A lot of times we will find people confused a relationship between two events and think that one is causing the other. When in fact all that's happening is that both of them are being driven by some external factor. I give you kind of a silly example. It happens to be the case that more people are bitten by sharks at times when more ice cream is being sold. So, a crazy correlation causation error would be to assume that because those two are related to each other that eating ice cream and then going swimming happens to make you more attractive to sharks. Clearly nonsense, obviously there's some other external factor that's driving both of those, and that very simply is just the heat of the sun. We're out swimming in the sea where sharks are, at times when it's hot we're more likely to eat ice cream at times when it's hot. No one's really going to make that mistake, but we'll see as we go through the entire course there are any number of places. Where people mistake correlation being driven by some other factor, the heat of the sun, the causation eating ice cream makes you attractive to sharks. Here is a great standard example from the financial markets, when equity prices are going up, when the market is doing well, and the S&P is rising. Guess what? Most investors are making money, not that surprising. Most investors are going to make money with their equities. When equity prices in general are going up. But what we tend to do, and what we see happen a lot, is people mistake this correlation between the equity markets going up in general, and therefore my equity investment's going up. People confuse that for causation. And tend to assume that they're smarter with their investments than they actually are, look I'm making money I must be a really smart investor no dude a rising tide floats all boats okay. The equity markets are going up and you own equities Guess what? You're going to make money. Saying it objectively like this in this quiet context it may seem ridiculous to you that people would actually make that mistake. Count on it. People make that mistake even professional traders make that mistake all the time. I want to take us through a slightly more complex example of a slightly different problem. And the reason I want to do this is the example that we're going to go through is specifically one of the key causes of the massive financial down turn in 2008. So being able to deconstruct part of why 2008 happened is in fact a key goal of this class. So lets go through this example and see where we go. In this case, it's not Not going to be a correlation causation error. It's not people thinking that their intelligence is causing their equity portfolio to go up. It's almost the opposite. We're going to look here at an invisible correlation error. We're going to look at a situation where people don't think that outcomes are correlated or related to each other, but it turns out they actually are. So let's start with a quick explanation of how mortgages work. It's not that hard. I want to buy a house. I need to borrow $200,000. So I go to the bank, they lend me $200,000. And for the remaining 30 years of the mortgage, the bank will tell me exactly what dollar amount I need to pay to them every month to cover the interest on the mortgage. And also to reduce the principal on the mortgage so at the end of the 30 years the house is completely mine, I've paid it all off. Quick note by the way and again this is a finance class so lets not forget finance for a moment, in general mortgages don't last 30 years. Why not because most people don't live in the same home for 30 years, they tend to move house so on average. Or if interest rates are coming down, they may find that they can refinance into a mortgage that has a lower interest rate. So actually, on average, mortgages last about ten years. That's just a little detail. Okay, so until, a quick history lesson here on mortgages, until around 2001, the vast majority of mortgages that were issued by banks Went to people. To families that were considered prime borrowers. Prime in finance terms really usually just means good quality. The people who were getting mortgages had proven savings. And they probably had to use some of those savings to put in a down payment on the house. They had proven monthly income. They had a job. And they had a proven credit history, historically the credit card companies got their payments on time. This is not somebody who'd gone five months without making a payment or had been repeatedly overdrawn from their bank Account. Okay, so if I'm making loans, it makes sense to me that I'm going to lend money to people that have a proven quality to make their loan payments on time. And have a proven likelihood of income going forward so they will be able to make their future payments. It's on time. However, actually sorry, before I go there let's also talk about a couple of quick historical situations over the last 40 years or so, 50 years. Up until 2007 It was very, very unusual to see all house prices in general across the US all go down in value together. The last time we really saw that was in the 1930s during the Great Depression. Guess what? Most people who are alive right now, don't actually remember the 1930s. So for all of the banks and other lenders who are making loans, they tended to assume, prior to 2007. That it would never be the case, that all price, house prices, across the entire US would go down together. And this is where our invisible correlation comes into it. So let's see what happened when suddenly banks and savings and loans and other lending companies started to lend to borrowers who are not primed, okay. They started to lend to borrowers who did not have good savings. Who did not have proven income and who did not necessarily have a good credit rating. Now there's a big question about why lenders started doing that in the first place. I don't want to get into a lot of details on that. It's not relevant to what we're talking about., but I will say there was a Political piece to it. In the late nineties some legislation came through Congress that said lenders need to work harder at making loans to slightly lower credit quality people. They wanted to push the idea of the American dream and homeownership for all. But, let's just come back to the finance Of this. Suddenly, from 2001 onwards, a lot more loans were made to people who had lower credit quality. Those people were more likely to default on their loans. They were more likely to miss a mortgage payment in a way that prime borrowers typically don't. On average, prime borrowers if