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Alan Cring Productions in association with the Emergent Light Studio presents

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the Illinois State Collegiate Compendium, Academic Lectures in Business and Economics.

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This is Business Finance, FIL 240 for spring semester 2024.

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Today, interest rates. I have a few minor topics to cover before I get to the main show,

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but as always, we have a look at the numbers and see what the numbers are telling us is going on.

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And as you can see, it was definitely a bear, it's a bear day.

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Matter of fact, it has turned really sour in the last maybe hour or so, as you can see from the spark charts.

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They were kind of floating along, being grouchy up and down, but not too much movement continuously down.

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And then about, we got an hour left before the bell, and the markets are really taking a tumble now.

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The Dow is down more than a third of a percent, the S&P down 0.41 percent, and we got the NASDAQ down almost a full percent.

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So something is really making the markets grouchy right now.

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Kind of hard to say what it is, but at least from where I'm seeing.

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But on the bright side, crude oil is back in its trading band from 72 to 79.

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It popped its head above 79 for a little while last week, and now it's calmed back down.

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It's up a little bit today, but we're still not going to have gasoline prices going through the roof or anything like that.

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And gold is taking a tumble, which is a good sign.

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So things are not dire, and we're just having a blip in the market.

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Now, bonds, the prices are up, rather the yields are up.

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That would mean that the prices are down.

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The yields are up, so the prices are down.

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That would mean that there's a sell-off in the bond market right now.

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As you can see, the yields have actually gone up about five and a half basis points so far today.

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So that's a little concerning.

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We don't want interest rates going up, and we'll talk a lot about that today in the lecture.

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But on the other side of the world, as you can see, Tokyo was in a grouchy mood.

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It just kind of just was down negative all day.

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Once it got down, it sort of just stayed there.

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And London was about the same way.

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It just started down, and then once it was down, it just kind of floated at that lower level.

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There was no good news, no more bad news.

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So it just kind of stayed where it was.

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And now, let me show you something real quick I had mentioned on the last lecture to keep an eye on Rivian.

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Now, Rivian is not going to release its earnings for the quarter until after the close of the markets,

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which may or may not be a bad sign.

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But as we can see, Rivian has taken a dip.

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It's dropped very hard early in the trading today, probably on rumors that they're going to come out with a bad earnings report.

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But once that information had gotten into the market, then it just sort of bounced along.

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Looks like it got some more rumors of bad earnings report.

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It's gotten them in the last hour or so.

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However, if Rivian does report sour earnings against forecast, then the market has already taken that into account.

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If Rivian actually comes out with a surprise of good earnings, better than they expected,

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you should expect to see Rivian pop in the aftermarket.

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And certainly tomorrow, it will go up nicely.

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We don't know yet.

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It looks like the rumors are sour on it right now.

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So by the time we get to tomorrow, tonight, when they release their earnings, tonight, yeah, tonight,

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if it is sour earnings, well, the markets already put that into it before it even happened.

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That's the power of expectations in markets.

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They are what drives prices, not what has already happened.

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We'll see a dramatic example of that in today's lecture.

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I did want to show you one thing, though.

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And I've shown you this before.

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The VIX.

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This is not a stock.

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It is an index of volatility.

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Volatility is an enemy of stock prices.

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More volatility tends to cause stock prices to be lower.

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And if I look at the VIX right now, you can see that it has, even today,

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the volatility of the volatility has been all over the board.

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But the green means increased volatility.

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But this up and down is like the second derivative.

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It's the rate of change of the volatility.

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So the VIX itself is acting all kinds of excited about something or other.

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So that indicates that right now, volatility is a measure of uncertainty.

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Some think it's going this way, some think it's going that way.

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And so they pull back and forth hard against each other.

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And that causes the volatility of securities in general to bounce around more.

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So there you are on that.

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Let me show you something here.

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Go back to the original.

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We've got a bear day going on.

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Suppose you're the kind of, and I think I've shown you this before,

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but I'm going to emphasize this.

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Suppose that you are a bearish investor.

