock Exchange, when they first saw
Archipelago, they said, oh, this is a bunch of college kids fooling around, some computer game, sort of.
And they didn't take it seriously. But eventually, the New York Stock Exchange had to take it seriously,
because Archipelago was growing so fast. So eventually, New York Stock Exchange merged with
Archipelago. So, they're now--I think most of their trades go through ARCX. I'm not sure if that's right, but
a large fraction of their trades go through ARCX. So, the New York Stock Exchange bought Archipelago in
2005. And at that time, ARCX was breathing close on New York Stock Exchange for trading volume.
Things are happening fast in the stock exchange, because the technology is changing. Whereas we had the
New York Stock Exchange in the old days, it was this single prestigious exchange that lasted for over 150
years without any substantive change, but now electronic trading is coming in and everything is being
shaken up.
So, the New York Stock Exchange merged with Archipelago in 2005, and then they did another merger--
let's say this--New York Stock Exchange, with Euronext, which is another exchange in Europe, in 2006.
And right now, they're going through another merger process, apparently with the Deutsche Brse. And
that's 2011. It's not finalized yet. And now NASDAQ is getting in, NASDAQ is making an offer for the
New York Stock Exchange, and so is another exchange called the Intercontinental Exchange. [addition:
The description of these events is as of April 13, 2011.]
But the little guys are buying up the old-time big guys, so it's--Laura Cha was saying in her lecture, that she
was struck, that we used to think of stock exchanges as like utilities, each country has its own stock
exchange, it's the pride of each country, but now it's not happening anymore. And this reflects a bigger and
broader trend that economies are becoming more and more integrated across the world. So, the idea that
there would be a stock exchange for each country is becoming dated. So, the New York Stock Exchange
may soon be a German company, but that's what happens in modern times.
Chapter 6. Instabilities Related to High Frequency Trading [00:44:46]
I want to talk about some problems with high frequency trading, as things get so electronic. Let me give
you one example. In 1987, this was the early days of electronic trading, but still had advanced pretty far.
On October 19 of 1987, the stock markets in the United States fell, according to the S&P 500, over 20% in
one day. The government did a study, President Reagan ordered a study, and put it in charge of Nicholas
Brady. And so, the so-called Brady Commission did a report on why the stock market--that was the biggest
single stock market drop in U.S. history. And the Brady Commission did a report on that stock market
drop, and concluded that program trading, computer trading, had played a big role in the drop.
There had been a development of programs that were called portfolio insurance sell strategies. They called
it portfolio insurance, but it wasn't really insurance. It was an automatic sell strategy. It's like a stop loss
order, but a more sophisticated one that could be executed in continuous time by a program. And that led to
an instability in the market that was not anticipated and shocked the world. So, the Brady Commission
made a number of recommendations, notably the commission recommended that the exchanges impose
trading halts that would prevent stocks, the whole market, from crashing.
So, the New York Stock Exchange and other exchanges, after the Brady Commission report, instituted
what are called circuit breakers. And these are automatic market halts that stop the market, when prices are
falling, to help prevent another 1987-type stock market crash.
But the system is getting complicated. Even before this, the United States government had created--had
passed a set of rules in response to complaints about people not being given the best price. So, here's the
problem. We have multiple exchanges. The New York Stock Exchange is one of many, and if you call a
stockbroker, the stockbroker has discretion over which exchange the broker will use to fill your order. And
so, the broker might choose an exchange that doesn't give you the best price. The broker can, in effect, rip
you off as a broker.
In fact, there's a practice called a payment for order flow. So, a stockbroker, who's receiving orders from
retail clients, may find that there is a dealer that's willing to pay for order flow. When a customer asks to
buy the stock, don't put it through the New York Stock Exchange, give it to me. And I'll give you, the
broker, a fee for directing the order my way. And that may not serve the client well, because the client then
might end up paying a higher price. So, there were a lot of complaints about this, and it's a difficult
problem, because it's hard to monitor everything that people do. And there might be justification for
payment for order flow.
But there've been efforts to try to make it a fairer system. And in 1975, the U.S. Congress set up something
called the National Market System. So, NMS is the National Market System, and the ITS is the Intermarket
Trading System. What the government in the United States did is it said that brokers have to get the best
price, what's called best bid, best offer for their clients. And they have a responsibility for their clients to
take the market with the best price.
In conjunction with this, the exchanges built something called the consolidated quotation system, that
allows brokers to see prices on various exchanges and direct the order of the client to the exchange that's
showing the best price. So, that is the system that was started in the United States in 1975, and brokers still
have an obligation to get the best price for their customers regardless of exchange.
But the obligation is hard for the government to monitor, and it gets complicated. For example, if you're
confronting this system, and your broker wants 500 shares, well, I can't fill them all at the same price,
right? Well, actually I could here. If the broker wanted 10,000 shares, they'd be all different prices, because
Ive all these different customers asking different amounts. So what do you want us to do, SEC? And so the
SEC recently clarified this. I think, it was in 2006. Well, we only mean that you have to get this, this one up
here--2,400 for 25.24. How do you fill the others? Well, we can't get into that. So, it's not a complete
protection for customers, but there still is this obligation for brokers to use the National Market System to
get the best price. But the system is complicated and confusing, because there's so many computers
involved, there's so many different exchanges, and there's so many rules. It's hard for people to keep up
with it all.
I had on the reading list I had a report that I--I found the report. It was very much in the news a while back.
This is a report on May 6, 2010. Do you remember what happened then? That was not that long ago. The
stock market, as of around 2:30 in the afternoon in the United States, had fallen 4%, and then, within a
matter of minutes, it dropped another 6%, and then, it rebounded quickly. Some individual stocks dropped
practically to nothing, and you could buy a $30 stock for $0.30, or something like that. And then, they
rebounded.
So what happened? Why did we have this very brief crash in the stock markets? It wasn't like 1987, where
the market went down and stayed down. If you look at closing prices, nothing much happened. It was this
brief glitch, which probably cost some people huge amounts of money, because, if you were trading right at
that moment, you'd have a problem. So, I have as an optional reading on the reading list a study, that was
made of May 6, 2010 by the SEC and the Commodity Futures Trading Commission, trying to understand
what happened then. And the study does focus on high frequency trading. There were a lot of computers
trading automatically at that moment in time.
So, what apparently happened on May 6 is, the market was already in a stressed mode before 2:30 PM. The
VIX index had shot up. There was some bad news--the market was down 4%--there was some bad news.
So, that meant that some traders were wondering, what's going on? And maybe, they decided to drop out
for a while and just be cautious, but the computers were still trading.
And then, something happened. The computers started trading back and forth in milliseconds. And I don't
know what the programs were supposed to do or what they--maybe nobody knows the whole picture--but
the volume of trade just went to an astronomical level, and it scared people off. And so, there were a lot of
trading pauses that were put. Exchanges have rules about that, and individual dealers will say, I'm dropping
out. I see all this volume, I'm not in here anymore. So, it remains that the trading that was left was
substantially computer trading, and the market became very illiquid.
So, this study has recommended fixes for this, but it doesn't recommend ending high frequency trading. A
lot of people would recommend doing that. There's a popular anger, especially since this May 6, 2010 crisis
occurred during the period of financial crisis, and people kind of imagine that the two are linked. I think,
they're kind of independent. I think the May 6, 2010 phenomenon was due to some kind of anomalies, or
unfamiliarity with high frequency trading. It's a glitch and not a major fault, but it lead to a lot of anger
about high frequency trading.
I've talked to some people at the Chicago Mercantile Exchange and others, who think that the public
anxiety over high frequency trading is misplaced. It's kind of inevitable. The future is computers. They're
replacing people all over. Not in a judgment thing. You know, someone was saying at the CME meeting,
where I was, that the basic business that we're doing is still the same as it was 100 years ago, but now we
have laptops, right? It's just like, when you write a term paper. It's basically the same thing that somebody
would have done with a feather pen and a piece of paper 200 years ago. Right? It's basically the same. But
we live in a computer age now, and we don't want to go back. And so, high frequency trading means that
we have to be a little careful, things can happen with lightning speed, but we'll learn. There hasn't been
another May 6, 2010 since. It was just an anomaly, because people were unfamiliar with that kind of event.
So, I think it will be all right.
One thing that it does, however, is it's changing the geography. It used to be, that in the 18th century, a
stockbroker had to live in London or Paris or New York in order to be close to the trading, because they
didn't have any way to make phone calls. When they invented the telephone, people said, fine, I don't have
to live in New York anymore. I can live in anywhere, and I can just send my call by telephone. But now,
high frequency trading is bringing it back, that people have to live close to the exchange because the
trading goes so fast, that your electronic signal--if you try to set up a high frequency trading operation in St.
Louis, and your operating by wire to New York, the time it takes for electricity to get from St. Louis to
New York is too big, and you will be behind on the trade. So, you want to get as close as physically
possible to the exchange, to the computer.
The regional exchanges, there used to be exchanges in every big U.S. city. And they were there, because of
social reasons, that people in Chicago wanted to talk to a broker in Chicago. They wanted to be able to go
to his office and see him, so there were social reasons for connection. But now we're coming up with a new
electronic reason. And because of basic theoretical physics, you can't move anything faster than the speed
of light. This is going to be with us now that we have microsecond trading.
Chapter 7. The Frustrations as Trading as a Dealer [00:59:14]
I wanted to talk a little bit now--and I think maybe this would be the last topic--about how you think about
trading as a dealer, who is confronted with this kind of book. As a dealer, you can put orders on this book,
and enter them, and leave them there. That's basically what you do. So, you see various dealers, and their
names are shown, and for example, well, I don't know who these people are. But each dealer is going to be
posting a bid and an ask, and a quantity for these. And if you do this, if you're sitting at your NASDAQ
screen, and you're a dealer, you can enter your own number on either the bid or the ask or both of them. So,
you have your own bid-ask spread, OK?
It's the same thing as an antique dealer, OK? An antique dealer has an idea--maybe it's not posted--of how
much he or she will pay for a chest of drawers from a Yale student at the end of the semester, and how
much he will charge to sell that. And the difference between the ask and the bid is called the spread, or the
bid-ask spread.
So, I want to just think a little bit about the theory of this. How do you decide of the bid-ask spread of what
to do? And why is it what it is? The spreads are obviously very tight here, because they're off only by $0.01
on the inside spread, but it doesn't correspond to one person. Maybe some of these are customer orders and
aren't dealers.
But think of placing an order as a dealer and leaving it on the screen, so that anybody can come and--the
risk that you face is, that you will be picked off by people with superior information. And let me put it in
the context of an antique dealer. One thing, antique dealers don't like is, when professional antique dealers
come shopping in their store. So, what do they do? You know, if you're a good antique dealer, you go to all
the antique shows, you try to disguise yourself, because they don't want you, if you're a dealer.
What do you do? You look through all their stuff and you find anything that's mispriced. You know, there
will be some chest of drawers that you recognize as an 18th century--by a famous furniture maker. So, you
buy that at the guy's price. You pick him off, right? So, he doesn't want to be picked off, because somebody
will come by, who knows more, will pick off all the good stuff, and buy it, and leave you with the junk.
So, how do you prevent that? Well, you might think that you could prevent it by just being smarter, you can
try it, try to be as smart as you want, and read up about all the antiques, but it's impossible. You cannot be
the smartest guy out there. Impossible. There's just too many antiques, and there's too much inside
information. So, that means you have to set your bid-ask spread wide enough, that you can be picked off
and still make a profit, all right? You know you're going to get picked off, and it's the same for stocks.
If you're going to put a bid-ask spread up on the screen for some stock, you're just a sitting duck, because
there'll be some news story that's either good or bad, and if it's either way, somebody else is going to hear
of it first, and when you get a hit on your order, it's going to be deadly, because it'll be at the wrong time for
you. So, that's the theory, that you have to make the bid-ask spread wide enough.
