Introduction to Basic Principles of Finance

Management from Professor Robert Shiller

and

Risk

0:09
Hello. I'm Robert Shiller, a professor at Yale University, and this is Financial Markets, a
course for Coursera Online. Right now, I am at Davenport College, which is one of the
colleges of Yale University.
0:28
This course derives from an earlier course that I had in 2011 on what we called Open
Yale. It had the same title, Financial Markets, but it was a longer course. We've decided to
condense it somewhat and get the key points this time, but expand it in another
direction. That is to add problem sets and exams, so that the experience of someone taking
the course online is much more solid and more similar to the experience that my students
here at Yale have had. But I think that there is a problem that in excerpting it down, we
sometimes found it, that some terms might not have been defined as well as I'd like. For
example, in the sections that we'll follow this week, I, spoke of the, VOC, or Dutch
East India Company, and it wasn't defined. Well I can tell you now, to help that, that the
Dutch East India Company was the first, company in the world, that was traded regularly on
stock market.
1:42
VOC stands for Vereenigde Oost-Indische Compagnie. That's Dutch, and I'm sure I didn't
pronounce that right, but it was just an example that I used to illustrate what finance does
and how wonderful an invention our financial institutions are. When people in Holland in
1602, when that company was first launched, when they discovered that they could
trade the stock every day and watch its price go up and down, it developed a sense of
excitement and possibility in their lives, and it led to the financing of many more
corporations. When I gave these lectures, we were in a period of economic crisis. It's been
called the Great Recession. It was the biggest world recession since the Great Depression
of the 1930s.
2:40
Among the events which triggered the Great Recession was the 2007 sub-prime crisis in
the United States, the 2008 Lehman Brothers crisis, the failure of an investment bank,
Lehman Brothers. And then in 2009 and into 2010 and beyond, the European sovereign
debt crisis which originated in Greece and rapidly spread to Spain, Portugal, Italy, and other
places. These were the crises that launched the Great Recession. And these crises caused
great consternation because the, the Great Recession caused millions of people to lose
their jobs, or lose their homes, and, and, and find that their career prospects were
derailed. And fingers were pointed at the financial community. That's the problem. It
seemed like the financial community was the cause of our most serious problems, but I
found myself thinking, yes, this is a problem, and I don't mean to minimize it. But what
about all of the strength that has developed prec, preceding this crisis. The strength of our
economies. The world is going through an amazing revolution. Ever since Deng Xiaoping in
China or Boris Yeltsin in Russia, we saw the development of financial capitalism all over the
world. That development is real and important, and it has its ups and downs, it has crises,
but those crises are manageable if one understands finance. So, I, I wanted to start with
the first week. My impulse was to plunge into some of the technology at the beginning, and
then leave some of the more
4:41
philosophical eh, forays into it later. So the very first week , I wanted to, get right into, what I
think is the core model underlying finance. It's something that's called the capital asset
pricing model. And this model is the model that helps us understand how risk is spread
and diversified and managed, and it helps us understand the really important concept of
leverage, which tells us how ri, risk can be magnified or reduced in very simple terms. It

also helps us understand our own individual investing decisions. What does it mean to
invest well?
5:30
How important is diversification? And what does it mean really to diversify anyway?
5:38
I wanted to start with the capital asset pricing model. Maybe that sounds formidable. But
maybe it should be because it is real and important technology. And that's what we're going
to do at the beginning.
5:52
Then I'm going to talk about, in, also in this first week, I'm going to talk about insurance.
6:00
Insurance is sometimes considered a separate field outside of finance, but I, I think it has to
be integrated in with finance because it deals with the same issues. It's a somewhat
different tradition, and a somewhat different jargon, but it deals with the same issues of
managing risks and allowing people and organizations to get on with their goals effectively.
6:26
Now in, we have an outside speaker in the first week. That is Hank Maurice Greenberg,
who was for better part of a half century the leader, or CEO, of the biggest insurance
company in the world, AIG, American International Group. This company, unfortunately,
took a hit, in the recent financial crisis after 2008. And that was after Hank Greenberg had
left. The company was a spectacular success before the financial crisis and on until
Greenberg left. After the crisis, it rapidly fell apart, and in fact, the United States
government decided to bail out the company to keep it going with bailouts that set a
record. The government committed $182 billion to bail out AIG.
7:29
I felt a little diffident about inviting Hank Greenberg to come and talk to my class of
undergraduates because I thought, i, it's a difficult time for him. The company that he'd
spent a lifetime building up had gone through a terrible turmoil. But he agreed to do this,
and he spoke quite candidly about what happened in, in his life. It's a little bit
technical. Some of you again, you might find that he uses jargony terms, from finance that
are not explained. But I think that you'll get the general picture, from Hank Greenberg, and
it's a picture of both institutions and technology and people. And it highlights, for me, the
really essential drama that underlies finance.
8:24
Hank Greenburg was a man with big and important vision. He was driving a company that
was setting new standards for its breadth of risk management, of risks that impinge on
people's lives. But du, driving such a big company is like, like a ship. It could be either the
Titanic or it could be a successful voyage. Nobody knows in advance.
8:48
And so, it, it left him with some life's adventure. I think you'll detect a little bit of sadness in
his voice because he'd built such a great enterprise, which went through such terrible
problems. It's reemerging, and that's the hopeful sign.
9:04
But I, but I, I just want to conclude this little introduction to this week with the thought that
9:13
maybe I'm repeating myself a bit, but finance is a very important technology. It has a
mathematical basis. It has a intellectual underpinning that makes it a infrastructure for our,
our whole economy. And I want this course to help people understand this technology so
that they, they are not buffeted by it, so they can react to the technology and
its opportunities constructively in whatever walk of life they choose.