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But you really can't identify what stocks are going to be the victims of the bears.

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But you know that there's a bearish sentiment.

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Well, you can actually play that sentiment.

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If you are a bear, one place you could go is to SQQQ, Pro Shares Ultra Short.

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Well, look, it's up today.

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The market is bearish, and SQQQ is up.

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It's a bet on the general, more or less the general sentiment of the market

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instead of trying to identify specific securities that are problematic.

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So there's that.

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Now, we could go over, what if you're a bull?

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Well, there's one that's like this for bulls.

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That's TQQQ.

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And there are others.

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Don't get me wrong about that.

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But we have a bear day, and you're taking a bullish position.

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So look, it's down.

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These respond to the general market rather than to the specific stocks

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that you might be trying to figure out which to buy and which to get rid of.

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So whichever way your sentiments want to play,

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these are the kinds of investments that you could make

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to play the sentiment instead of the securities.

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This is something for you to have in your portfolio of thinking

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about how markets work, what the opportunities are in those markets

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to use your strength or what you perceive to be your strength

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and what your judgments are about markets.

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So there you go.

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Just as a quick mention here.

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What is a TQQ?

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Do you see the beta on it?

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Do you see that beta?

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Is that a high-risk beta or is that a low-risk beta?

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What would you say?

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Oh, yeah, that's stupid high.

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What is that, 3.47 beta?

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That's about as risky as trying to take my cheeseburger from me.

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Let's look at SQQ.

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See the beta on that one.

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Negative.

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In other words, it counters a bull market.

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Of course, that is a terribly risky negative beta.

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It's a counter, what we call a contrarian.

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It's contrary to the general bullish sentiment of markets.

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And so it has a negative beta.

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That's about as negative as you can get for a beta.

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Most betas you see that are negative are just a little bit negative.

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Where do you see negative betas?

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Gold mining stocks might be a little negative,

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but I mean these are just insanely negative.

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But if you're a contrarian,

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any down market will be magnified 350% on average by SQQQ.

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Any up market will be magnified by just about that much by TQQQ.

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So these are not quiet investments.

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They move on you very fast and very large.

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Enough of that.

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I want to show you one other thing here.

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Before I get to the lecture, I've added something to your spreadsheets.

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The one that you would want for a quiz.

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Now, I didn't say that there was going to be a quiz on Monday,

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but there might be a quiz on Monday.

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But I'm not saying that.

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Whoops, I didn't mean to do that.

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I've got to download it.

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Download.

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Now, as I told you, I encouraged you with this right here.

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This will find the present value of an annuity,

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the future value of an annuity,

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and payments on a loan and the effective rate on the loan.

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It will do all of that for you.

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And again, I don't say it's okay for you to use Excel on my quizzes and exams.

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I expect you to use it, to get comfortable with it as your go-to.

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Instead of tables, instead of financial calculators,

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you're going to be in a world of Excel.

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So I want you to start getting used to it.

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What I did with this one here is that I told you,

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I encouraged you to try to find out how you could calculate a balance on a loan.

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It occurred to me that that's not easy at all,

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because Excel does not have a function that calculates balance.

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You have to do a trick with Excel.

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But it's not, and I'll explain it to you here.

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Let me do a loan.

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Let's do a six-year loan, monthly payments, APR of, let's say, 5.49%.

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And I was looking at an outlander, which was outlandishly expensive, 38,000.

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My payments on that would be $620.66 a month.

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Okay, well, what if I want to know how much I would still owe after four years?

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Again, Excel doesn't have a balance after embedded function.

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So I had to create one.

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And it's weird how it's done.

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But let's say that I want to know how much I owe.

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It's a six-year loan.

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How much do I still owe after four years?

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I still owe $14,077.

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How did I do that?

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And I'm not just explaining this to have fun.

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I'm showing you that sometimes you have to get awfully creative.

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When I'm thinking about a loan and how much is owed after a certain amount of time,

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I'm starting out with a present value that is the loan amount.