you look over history about 1-2% of prime borrowers in any given year will fail to make their mortgage payments. With sub-prime, borrowers who did not have high credit quality or good income The probability of them missing a loan payment became much higher. Okay, now I am going to explain a product called a mortgage back security. You may also have heard the term CDO. Here's how they work. Let's imagine that we have one mortgage from every single state in the US. Pool all those mortgages together. Every one of those fifty mortgages will be making a certain payment every month. Now, if we pool all of those 100 mortgages together and take the payments each month. And then you sell this product, this mortgage backed security to investors who want to make money from it. So they're paying a dollar amount now, the investors it's as if they're all, all of the investors of this product are pooling their money together to make those loans. And then, for every mortgage as the money comes in each month that money gets passed through to the investors who own this parcel of loans. What the ratings companies did, what the investment banks did and with the help of the rating agencies, was to break up those big pools of mortgages into different credit quality. Let's suppose we assume that only a really, really small number of people are likely to default on their mortgage loans. Those defaults would have gone through to what we call the Tripe B tranche. The that you see here on the graph go from triple a to double a to single a to triple b, and we have pools of mortgages at each of those levels. So the triple b is the lower the more risky and it has five mortgages in it. If any of the mortgages default, the first mortgage that defaults it's the triple B Tranche that's going to miss a payment that month. If five of the fifty mortgages default, the triple B Tranche, the guy who bought that Tranche, won't get any cashflows this month. He knows that he's carrying higher risk than the guys up above him. And if the borrowers don't default, he will actually end up with a better rate of return than the other tranches. It's set up that way, the mortgage bank security is set up so that the lower credit tranches expect to get a higher rate of return, slightly larger cash flows every period. But if there's a difficult they're the ones that miss, Okay. So up five defaults out of 50, up to 10% of Default. The only person that loses out is the Triple B Tranche. If however, a sixth mortgage in that pull defaults. Suddenly the Single A Tranche is going to get a little bit less money this month. And the same again, if we go all the way up to 10 defaults out of 50, both the triple B, and the double A and the Single A have stop getting any payments what so ever. And so on all the way up to the AAA tranche, which has 30 of the 50 mortgages in it. It would need 21 of these mortgages to default before the AAA tranche loses any money. As far as the models were concerned that these investment bankers put together whether or not there would be defaults of that much. All of the model said it was impossible that more that 5 or 10 of those mortgages whatever default. Okay? 2 reasons for that, one. Historically, prime quality mortgages simply did not default that much. They underestimated the extent to which subprime mortgages, mortgages issued to lower credit quality people who didn't have good income. They underestimated the extent to which those mortgages would default. And then, there's another piece to this. If house prices continue to go up and we're in a strong economy, if one of those subprime borrowers all of a sudden can't make his payments on his mortgage anymore. There was an exit opportunity that that borrower had. The exit opportunity was he's go back to the bank and he'd literally swap the old mortgage for a new mortgage. Because if the price of the house was going up, the value of that house more than compensated for moving into a new mortgage. So in that case, even though that particular mortgage borrower was about to default. It wasn't a problem for this mortgage-backed security because he would effectively sell his house at a profit getting yet another mortgage somewhere else. And then, the Triple B tranche investor, would get the big lump sum that comes from that borrower selling his house. That is another piece of these mortgage backed securities, remember that we said earlier that most mortgages don't last 30 years. So if somebody stops making mortgage payments, And they go and sell their house and all of those triple three borrowers are still going to get cash flow. It doesn't count like a default. The only time it counts like a default, is if the borrower doesn't make his mortgage payment and he can't sell his house. And what happened in 2007 was that, actually house prices started going down slightly in around 2006. But by 2007 and late 2007 especially, house prices all across the country. We're going down. Okay? No one had seen that before. We'd never seen house prices all the way from Florida on the East coast to California on the West coast. But all of these house prices started going down. So we've got subprime borrowers who are more likely to default anyway. And if they do run out of money, the option for them to just sell their house and pay off the mortgage. That way is no longer available because suddenly the house that they bought for $200,000 is now only worth $150,000. So if they sell that house, that's $50,000 of that loan that they can't pay off because they don't have the money themselves. The invisible correlation here is the completely unexpected affect that this happened in all 50 states. Remember what I said at the beginning, each one of those 50 mortgages comes from a different state, if California had a house price collapse. The sub prime borrowers in California might have defaulted, but you would think that wouldn't affect the borrower in Florida, his house price is still doing fine. Okay, which again is a reason why you might only expect five at most of these mortgages to default. But no, every single state, for every one of these borrowers, the prices of houses are going down. And they don't have much income, so they're defaulting on their mortgage payments. And selling their house is not going to pay off the loan. That's the hidden correlation, house prices all across the US went down together, and guess what as many as 40 and 50. And even 60% of these sub prime borrowers were defaulting on their loans. And couldn't sell their house for enough to pay off the balance of the loan, and hence the subcrime mortgage crisis.