Portfolio Diversification and Supporting Financial Institutions I

0:00
I want 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, the core theory which is the capital asset pricing model in finance.
0:23
First concept I wanted to talk about, is leverage.
0:30
Well and also let me add the equity premium. These are the two main concepts.
0:42
Maybe I'll do equity premium first.
0:45
Here's the conundrum that people were presented with, and I'll, I'll keep, I'll stay in the VOC
story but it's much more general than that. VOC, after a few years out, people thought you
know, this this company is amazing. It's just growing so fast. It's making so much money.
1:03
It might have a really high return like unbelievably high. Like 20% a year or even more but
look, lets say, 20% a year and that's what generated the excitement.
1:16
If it, if some people have wondered how can it be? Maybe, it's earned 20%. But how can it,
consistently, do that? so, let me put puzzle.
1:36
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. I,
because you know, if, if you can make a, a higher return on some investment. Wouldn't you
think that enough people would flock into the investment so that it no longer You know,
there's too many people trying to do this, so it's no longer performing so well.
2:07
But, in fact,
2:13
It seems like the, the average return on stocks has been very high. This is a theme in
Jeremy Segal's book Stocks for the Long Run, which I have on the on the reading list.
2:32
Segal has data doesn't go back to 1602, but it goes back to the 19th century, and he says
that the geometric average return average 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 add a 3 or 4% inflation rate that's 10% a year That, let's compare that,
with, short-term governments which are the safest thing in the United States. The average
rate of return on them was only 2.8% a year, okay, so the difference is 4% a year. So, for,
well for a 100 years in the United States, stocks performed extremely well.
3:35
moreover, he points out that there was no 30-year period since 1831 to 1861 when bond
when
3:47
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? Think, if people learn,
they would all want to do the good thing. Why does anyone invest in something else? That
was, that was the That was the puzzle here.

4:12
It's not just a United States phenomenon.
4:17
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 of around the world.
4:35
And they found that all of the countries, and that this is looking over much of the 20th
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%. So, that's an interesting question. How can it be that some asset, namely stocks,
outperform all other assets?
5:12
Okay. So then that comes up then through what is the standard answer? Why is it? The
standard answer is 'risk'. Stocks are riskier, the price jumps up and down from day to day
So you have
5:34
you have a the the extra return is a risk premium. And so that is what I want to pursue
today in this lecture. Does that explain the equity premium And how should we think about
the the equity premium.
5:56
So what
6:00
I'm going to do is feature the the theory that was originally invented by Harry Markowitz
6:12
When he was a graduate student at the University of Chicago. And as a, or maybe it was
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.
6:36
It gets back at this core idea you know people looking at going back to the days of the
VLC. People had the idea you know I think stocks are the best investment.
6:52
OK I'm writing that down and I'm putting it in quotation marks because its not a term that I
would use. What is the best investment? Well they say that look the VLC is just returning
tremendous amounts.
7:07
it, 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
7:20
so what Markowitz, I, I went back and read his Journal of Finance article in 52. It's kind of
remarkable to me that what he was talking about wasn't known yet in 1952. He, he was
getting at this core idea of what's the best investment.
7:41
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.
7:59
so, let me,

8:04
question is.
8:07
Well, I, I've kind of paraphrased what Marowitz said.
8:12
Let's imagine that you got a job as a porfolio manager, okay? And you're kind of
mathematically inclined. And you know numbers and statistics. And you know how to
compute standard deviations and variances.
8:25
Things like that. So, what is the first thing you do? You're a numbers person, okay, you're a
math person, but imagine you've been in trusted 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, okay, and you're thinking alright what should I do. Well I, I want to collect data on
every possible investment I could make. Not just stocks and bonds. But real estate, and
commodities, whatever, okay? And I can for each of these, I can compute what the average
return was on those investments, okay? And I can compute the variance. And I can
compute the co-variance and the correlation, right?
9:08
So Markowitz, do, do you see, so 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, right. I, 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, let's step back. Let's do it basic. Let's just think, like a
Mathematician here, alright. Let's just take, as given, all the historical average returns and
variances and co-variances. Well Markowitz says, what's the best portfolio, given that,
okay? I can compute all these numbers, what's the best assembly of all these things.
9:50
And you know, he realized that nobody had ever thought that. Isn't that a well-defined
problem? I give you all the variants, I give you all the co-variants, I give you average
returns and I say, let's just assume that this is going to continue like this. What should I do,
as an investor?
10:09
And, it's funny Markowitz said, he was reminiscing, he won the Nobel Prize later,
and deservedly I think. This was a breakthrough idea. But he said as a graduate student,
he was chatting with someone in the hallway and thinking about this. He said, it suddenly
hit me as an epiphany. If I have the statistics, I ought to be able to compute the optimal
portfolio. It's, it's, it's mathematical, right? It's just one thing. I mean, what is the optimal
portfolio? It took them like two or three days to figure the whole thing out. And, I, you know,
it's almost like I could, haven't I set up in your mind? Do you see the problem? You cold
figure this out too, you put you ingenuity on to it, the funny thing is, nobody thought about it
before Markowitz.
10:59
So let's think about that, you see the concept I have, you all the variances, this isn't a
judgement thing, you know all the co-variants that, what should I do? Well the first thing I
want to talk about Is the very simple case of pure leverage.
11:16
Let's go back to 1602, okay, and there's only one stock, and that's VOC, okay.
11:26
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, risk-less 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 V.O.C., V.O.C. 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. And we'll call the riskless rate R sub F. Okay. And let's
say that's 5% a year, okay. 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, I can also borrow
at the interest rate.
12:16
There's a market rate and I can, I can borrow at 5%. You know, in practice, I would
probably have to pay a little bit more
12:23
as a borrower than I could get as an investor, but let's assume that away. This is 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. Okay. And let's say VOC, the Dutch East India Company, has
had a historic average return of 20%. This is a spectacular investment, all right?
12:55
But let's say it's, so that's its mean, this mu, the mean of the investment. But let's say, it's
really risky, so the standard deviation is 40%. Alright?
13:12
So what can I do? Suppose I have only, this is, let's do the simple problem first, okay. I
have only one asset, VOC, and I have riskless death.
13:25
So one thing I can do is, I'm going to draw a chart here showing okay. okay, I'm going to to
sigma on this axis and r on this axis. So sigma is the standard deviation. Of my portfolio.
13:51
Okay, and r is the expected return on the portfolio.
14:01
Okay?
14:02
Now I, I, and I can, all I'm going to do is choose mixtures. Of the stock and the risk-less
rate.
14:10
So a couple of points I can, I'm going to plot what the available options are. I, I can, I can
see right here that I can invest at 5%, right, the risk-less rate, and then I'll have no risk. So
do you see this? This is r sub F.
14:30
This is 0. Okay? And these are positive numbers. See what I've plotted here? This is 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 the VOC.
14:51
Alright is this big enough for you to see back there? OK so VOC is up here and is 20 this is
a risk of a 40
15:07
And a standard deviation of 20. Okay, so an expected return of 20 and a risk of 40, right?
15:16
So those are two points. But I can do other things too.
15:21
What if I borrowed money to buy Let's say I have a hundred guilder. I'm talking Dutch,
okay. That wasn't the currency of the time. The guilder. I'll write it for you.