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But what I am also looking at is how much of that loan has been amortized

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over a certain period of time.

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So what I'm really looking for for the balance is a future value, in this case at four years.

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So there is what I do.

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I take a future value.

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Now, the first thing that I'm going to do with this is I'll have to reduce the size of this a little bit

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so you can see it all.

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Okay, so in order to do this, I'm going to take, first things first, the rate,

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which will be the APR divided by the number of compoundings per year.

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So the monthly rate, 5.49 divided by 12.

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D4 divided by D3.

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So that will be where I get this D4 over D3.

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The next thing I do is it's going to want the number of periods.

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So in my case, I'm going to say that I've been paying for four times 12 periods.

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That's where you get that D16, the four, times the D3, the months per year.

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That's how I get that.

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That's going to tell me how many payments have already been made.

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And then the next thing that I'm going to do is what were those payments?

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They were $630 each.

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Then the last, then the next thing I'm going to do is I'm going to need how much I started with that I owed.

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Because that's the only way I can figure out how much I've paid.

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And then finally, D8, an ordinary annuity.

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And that's how I get that balance right there.

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I would not expect anyone in this class to have figured that out.

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Unless you went to Google and found, there are a couple of ways that are shown on Google that are really crazy.

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This is the fastest, most straightforward way to do it.

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Now notice something.

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After five years, I owe only $7,200.

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Now after six years, I should owe nothing.

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Let's hope, we'll know if it works if that comes out to be a zero.

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Yep, zero.

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So this really does do the job for you.

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I'm not sure how many people would have figured that out.

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But that's why I just did it myself and I've re-uploaded the sheet with that in it.

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Okay, so that should get you through anything that would be on the next quiz or on the midterm or for problems like this on the final.

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Now we'll be doing other Financi type things over the next few, over the rest of the semester.

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And I'll have a sheet similar to these for you to work with and to learn, maybe customize, so that you can rely on Excel.

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And that's the whole part of this, is getting you to rely on the Excel.

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The tool that is the, not just in finance, but in all manner of business, Excel is carrying the weight of the data world as it were.

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So anyway, that's for you.

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And I did this with my own hands and I did it just for you.

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Because I care.

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No, I don't.

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But you know what I mean.

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Now I'm going to take you to the lecture here.

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Now there is a part of this lecture that is historical.

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And I'm giving it to you because we saw this happen again.

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The historical part of this lecture happened starting in the 1950s and ending in the early 1980s.

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And then it came back again in your lifetime, just a few years ago.

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And you will see the process that was going on as this played itself out twice in modern American history.

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Now the 1950s one I wouldn't expect you to remember.

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For a lot of you, your parents wouldn't even know about it.

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They weren't born yet, which really upsets me considering I remember it.

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But anyway, there you are.

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So I caution in this part of the lecture.

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There is one point where I use quite foul language, quoting one of the major actors of the time in which it happened.

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So if you're into bad words, you might want to cover your ears for that.

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And I don't want to offend anybody, but this is actual raw history.

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What you don't hear on TV, what you don't read in your high school textbooks,

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now even the college textbooks are self-censoring so we don't tell history as it actually played out.

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And we'll get to that in a little while.

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But let me start with some fun facts here.

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There are many interest rates.

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There's no such thing as the interest rate.

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There's interest rate on a home mortgage loan.

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There's interest rate on a car.

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There's the interest rate that is paid by a corporation on its debt.

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That's called the coupon rate.

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There is the interest rate that would be charged to you on a personal loan.

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There's a rate that would be charged on a corporate loan of a credit-worthy corporation.

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That would be called the bank rate or the prime rate, something like that.

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There are rates that used to be called LIBOR.

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LIBOR is no longer out there.

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But there are rates of all kinds.

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Underneath every rate is a foundation, a substrate rate.

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And then other different factors build on that.

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But in order to start this, we have to start with an interest rate R

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that begins with this animal called R sub F, the risk-free rate.

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Now R in and of itself is a hypothetical.

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We cannot see the real R sub F.

