0:36 Intro. History, how financial system got into the mess it's been in. Wall Street. Characterized as free markets failed, but we don't have a free financial market, very regulated. Government encouragement to invest in houses rather than stocks and bonds. People investing without reading the fine print; promises of gold mines should be looked at carefully. Borrowing that shouldn't have happened. How so many people made so many mistakes; feedback loops, some broken by government intervention, some broke normally; in this case things went not just badly but disastrously. All for people being able to make stupid decisions and government not bailing them out. Call for regulation. A lot of blame going around. Look hard at each link in the chain, hard to blame people other than those carelessly putting their money at risk. If somebody offers you--you don't have a job or downpayment, if value of house goes up you get to keep it but if it goes down you lose nothing, foolish not to take it. How about the mortgage issuers? People buying those mortgages weren't looking hard at it. Promises of return without risk. Hard to blame the intermediaries. People bought these mortgages because they were triple-A rated. Not stupid people buying junk, innovative, creative aspect that appeared to insulate buyers from risk. But they were wrong. Why? Mortgage-backed security was a wonderful idea, share risks around the world. Hedge funds in Germany buy Kansas mortgage, take small risks. What does a rating mean? If you are promised 5% more than Treasuries and not take any risk, you are asking some agency to come give you a gold mine. Some risk, your job to look. Expect rating agency to read carefully but they can't explain risk. Greedy and stupid people who bought. Even AAA rating doesn't mean no risk.

9:01 Competition in rating agencies would help a lot. Some problems were devised as ways to get around silly regulations as opposed to sharing risk around the world optimally. Example: institutions are regulated, can only hold AAA-rated securities. Safe portfolio: take diversified portfolio and make them safe. Each security doesn't need to be AAA individually. People had an incentive to get things branded as AAA. Junk debt, 1980s, really stock. No economic reason to hold only triple-A stuff. Surprise: banks were holding back equity tranches: take a bunch of mortgages, put them in a pool, have agreement that when they start losing money, equity tranche is first to lose. Banks kept riskiest parts, so were writing insurance instead of borrowing and lending. If you hold the first tranche, the toxic tranche--usually banks borrow from depositors and lend it out for houses. All that is left with the bank is the little bit that is risky, saying to the people who bought the less risky part that they are taking the risk. Banks do a lot of explicit writing insurance, credit guarantees. Normally when banks borrow and lend they take the risk that something will go wrong, treated in a regulatory way more harshly than writing insurance; did the writing insurance part to get around a lot of regulation.

13:45 Many different financial institutions: standalone hedge funds, hedge funds within banks, brick and mortar FDIC guarantee-deposit banks. The big commercial banks in trouble now turned out to be ones that had a lot more mortgage risk than anybody thought. Banks were to sell the risks off as mortgage-backed securities; but through the tranching system them ended up with more risk. Typical neighborhood bank is doing fine, but get rid of the whole thing or keep it on their books and keep servicing it. Subprime originators, like Countrywide--pure intermediary. What did it have at risk? Was keeping some of the risk. Really stretching this business, in some cases actually fraudulent. Sometimes originators covering more than the cost of the house--closing costs. Only earn extra return for taking on some form of systematic risk.

17:45 Deleveraging. When a sector of the economy goes bad, people who invested in it lose money. Could have a bad quarter, a bad year--but this time, out of business. Why did such a small sector have such a destructive effect? Why didn't Bear Stearns and Merrill Lynch just have a bad year? They had borrowed a lot of money. If you borrow to make investments, then a little bit of loss can mean you can't repay your debt. Why did people lend these institutions money on an ongoing basis? Very active, very, very short-term market. Investment banks are not regulated banks, could do what they wanted. Borrowed every night. Every day had to borrow money to pay off the old money. Everybody wants the illusion of not taking risk because he can sell on the way down. Fallacy of finance: can't put in a stop loss order and not have risk. People lending to them thought they are just lending overnight, so they could just refuse to renew the loan if they get any trouble. Recipe for disaster. Leads to a run. That's what happened to Bear Stearns. You'd say, okay, we never said it was perfect, make a mistake, this part of the financial world made a set of bets that was riskier than it appeared. Cascade: financial market, overnight market, credit default market stopped almost entirely. Why? Banks trundling along. A lot of the credit markets are not working. Version 1.0 of the software had a bug in it. Example: Municipal bond markets--tax free, so they usually pay lower than Treasuries. Now paying more than Treasuries. People are afraid they are going to default, but interest rates too high for that. University of Chicago just sold municipal bonds at 6%, implies over 20 years, 50% probability of default. Sign of market where people are either very afraid or market isn't working well. Most municipal bonds are held by funds, which require that they be insured by an insurance company with AAA credit rating. Insurance companies got downgraded to AA, so funds had to get rid of municipal bonds, dumping them on the market; investors who were used to buying funds now have to buy them individually, which is a very difficult thing to do. Hard to get a good price. Quirky detail in the structure, hard to float bonds.