15:33
Guilder.
15:38
okay. So I have a hundred guilders to invest. I can put it all in VOC stock.
15:44
And I will get I would expect to get twenty guilders profit. And I'd have a standard deviation
of 40 guilders, right?
15:53
But what if I say, I'm going to actually borrow another 100 guilders. I only own 100 guilders,
and I'm going to borrow another 100 guilders and put it in VOC stock. So that means I own
200 guilders of VOC stock.
16:09
And I'm going to have a debt of 100 guilder. So what, what, what's my expected return
then? Well, my expected return is going to be 35%. Because look, I, I've got, 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 5 guilders to my lender, so it 35 is
what I've got, and as a percentage of my initial investment, that's 35%. So I've got another
point out here. With this is 35, and down here is 80 See my standard deviation is 80
guilders now, right. because I have $200. And the standard deviation was 40%, alright.
17:04
So this is, here I am two for one. Two for one leverage. I have $100 But I've, I've I've put
$200 in the stock. Okay, and it's easy to do. You know, you could do this in 1602. so, you
know,
17:26
you can see how I knew it. I, obviously I can, I can, this is a straight line here.
17:32
I could do anything along this straight line.
17:38
And like, here would be putting half of my money in the riskless asset and half into
VOC. This would be putting 1.5, 150 guilders into VOC and borrowing 50 guilders. You see,
I could go out any, as far as I want.
17:59
Then there's another branch to this. What if I short 200, 200 guilders of, of VOC stock?
Okay, so I go to the broker, and I say, I want to sell guild, I want to sell VOC stock. I don't
own any. And the broker would say, alright, fine, I'll lend you some shares and then
18:22
you can sell them and then, but you owe me the shares, alright? So then I have minus 200
guilders worth of VOC stock. So what is my expected return then? Oh, 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, okay? So, what do
I get? I expect to lose 40 guilders, because i got $200, 200 guilders of the stock.
18:52
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'll, I'll get 15 guilders. So the expected return is
15 minus 40, or minus 25. So that's this point down here.
19:13
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.

19:32
And I'll, I, I can do that.
19:39
So, so here's where you got, saying, what is the optimal portfolio anyway? I can get any
return I want. You know, that 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 100% return can get it. I'm just going to leverage. So, so that, so this is
what. 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. Well, 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 if we have to think
about the best trade-off. And in this case, I've shown the trade-off here. It's this, this is what
you can get. And any one of those points is available. And so anyone who Who wants to
invest with you has to choose between risk and return. There's no optimal portfolio in
that, in a fundamental sense. It's a matter of an optimal trade-off. And you know, nobody
knew that before 1952. So
21:06
let me just show you formally this. What I just did on the blackboard.
21:11
That, that you can say, we're going to put. I, I've switched to dollars from Guilders. Now
we're in the, in, in USA and so put dollars in a risky asset. X dollars in a risky asset. 1 minus
x dollars in the riskless assa, asset. The, the expected value of the return on the portfolio is
r is equals to x r1 plus 1 minus x times rf. Alright? It's linear. That's because that's how
expected values work.
21:41
The variance is x squared times the variance of the return.
21:48
And so if want to write portfolio standard deviation as a function of, of the expected return I
solve for x. Taking this equation for x. Solve for x in terms of r. So x equals r minus rf all
over r1 minus rf. And then I substitute that in to this equation. Well, I want to take, I want to
do it, take the square root of it. Because this is sigma squared and so I've got sigma equals
r minus rf times r1 minus rf. Well actually I have these absolute value marks. So I always
take the 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.