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What we see are interest rates sometimes that are very, very close to it.

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And we use those interest rates.

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The one that is the best, that's the most popular to estimate or to proxy for the risk-free rate

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is the rate on a one-year treasury bill.

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Because it is so close to being risk-free that it's a good estimate.

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And we can see that one right here.

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And I'll put up a link to this.

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This is from the Department of the Treasury.

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If you look right here, see this one year right here?

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Whoops, I can't do it that way.

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See that one year right there?

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That's oftentimes the one we will grab, the one that is the most recent for R sub F.

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And you'll see R sub F formulas in this class, capital asset pricing model, and some other formulas.

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The risk-free rate is critical that we have an estimate of it.

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This isn't the real one, the one-year treasury rate, but it is still pretty darn close.

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Compounding this little issue of we can't actually see it, we know that the risk-free rate has two pieces in it.

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We can't see those directly at all.

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We have econometric methods to tease out estimates of them.

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But this is very similar to what happens in, let's say, quantum mechanics in the world of subatomic physics.

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Where we can't see a proton, much less can we see the quarks that are the building blocks of the proton.

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It's the same kind of problem.

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We know they're there, we see their effects, we know that these are the pieces, but we can't see them directly.

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So within the risk-free rate are two pieces.

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The real rate of return, which is purely the supply and demand dynamics of money, the equilibrium.

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There's a supply of money, there's a demand for money, and where they meet at any given time,

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the equilibrium is the real rate of return.

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But then there's this second piece.

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Now the book uses a slightly different lettering for it.

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They say the inflation premium, but it's not exactly.

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It's the expected inflation premium.

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The book even goes into it, the expected inflation premium.

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You see, we think about the inflation rate, the CPI, consumer price index, the PPI, the producer price index.

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Those actually don't matter to finance.

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Now they might matter to you because of inflation, but actually even to you they don't exactly matter.

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You see, we don't care what the inflation rate is.

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We care what it is expected to be in the next period.

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So I will take an example here.

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I decide I am going to hire you, madam, as my employee.

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I'm going to hire you full-time 40 hours a week, and I'm going to give you a salary of $100 a week.

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I'm a giver.

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$100 a week. So you get to work for me.

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Well, I'll come to your annual review after one year, and you come into my office,

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and I go, well, you've been doing an excellent job here.

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I'm so glad I hired you.

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So I'm looking here.

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I see inflation over the last year was 2 percent, so I'm going to give you a 2 percent raise.

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Now get back to work.

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Okay.

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Well, one year more comes around, and you come in for your annual review, and I say,

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well, you're still doing a great job, so I'm going to – I see inflation last year was 4 percent,

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so I'm going to give you a 4 percent raise.

302
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And you – I send you off.

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Well, you come back the next year, and I start, well, still doing great, looking at inflation at 6 percent,

304
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and you say, stop right there, fat boy.

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Fat boy? Yes. Stop right there.

306
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I'm not going to take 6 percent.

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I want 8 percent.

308
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Why?

309
00:25:01,000 --> 00:25:04,000
Do you know why?

310
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Okay. Because when I gave you 2 percent, you had already lost 2 percent of your purchasing power.

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The inflation had already happened to that.

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So when I give you 2 percent, you're facing the hurricane of the 4 percent before I give you 4 percent.

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And so at the next time when I try to give you 6 percent, you know very well that the next inflation is probably going to be 8 percent.

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You expect.

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You're not going to take what has already happened because you've already lost that money.

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You're standing on a train track, and a train comes along, ding, ding, ding, and it runs over you.

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Do you look up at that train that's leaving and say, curse you, or do you look back, ah, here's the train, I better get off.

318
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Oh, I don't have my legs.

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You're going to look at what's happening next.

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A bank. I lend you for a mortgage on a loan.

321
00:26:05,000 --> 00:26:12,000
Well, I'm not going to lend you money at what the interest rate was.

322
00:26:12,000 --> 00:26:18,000
I'm going to look at it what I expect it to be over the next 30 years.