I wanted to then just give you a little bit of math--I shouldn't end a lecture on mathematics, but that's what
I'm doing here this time. And I wanted to just talk about the frustrating life as a dealer. I was telling you
about frustrations in life as an investment banker. There are different frustrations in life as a dealer, and I'll
tell you what is the difference is.
Life as a dealer is very different than life as an employee or something. You are a dealer and you have
whatever money you make. And the problem is, you can get ruined, this is a classic--in other words, you
can be working as a dealer for 20 years, and you see your portfolio growing, because you're making a lot of
money selling. But you know, all it takes is a few bad moves, and you can be wiped out. You know, 20
years of work, and you are ruined.
So, I wanted to just think about that, and this is my last bit of mathematics. This is the mathematics of
Gambler's Ruin, and it's also a mathematics of Dealer's Ruin. And so, here's the theory. If I start up with S
dollars, S is my initial amount of money as a dealer, OK? And let's say I take a series of bets, which have a
probability--p is the probability of a win. What is the probability of eventual ruin? Oh, and if I make $1 on
each win and I lose $1 on each--minus 1 on each loss--I'm doing a sequence of bets--on each loss, all right?
What is the probability that I will eventually be ruined? That probability, and I'm not going to derive this,
but it's simple to derive, actually.
if p is greater than 1/2. So, if my probability of winning is 1/2, the probability of my being ruined
eventually is 1. And if my probability of winning is less than 1/2, my probability of being ruined eventually
is also 1.
I have to somehow raise the probability of winning on each particular sale above 1/2, but even if I do that,
if I make it, say, 0.6, if I make the probability 60% on one bet, then 1 - 0.6 is 0.4 over 0.6, then my
probability of eventual ruin, starting out with $1 is 4/6, if I did that right. Goes down with the number of
dollars I start with, but it never goes to zero.
So, the theory of a dealer is that a dealer has to be thinking about being ripped off. I've got to set my bid-
ask spread high enough, that the probability of winning on each of these little trades that I make is
sufficiently above a 1/2, that my eventual ruin probability is satisfactorily low for me. But it's never going
to be zero. This is the irony of being a dealer. You don't sleep well at night, because you never know that it
won't eventually unwind. And it's a competitive business, because you can't just set your bid-ask spread
arbitrarily high, because then you lose all the business to other people. So, you've got to kind of fix the bid-
ask spread enough, that you get business, but you don't want to fix it too narrowly, so that this probability
falls too close to 1/2, because then you're courting the risk of disaster, and eventually having all of your
life's work being wiped out.
So, that was kind of a quick description of the--I've said, different personalities go into different parts of
finance. You have to be kind of a game player, someone who is not bothered by the possibility of eventual
ruin, in order to go into becoming a dealer. Very different from other aspects of financial life.
All right. I'll see you soon with--we're getting close to the end of the semester. Some wrap-up lectures
coming.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 22 - Public and Non-Profit Finance [April 18, 2010]
Chapter 1. Organizations Supporting Individual Causes [00:00:00]
Professor Robert Shiller: All right. For this, the penultimate lecture for ''Financial Markets,'' I wanted to
talk about nonprofit and government finance.
So, let me first recall some of the basic themes of this course. Finance is really about incentivizing people
to do good work, and managing risks. These issues are not confined to the private sector, to the business
sector. They're very deep and central problems to all people.
The big problem--I'll put it in the most broad terms--just about everything that we do that's good is done as
part of a team. It's hard to think of something that you alone can do. And so, the problem with teams is that
people have their own individual concerns and incentives, and doesn't always yield teamwork.
So, that's what I think finance is really about. You might think, I'm wrong, and some of the greatest
achievements in history were done by single individuals. So, I don't know, what you might think of. What
comes to my mind is, how about Albert Einstein, all right? His theories, he was sitting in a patent office in
Switzerland, and just doodling on a piece of paper, and came up with the whole theory of relativity. But
you see, that would be a mistake to think that, because, in fact, he had gotten a PhD in physics from the
Zurich Polytechnic, which is a nonprofit organization. And he relied on journals of physics. He could not
have done it, if he didn't read what other physicists were doing. And journals were organizations that had
financing, I assume nonprofit.
But I thought of another example. Charles Darwin, the great physicist--not physicist, the great naturalist.
People point out that he wasn't affiliated. He was on his own, he wasn't part of a university. I guess, he got
financing, but kind of on his own. But he couldn't have written The Origin of Species by himself. In fact, he
got financing from private donors for the Beagle. You know, this two-year voyage he made around the
world, where he collected specimens and information? And actually, he goes back to his professor. He had
a Professor Henslow at Cambridge University, who was a botanist. And Henslow arranged for Darwin's
voyage and sent him off.
So, these are organizations that--I don't think, you can do much good [addition: without the support of any
organization]. Some people say, well, how about a poet? A poet? Even Homer was a blind poet, right? He
didn't have anything. He memorized everything. He didn't even write it down, he just memorized
everything. He just sat there and thought. But even he must have had financing, because he traveled around
the world of his day and made his poems known, otherwise they wouldn't survive. Other people learned
them. He must have had financing for this. It must've been a business. So, that's the general theme.
I'm going to talk today--there's so much to talk about--I'm going to try to see, how much of this I can cover
well. I want to start by talking about nonprofit organizations. These are organizations, which have a
purpose stated in their charter other than making money. And then, I want to talk about government
involvement in for-profits, that for-profit companies are not completely clear of a social interest as well.
Then, I'm going to talk about government finance of projects, and then finally, government social
insurance.
I'm hoping, that this lecture will remind you of things that you can do, because in all these sectors there are
things that you can do. But one of the themes of this course was, you should have a purpose in life, and it
should not be making money, per se, and think of finance as a tool that you can use to help you achieve this
purpose. So, that's what I want to talk about.
Let me start, then, with nonprofits, OK? A nonprofit organization, it can be corporation, that is an
organization set up to for a charitable cause or a good cause, and it has no owners, in the sense that there's
no shareholders. The profits go back to the organization for its purposes. So right now, you're sitting--as I
mentioned before, Yale is a nonprofit. It has no owners. It's a person, a legal person in itself. But it has a
board of directors.
In the United States in 2010, there were 1.6 million nonprofits. It's huge. The U.S. is probably the country
that has the strongest nonprofit sector. My number for the United Kingdom may be out of date--it was
120,000. It's part of the U.S. culture, that nonprofits are big. It goes back to the founding ideas of this
country, that we don't have a government running everything. We do things on our own, on our own
initiative. Of course, it's not just the U.S. There are nonprofits in every country. But that's a lot of
nonprofits. And they recently accounted for about 4% of gross domestic product [in the U.S.]. So, OK, it's
not huge, but it's a very important component of gross domestic profit [correction: product].
Chapter 2. Nonprofits: Pursuing Common Interests [00:06:45]
I just want to start by thinking about nonprofits, and maybe put the idea in your head of creating one at
some point in your life, sooner or later. I thought, I'd start with some examples, that are familiar to me, of
nonprofits. When you're thinking of some activity or some idea you have, you can set it up as for-profit or
nonprofit. And let's just think about why you would do that.
So, I'll give you an example. Peter Tufano--he's a professor at the Harvard Business School--set up a
nonprofit on his own, just as a professor. I know him. And he gave it an inspirational name, Doorways to
Dreams, OK? And it's about personal finance and about helping people do things better in their personal
financing. So, one of his ideas--and he raises money for his foundation to promote it--one of them is to
have an automatic check-off on the tax form, so that, when you get a tax refund, instead of getting it in
cash, it could go right into U.S. savings bonds to encourage people to save, all right? This is based on
Behavioral Finance, and the fact that a lot of people, especially lower income people, don't save. A little
nudge like that would help them save.
Another thing, this sounds like a strange idea, but this is the kind of thing he can pursue on his own genius,
as long as he can raise money to get them to do it. He has the idea that a lot of people like to play the
lottery, OK? Obviously, they do. And they just are steady losers on this. You know, on average, they'll
always lose. But given that people want that, why don't we create savings plans that pay out randomly, like
winning the lottery, so that the government doesn't have any take in it, it just encourages saving.
That's a strange, original idea, which you might find--I don't know if I defended it well enough to you--you
might find it hard to convince the government to do it, but he can just do it. He doesn't have to talk to the
government. He talks to individual banks, and he's gotten some now to offer this plan.
But what was striking to me is, he said, when I go into some company trying to raise money for my
projects, when I tell them I'm nonprofit, it changes the whole atmosphere, because they know that I'm not
profiting from this. And so, it opens up opportunities.
I'll give you a second example. Dean Karlan here at Yale--he came here as an assistant professor. In 2002,
he created a charity called Innovations for Poverty Action. So, Dean Karlan. Some of you may have taken
his course. Anyone took his course? Some of you, yes. Actually, the doorbell rang at my house here in New
Haven, and a young woman was collecting money for charity, and it was his charity. I was shocked. He's
actually sending people door to door, at least as part of his course.
But since then, he's developed--again, when it's nonprofit and it's aimed at alleviating poverty, he can bring
in lots of money. So right now, last year, in 2010, the income of his Innovations for Poverty Action was
$25 million. And he has a staff of 500 people all over the world, operating in a lot of poor countries. That's
a couple of examples that are familiar to me, because they were set up by friends of mine.
Another example. This is Bill Drayton. He set up something called the Ashoka Foundation. Ashoka is a
Hindi name for--what is it--it's a ruler of India, who advocated non-violence and philanthropy. And he went
to Yale Law School, as well as Harvard College. So, sort of local here. But it's been a huge success, and it
encourages sort of entrepreneurship, or social entrepreneurs. But he didn't stay on as a professor. He taught
at Stanford Law School, but dropped out, because he wanted to pursue his nonprofit. I'm amazed that these
two guys can be both professors and running big nonprofit shops as well, some people can do that.
My last example is Wendy Kopp. I like this example for your age, because her story starts with her senior
essay. Do you know this story? She was an undergraduate at Princeton, graduated in 1989, and she had to
write a--maybe they call it a senior thesis. And so, she wrote something about education, that she had an
idea, that often it's hard for elementary education to find people who are passionately committed to science
or mathematics or other fields, because these people typically don't want to devote their lives to teaching.
But they might devote a couple years to teaching. And so, she thought, that it would be a good idea to get
people, when they graduate from college, to spend a year or two in elementary education, and that it would
be refreshing and good for the educational system to get enthusiastic young people, who are really
interested in the disciplines.
So, that was her senior thesis. Now of course, you can't get the government to pay for that. Maybe you
could. It might be hard, because, well, the teachers union might not like this, or they might--you know, it's
sort of a controversial idea. Some people would say, someone, who's taken a course in mathematics at Yale
University, is really not qualified to teach young children, because he or she didn't take the educational
curriculum. And that's always going to be controversial. But here, where we live in a society that
emphasizes nonprofits, you don't have to convince the government, all right? You convince anybody to
finance this, and you can do it.
So, right out, she was 21 years old, she graduated from Princeton, she raised $2.5 million in her first year to
set up an organization, called Teach for America. And the organization merely recruited young people, who
had just graduated college, to go into teaching. So anyway, that's become her life's work in the 20-plus
years since. She's heading what she created.
I like this story, because some of you are writing senior essays, right? And you should consider it as a
model for some--you might consider it as a model for some great idea, that you might have, that you could
carry to the world. And one way to make it happen is, if it's that kind of idea, you just set up a nonprofit
right there.
Actually, I wanted to give you some other examples. In New Haven, we have two major hospitals, OK?
Where did they come from, and why do we have them? Well, one of them is called Yale New Haven. So,
how did that get started? Well, it was started by a nonprofit in 1826, called the General Hospital Society of
Connecticut. Back then, there weren't many hospitals, and so, someone set up a nonprofit to set up a
hospital, and it was then the only hospital in the state of Connecticut, and so they called it State Hospital.
Later, as more hospitals appeared, it didn't seem good to call it State Hospital anymore, so they changed the
name to New Haven Hospital. That was in 1884. And then, in 1913, they joined with another nonprofit
called Yale University, and then later, they changed their name to Yale New Haven Hospital. But it's been a
nonprofit all the time. There are for-profit hospitals, but this one was always a nonprofit.