Portfolio Diversification and Supporting Financial Institutions II

0:00
Now, I want to move to another example, which is too risky assets.
0:07
Now there's, when we move 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 x1 in the first risky asset
that's stock number one and I can put 1 minus x1 in the second risky asset. That's stock
number two. Okay, so what, what do I get here?
0:35
The expected, the, the portfolio expected return is just the linear combination of the two
expected returns. So r1 is the expected return on the first stock, and r2 is the expected
return on the second stock. And it, you just, or actually, I'm assuming, I'm assuming you
have $1 to invest in this example. And so I was assuming you had 100 gilders over
there. Now, I've just made it $1. Unrealistically small amount. But I just wanted a nice, a
nice number, okay? So you, let's say $1 is 100 gilders and then I haven't changed

anything. Okay, so so I have one, see, I start out with $1, so if I put x1 dollars in the first
one, I have 1 minus x1 left for the other one, so it's very simple. And this is the, the formula
for the variance of the portfolio, which we saw
1:31
essentially we saw that in the second lecture.
1:36
So what I can do is go through the same sort of exercise I did there with two risky
assets. Alright, and so I, what I want to do is draw a, a curve, something like this, but I'll, I'll
solve for x1 in terms of r just like I did for the riskless asset and I'll plug it into the equation
for the variance.
2:02
I'll have to take the square root of that and I can plot that, okay.
2:08
And, you might think it would look something like that. Well, its not going to look exactly like
that because it's risky. Something's risky. Well I did that, in the calcu, and, and see that
in your problem set you're going to have to think about issues like this.
2:23
But what I did is I took data on the average return for the US stock market as measured by
the S&P 500. And the variance.
2:35
And then the alternative investment I took was ten year treasuries for the United States
government.
2:41
Long term because they're ten 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.
2:55
And I computed the relationship between the standard deviation of the portfolio and the
standard deviation and the expected return, just as I showed you
3:10
again using data from 1983 to 2006. And
3:16
it kind of looks like this curve, doesn't it, except this is a degenerate problem, but it's, since
it, it looks like this, right?
3:30
I said parabola, I said it wrong. Hyperbola. You know how hyperbola, you remember this
from math? Hyperbolas, well, they look like that, and they approach asymptotes.
3:45
Which are straight lines.
3:48
So here is here is the hyperbola for stocks and bonds. Though, just as I had a point here
which represented a 100% VOC, I can have over here a point which represents 100% US
stocks, okay? 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, okay? And I can see that
this is the choice set that, that I as an investor have between stocks and bonds.
4:30
so, is that clear? Or, is there any, so again there's no, you see that all these are different
portfolios. If, if you're going to do just stocks and bonds and nothing else what you choose

to do depends on your taste. And your risk tolerance. I could go 100% stocks, but I'm going
to have a lot of risk, I'm going to have, 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.
5:13
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 this? First of all, you learn, there isn't any single,
optimal portfolio,
5:26
but there is something. Let, let's talk about being 100% bond investor. What do you think of
that? Is that a good idea? You'd get this point right here.
5:40
Well, right, you definitely should not be 100% bond investor. That's one thing we just
learned. Why is that? Because, if I go up here, I have no more. See that's the same
standard deviation, the same risk but I have a higher return. Right, higher expected return.
6:03
So what have we just learned? We learned that if we 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 a 100% bond investor, okay? 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 a 100% bond invested, believe it or not. They couldn't figure it out in those
days. The 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 and these these, simple mathematical curiosities like hyperbolas are just
fascinating to me.
7:14
It goes back to, Apollonius of Perga, writing in around 200 B.C., 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, 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
section, you know, ended up applied to astronomy by Kepler and Newton. And now it hits
into finance. Isn't in amazing how there's a unity of thought? And, and this simple diagram
has just taught us something about investing that's not obvious, not obvious until you think
about, I've just told you, never invest only in bonds. But it doesn't tell you how much stocks
and how much bonds to, once you, you know, once you're above the, once you're above
this point, it seems to be a matter of taste. There isn't any, any single decision that you can
make. So, now
8:31
I want to move to a more complicated world, where we have three assets, okay? We're,
we're doing, we're starting from. We had one risky asset. Now, then we had two. Now let's
go even further. Let's say three risky assets. Well, the the expected return is the same. It's
the weighted average. Now, now we have three weights, x1, x2, and x3. And they have to
sum to $1. I could, I could have written x3 as 1 minus x1 minus x2, but 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 x1 squared times the variance of the return on the first risky asset plus x2
squared times the variance of the return on the second risky asset. Plus x3 square 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 asset

because if they move together they, if they all go in the same direction at the same time,
that's going to make your portfolio riskier.
9:42
And, and so that's the portfolio variance, and the portfolio expected return is just, why didn't
I write it there, it's x1 r1 plus x2 r2 plus x3 r3, where the sum of the x's is one, $1. So it's
something that you can do to calculate.
10:02
What is the optimal portfolio. So, I've decided to add a third asset to my diagram. The, the
pink line up here is the same I would call that an efficient portfolio frontier. I've, 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 stocks. Three assets, stocks, bonds, and oil. Oil is an
important investment, because it's it, our economy runs on it. And the total value of oil in
the ground is, is comparable to the value of the stock markets of the world. So, it's big and
important, so let's put that in.
10:54
And what, what I have actually here is the minimum, the minimum variance mixture
11:01
for any given return. Expected return for the three assets.
11:08
And you can see that it's possible when you add a third asset, oil, to bring the efficient
portfolio frontier to the left. Okay? 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, we're, we're
putting more eggs in our basket, okay? And and so then we are,
11:45
we have a better, a better, a better choice set now. We can pick any point on that blue line.
11:54
And so we shouldn't just have stocks and bonds. We've learned we should have stocks,
bonds, and oil.
12:01
We're, we're leaning, 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, for any given
expected return. And so the better off you are, so this is diversification. So while
diversification was applauded in the 19th century, no one had ever done the math like this
before. And now we can see that that you, 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, there's a
emotional resistance to this implication.
12:50
So I have shown here three assets. The, 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
can say, what portfolio would guaran, would give me 9% return with the least risk? Well,
turns out it's a 100% bonds. But I just told you, never do 100% bonds. because you can go
up to this point.
13:20
Alright. So you never go 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.