26:23 Municipalities will struggle, rolling over debt hard. Commercial paper market frozen. Hard to match receipts to outflow, costs up front, revenue comes later; businesses borrow to make that match. Point of commercial paper market is that it lets companies smooth things without having to go to banks. You have to pay your workers on Friday but cash doesn't come in till next Wednesday, short term loan. In the fall, the commercial paper banks were issuing froze--no such thing as "froze" for economists, just supply, demand, and a price. But investors worried that banks would go under and demanded a price that banks weren't willing to pay because banks knew they could always borrow from the Fed. So banks stopped trying to borrow from the commercial paper market, high interest rates. Rest of commercial paper market: Big non-financial companies having a field day. The money is there and is being lent at low rates. Kraft Food. People with a little less credit rating face very high interest rates. People with money to lend are very averse to holding any risk. Lending hasn't stopped--they've made a distinction. Auction securities, etc. So, if companies that are not in the financial sector are still able to borrow, maybe okay, we shouldn't have a depression, but we hear that the entire financial system is in disarray. There is really disarray but it's not really in the banks. "We don't lend to hold, we lend to sell." Loans may get made by a bank but it's packaged and sold. That's not working now, real problem. When Paulson was worried about what to do with the $7 billion, worried about car loans, etc. Munger on middlemen podcast. These loans couldn't be bundled. Why are we worried? Got into this mess by borrowing, so isn't it a good thing if there's less? Why encourage more? The fact that lending has gone down is not necessarily a sign of problems. Savings will increase, prudence. Suppose gas sales are down. Might be we are in a recession and people just don't want to buy as much gas. Doesn't mean anything is wrong with the oil industry. So we would expect loans to be down now anyway. Gas sales might be down because supplies got tighter. Worry is: suppose some of the refineries blew up. Middlemen system in credit markets has blown up. Hard to turn oil into gasoline right now. Maybe everybody's massively risk averse but hard to see why it should be so off the charts. Warren Buffett: When everyone is greedy, be fearful; when everyone is fearful, be greedy. Are people not buying corporate bonds because they don't want to take the risk or because the way they are used to doing it through a fund isn't there? Hard to tease out, some of both. Hopeful signs: system of intermediaries is rebuilding, but lots of stuff is having a government guarantee slapped on it. Hedge funds are being started. Good pools of mortgages, student debt, etc. Building new refineries. Government could nationalize the credit system for a generation. Finding it fun to be in.