The other hospital that we have in New Haven is St. Raphael's, and that's newer. It was created in 1907, and
the story is, that a group of physicians from the New Haven area thought we needed a second hospital, and
they went to Sisters of Charity [addition: Sisters of Charity of Saint Elizabeth], which is a--I don't know
much about them, it's a nunnery, I suppose--and worked with them to create a second hospital. And they
chose the name Raphael, after an archangel recognized by many faiths, which means God has healed.
Interesting to think about this hospital. So, whose idea was it, and how did it happen? Well, apparently the
idea wasn't from the Sisters of Charity, it was from physicians who were in New Haven. So, why did they
go to the Sisters of Charity? Why didn't they just set up a for-profit hospital? They could have bypassed
them completely. What's the link?
Well, I think that--I don't know all of their reasons, but I'm suspecting the reasons are, that, when you
affiliate with a religious organization, it gives a sense of moral mission and social purpose to the
organization, that it wouldn't have otherwise. And it makes it very clear that it's nonprofit and encourages
people to donate. So, I think that this same idea has dawned on many people. The people, who see a need
for a new hospital, are probably not leaders of churches, but they see a common interest in pursuing
hospitals.
There have been many studies about for-profit versus nonprofit hospitals, and who gives the better care. I
think, that the studies are generally inconclusive, because even people, who are operating for-profit
hospitals, have a social mission as well. They have morals. It's not just churches. People outside of
churches have morals as well. And so, the actual distinction between for-profit and nonprofit is often
somewhat ambiguous.
Chapter 3. Government Involvement in For-Profits [00:18:55]
Let me move on to the second point, that I said I was going to talk about, which is government involvement
in for-profits. So, governments exert control over both nonprofits and for-profits, and it's often a difficult
distinction between a government activity and a private activity, because of the regulation that governments
impose over companies and the taxes they collect.
Let me first make it clear, that virtually every country of the world has a substantial corporate profits tax,
and in that sense, governments are co-owners of corporations, private corporations. So, the corporate
profits tax is in effect a sort of partial nationalization of all the private companies in the country. So, in the
U.S., it currently stands at 35% federal, and up to 12% state and local, depending on the state. So, it's as
high as 47%--it's basically half. So, you could say that the U.S. government has nationalized close to half of
the private sector. The government is collecting from their profits, as if they were a shareholder. This is
state and local.
But it's the same in other countries, or similar. Canada, Ottawa collects 16.5%, and the provinces, up to
16%. A little bit lower than the U.S. Japan, the national government has a 40.6% profits tax. Brazil, 34%.
You might think that under the Lula government, the recent Lula government, they would be more left
wing, and would have a higher profits tax, but they don't. It's about the same. China is 25%. India is 33%.
And I could go on and on. There's almost no country that doesn't have it. So in that sense, everything is part
of the government. It' about the same all over the world. And that's because--I think there's a reason for
that--because if you charge too high a profits tax, then business will leave your country.
Why do we charge a profits tax? Well, I think the corporate profits tax is justified by recognizing, that this
thing about for-profit or private always has its limitations, and anything that's private is not completely
isolated from other interests or activities.
I thought, it would be useful to think of one example. There's a company called TEPCO. You heard of this
company? I don't expect that you would. It's the fourth largest electric power company in the world, and it's
traded in the U.S. And you may own shares in it and not know it, because it's such a big and important
company. Or at least your parents, good chance that they own shares in it, because they probably own some
diversified portfolio in their pension plan, or maybe they even have it set up in a trust for you already. So,
don't judge TEPCO too harshly.
All right. But let me just tell you about your investment in TEPCO. Guess what country it's in?
Student: Japan.
Professor Robert Shiller: You got it. So, somebody knows.
Why would that matter right now? Big electric power company in Japan. That sounds like a great
investment? Yes?
Student: They own the power plant has been affected by the earthquake in Japan.
Professor Robert Shiller: That's right. They own particularly the Fukushima power plant. So, I checked
out this morning, what the share price is going for in TEPCO. So it was, as of a month or so ago, $25 a
share. And it's down to $5 a share. It just went [SOUND EFFECT INDICATING DOWNWARD
MOVEMENT], and you know exactly why. So, I looked at this further. J.P. Morgan estimates now, that
claims against TEPCO will be $25 billion, or a couple of trillion yen. But that's not all. They're also
damaged, right? Everything's in ruins. So, some people are predicting that TEPCO will go bankrupt, all
right?
So, they've created this whole mess in Japan, and they're just going to go bankrupt, and we have limited
liability, all right? They're not going to come after you, all right? The Japanese government could do
diligence and find out that you own shares in TEPCO, and TEPCO was negligent, right? They messed up.
They didn't do their safety procedures well enough. But they'll never go after you. This is the whole idea of
limited liability. So many people all over the world are owning shares, and we can't expect them to be
responsible for--you can't inspect the Fukushima plant, even though you may be a beneficiary of its profits.
So, that's why they collect the corporate profits--Japan is collecting 40% percent corporate profits tax, and
that can be used to offset the damages that the Japanese government now has to pay for. So, it all seems
right. There's a plan here. So, you wonder, is TEPCO private or not? Well, it is private in the sense that
there are shareholders and there are profits, but it's regulated by Japan, it's taxed by Japan, and Japan pays
for their mistakes. So, that's typical.
I'll give you another example from this country, General Motors, OK? General Motors was the biggest car
company in the United States, and then, it had a little problem during the financial crisis and had to file for
Chapter 11 bankruptcy.
What am I referring to, when I say Chapter 11? The Bankruptcy Act has chapters, and each chapter says
something different. The two most important chapter for companies are Chapter 7 and Chapter 11, OK?
What the bankruptcy law does is, it creates a framework for dealing with insolvency. And the framework
says that a company that is in trouble can choose to apply for bankruptcy, and there's basically two
important ways to do that. Chapter 7 details one way you can apply for bankruptcy, and Chapter 11 details
another way.
Chapter 7 is liquidation. That means that the company is in such trouble, that we're going to shut it down
and sell off all the assets. Chapter 11 is for a company that is in trouble, but there's something worth
salvaging in terms of operating, continuing the business.
So, GM chose Chapter 11 bankruptcy. They thought, obviously we've been making cars for now close to
100 years--well, at least the companies that went together to form GM--and we have a big future. So, we
can't pay our bills now, but we should continue. So, they filed for Chapter 11 bankruptcy. But they were in
such trouble, that they couldn't get out of it, so the U.S. government and the Canadian government invested
in GM.
What happened was, General Motors--they changed the name in the most subtle way. The official name of
the company was General Motors Corporation, OK? When they filed for Chapter 11 bankruptcy, the
shareholders were wiped out--nobody got executed--you lost all your money. And so, if you find in your
attic some nice, beautiful share certificates for General Motors Corporation, you can just use them as
wallpaper or whatever. They're worthless. But if it's different, if it says General Motors Company, because
that refers to the new GM--they wanted to change the name, but they didn't really want to change the name.
They had to change the name, so that people wouldn't confuse the two.
So, what happened? How did we get a new GM? Well, the new GM was owned by the U.S. government. It
was equal to--where is it, I had it here--60.8% U.S., Canada owned 12%. The UAW, United Auto Workers,
got 17.5%. Why did the union, by the way, get 17% of GM? Well, I don't know the whole story, but I'm
sure it has something to do with GM's obligations. Maybe they failed on something, I don't know the
details. But it seemed, in the bankruptcy proceedings, that the implicit debts, that the company owed to
their workers, would be represented by a share in the company. And then, the rest went to the bondholders,
people who own debt, not equity, who own debt in GM, got the remaining share, and they also got
warrants, which are options to buy more shares, which will dilute down the U.S. and Canada and UAW
shares. So, that's the settlement.
The result of the settlement was that, it was a government owned organization. Now, they've just done an
IPO, so they're reversing this ownership structure. But the point is, that companies that look private may
end up government eventually, one time or another. So, companies have to kind of think of themselves as,
even in an arch-capitalist country like the United States, as partly government organizations.
By the way, there's something else called personal bankruptcy. And personal bankruptcy is another
involvement of the government in risk management. You as an individual can declare bankruptcy, and you
can choose these chapters or you can do--there's other provisions as well. But you can use Chapter 7 to
wipe out all of your debts. The new bankruptcy law that Congress passed a few years ago tends to limit
your ability to do that. But within limits, the same government is kind of a shareholder, just as individuals
are. I mean, a shareholder in individuals' lifetime incomes.
Chapter 4. Social Entrepreneurship and Distinguishing between Nonprofits and For-Profits
[00:32:26]
I guess, what I'm saying is, that the whole idea of public versus private is a complicated one. And what
seems public at one time will seem private at another.
The behavior of nonprofits is not strikingly different than the behavior of for-profits. So, I found a statistic,
that 42% of nonprofits pay bonuses to their executives. That is, they're using the same kind of incentive
plans that private corporations do. Why would they do that? Well, they do that because they have to hire
people, and people in the for-profit sector are getting bonuses. So, how do you hire someone, and get
someone good, unless you pay the bonus as well?
The government faces a big problem, in that the public is very sensitive to paying high salaries to
government employees, because they think it's unfair. Why should some government bureaucrat be paid
more than I get? As a result, they have trouble hiring good people. But in the nonprofit sector, the nonprofit
sector is not constrained--well, they have some constraints over--they're regulated to prevent them from
stealing the money.
I think, part of the idea of having nonprofits--this is a general point--is, that the government is kind of
confined to politically correct, conventional wisdom type activities. And they can do things that are just
generally acknowledged by the average person as a good thing, but they can't do something innovative as
well or controversial as well. And I think, that it's often in those controversial things, that some of our
biggest progress is made.
So, I gave the example of Charles Darwin and his professor, who advocated his voyage around the world.
Professor--I'm trying to see what his name was, Henslow, I think it was, was actually a--John Stevens
Henslow, a botanist but also a advocate of natural theology. And he sent Darwin out on this voyage,
because he thought, that studying nature enabled you to discover God. Little did he know, Darwin would
end up an atheist after his voyage. But it's this kind of weird stuff that gets financed. Or Wendy Kopp, I
gave as another example, whose ideas were too controversial. I mean, the idea of sending someone out,
who didn't have an education diploma to teach, too controversial.
So, I think that there is maybe a growing recognition of the importance of having people who are--well,
there's a term--social entrepreneurs. I don't know, whether they're for-profit or nonprofit, but they're people
who do things out of a sense of mission, beyond making money, but helping the world. And you see this
reported in newspapers and magazines, that the 21st century seems to be a century, where there's more and
more of this kind of thing. And it's in substantial measure, I think, nonprofit.
Chapter 5. Municipal, State and Local Finance [00:36:43]
Now, I wanted to move to the third thing, which I said is municipal, or state and local finance. It's a big
topic, but an awful lot of what gets done in this country is done by state and local governments. It's
something on the order--it's bigger than the federal government. The state and local governments spend
about twice as much money as the U.S. federal government. They run all the public schools, fire
departments, police departments, most of the parks. What else? I mean, a lot of things are being run by state
and local governments.
I think, another thing that one could do to make things happen in the world--I mentioned the possibility of
setting up a nonprofit. You can make things happen by doing that, but you can also make things happen by
approaching a local government and saying to them, I think that you would do well to build a hospital, or
build a bridge, or build a new school, or even kind of business-oriented things, that would be projects that
the government can undertake. And then, they can finance it as a state and local government.
Now one thing, in the United States, every state in the United States has a balanced budget rule. That is,
they have to tax people for all of the expenditures they make. They are not allowed to go into debt. But we
have to be careful about what the balanced budget rules in their constitution say, because, obviously, there
is municipal debt. Governments do borrow money.