13:43
But that's not necessarily the best thing, because people allow some risk. This is having the
minimum risk. So, I can get my return up much higher without taking much risk. So I'd
probably do that.
13:55
Okay. 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 ad 1952 here, Marcowitz had to do
it all by hand. But now that we have computers, it's so easy, you know there 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.
14:23
But what I want to do now, is add the riskless asset. So what we've done with the blue line
takes three risky assets. It looks at 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 one-year
governments. 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
15:06
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, I can compute just how leverage allows me to
combine that with the riskless asset, and that portfolio.
15:34
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 on it. I maybe should have 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 form, 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.
16:31
So what do I want to do if I have, I want to get the highest expected return for any standard
deviation? I want to take a line that goes through 5% on the, on the y-axis, and is as high
as possible. So I'm taking a point.
16:49
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.
17:04
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 taking what does it look like? I don't have it
indicated. Probably something like 11% oil, 30% stocks, 50% something like that, it doesn't
add up and that would be holding no debt, right?
17:44
But I could, I could get even higher return, 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.
17:58
Now, what, what Markowitz theory shows is that.
18:06

Once you add the risky asset, the relevant efficient portfolio frontier is now really this
tangency line, and so I want to do a mixtures of the riskless asset and the tangency
portfolio
18:22
that, that. The cards with my risk preferences, but I don't, I don't want to ever just move to
one of these other portfolios, because these other portfolios, like 15% oil, 53% stock, 32%
bond is dominating, has a higher expected return for the same risk. By a portfolio of the
tangency portfolio leveraged up a little bit by borrowing.
18:50
And similarly, well yeah, and so this is, and then it comes out and this is the I don't know if it
was marked clear in Markowitz's paper but it became clear soon after. There really is, in a
sense, an optimal portfolio.
19:08
It's the tangency portfolio. Because everyone wants to invest at, on this line. And, and that
point is a, 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 and, which it's in a sense, that everybody wants to do the same risky
investments.
19:42
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, of the
risky portfolio, 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.
20:31
First of all, I have to just define for you, what is a mutual fund. You might not know that. A
mutual fund is a certain kind of investment company aimed at a retail audience.
20:44
They could have just called this the investment company theorem but history, I can't tell you
the history of thought on this. It's it's
20:57
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, it's just one class of investors
all of, they're all equal. So it's mutual. But that's irrelevant because the idea is that all
we need is one mutual fund, there's thousands of mutual funds.
21:22
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, and our fund is the optimal mix
of, 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,
21:48
mixtures of that mutual fund and the riskless asset. So everyone holds, you only need one
investment company. See, this is the other, I, 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. And I haven't gone through all the
math details. There is a best thing to do.
22:13
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 Marcowitz theory, and all the investors in the
world will just invest in this one. And that's case closed. We don't need thousands of mutual

funds, under the assumptions of Marcowitz, which is that we're, we're agreed on the
variances and co-variances and expected returns. There's a single optimal, risky
portfolio. And then the instructions to investors are very simple.
22:55
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, two to one, three to one, it's up to your
tastes. But you don't need to look at anything other than the mutual fund.
23:22
So that, that's an important insight.
23:27
And what it means, then, is, that leads to something else. So Markowitz didn't get this
idea. It came out later. But somebody was thinking, well, if everyone should be investing in
the same portfolio, it doesn't add up unless that is equal, that portfolio, is equal to the total
assets out there in the world, right?
23:51
If, if the if, if there's twice as much oil as there is stock then there has to be twice as much
oil as stock in the, in the tangency portfolio, otherwise it doesn't add up, right? because
everyone has to own everything. It's supply and demand have to equal. So, it means the
mutual fund theory implies that the market portfolio equals the tangency portfolio.
24:28
Okay, and now I've, I've pretty much finished the theory. All right, I should say it implies, if
investors
24:41
follow this model that we're having, that they all want to the Markowitz 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.
24:54
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?
25:08
How does it add up, right? If, if VOC stock is just better than something else. Then, that,
that suggests everyone wants to put all their money in VOC stock. But we're realizing they
don't. Because they're concerned about, they, they see this tradeoff 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.
25:36
And more generally, if there are many assets, all the assets have to end up owned by
someone. And so, the, the, the cardinal implication of this theory is that the, the market
portfolio, which is everything that's out there in the world to invest in, has to be proportional
to the tangency portfolio.
25:56
And so, one of the implications is if that's true and I'm done with, I have a couple more
slides here.
26:06
And we go to here. The capital asset, now it's called the capital asset pricing model in
finance. So that's capital
26:19