37:15 What is role of mark-to-market accounting? In principle the idea: you're a business and you have some assets and some loans you have to pay back. What are your assets worth? Mark to market: When there is a market price, we should write the value of your assets at that price rather than its historical cost or a made-up number. Seems sensible. Alternative is accountants wave some dead chickens and come up with a number. If price of assets falls, you have to tell the world. Close the company down. Schizophrenic: half the time tell us it's mark-to-market accounting that's the problem and other half tell us banks have all these assets on the books that they don't know how to value and are secretly worth less than their accountants are telling us. Either it's marked to market and the assets aren't worth anything, or there are assets that would be worth less if they were marked to market. Can't have it both ways. Isn't it true that marking on your books at market rate, if I'm a bank holding a bunch of these equity tranches; we know they are worth less than I paid for them because of the default rate; not sure how much they are worth either because they are worthless or there is a lot of anxiety, which may be the same. Bank now has to write down its assets so is not satisfying its capital requirements, forced to sell off assets to make their balance sheet healthier; spiral occurs. A lot wrong with that story. If you think that's the problem, you don't have to change the books. You can change what you do with the piece of information. If you think the market is sending the wrong signal, don't have to close the bank down. Bank appears on paper to be in distress. The anti-mark-to-market people say it's not really in distress, worry about toxic assets, we should not force them to mark to market and they'd be healthier. You don't have to cook the books. Just change the capital requirements. Suppose you lent me money and I was paying you back regularly $100 per month. Economy goes bad, worried I might lose my job. To sell this asset, you'd get a lower price for it; expected flow of $100 is not going to be $100. But I'm still paying you, so you are not in immediate trouble. Value of loan on open market has fallen, but no reason to close you down. Should we write a new set of books that says my loan is good because I'm still paying you? No. We want the information that this bank is holding loans that are questionable. Should we close you down today as a result? Maybe we shouldn't. Need to think about chance of experiencing problem in the future, maybe need to set aside a little more capital as a result. Deleveraging: banks can and do issue capital all the time. When they write down the value of loans they can sell new equity. Look at the numbers and they do. Banks can also fail. Bedford Falls, NY. When a bank fails, the people, the computers, etc. are back in business with somebody else's name on it. WaMu--the week of the TARP. Later that very week it was taken over and back in business the next morning. Investors in the bank fear bank failure, but modern failure means the operations keep going. Contagion of fear.

47:22 TARP. Last fall Congress gave $700 billion in two steps, toxic asset relief program--Troubled Asset Relief Program. Government would buy up the troubled assets to take them off the books. That lasted a week. Opposed by various economists. What would have been better? Original TARP idea even loonier. Not just to buy up assets from banks. Wouldn't work. Holding on books at $.60 on the dollar and they are only worth $.30; if you buy them at $.30 you aren't doing anyone a favor because now the bank has to mark them down to market. Wouldn't be enough in bank to cover its debt. If buy them at $.60, transparent subsidy to bank's shareholders. Told that even if we bought them at $.60, taxpayers might make money because they could go back to $1.00. Original TARP, idea was that the government would buy not just from banks but from the open market from anyone who wanted to sell them; supposedly by buying up just a few hundred million of them you would increase the liquidity and it would somehow help all of these things. Argument was that prices were artificially low. Demand curve was nearly vertical, stir lake a little bit. Can't make $13 trillion worth more by buying up a little of it. Realized that wasn't going to work. Buying stuff from particular banks was a transparent subsidy. Instead bought stock in a bunch of banks to "recapitalize" them. Argument for it was taxpayer needs to get something in return. Banks have lost money, so now they don't have as much capital as they used to have. Can just issue more stock and get more capital. Idea was government would give the banks this stock and everything would be hunky dory. They got the capital, though, and they still don't want to make loans. Can't sell them; and making shaky loans is a bad idea. Problem was not that they had a constraint of capital. Gas in the tanks, but no electricity in the pumps. Claim was that the government would give them electricity; discovered that there was some other reason gas wasn't selling.

55:52 What would have been more effective? Problem we have now is that people are scared. Lack of confidence in the future, innovation is slowing, risk-taking is slowing. We don't have a model for creating confidence. More than confidence: supply and demand and the things that make them go together. One reason people are scared is they don't know what huge program will come down the line. In one auto bailout loan, government wipe out all the loans of the senior creditors. How can bank every do anything again? Citibank more trouble, British banks. Bad banks eventually have to get closed down, but with government as a stock holder that won't happen. Bank of America got TARP injection. Merrill Lynch. Hard for Bank of America to borrow more. Why? All about what the government's going to do with it, not about the business operations. We overly fear bank failure. Economic equivalence of bankruptcy is not so terrible. Risk-free haven: savings and checking accounts. If you invest in a bank we expect you to keep an eye on it. Don't want to live in a world where people who buy bonds and stocks shouldn't have to worry about their risk. We don't want the ATM machines to fail for a week. Economic equivalent of letting them go.