State and local governments in the United States have typically--it differs across state--they typically have
two budgets. They have an operating budget and a capital budget. The operating budget is what has to be
balanced, according to their constitutions. The operating budget involves a list of all the expenditures they
made for operations, and the taxes. And they cannot--it differs by state on how it's worded--but they cannot
plan to run a deficit in some states. Or if they do run a deficit on the operating budget, they have to correct
it soon or have a plan for correcting it soon.
But the capital budget is different. If a city builds a new school, for example, that's not an operating
expense, right? It's a capital expense. So, it's building something that will last through the ages, and so it
goes on the capital budget, and not on the operating budget. And all the states allow this. They can raise
money by borrowing, and they routinely do that. So, that means they get into debt, and then they have a
potential for going bankrupt as well.
So, this is the way it works. Imagine that you're setting up a new town, and it's small right now, right? Little
town, but we know, that people are coming this way, and it's going to be a big town in 20, 30 years. So,
what do we do? Well, you lay out the streets, and you plan for a big town right now. You better plan for it
or it'll get congested. So, better lay out wide enough streets. That's easy to do. But you want to build the
streets, before the people come, have the layout, and have lots, and have it all planned.
And how about a sewage system? The people aren't here yet. So, you consult a sewage engineer, and the
engineer tells you, you know, if you're going to build a sewage system, you should do it all at once. It's
going to be too expensive to do it year after year, just adding a little bit, a little bit. You've got to have a
plan, have an idea, where this city is going. Let's build it for a city of 20,000 people. We can do it now, but
it will cost you $100 million.
So, what do you do? You might say, we can't pay for that. There's only 30 people living in this town. How
do we come up with 100 million? Obviously, you borrow, right? You put it on the capital budget. And that
is fair and just, because then, as people come to the city, they will then pay taxes and pay back the debt.
This is the way it works, and it's the way it's always worked.
Now, you could say, well, no, it shouldn't be this way. Why don't we have all of the individual people pay
for their own sewers, and add to the sewer system as they build their houses. It's not going to work, right?
That would be crazy. You've got to build the whole system in advance, and so that's what city governments
do routinely. And they go deeply into debt as a result of having created all of these capital investments, and
having the debt against them.
So, your city that has 20 people has borrowed $100 million, and it's going to be a city of 20,000 people,
you think. What if it doesn't work? What if they don't come? Your plan was wrong. Then, the city is at risk
of going bankrupt, right?
So, there's another whole chapter for municipal bankruptcy, Chapter 9 of the Bankruptcy Code. And
Chapter 9 is for city government. There's a problem, that cities going bankrupt are different, because they
don't have any shareholders, right? They do have an ability to tax people. There's a question of how much
you should tax people in a bankrupt city. If you get tax them too much, they'll just all leave. So, it's a subtle
problem.
But fortunately, there haven't been, and I'm not sure we really understand why, there have not been many
municipal bankruptcies at all. Between 1975--OK, I'm sorry. Do I have data? I thought I had data on
numbers of bankruptcy There are some famous municipal bankruptcies. New York City went bankrupt, or
it was about to declare bankruptcy in the 1970s, but it was saved by bailouts. Maybe, that's the reason why
we don't. Basically, when New York City said, that it couldn't pay its debts, the State of New York came by
with a bailout. And then also, although reluctantly and with a lag, the U.S. federal government came in with
a bailout. So, New York never declared bankruptcy.
A lot of cities will have what's called a ''rainy day fund.'' So, they will accumulate assets to help them over
troubled times. So, you can collect somewhat higher taxes, and then, you have an endowment, the city has
an endowment, which can help tide them over through difficult times. But recently, most of the rainy day
funds have been exhausted. The state and local governments saved for a rainy day, and this was a rainy
day, this financial crisis. And so, most state and local governments are in trouble right now, because of the
recession causing their tax revenues to decline, and there's increasing worry about municipal bankruptcies.
So, I said that there haven't been many historically, but people are edgy now thinking that there could be
some now because of the financial crisis. And so, the yields on municipal bonds have gone up.
Chapter 6. Tax-Exemption of Municipal Bonds [00:46:06]
Municipal bonds are tax-free in the United States. [clarification: Predominantly, municipal bonds are tax-
free in the U.S., but there are a few exceptions, as outlined in the Fabozzi et al. textbook.] So, if the City of
New Haven issues debt, and you buy the debt, you are not subject to federal income tax on the interest that
you earn. That's because in the constitution it says, that there's a separation between federal and state. The
federal cannot tax the state, so they don't tax your municipal bond. There's a subsidy toward municipal
bonds implicit in the tax law.
By the way, let me just mention the fact that municipal bonds issued by local governments are not subject
to taxes, extends, as well, to Yale University. So, Yale University issues bonds, that are in the same
category as municipal bonds, and they're not taxed. So, there's an advantage, a tax advantage, and
especially higher-income investors like to invest in municipal bonds, because it matters more for higher
income investors, because the tax rate hits them more, so there's an advantage. So, Yale issues municipal
bonds, and Yale is an important debtor.
Now, you might wonder about that. So, let's talk about Yale as a municipal bond issuer. Yale has an
endowment of 16 billion as of last year [addition: 2010], and it has a debt of 2.5 billion. So, that leaves
Yale with only 13.5 billion in assets after debt. So, you might say, why does Yale borrow money? Right? I
mean, it's got 16 billion in investing. Why is it borrowing? Well, there are many reasons, I suppose, but the
immediate and obvious reason that comes to mind is that Yale borrows money, because it can borrow at a
tax-subsidized rate, right? If Yale's debt is not subject to income tax, then that means it can borrow at a
lower rate, and Yale would be inclined--or any nonprofit that can issue non-taxable debt--would like to do
that, in order to invest in assets that are taxable. Yale doesn't pay any taxes on either of them.
So, you see what I'm saying? Municipal debt has a lower yield in the market, because everybody knows, it's
not subject to income taxes, so it has a low yield. So, Yale could issue that debt, and use the money to
invest in high yielding things that are taxable, and it's not going to pay taxes on them, either. So, there's an
arbitrage game that Yale could play, or any nonprofit could play, but it does not, because it's not allowed to,
unless it's using the proceeds of the debt for appropriate causes.
You have to understand, this is why Yale University has a substantial debt, and why the City of New Haven
has a substantial debt. It all makes sense in some basic finance framework.
But there's a lot of concern about indebtedness right now, because, with the financial crisis, the U.S. and
Europe and many other countries are suffering debt crises right now. So, it's renewing calls for a balanced
budget amendment. The U.S. government does not have a balanced budget amendment, like the state
governments do. And in fact, the U.S. government has only one budget. It does not have a capital budget.
So in some sense, the state governments are more sophisticated than the federal government in the U.S., in
that they have the distinction between operating and capital budgets.
I guess the reason why the U.S.--the U.S. government has considered adopting a capital budget, but it has
never done so. I think, maybe, it's because the U.S. government has fewer investments, like schools or
parks or water facilities, sewage facilities. It doesn't do that kind of thing, so it doesn't have as many clearly
capital projects. It has a much bigger debt than the state and local governments.
Chapter 7. Government Social Insurance From Progressive Taxes to Old Age, Survivors, and
Disability Insurance (OASDI) [00:51:24]
I guess, then, I'll move to my last topic today, which is about government social insurance. And this is
along the same theme, I'm talking today about the roles of--finance is about risk management, and it's about
incentivization. And some of the basic rules are classified under the rubric of social insurance, which is
offered by the government. This is a huge topic.
Social insurance refers to insurance that is not available by a private insurance company, but that is offered
generally by governments, and let me just give some examples.
I put it first, progressive taxes. Progressive taxes are income taxes that tax higher income people at a lower
rate [correction: at a higher rate]. And progressive taxes have increasingly, in recent years, adopted
something analogous to the earned income tax credit, the EITC--that's the U.S. name for it, but it's now in
many countries around the world--that provides negative taxes for the lowest income people. So, the effect
of progressive taxes with earned income tax credit is to insulate people somewhat from shocks to their
income.
They call it an earned income tax credit, by the way, because you have to have earned income to get the
credit. You can't be just unemployed. But if you are working and earning very little, especially if you have
a family, then you have a negative income tax rate, so that the government augments your low income with
a negative tax. I think this is very important, and it actually is effective. Otherwise, the world would be
much more unequal than it is now.
I would add, by the way, public services, which are offered out of taxes, to everyone in a country, notably
education. School systems are generally free and that is, again, something that--I consider these a form of
insurance, because they benefit people, who are unsuccessful in earning money. So, it's like an insurance
program against possible failure in achieving status in the economic system.
So, we also have--I'll go up here--three, Social Security. And I'm using U.S. terms, but these are terms that-
-these things happen in virtually all advanced countries. In the U.S., we call it OASDI. That stands for Old
Age, Survivors, and Disability Insurance. Old age insurance is pensions, and that's the biggest part of the
social security system in the United States. It's insuring--well, it's really something you know is going to
happen--you're going to get old someday, but we call it insurance.
Survivors insurance is life insurance. I mean, it benefits you. You're getting too old for this now, but if your
parents die when you're young, the U.S. government will give you an income. You're an orphan, you have
nothing, your parents died, and left you nothing, you get survivors insurance. You didn't know you had this,
right? It's not publicized a lot, but it's part of what protects people, and it's offered by the government.
And then thirdly, disability insurance--again, offered by the government--is against you breaking your neck
and becoming paralyzed, OK? Or anything like that, that makes it impossible for you to work. The U.S.
government will give you an income for life. So, if you are permanently paralyzed, you get an income for
life.
All three of these are purchasable in the private sector. You can buy a pension. You can buy survivors
insurance--they don't call it that, they call it life insurance. Just turning it around to a different name. The
sellers of life insurance don't want to remind you that you already have a life insurance policy from the
government, because you might say, well, I got enough already. So, they give it a different name and they
probably won't remind you that you have it. And then, you can buy disability insurance.
But part of the problem with private offering of these insurances--disability insurance, if it's offered
privately, suffers a selection bias problem, that some people, who realize that they are going to have a
disability, will buy the insurance right away.
And then, we have health insurance. And I don't want to use the U.S. as an example for this, because we're
kind of a laggard on most of these things. But we had a new health bill that passed under Obama last year,
and it's starting to gear up, but the U.S. is not the world leader in health insurance. It has currently about 40
million people with no health insurance.
And then, there's workers compensation. These are the main aspects of social insurance today. Workers
compensation is an older form of health insurance that preceded health insurance, at least in the United
States. And it compensated workers for accidents that occurred at work, and, in the U.S., this came in in the
progressive era. But all these are risk management devices that are offered by governments.
Now, these social insurance schemes are relatively recent innovations, and, in fact, I think, that the first
national--I know that--the first national social insurance programs began in Germany in the late 19th
century. So, another theme of this course has been that the ability to do things like this requires a developed
society with a certain technology, with an information technology, with a bureaucratic technology. And
they haven't been around for that long. If you go back in history 200, 300 or more years, there wasn't social
insurance anywhere. Maybe there was, in some isolated community, but basically it didn't exist. And so, the
history of social insurance is interesting, and I think, it reflects information technology growth.
Chapter 8. The Invention of Social Insurance in Germany [01:00:10]
The country that is most remarkable for having invented social insurance is Germany under Otto von
Bismarck in the 1880s. And I think, that it happened there first because of the information technology.
It's an interesting story that--there were various attempts to start social insurance in different parts of the
world, that were half-hearted and failed. In the United Kingdom in the late 1700s, there was a town called
Speenhamland, a tiny town in U.K., that decided they would start social insurance. They decided, that there
was a living wage that anyone ought to be able to earn, and anyone, who earned less than that, would have
the difference paid by the town. So, it's called the Speenhamland Law, and that town offered to pay the
difference. The problem was, it didn't work. Too many people reported, that they were getting less income
than the living income that they defined, and the town discovered it was being ripped off. The problem is
they couldn't identify what a person's income really was, accurately. They couldn't tell whether someone
was goofing off or not, and so, they dropped it.