asset, which was, pricing model, which was not invented by Markowitz. But was invented
by Sharpe and Lintner
26:37
and 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 ith asset, equals
the risk free rate plus the beta of that asset times the difference between the expected
return on the market, and the expected return on the riskless asset.
27:04
I was just going to try to explain this intuitively. And then I'll, I'll be done. Alright, one more
slide about this Sharp ratio.
27:12
But the intuitive idea. Let me just say, everything should have a very simple
explanation. The intuitive idea is this.
27:20
The, starting from Markowitz, we got an understanding of what risk is. And people didn't
clearly appreciate that. People used to think that risk was uncertainty, right, in, in finance. If,
if a stock has a lot of uncertainty, that uncertainty means that it is a dangerous stock, and
people will demand a high expected return. Otherwise they won't hold the stock. But the
CAPM says, no. People don't care about the uncertainty of a 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. But what is
it that people care about? People care about covariance. Risk, this is 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 if, I could, I could 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 whole, 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 it's risk. So that's measured by
beta. The beta is the regression, the slope coefficient when you, you regress the return on
the ith asset on the return on the market. So high beta stocks are stocks that go with the
market. That we found out that Apple has a beta of 1.5 or roughly that, that means they
respond in an exaggerated way. It's not one, it's greater than one. They more than move
with the market. And so, investors will demand a higher return on Apple stock, because its
beta is greater than for other stocks. That's the core idea that underlies it. You see that
intuitively? So you have to change your idea of what risk is. Risk is covariance. It's co
movements in that I have just one more slide here. Its named after William Sharpe who is
the inventor of the, with Lintner, of the capital asset pricing model. The Sharp ratio is for
any portfolio. The average return on the portfolio minus the risk-free rate divided by the
standard deviation of the portfolio.
29:54
And if you take the CAPM model, the, the Sharpe ratio is constant along the tangency line.
30:04
This is a way of correcting, the ex, 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, that's the first thing you should learn from this course. Someone
advertises that they had 15% return, you say hah, I want to know what your leverage was. I
want to know, really, you know, how to, 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, so how do
you correct for leverage? You might say. Well I want to look at what fraction of the investor,
company investment portfolio is in the risky asset, and what fraction is in the risk-less
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,
31:20
well, I'm going to look at the standard deviation of the portfolio. That's evidence of how
leveraged this guy was. And I'll compute the Sharpe ratio and unless it's bigger than the
Sharpe ratio for the, you know, the typical stock, I, I don't, I'm not impressed.
31:37
anyway, so, I think I've come to an end in this lec, so what you should have gotten from this
lecture is a concept of risk return tradeoff. A concept of 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 management that comes out of
it.

Insurance and Risk Management

0:00
So what I want to start today is talking about insurance starting with the concept of
insurance, of, and then I want to reiterate a theme of this course that financial institutions
are inventions. There are structures that someone had to design and made work
right. Sometimes they don't work right. Then I wanted to move to an particular example of
insurance
0:32
which was until recently, the biggest insurance company in the world called the American
International Group, or AIG.
0:43
And it's particularly important that, 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. So,
1:12
the fundamental concept again is risk pooling.
1:19
the, the idea of insurance goes back to ancient Rome,
1:25
but only in very limited forms.
1:28
But the idea of risk pooling is, is is kind of an obvious one. People form organizations
probably to risk pool.
1:40
So in ancient Rome, a form, a common form of insurance was death insurance that would
pay funeral bills. And people in the ancient world believed that, you had to get a proper
burial or your soul would wander forever.
1:55
not, so insurance salespeople associated with guilds, or business organizations would sell
funeral insurance.
2:06

But they didn't have a very clear idea of the risk pooling concept, it must have under,
underlain their thinking.
2:15
But it wasn't until much later that people began to understand the concept. There were,
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 and translated into English. But it was hardly recognizable to
me as an insurance concept, contract. It didn't have the concepts down. It seemed to have
a lot of religious language in it.
2:52
Which normally, we don't think of as something that's part of an insurance contract.
2:57
But it, it seemed like insurance came in, in the 1600s, at the same time that certain
concepts of mathematics were began to be developed.
3:08
Notably the concept of probability became more widely known in the, in the
1600s. According to one historian, the oldest known description of the insurance concept
goes to a, 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, 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 the 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 for the sum that would be collected in that time. Okay. 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 it didn't, it 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 a statement, approximate statement of the law of large numbers. I'm thinking
of Aristotle, the philosopher. He wrote in 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 a dice a thousand times and come up with a same
number every time. Now we have a probability theory about it. So, we know that if you have
n events,
5:39
each occurrent with the probability of P, then the average proportion out of the, the, the n
events, that are, that are, that occur, oh I'm sorry, yeah, n trials, an event occurring with
probability P. And the standard deviation of this proportion of events that occur is P times 1
minus P all over n to the 1/2 power. And that's the theorem from probability theory.
6:16
The standard deviation of the proportion of trials for which the event occurred, assuming
independence,
6:26
is given by this.
6:30
And so you note that it goes down with n, as n entries as it goes down, I should say, the
square root of n.
6:38

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.
6:58
But making insurance work as a as a
7:06
as a institution to actually protect people against risk is, is,
7:13
is rather difficult to achieve.
7:17
And that's because it has to, things have to be done right. So, let me, let me just remind
you. What are the basic types of insurance? This is what Fabozzi talks about. There's life
insurance that ensures people against early death. Of course you still die. What it really
insures is your family against the loss of a breadwinner, the father or the mother. So you,
life insurance is suitably given to families, especially with young children, to protect the
children, was very important. 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.
7:57
Another example is health insurance. This is insurance, of course, that you get sick and
you need medical care.
8:06
Then there's property and casualty insurance insuring your house or your car. And then
there's other kinds of you might call investment oriented products like annuities. This is a
table in your textbook by Fabozzi, which lists these categories of insurance.
8:28
But but any of these insurance types are inventions and I want to,
8:40
specify that. We have the idea that an insurance company could be set up that would, say,
insure houses against fires. And we, 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. So it's
like, you know, 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 moral,
that, that insurance companies reach is moral hazard. Something rubbing when I.
9:33
Okay, I'll try not to. What's doing this? It's this one. Oh okay.
9:43
Moral hazard is a expression that appeared in the 19th century to refer to the effects of
insurance on people's behavior that are undesirable.
9:55
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 give, to support your family.
10:12
These are undesirable outcomes.
10:16
And they, 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.

10:24
So what they do in an insurance contract is they exclude the risks that are particularly
vulnerable to moral hazard.
10:34
And so that means they
10:38
you would exclude certain causes of death that, that might look like suicide.
10:47
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, 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, no point in
burning it down, 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.
11:30
That occurs when, chalk keeps breaking. Selection bias occurs when the people who sign
up for your contract know that they are higher risk. And so that they then want to what, for
example, health. People who know they are, have a terminal disease and are about to die,
they'll all come signing up for your life insurance contract.
11:59
That will put immense cost on the insurance company. And if they don't control the
selection bias, they will, they will have to charge very high premiums.
12:08
And then that will force other people who don't know they're going to die out of the
business, so, so out of buying insurance. And so that's a fundamental problem. But 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, that people wouldn't be able to predict about themselves.
12:42
okay. Another aspect of insurance is that you have to have definitions of the, very specific,
precise definitions of the loss, and what constitutes proof of the insured loss.
12:58
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. That's a constant challenge for the insurance industry. Then we
need, third, we need a mathematical model of, of risk pooling. Well, I just wrote one down
here, but it might be more complicated in some circumstances. This is assuming
independence. And that's
13:29
if you don't assume independence, you can do you can make more complicated models.
13:36
Then third, then fourth, you need a collection of statistics on risks and, to evaluate and you
need to evaluate the quality of those 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
that. It began in the 1600s because people were building an insurance industry and they
needed to know those things.
14:04
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, our handling of moral hazard or
selection bias wasn't right.
14:25
Some insurance companies are mutual, rather than shared. The, the insurance is run for
the benefit of the policy holders and they're, and they're, 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.
14:45
Then you need a government designed 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
15:24
that have inhibited
15:29
making insurance work. I want to give you an, an example. Let me start, and adding it
makes it more concrete. If we start out with talking about a particular example, and I said I
was going to talk about AIG.
15:45
It's a very important example, not only because it was the biggest insurance company, it
was also the biggest bailout in the entire, sub prime financial crisis we've seen now.
15:58
So, AIG, it's an interesting story. It was founded in 1919 in Shanghai. And you why,
wonder why it's 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
Van der Starr. It 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, it had constituencies representing many
different countries.
16:54
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 the you know what HSBC means? They haven't, they don't
emphasize that any more. It's Hong Kong and Shanghai Bank Corporation.
17:14
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
China.
17:32
And then it became a kind of a Chinese investment company in the United States.
17:40
Cornelius Van der Starr ran the company from 1919 until he died in 1968. So he was
CEO for 49 years, a half century. And then when he, 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.
18:26

Since 2005, Greenberg is is has been succeeded by three CEOs. The usual thing the
usual company has, turns over CEOs. The real problem occurred with AIG after
Greenberg left. So Greenberg left in 2005 and then the company absolutely blew up, and
absolutely had to be bailed out. And the reason they had to be bailed out was, it was
primarily due, almost entirely due to, and a failure of the independence assumption, I would
say, that underlay their risk modeling.
19:15
Namely, they, the company became exposed to real estate risk.
19:21
And the idea that their risk models had was that it doesn't matter that we take on risks that
home prices might fall. Because they can never fall everywhere.
19:34
They can fall in one city, but it won't matter to us. That's just one city, and it all averages
out.
19:41
But what actually happened after Greenberg left was the company took huge exposures
towards real estate risk. And it, it fell everywhere. Home prices fell everywhere. Just exactly
what they thought couldn't happen.
19:58
So the the company was writing credit default swaps, which are, I told, 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 US federal government was 182 billion.
20:53
That 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 anytime.
21:08
So a lot of people are angry about this.
21:15
You know, part of this bailout came from what we call TARP.
21:23
This is the Troubled Asset Relief Program which was created under the Bush
administration, and it was a proposal of Treasury Secretary Henry Paulson. And it was
initially run by Paulson.
21:39
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.
21:51
So why did they do that?
21:55
Why did the government bail out this insurance company?
21:59
The, the main reason why they did so was their concern about systemic risk.
22:11

It wasn't I'll come back to other kinds of bailouts of insurance companies, but the problem
was that AIG, if it went under, all kinds of things would go wrong. All kinds of things would
go wrong.
22:28
All these insurance policies that it wrote on people's casualties. Their, their their travel
insurance, their
22:38
any of these policies would all now be subject to, to failure. Because people who have
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.
23:10
If AIG failed, anybody who had any business with AIG would be starting to wonder, what's
going to mean, what's this going to mean to me? AIG owes me money or what's going to
happen.
23:25
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. He got sort of a blank check from
Congress because the, the story was told. Paulson told the story that if we don't do this, if
we let a company, he didn't say AIG, he was, 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. And so, nobody liked to hear that, but they believed him. And
they didn't know what else to do, and so they allowed they allowed the TARP money, and
they allowed the Federal Reserve and to, to bail out this company.

Guest Speaker - Maurice "Hank" Greenberg

0:00
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.
0:11
It's starts when you landed on D-Day, right? On Omaha beach, that's amazing at age
17? 18? >> Little over 18 then. >> And, and, this goes way, and then liberated participated
in the liberation of Dachau after War, at the end of World War Two. And then, not to be
stopped, was involved in the Korean War as well. And then took over a insurance company
and made it into the most important insurance company in the world.
0:50
And experienced a number of vicissitudes connected with that as well. So I, I was asking
Mr. Greenberger. He would talk about what he did, how he made this enormous success,
what kind of. We're
1:13
interested in finance here, so it's something about how it was financed, but that as we've
been emphasizing in this course, it's more than just. Mathematical countdown 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 for so many years. I'll turn over