I think, there are other examples of failed experiments like this, but it took hold first in Germany in the
1880s, and they got accident insurance, health insurance, and old age insurance, or retirement, for everyone
in Germany in the 1880s, and it was considered a fiasco by other countries of the world. When Germany
announced these plans to create social insurance, the London Times wrote an article saying, this whole
thing will fall through and fail. The government is going to run all of these insurance policies for something
like, I think, there were 11 million workers in Germany at the time, and in London they said, you've got to
be kidding. No government in the world has ever managed to run something like this.
Let's think particularly about retirement insurance. The German government set up a plan, whereby people
would contribute over their working lives to a social security system, and the system would then years later,
30, 40 years later, keep a tab, about how much theyve contributed, and then pay them a pension for the rest
of their lives. So, the Times wondered aloud, are they going to mess this up? They've got to keep records
for 40 years. They were talking about the government keeping records, and they thought, nobody can really
manage to do this, and that it will collapse in ruin. But it didn't. The Germans managed to do this in the
1880s for the first time, and actually it was an idea that was copied all over the world.
So, why is it that Germany was able to do something like this in the 1880s, when it was not doable
anywhere else? It had never been done until that time. I think this has to do ultimately with technology.
Technology, particularly information technology, was advancing rapidly in the 19th century. Not as rapidly
as in the 20th, but rapidly advancing.
So, what happened in Europe that made it possible to institute these radical new ideas? I just give a list of
some things.
Paper. This is information technology, but you don't think--in the 18th century, paper, ordinary paper was
very expensive, because it was made from cloth in those days. They didn't know how to make paper from
wood, and it had to be hand-made. As a result, if you bought a newspaper in, say, 1790, it would be just
one page, and it would be printed on the smallest print, because it was just so expensive. It would cost you
like $20 in today's prices to buy one newspaper. Then, they invented the paper machine that made it
mechanically, and they made it out of wood pulp, and suddenly the cost of paper went down.
By the way, I found an old textbook from Yale University from 1837. It's still sitting there on the shelf in
the library. I was looking--we were using a Principles of Economics textbook for all Yale students, they all
had to take the same course. And theres a nice little book, but it was so small--I picked it up--it was like
that big. You could put in your pocket. I think it's because books were just expensive, so the students--you
have these huge textbooks now, that weigh so much they probably challenge your back--back then, you
could carry your books. There was a fundamental economic difference, and so, paper was one of the things.
And you never got a receipt for anything, when you bought something. You go to the store and buy
something, you think you get a receipt? Absolutely not, because it's too--well, they wouldn't know why, but
that's the ultimate reason--too expensive. And so, they invented paper.
Two, carbon paper. Do you people even know what this is? Anyone here heard of carbon paper? Maybe, I
don't know. It used to be, that, when you wanted to make a copy of something, you didn't have any copying
machines. You would buy this special paper, which was--do you know what--do I have to explain this to
you? You know what carbon paper is? You put it between two sheets of paper, and you write on the upper
one, and it comes through on the lower one. This was never invented until the 19th century. Nobody had
carbon paper. You couldn't make copies of anything. There was no way to make a copy. They hadn't
invented photography, yet. They had no way to make a copy. You had to just hand-copy everything. The
first copying machine--maybe I mentioned that--didn't come until the 20th century, and they were
photographic.
And the typewriter. That was invented in the 1870s. Now, it may seem like a small thing, but it was a very
important thing, because you could make accurate documents, and they were not subject to
misinterpretation because of sloppy handwriting--and I'm doing sloppy handwriting here for you, but I'm
using the old technology here. But the typewriter. And you could also make many copies. You could make
six copies at once with carbon paper. And they're all exactly the same. You can file each one in a different
filing cabinet.
Four, standardized forms. These were forms that had fill-in-the-blank with a typewriter.
They had filing cabinets.
And finally, bureaucracy developed. They had management school. Particularly in Germany, it was famous
for its management schools and its business schools.
Oh, I should add, also, postal service. If you wanted to mail a letter in 1790, you'd have trouble, and it
would cost you a lot. Most people in 1790 got maybe one letter a year, or two letters a year. That was it.
But in the 19th century, they started setting up post offices all over the world, and the Germans were
particularly good at this kind of bureaucratic thing. So, there were post offices in every town, and the social
security system operated through the post offices. Because once you have post offices in every town, you
would go to make your payments on social security at the post office, and they would give you stamps, and
you'd paste them on a card, and that's how you could show that you had paid.
So, I think that this kind of information technology brought us the social security system. And the kinds of
advances in information technology that we've seen more recently will eventually lead to changes in the
system. Ultimately, technology drives finance, and the system responds to changes in technology.
Chapter 9. Review of the Social Purpose of Finance and of Behavioral Finance [01:10:20]
All right. So, I just wanted to just wrap up. I talked today about a broader social purpose that's served by
our finance, and it takes place in terms of for-profit as well as nonprofit. But the distinction between for-
profit and nonprofit is a subtle one. I think, what happens is, people think of a purpose of something they
want to achieve, and then they think, how can I use our financial technology to incentivize people to
subscribe capital to this project or to give their personal attention to this project? And then, our system of
finance has a lot of things, a lot of devices, that can allow the providence of capital, and that will
incentivize people.
I think, another theme of this course has been Behavioral Finance that I think--people are psychological,
they have emotions, and they react in complicated ways. One of the oldest themes of economics is that
people respond to incentives, but they respond to pleas to their morality as well, or their ideals as well.
When we talk about the nonprofit sector, it seems that the financial arrangements reflect a combination of
selfish money-oriented incentives and more social-purpose-incentives. And the same thing goes with
government activities.
Anyway, I guess, I have one more lecture, and I'm going to talk next time more broadly about, what finance
offers us, and how it allows us to achieve social purposes.
[end of transcript]


ECON 252
Financial Markets (2011)
Lecture 23 - Finding Your Purpose in a World of Financial Capitalism
[April 20, 2011]
Chapter 1. The Course and Its Major Themes in Retrospect [00:00:00]
Professor Robert Shiller: All right. This is the concluding lecture for ''Financial Markets.'' And in this
lecture, I want--oh, I titled this lecture, Finding Your Purpose in a World of Financial Capitalism--but I just
want to give a lot of summary thoughts about the course and about your place in the world of business and
finance.
So, we had two--well, we had the major textbook for this course was by Fabozzi et al., and it gave you a lot
of detailed information about financial markets and institutions. Did you like it? I'm getting approval, I
guess. I put you through something, because I thought you have to know that material. Finance is like a
language. Well, it is a language. There's a lot of jargon, and behind the jargon are concepts, and I wanted
you to immerse yourself in that.
I also assigned my manuscript for my new book, which is tentatively entitled Finance and the Good
Society. I'm still not sure that that will be the final title. Some of you have been offering me suggested titles,
I appreciate that. You can never know what the title of a book will be before you publish it, because
someone else can always grab the title, and then you've got to change it.
But that book was about--see, Fabozzi is more about all of the language of finance, and all of the technical
details. I wanted to supplement it with something about the purpose of all this, and how it fits into our lives.
So, it's not done yet, as you may be well aware in reading it. My apologies. But I benefit from interacting
with you about it. It's a dynamic thing.
I have a number of themes. They're all just kind of random thoughts about the major things in this course.
But I mean, I'm really thinking this time about the kind of tools we've learned about, tools that are
particularly useful for people who specialize in finance. But I think, this almost should be a required course
for everyone. Maybe, I'm just too enthusiastic about it, but the way things get done in our society is through
financial arrangements. And too many people talk in vague terms, not, how are we going to make
something happen? And finance is about that, so, that's why I think this course should be--there should be
more students taking it than are.
I also said, that I think that finance is not a purpose in itself, it's a tool. And that you should be building
your life around some kind of purpose. There's a million different purposes, so that's something for you to
create in your own mind. But that's where the meaning of life comes from.
So, another thing I've emphasized in this course is, that finance is like engineering, so you have to design it.
And once something is designed and it works, it gets copied all over the world. You all have learned how to
drive a car. Is there anyone here who hasn't driven a car? I won't ask for--no one raised their hand. So, you
have to know a little bit about mechanics to drive a car. Maybe not too much. But ultimately, what I wanted
to do in this course is, maybe not teach you how to build a car, but how to drive a truck, something big and
powerful, and get you beyond the simple things.
So, finance, what does it do? It does really important things. It helps allocate scarce resources, it
incentivizes people to do good work, and it manages risks. And this is what makes for the developed world
that we have now.
Another theme of this course is about information technology, which is something that's rapidly expanding.
I don't have to tell you that. But I think that it will change the world of finance. The last 50 years have
shown tremendous changes, the next 50 years will show even more dramatic changes.
Or anyway, more specifically, I have seven themes that I want to cover in today's lecture.
The first one is just about the morality of finance. I've been talking about this here and again, but let me say
a little bit more about that in concluding. My second theme is hopelessness. There's a tendency for people
to think, that, at some level, because of the world's problems, it's all hopeless, anyway. I don't think it is.
Well, I've come to--I'll have to tell you what I mean by that. Then thirdly, I just want say something about
financial theory. Then to come fourth, to come back to another theme, which is wealth and poverty, which
I've talked about a lot. Then, the world of the next century. And I think, one trend we'll see is the
democratization of finance, that finance will become much more of an integral part of our lives in a new
information-technology-enriched world. And then lastly, I'll say something about your career, whether it's
in finance or in something completely different. But I'm thinking that a good chance it has something to do
with finance.
Chapter 2. The Morality of Finance [00:06:48]
Let me start, though, with the first thing, which is about morality. I have--actually, the two optional
readings I have on this part of the reading list are both about morality. And one is the book by Unger called
Living High and Letting Die. I think it's a dramatically well-written book, but on the first page of the book,
he refers you to UNICEF, which--actually, his book was written before the web got popular. The book is
1994, I think. 1996. He could have referred to the web, but he gave the address. UNICEF is the United
Nations--what does the I stand for? Children Educational Fund, but what's the I? Can someone tell me?
[Correction: United Nations International Children's Emergency Fund ]They don't actually emphasize, what
it's spelled out. It's the United Nations fund for children of the world, and that's their website.
So, he opens the book by saying, why don't you get out your checkbook right now and mail in $100 to
unicef.org, because the estimate, as of 1996, is, that UNICEF can save a child's life for $3. So, you will
save the lives of 33 children for your $100 check.
How can they do that? How can they save a life? I think, maybe he's referring to things like vaccination
programs, things that are really cheap, that some children are not getting. And so, statistically, you can save
a child's life for $3. So, he says, write out a check, but of course, I can tell you what to do, and that is, just
log on to that and get out your credit card. And I don't know if you can save 33 lives with $100, but maybe
you can.
So, when I first read the book, I thought about that, and then I turned the page--because most of us do--and
I realized later, a month later, that I never had written out $100 check. So, I finally did. I went on to
unicef.org and I gave exactly $100, as he called for. Then, I started--that was thought-provoking to think
about that, because why did I stop at $100? Why is it that most of us don't do that? There are intellectual
defenses we have--we think of ourselves as good people--but if you were to see a dying child, you would
emotionally be driven to do something, if there was something you could do, right? But somehow, when
they're not visible to us, we don't take action to make them visible. What the book consists of, Unger's book
consists of, is an analysis of all the excuses we give for not doing it, for not doing that sort of thing. So,
living our comfortable lives and letting other people die.
And I think, it's really an interesting book, because it is referring to a paradox of human behavior. I think of
this as at the juncture of philosophy and psychology. And now, those two departments are starting to--I
understand, I'm not in either one of them--are starting to come together, because they're realizing that
philosophical issues are related to psychological issues. So somehow, the human spirit is very empathetic
and sympathetic in certain dimensions, but not so in others.