to you. And then we'll have we'll stop at around ten. And then we have time for a few
questions from you.
1:52
>> The credit default swap originally, originally was created so that if a, a security and in
this case CDOs 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
credit, before a CDS, credit default swap, would respond to that instrument that defaulted.
Some place along the line that was changed so that you didn't have to, the instrument
didn't have to default. It simply had to be, lose value. And you had to put up collateral, the
ones who issued the credit default swap had to put up collateral equal to what the loss of
value, even though it wasn't realized, what the CDO and lost in value. That change had a
ma, had a majo played a major role in what happened in the recession that we'd just been
going, 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 became a
very
3:26
important issue as to the ultimate demise of several companies including the problems that
AIG ran into.
3:36
They were called on for billions and billions of dollars of collateral.
3:42
Which ultimately, I don't care how big you are, you run out of cash.
3:46
Which they did.
3:50
One of the problems was in trying to determine what is the value of a CDO. Since there
was no there was no price discovery, because there was no exchange in which we traded
the CDOs on. That was strangely enough during the Clinton administration. The Treasury
Department then run by Bob Rubin turned down the, the question of having an exchange.
And regulating credit default swaps. So you had a, a situation where every broker-dealer
had a different price for a CDO. So what was the, you know, 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 CDO's 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 out for more and more collateral, they ran out of cash.
5:04
Now, the insurance companies were all very, very solvent. They had, state-regulated, you
can't just take their capital for something else. They were protected, all the policy holders
were protected under the fact that there were state law and not federal law not governed
the the insurance companies but AIG ran into difficulties. I was not in the company. I
wouldn't have. I would of handled it much differently had I been there.
5:37
I would not have responded to the call for a collateral when you couldn't tell what the price
discovery really was.
5:46
We said you know and one other thing AIG was a triple A rated company when I was
there. The day I left the company, it lost it's triple A rating. So if you, if you were triple A
rated you did not have to post collateral, if you were not triple A rated you had to post
collateral.
6:10
So,

6:12
AIG ran out of cash. They turned to the, they turned to the Fed for for help. You've got to
remember this is now at a time when Bear Stearns first got in trouble and they found a they
found a buyer. And JP Morgan, which really JP Morgan got Bear Stearns for nothing
practically.
6:41
There were six months in between Bear Stearns and Lehman Brothers.
6:47
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 the descend in the
financial markets in the United States. So, Laymen 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 Layman Brothers was let, was let go, 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.
7:40
So there was an ad hoc approach to doing things. So, so Goldman Sachs and Morgan
Stanley both of which, were going to have a, a problem, were given a bank holding
company license.
7:54
That gave them access to the Fed window, and they had, and they can borrow money at
very, virtually no cost at all practically. The Hartford Insurance Company here in Hartford,
medium size 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, 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.
8:48
So they essentially nationalized the company.
8:52
Now the the money that the AIG got the 85,000,000,000
9:01
these terms which was outrages. They then had to pay the CD the CDOs that you couldn't
tell what the real price was because there was no real price discovery. You could, you could
have negotiated to the value of those at about 40 to 60 cents on the dollar, but the Fed
made them pay 100 cents on the dollar.
9:25
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.
9:36
So things began to unravel very quickly after that. They, they obviously they lost credibility
in the market place. They were losing business left and right. They had to pay back the
government. So one thing lead to another. The Treasury put in
9:57
a man named Ed Liddy to run the company. He'd be on nobody's list to succeed running
AIG. He had not a clue how to do that. And they began to sell off assets of AIG at and really
at prices that its just outrageous.
10:16

So the outcome is that AIG is a is a shadow of what it had been. The government now
owns 92% of AIG. They want to sell that 92%. It will 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,
10:44
and so the stock will go no place. So you know, do I feel bitter about it? Yes, I do.
10:53
I feel very bitter about it. 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.
11:09
There wasn't much. It wasn't much differentiation whether you can aff, afford one or not
Historically in our country
11:19
mergers were granted by local banks were newly individual and would work with that
individual as they got into any trouble.
11:29
Under the, in the, in the Clinton Administration decided to expand housing Fannie May and
Freddie Mac were buying mortgages from these local banks. And the local banks would
only service the mortgage, but they really didn't have any, any financial involvement after
the mortgage was sold.
11:50
And clearly many people got got mortgages and homes that couldn't afford it.
11:56
So that was one thing that was going to lead up to ultimately their problem. The second
investment banks in United States
12:08
were leveraging their capital. 30 and 40 times.
12:14
We can't, that was outrageous.
12:17
Going from, say, five and six times, or seven times a capital, to 40 and 50 and 30 times in
capital. It was obviously a risk that shouldn't have been taken. The SEC just ignored that
fact.
12:32
Why, is hard to understand. But it was clear that the, 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.
12:48
Then some of these investment banks said look, my job is to be creative and to make
products. So, they took some of these mortgages that were being now written by for people
who didn't have really the right to own up a home. They, they just didn't have the financial
needs, they didn't have the financial background for it. They packaged these mortgages
into a product. They took mortgages, they said from the east, the west, the south, and the
northeast, put them all together. They said the, the diversification.
13:28
is, is terrific and that, that means you can have, it, it'll be, it'll be mock triple A. They went to
the rating agents and, and sold the rating agencies and wrest. That these, this
diversification they deserve a triple A rating. And the rating agencies accommodated

them. Didn't do very much analysis of their own. And they were marked triple A. And they
sold these mortgages then, these products, these CDOs, to every client they could find all
around the world.
14:05
And of course, they weren't triple A. And then as I said earlier these, these credit default
swaps that respond to a normally a default. Had been changed so that you responded to a,
just a reduction in value
14:28
Blew up in everybody's face.
14:30
The same time they were doing all of this, the accounting principles board, located here in
Connecticut
14:40
came in with market to market accounting at the wrong, couldn't have picked a worse time.
14:48
To do that. And that month's balance sheet
14:53
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've happened. SEC who oversees that, kept silent. And so, so
you had all of these things come together at the same time that lead to the, the destruction
that took place.
15:25
There're other things that happened. I go through list of them but But I don't think a real
story of what truly occurred in our country has been fully recognized yet.