When you read his book, you get a sense of meaninglessness or loss of purpose. It's not entirely
comfortable to read it. He has a lot of examples of moral dilemmas. I don't mean to find fault with his book,
but when I think further about it, it seems, that maybe the book is a bit circumscribed by the kind of moral
dilemmas that he poses. In some sense, moral dilemmas are--it's almost like there's a moral imperative for
us to take action to do things. That's sort of what he's getting at. But there's almost a moral imperative to be
entrepreneurial to do things.
I mentioned before, Paul Allen, who was one of the top people in Microsoft, who made so much money
and squandered some of it, apparently, on conspicuous consumption, but on the other hand, gives a billion
dollars to charity. So, it seems to me that--let's not conclude that people who don't write the $100 check are
evil, and let's think of the many, many dimensionalities of morality.
The other book I had on this part of the course was by William Graham Sumner, and it was written over
100 years earlier--1883--called What the Social Classes Owe Each Other. And Sumner was actually Yale's
first real economist. Interesting person. He graduated Yale College in 1863, and he was hired by Yale as a
tutor in mathematics in 1866, and became interested in economics and sociology. He has the distinction of
being the first American professor to teach a course called Sociology, and in those days, there wasn't the
distinction between the social sciences that there is now. So, he could teach both sociology and economics.
So, in his book, I think, he started a Yale tradition of conservative economics that lasted until the 1940s.
And then, Yale kind of drifted more toward the liberal end. But he writes, anyway, in 1883, "Is it wicked to
be rich? Is it mean to be a capitalist?" And he says, first of all, it seems, if capitalists are just richer than
other people--he asks, where's the dividing line, when someone is rich? So, is it wicked to be above that
line? But where do you draw the line? And if you learn from Unger, maybe we're all wicked, because
anyone who doesn't write a $100 check every day to UNICEF, when children are dying around the world,
is wicked.
What Sumner is saying, and it seems to be a theme that survives the centuries, in favor of capitalists. I'll
quote Sumner. "The great gains of a great capitalist in a modern state must be put under the head of wages
of superintendents. Anyone who believes that any great enterprise of an industrial character can be started
without labor must have little experience of life. Let anyone try to get a railroad built or to start a factory
and win reputation for its products, and he will find what obstacles must be overcome, what risks must be
taken, what perseverance and courage are necessary."
I don't know, that I entirely agree with Sumner, but he has a point, that part of our morality is to do good
for the world by doing things like set up railroads, or Microsoft. And the kind of activities that that entails,
will create opportunities for conspicuous consumption, but not necessarily make that the defining
characteristic of someone who does it. Nobody is perfect, and it's hard to judge people ultimately, but it
seems to me that there's almost a moral imperative to entrepreneurship.
Chapter 3. Hopelessness: Challenging Malthus's Dismal Law [00:16:06]
Let me go on to the second theme that I said I would talk about, and that is hopelessness. A lot of people,
from their education, get the idea that ultimately there's nothing we can really do. This is one of Unger's--
Unger talks about rationalizations we give for not being moral, and he calls it futility is a rationalization.
Ultimately, there's always going to be starving people in the world, and I can try to help this child, but
something's going to get him later, and so there's no point. If you have that kind sense of futility, it can
justify any amount of hedonism.
But I think, that the classic article that lends most people to that sense of futility, and I assume you know
about this already, but it's Malthus, 1798, his essay on--well, the title of it is Essay on the Principle of
Population. So, Thomas Malthus wrote about the population problem. It was such a celebrated essay, that
he went through six editions of it, but I'm going to quote from the first edition, just to remind you. He said,
in 1798, "Population, when unchecked, increased in a geometrical ratio and subsistence for man in an
arithmetical ratio." So, the population growth follows an exponential growth curve. He says geometric, but
it goes like that. Whereas he said, at best, the increase of our ability to produce is linear. He calls that
arithmetical. And so, the population will run off with all of our resources. There's nothing we can do,
population will continue to put pressure on our resources. He says and I'm quoting again from his 1798
essay, "Population, when unchecked, goes on doubling itself every 25 years. If you go through two 25
periods where there was no check on population growth, it is impossible''--I'm quoting him--"to suppose
that the produce could be quadrupled. It would be contrary to all our knowledge of the qualities of land."
And he comes now to his dismal law of economics. He didn't call it that, but I will quote him. "No possible
form of society could prevent the almost constant action of misery upon a great part of mankind if in a state
of inequality and upon all if all were equal." So that the natural state of humankind is bordering on
starvation and dying. The force of his argument was quite profound, because it was hard to argue against
him, that there's nothing you can do about it. That's just it. And all the theorizing of people can only result
in a world, where more people are suffering and dying.
If you want to think more about this, I suggest you might go to Robert Wyman, who is a professor here at
Yale on Open Yale, which means it's another of these courses open on the internet. Has of course called
''Global Problems of Population Growth,'' where he spends a whole semester thinking about the Malthusian
problem. One thing that he talks about in that course is that there's a popular sense that the population
problem is not so bad anymore, because many countries have introduced birth control policies. Notably,
China has a one-child policy, supposedly. It's not really a one-child policy, it's not enforced that well. It's
more like a two-child policy, or people have even more than that. But other countries--India, certain regions
of India have made great progress, we're told, in birth control.
But still, despite that, Wyman estimates that the world adds a billion people every twelve years. So, that's a
problem, and our resources are limited. So, the problem is that people are crowding into the cities, because
there's no room for them on the land. They're trying to get an education to push themselves ahead, but the
sheer numbers of people make it impossible for them all to get ahead. So, I suggest that you might take his
course. It's a problem that people don't want to face up to.
So, I'm sounding very dismal here, but actually, I think that the problem is not as bad as it may seem. This
is my take on it. I tend to be a realist about these things. We have a population problem, it's going to be
with it us, but, hey, it's been with us forever, going all the way back in history. So, it's a tough world that
we live in, because the human race is naturally procreating, and naturally creating population pressures and
conflicts that lead to wars and famines. We've been going through a good run in the last few centuries, but I
don't know when the end--it's not an end--when we're going to see more severe problems, but that just
seems to be right and inevitable.
I think, that the weakest part of Malthus' argument is the last step, saying that it's necessarily a dismal
world that results. I wanted to put the bright side on Malthus' dismal law, and that is, most of the time,
everyone's fine in the world. Most people--it's famines and wars are intermittent events that reduce
population. Between those big events, pretty much everyone is doing all right. So I mean, maybe it's not as
bad as you think. You know, you might get killed in a war someday, but you enjoy life until that happens. I
mean, that's very basic, but I think it's true.
Moreover, I think that there's a lot that we can do to make life better, even in the context of dismal law,
even accepting the dismal law. And I think that civilization is improving, so that life is better, even though
there are population pressures. And that's why I think there is--maybe I'm saying the obvious here, but I
want to say it anyway--that there are plenty of purposes and goals that people can fulfill, even taking as
given Malthus' dismal law.
I talked last period about nonprofit and charity, and government as well. There are a lot of people, who are
doing specific things to make the world respond better to the dismal law of Malthus'. And I wanted to
mention certain examples, just to make this clear. I think, that there's work being done by governments of
the world, there's also work being done by individuals who don't need government, they set up their own
organizations. Specifically talking about the environment. This is what's being threatened by population
growth. And so, there are many foundations that deal with the environment. I'll just mention a few. The
Nature Conservancy, the Worldwide Wildlife Fund, the Wildlife Conservation Society. And there are
specialized ones, like African Wildlife Foundation, the Jane Goodall Institute, the Diane Fossey Gorilla
Fund. You know, you think the gorillas out there are wild, but there's finance and support. They've
collected money. Someone is managing an endowment for the gorillas, OK? This is creative finance.
A part of the problem with--you think about, what's happening with the population pressures of the world,
and is it bad or not? Well, in some sense, it's good. Having 10 billion people out in the world would just
make for a more interesting place, right? There'd be more arts and sciences, and fun things to do.
Eventually, we're going to colonize the Moon and Mars, and there's going to be fun trips to do, so, I don't
know, if it's a bad world we're coming into, even if there are conflicts.
But I think theres specific problems with that world, and one of them is the extinction of species. You
think about that, we're destroying habitat for species, and they're going to be gone forever. But the thing is
that those kinds of problems are problems that have sort of business solutions.
I wanted to talk about one particular foundation. It's a nonprofit. I'll just give this as an example, the Nature
Conservancy. It was founded in 1951 in the United States, but it now operates in 30 countries. Its total
assets are 5.6 billion, which makes it the third largest charity in the United States. And they have a
principle of ''conservation by design.'' The idea is, our purpose is to prevent extinction of species. Because
extinction is forever. You know, these species have taken hundreds of millions of years to evolve, they get
wiped out, they're gone. As far as we know, they're gone forever.
So, what they do is they get scientists who specialize in environment and biology, and they say, which
species are endangered, and what can we really do to prevent their extinction? And one thing that the
scientists have been telling them is that you have to preserve habitat for species, and you have to do it with
purpose and clarity. What do these animals need? Some of them are migratory, for example, and they
migrate over long distances, so you have to preserve a migratory route and stopping places along the way
for them. So, it has to be done well.
So, the Nature Conservancy believes, also, that the way to protect habitat is to buy land, and put up fences
around that to keep people out, and then have a forest manager run it, so that the species will have it, will
have that land. They say that they have 500,000 square kilometers of land that they've bought around the
world. I calculated, that there's 150 million square kilometers of land on the earth, so they have 1/3 of 1%
of the world's land protected by their charity. That might seem small, but you know, that's a big difference,
right? Because, if it's the last habitat, that might be enough to keep a lot of species' diversity going.
So, that's an example of what--this is really finance. We have portfolio managers managing portfolios and
properties of land with a good purpose.
That's where I say, the moral dilemmas are not so simple. You could take a job managing a portfolio for
one of these foundations. Peter Unger, in his book, is talking always about, would you save a child who fell
in the water or something like that? But that's not the kind of moral dilemmas that we really face, that an
energetic intellect would find. The moral dilemma is to prevent big, bad things from happening, and that
takes a sort of entrepreneurship and big thinking to manage.
Chapter 4. The Endurance and Survival of Financial Contracts [00:30:05]
Another thought I had in this context is about wars. I was saying that population pressures are a fact of life,
and I'm skeptical that anyone will change the basic nature of the situation. But I wanted, in this context, to
emphasize that financial arrangements are capable of enduring and surviving wars and catastrophes.
I wanted particularly to make it clear, that there's a tendency for people to think, that finance is something
that the government runs. You can easily get that impression, because, when you go into finance, the first
thing you have to do is get licensed, and you have to file some papers with either the government or a
government-approved organization. And then, you will find, there's a whole list of laws and regulations that
you have to memorize, and forms that have to be filed with government agencies, and permissions to be
granted. So, it sounds like this is just the government. But I think that's the wrong view. I think that you
should think of finance as people making arrangements with other people, and governments are helpful,
and they enforce a contract, but they don't determine them.
And in particular, I wanted to give you a few examples that clarify this. What do you think happened after
World War I with financial arrangements? Germany lost the war. People were really angry with Germany.
In the Versailles Conference after World War I, Germany was made to pay huge reparation payments,
payments that some people thought were so heavy, that the country will never be able to do it. So, what do
you think they did to financial contracts? Germany was at its knees, people thought they were evil, or many
people thought they were evil. Well, there was talk about taking away--people who own stocks or bonds,
let's just confiscate them, and tell them, you were in the wrong country at the wrong time--tough on you.
Well, they talked about doing it, but they didn't do it. The reparations were obligations of the German
government, and they were paid by taxing people. And they taxed people in an equitable--they didn't
actually pay them, by the way. The skeptics were right. Germany never was able to pay the reparations, but
it tried to pay them by taxing people, not by confiscating. Because ultimately, when it came down to it, they
thought, well, Germans are all different, and some of them supported the war, and some of them didn't, and
some of them saved all their lives, and they've got a big amount of money, so let's not confiscate their
shares. So, they didn't. That's my first example.
Second example. Iran. Remember, it was ruled by the Shah of Iran, who was a secular ruler, hereditary
ruler of Iran. Overthrown by a people's Islamic revolution, and the Ayatollah Khomeini became the
spiritual authority for the new country, it became much more Islamic. All right. So, what do you think
happened to financial contracts in Iran? In particular, the Iranian government under the Shah had a social
security system, and they were paying, to government employees, pensions.
So, what do you think the Ayatollah did? A guy is working all his life for the Shah, we've overthrown the
Shah--do you still get your pension? What do you think? They did. They didn't cancel. I think, it's like
common sense. You come in, you are a totally different government, now you're a radical Islamic
government. Now, I don't say, that they won't do some things that you don't like, but they see the basic
financial contracts and they preserve them.
The other example I'll give is South Africa. And that is, in 1994, the white apartheid government was
replaced by a government that was elected by the black majority in South Africa. So, what do you think
happened to their pensions or their insurance? Where they confiscated? No. So, I think that this is a
principle in history.
Now, I can give other examples, of course, where things went badly. Vladimir Lenin wasn't so kind to
stockholders in Russia after this Russian Revolution. Lazaro Cardenas, in Mexico, nationalized the oil
industry. Mao Zedong--you know who he is, in China--not kind to capitalists. Mohammad Mosaddegh in
Iran nationalized the oil industry. Gamal Abdel Nasser in Egypt nationalized a wide range of industries.
Even in India, Indira Gandhi did widespread nationalizations that were effectively confiscations.
Even the United States has in some sense been involved in those sorts of things. After World War II, the
United States was not going to confiscate wealth of wealthy people in general, but in Japan, there were
these wealthy families that maintained industries, called Zaibatsu. These were the family-owned businesses
that dominated Japan before World War II. The big four, Mitsubishi, Yasuda--who else? Mitsui--and what
am I thinking of? It's not in my notes. [Addition: The big four were Mitsubishi, Mitsui, Sumitomo and
Yasuda] But these big, wealthy families were thought to have supported the war and made Japan into more
radical than it would have been. So, there was a lot of U.S. thinking that we had to break up the Zaibatsu.
So, what the United States did is force these families to convert their holdings of industry in Japan into yen-
denominated government bonds. And then, the Japanese government had a huge hyperinflation and wiped
them out. So, it wasn't actually a confiscation. The U.S. government didn't deliberately confiscate the
wealth of the Zaibatsu, but they effectively did that. By the way, we still have Zaibatsu in Japan, but they're
not owned by those families anymore. The same industrial conglomerates still survive.
Chapter 5. The Importance of Financial Theory [00:37:41]
Third topic, I was saying I would talk about is--maybe I'll be brief about this--importance of financial
theory. I'm an advocate of two seemingly disparate things, and you know this from this course. One of them
is Mathematical Finance. We spent some time on it, but not very much, because there's another course--it's
also on Open Yale--that John Geanakoplos has on Mathematical Finance.
But the other side of it is Behavioral Finance, which is a particular passion of mine. And Behavioral
Finance is the application of psychology and other social sciences to finance. And I think that the two
actually work together symbiotically, and that we should consider them together. Some people in
Mathematical Finance are very opposed to Behavioral Finance, because it kind of muddles their world, but
in fact, I think, they should consider it their salvation, because without Behavioral Finance, they're kind of
bordering on irrelevant. You have to consider things in a broader context and think of the interruptions and
problems that are caused.
Chapter 6. Welfare and Poverty [00:39:13]
I said, the next topic I would talk about today is--I've already been talking about it a bit--is about welfare
and poverty. It seems to me, it's fundamentally connected with our thoughts about finance, because--I've
referred to this problem before, that people think, that people who go into finance are money grubbers.
They want to make money, they don't have human feelings or something like that. And there's also the
sense, that we're living in a world that's increasingly plutocratic, that the wealthy people are controlling the
world. That was a theme that took a lot of impetus in the 19th century with Karl Marx, who said exactly
that. And in some sense, it's coming back--maybe in not such an extreme form.
So, Jacob Hacker, who's in our political science department, and Paul Pearson, who's at Stanford
University, have a new book that just came out called Winner-Take-All Politics. And that book is about--
they have a claim in that book, that the world is getting more polarized by the political power of financial
institutions.
Basically, they have something, they call the ''30 years war.'' What's the 30 years war? You might think, it's
something that happened in the 17th century. Not for them. The 30 years war is the war against the people
of the world, fought by the financial community in the halls of Congress and Parliament, by lobbying. So,
they argue that the companies have gotten more and more sophisticated in lobbying governments to fulfill
their ambitions, and so, the income inequality that we're seeing increasing, particularly in the United States,
but also elsewhere in the world, is a consequence of this.
So, Hacker and Pearson say--much of the literature on income inequality says, it has something to do with
the information revolution, which is eliminating jobs for low income people, and the increasing importance
of education, which rewards college graduates at the expense of uneducated people--but they say, that the
real increase in inequality has not been between high school graduates and college graduates, it's between
the whole population and the top tenth of a percent. There is this small community of super rich people,
that are developing, who are very adept at lobbying governments. This is a trend that's developing.
Well, I think to some extent, they are probably right. I think, maybe they overstate that, but I think, it's a
concern, but I think, that we do have democratic institutions, and we can respond to that. So that I think,
maybe, they overstate it, because I think that, I've met billionaires in my life, I have a sense, that they are
not--I haven't met enough of them to make generalities about billionaires--but maybe, they have a little bit
of a self-serving mentality, but in some sense they seem not to care. They don't want to be viewed as evil,
they want to be--a lot of what drove them to become billionaires was a sense, that they would be a
benefactor of some sort, and so they're ready to give it away. Anyway, that may be a casual impression.
But one thing that angers people about wealth is the tendency of wealthy people to build monuments to
themselves. So, I was thinking of that, when I was at the J.P. Morgan Library in New York, and also there's
something called the Metropolitan Club, which is another building that he built to himself, this huge
mansion in Manhattan that he built. And I was thinking, is J.P. Morgan evil? I mean, people are starving in
the world, and he's building a mansion for himself. But then, I reflected further--here, I am having dinner in
his mansion. He's gone. And is it really so bad in the scheme of things? I guess you can view it in different
ways. You can view J.P. Morgan as a great success, who ended up helping the world, or you can view him
as a selfish monument builder.
His life overlapped with Karl Marx, that I told you, about. But one of Karl Marx's themes was, that the
system is unfair. That some people have capital, that was a theme of his book, Das Kapital, some people
have capital, and they are wealthy as a result, and they will continue to be wealthy, and they'll make their
children wealthy as a result.
I actually have a quote from Karl Marx. "It is not, because he is a leader of industry that a man in is a
capitalist. On the contrary, he is a leader of industry, because he is a capitalist. The leadership of industry is
an attribute of capital, just as in feudal times the functions of general and judge were attributes of landed
property." That comes from his book, Capital, in the 19th century. So, Marx thought, that ownership of
capital was like a key to the good life, and that the population was excluded from that. But I'm going to
come back to the democratization of finance, but it seems like capitalism--it isn't essential to capitalism that
some social class dominates capital. We can have a capitalism that is divided up among--that is more
people's, it belongs to people, and its not a privileged class.
So, another thing I wanted to talk about is my concern. Marx was impressive--I think I may have said this
before--he was impressive, because he read emerging sociology. And the sociology of his day was
beginning to recognize, that people do form themselves into social classes, and they have a sense of loyalty
to others in their social class. But I think, that anything he said is of limited relevance today--was always of
limited relevance. Interesting, but wrong in many ways.
I'm thinking of the works of another important thinker, Robert K. Merton, who was a sociologist at
Columbia. He is the father of Robert Merton, the economist, who helped develop option theory. But Robert
K. Merton referred to, what he called the ''cosmopolitan class.'' He was looking at social classes. He picked
a small town in the United States, and interviewed a lot of people, and was trying to understand their class
structure. You know, who do you identify with? Who are you loyal with?
He was a deep thinker, I think, and looked at what really seemed to separate people. And he decided, that,
in this little town, that there were really two classes of people. He called them cosmopolitans and locals.
So, the cosmopolitans had a very different worldview. They tended to not care about what's going on in
their town. They would talk about national or international things. He'd listen to what they say. They were
focused outside, they thought the town was irrelevant, and they tended to have maybe higher-level
positions.
The locals were people, though, who would talk all about their town, and they would talk about people they
know. They seemed to value their connections within the town. And when you asked for opinions about the
local town, the locals would tend to give almost loving expressions. This is a great town, we have a great
people here. And the cosmopolitans would act totally indifferent, and they don't know anybody. They don't
know who's the head of the fire department, or who holds the--maybe they know the principal the school,
because they may have their kid in the school, but beyond that, they don't know anything about their town.
So, Merton wrote that over 50 years ago. I have a sense, that it's developing further, this split between
cosmopolitans and locals. And it's developing on a world scale. There's now a world cosmopolitan class,
and with increased communications we're kind of split that way. So, people around the world who are
learning to speak English well, that's the world language, people who travel around the world, and people
who are finance savvy, are developing into a social class. And I think, that there are animosities and
conflicts, but it's a little bit harder, because the cosmopolitans are so scattered and they're relatives of us, so
it's not as intense a social contrast.
But you know, I think, that the animosities that we are feeling now have to do with the fact that
cosmopolitans know and understand finance, and they have lawyers and advisors. The rest of the
population feels excluded from that.
Chapter 7. The Democratization of Finance [00:50:36]
So, that brings us to what I said was the democratization of finance. And this is a theme of my own that I've
been emphasizing. So, the democratization of finance is sort of trying to make it move beyond the
cosmopolitan class, OK? So, cosmopolitans know how to get things done, how to raise capital, and they
know how to manage their risks, so they don't get into trouble. Inequality is substantially due to a failure to
manage risks. Right? I mean, some inequality is due to fundamental things, like someone is talented and
can make more money. But it's also due to random things that are not controlled.
Notably, in the current financial crisis, we saw a huge drop in home values. And we saw people who
bought homes at the top of the market, and then they find that their mortgages are worth more than their
homes are, and so they have a negative net worth. They're in trouble, they would be bankrupt--maybe
they're not bankrupt yet, but they're verging on that--they're very unhappy. This was a failure, I think, of
bringing finance to the people. So, it's not democratizing finance--we haven't finished democratizing
finance.
So, it's kind of chaotic, the way things work for most people. Most people who, a, do not have a lawyer, b,
do not have a financial adviser, c, do not have an accountant. Or maybe they go to some storefront tax-
paying service, but that's as far as they go. And these people make a mess of their lives.
So for example, we have laws that allow people to go bankrupt and wipe off their debts. All you have to do,
if you are in trouble, financial trouble, is go to a lawyer and say, can you help me file for Chapter 7
bankruptcy? I'd like to wipe out all my debts. But usually, you have to have $1,000 to pay the lawyer to
help you do this, and these people can't get it together to do that. So, what happens? What happens to this
typical person, who is uneducated, has gotten deeply in debt? What do you think happens? Do they ever
declare bankruptcy? No. What do they do? They stop answering the phone, because they're getting these
dunning calls from creditors.
And so, the creditors then--it's called informal bankruptcy. They will go to court, and ask the judge to allow
them to garnish the wages of the person who won't pay and won't answer the phone. So, they'll take another
deduction from the person's paycheck, eventually. The person never figures it out. His paycheck just went
down, he is paying off his debt. What a mess. But that's because of the failure of financial institutions to
handle things well.
So, Elizabeth Warren, who is at--I mentioned her before--at the Harvard Law School has written a couple
of books about these problems that people face. And it's a testimony to the success of our democratic
government, that she managed to persuade Dodd and Frank to put it in their bill, the Consumer Financial
Protection Bureau, which would create a government agency that would try to limit the abuse of lower
income, less educated people. We were hoping that she would be made head of her bureau, but it turns out,
that she's only acting--I forget what her exact title is--transitioning into finding a head for the bureau.
Because the lobbyists that I told you about, representing credit card or the mortgage industry, are
adamantly opposed seeing her put on as head of the bureau. So, it looks like it's politically impossible to
put her in charge of it, but she's at least involved in helping pick the person who would make that happen.
So, I think these are nice steps forward, but I wrote a book--let me just mention my own book--in 2008,
called Subprime Solution. And so, I was trying to think of the future. Again, I'm trying to think creatively
and expansively without thinking punitively, as Elizabeth Warren seems often to do. Her view tends to be
that there are exploiters who need to be regulated. But I'm thinking, that maybe there's something positive
we can do.
So, I have various ideas. Also, I had--this was 2008--I also had another book, The New Financial Order, in
2003. I'm getting on toward 10 books now in my life, and I'm having trouble remembering which one is
which. I was just commenting to my wife, it's a little bit of a problem. But somewhere in these books, one
of the ideas I had--actually, it's in The New Financial Order--is for livelihood insurance that would help
protect--this is a financial institution that would protect people's livelihoods. I viewed it as an expansion of
something that we've got already, called disability insurance. In fact, it's been offered by the government in
the United States as part of the social security system, but it handles certain insurance against certain
specific kinds of risks to livelihoods, namely health risks. If you become paralyzed, if you become mentally
ill, any of those things that a doctor can attest to, is insured already. Very important, because things like
that happen to people and they can't earn a living anymore, and it happens to young people.
And so, we have private insurance, the government has taken over part of disability insurance, but there's
also private disability insurance. But none of this covers the biggest threats to people's livelihoods. Most
threats to livelihoods are not due to medical events. It's economic events that make you--you know, you're
40 years old, you've trained for, let's say, nuclear engineering, and then we have the Fukushima or the
Sendai disasters, and then suddenly no government of the world wants to build nuclear plants anymore.
So, here you are, you're 40 years old, you're reaching your prime, you would normally be making a good,
high income, but now it's useless. No fault of your own. This is a risk that you cannot now insure, and it's
part of the thing that contributes to inequality. And so, I think that we can insure those things, and in the
future, as finance develops, these are some of the missions that we have to do.
Another thing is home equity insurance. I mentioned before, that the crisis was caused by failure to insure
against home price risk. I've been working on trying to get home equity insurance started. Some of my
colleagues at Yale, Will Goetzmann and Barry Nalebuff particularly, have actually created an insurance
policy that would insure homes against price declines in the city of Syracuse, New York. Didn't really take
off, so this is still not happening yet. But here's the idea--you can buy insurance against your home burning
down. That goes back 300 years. But how often do homes burn down? Not very often. What's the real risk
that you face? It's the loss of economic value of a home. And so, that is not insured anywhere in the world.
Why not? We could insure it. I think, these are things that would--developing home equity insurance or
livelihood insurance would be positive steps.
I have one more example from this book Subprime Solution, something that I call a continuous workout
mortgage, OK? In the financial crisis today, right now, there are 2.5 million households that are on the
verge of defaulting on their mortgages--haven't yet, but they are at risk of defaulting and being thrown out
of their houses. So, that's something like close to 10 million people. Big time event.
Why is it that they're being thrown out? Well, because their home value has dropped, maybe they're
unemployed, their income has dropped--we still have 8.8% unemployment--and they can't pay their
mortgage. And maybe, they think it's futile, because they're paying a debt that is bigger than their wealth.
So maybe, they don't feel in a very good mood about it. They go back to the mortgage lender and ask for a
workout, and the mortgage lender typically says no. The government has done a sequence of programs to
try to encourage the servicers of mortgages to do work-outs, that means lower their payments or somehow
make it easier. But it's been disappointing. They haven't succeeded in getting cooperation on these
programs. It's one of the big tragedies of the financial crisis.
So, what I proposed is, that we should think forward. I don't know how we can solve this mess right now,
but think about in the future, having mortgages that have a pre-planned workout. And the workout would
lower the cost of--lower the payment on the mortgage. Continuously, not just--the other problem with
workouts is, even when people get a workout on their mortgage, they default anyway, because things get
even worse later. And you've got one workout, you go back and say, I'd like another workout. They say,
you have got to be kidding.
And anyway, the government, like the HAMP program, that the Obama administration has promoted, has
only one workout for each family. So, I think they should be continuous and automatic. And they don't
require anyone to apply for a workout.
Chapter 8. Advice for the Right Career [01:02:18]
So, how much time do I have? I think I'll move to my last subject, which is your career. Because you are
young people and you may be wondering what you want to do.
I think, I maybe have reflected on this before. You probably feel that you want to do something important,
and you want a sort of perfect career, something that tells a story, makes a story of your life and ultimately
serves for good causes. But when you read Unger, you don't get an inspiration like that, right? You get--he
says, write a check right now to UNICEF. Well, I can do that, but it seems unrewarding just to give to
charity. I can just live like a monk, right? I could take a job at a hamburger joint, and then give all my
money away to UNICEF. Somehow that doesn't feel--I think, that you know, that you have abilities, and
you want to see them flourish, and you want to--that's why I think, you shouldn't be flipping hamburgers
and giving the money away. That's not what you should be doing now. And instead, it would be learning
things that make it possible to do good works.
What is the perfect career? I mentioned Paul Allen or Bill Gates. Bill Gates--I shouldn't give you an
example of dropping out of college, but he dropped out of college. And by the way, you should do that, if
you have a Microsoft-size idea, but I think I've said this before.
I don't know. What is the perfect career? I'll give you another example. Mohammad Yunus. You've heard
of him. He went to a Ph.D. program at Vanderbilt University, got his Ph.D. in 1969, became an assistant
professor of economics at Middle Tennessee State University. But then, the big thing that he did is, he went
back to Bangladesh and founded the Grameen Bank. The Grameen Bank, which specialized in making
microfinance loans in Bangladesh, and that was in '76. [clarification: Mohammad Yunus started making
microfinance loans in Bangladesh in 1976, but the institution of the Grameen Bank was not established
until 1983.]
Grameen apparently means ''of the village'' in Bengali. But what he did is he conceived of a new way of
making loans to very low-income people. Banks before Yunus didn't have much interest in lending to low-
income people, because the costs of administering the loan seemed to be too high, relative to what you
could get back. But he had a scheme for getting people to pay back the loans. Often, they would make loans
to women in groups--impoverished women, but he would lend to the whole group and say, that the whole
group is jointly liable to the debt, that's the only way we'll make it. And it's for business, for starting a
business, like getting a wheeled cart, where you could sell food on the street. Some simple, low business
like that. You can't do it, unless you get a little bit of capital, enough to buy the cart and buy the first food
to start selling. And these women can't get that capital, but when he makes it available to them as a group,
they then interact with each other and enforce the good behavior of each other. And it's a system that
worked.
So, he won the Nobel Peace Prize in 2006. It was not the prize in economics, it was the prize in peace. So,
that's an example of the kind of careers that, I think, some of you might think about.
So, I think that in looking forward to your own careers, you have to think about the next five decades.
You're going to be working--I said this before, I think--but you're going to be working for another 50 years,
right? More, if you enjoy it. With modern health care, you might live to 100, but you won't be working at
100, probably. You'll probably retire by then. Maybe not. Maybe, you've got a century ahead of you. And I
think, that the world will change a lot over this interval of time.
I think that, by the way, information technology will be changing so many things that we do in ways that
we can't see. And financial markets will be everywhere. So, I may be presumptuous to think that some of
these ideas here are likely to come about, but I've come to start to think that they're all inevitable, because
we've already seen the past. We've seen how financial markets have captured more and more risks. And we
have such an advance in our technology, that there really ought to be big changes that will come.
So, I guess, what you have to do is, maintain a century-long personal outlook. I mean, just think about how
much happened in the last century, right? We had two world wars, we had the whole communism came
and--extreme communism came and disappeared. Things like that are going to happen in the next century.
And so, I think you have to reflect on your role as an agent, not to think of it as something that a remote
government is handling. This is something that you have responsibility for helping develop, how the world
will turn out in the next century. I was just saying that governments come and go, but financial contracts
and institutions and the people who manage them continue.
I think that you face great career risks in this new environment. I mentioned before, the 40 year-old, who
finds that his career is suddenly eliminated because of some random change. There's evidence that, what
happens to you in life, depends on random events. It's really so much unforecastable. I'm thinking of
myself, for example. What did I think I would be doing? I'm still--I just stay in the same place. I've lived in
New Haven for almost 30 years and I've been a college professor. But when I was your age, I never thought
that I would be doing public speaking the way I have been. I get--I'm all over the--I don't mean to
exaggerate, but I didn't have the confidence. You know, I was on my high school debate team, and I didn't
particularly do well. I think you just develop, careers develop and random things happen, and you discover
things about yourself.
I was going to point out studies that show how random events affect where you go. So Joshua Angrist,
who's an economist, did a study of the effect of the draft lottery on success of people in life. In 1969, during
the Vietnam War, the U.S. government decided to use a lottery, based on birthdates, to decide who gets
drafted into the U.S. Army and sent to Vietnam. And so, Angrist thought that was a good controlled
experiment. Let's compare the lifetime income of people who--they way they did it is, they drew out of an
urn all birthdays--there's 366 days, birthdays--they drew them out of an urn, and the first one who was
drawn was the first one to go to Vietnam. And then, as it went down, the higher the number, the less likely
it is that you would ever be asked to go.
And so Angrist--by the way, I got 362. I couldn't believe it. What great luck. We were listening on the
radio--I was a graduate student--we were listening on the radio for the lottery numbers, and we were
drinking beer, and people were all excited, wondering who was going to get drafted. And I thought, you
know, when it got into the 350s, 350, 351, 352, I thought, I must have missed my birthday. I can't be this
far down, but I got 362. And that's part of my success story, because according to Angrist, people who were
drafted, who got the low number on the lottery, ended up with lower lifetime earnings. That kind of random
event affects your whole life. You know, the word career goes back to the sense, that there are random
things that happen, opportunities that come, and lack of opportunities that hurt your life.
So, I think that you have to accept the fact that it's a risky world, that you have to try to position yourself,
maintain--I think one important piece of advice I like to think of is, maintain an orientation toward history
in the making. That there's a tendency for people to orient themselves in terms of their own life cycle. They
think, what's going on now? Well, I'm a junior at Yale, and I'm going to be applying to graduate school
next year. You should be thinking, well, this is a time in history, when the Middle East is changing rapidly,
that the emerging countries are developing new technologies, and thinking about the opportunities that are
happening in the world.
That's kind of what we got from Hank Greenberg in his lecture. Remember, that he said, that the founder of
his company decided to move to China at the beginning of the 20th century, and founded a business
because of what he saw was happening in Shanghai, which was an international city at the time. So, I'm
going to go there, and I'm going to make a business. That's kind of positioning yourself with history. And
then, he moved out of China before Mao Zedong took over, and then moved back in. I mean, this is history
awareness, and I think that it matters enormously.
But you still can't completely eliminate the role of chance in your life, this is a time-honored principle. I
was actually going to quote the Bible. Ecclesiastes was a book of the Bible written in--when was that
written--around 500 BC or 600 BC. [Clarification: The reputed author of this book was Solomon, tenth
century BC, but analysis of the language suggests to some biblical scholars that the book was actually
written between the fifth and second centuries BC] And this is, you probably already heard this, "I returned
and saw under the sun that the race is not to the swift, nor the battle of the strong, neither yet bread to the
wise, nor yet riches to men of understanding, nor yet favor to men of skill, but time and chance happeneth
to them all." So, that's a time-honored truth, that randomness--
I actually had this "time and chance happeneth to them all," I actually had that inscribed in Latin when I
had my office redone. It's over my desk in my office at home, "tempus casumque in omnibus." Chance
plays a huge role in our lives and this risky world plays a sequence of events over your lifetime that we
have to try to manage.
So, what I hoped to do in this course. This was really a course about managing risks as well as enterprise
and creating a cooperative spirit. I wanted to try to convey to you that we have a technology for that, that
should be a part of your life. All right, thank you.
[APPLAUSE]
[end of transcript]