323
00:26:18,000 --> 00:26:21,000
Because that's where I will lose my money.

324
00:26:21,000 --> 00:26:24,000
I won't lose any money for what already happened.

325
00:26:24,000 --> 00:26:31,000
I will lose money if I don't adjust the interest rate to correct for future inflation.

326
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That's the expectation.

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And that's what drives all capital markets.

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It's not inflation.

329
00:26:38,000 --> 00:26:41,000
It's the expected inflation rate.

330
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That is what drives the decision on what the substrate R sub F, risk-free rate, will be.

331
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Okay.

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Let me start you on a journey here.

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It begins in the 1950s.

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With the president in, for most of the 50s, was a former general named Dwight Eisenhower.

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I call him and others do, the last of the great moderate Republican presidents.

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Conservative, but moderately so.

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And he was one, he wanted the government not to go crazy with all kinds of programs, military, social programs.

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The Republican right wing was screaming, as they always do, for tax cuts as far as the horizon and beyond.

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The progressive liberal interests were pushing for more social welfare programs.

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And he said, no, no, we are the government.

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We stay small and we do what government does best.

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We manage the economy.

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We have a military and all of that.

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But we don't go crazy with tax cuts or lots of extra spending.

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Okay.

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00:28:07,000 --> 00:28:09,000
That was Dwight Eisenhower.

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Well, he finished his two terms in 1960.

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And the two candidates that were going to run for the Republicans on one side and the Democrats were on the other side.

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On the Republican side was Eisenhower's vice president, much more hard right than Eisenhower was.

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His name was Richard Milhouse Nixon, who would later, much, much later become president and then be the only president who resigned.

351
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But that's not here nor there.

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Now Nixon came up against a very new kind of Democrat.

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This was an East Coast Irish Catholic liberal.

354
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He had been a hero, a war hero in World War II, commanded a PT boat and all that kind of good stuff.

355
00:29:03,000 --> 00:29:05,000
And he was a very different man.

356
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He was very with it to the time.

357
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He wore the best, nicest suits.

358
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He knew all of the famous people from his social circles.

359
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He knew Sinatra and all those great singers.

360
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There were even rumors later that he had an affair with this model actress, Norma Jean.

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Her stage name was something like Marilyn something.

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I don't know.

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But anyway, he was a very different guy.

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So they did the very first live televised debate between Nixon and Kennedy.

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And unfortunately, poor Richard Nixon, he was very uncomfortable.

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The lighting had to be extraordinarily strong.

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It was black and white.

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And he sat hunched over, he stood there hunched over like this, kind of fearful of what was happening around him.

369
00:30:00,000 --> 00:30:05,000
Kennedy just walked out there and just let the lights shine on him.

370
00:30:05,000 --> 00:30:06,000
And of course, he won.

371
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He became the president.

372
00:30:08,000 --> 00:30:12,000
And so began what was called the era of Camelot.

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The White House was redecorated to his wife Jackie Onassis,

374
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took the country on a live tour of the White House after it had been redecorated with all the best from Paris and all this.

375
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And she dressed in the nicest fashions.

376
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And Kennedy, he was very forward looking.

377
00:30:36,000 --> 00:30:40,000
He leaned into what he wanted to have happen.

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He, on one hand, he's 61.

379
00:30:44,000 --> 00:30:48,000
He said, we are going to put a man on the moon by the end of this decade.

380
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This was when the very first few satellites had shot up.

381
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Rocket scientists, it's that funny.

382
00:30:55,000 --> 00:30:57,000
Jack, you're serious.

383
00:30:57,000 --> 00:30:59,000
Well, he said it.

384
00:30:59,000 --> 00:31:04,000
He also, he was of the mind, he came out of World War II.

385
00:31:04,000 --> 00:31:08,000
We had whipped the asses of the filthy Nazis in Europe.

386
00:31:08,000 --> 00:31:18,000
We had crushed the maniacal Japanese Imperial Army on the theater on the Pacific.

387
00:31:18,000 --> 00:31:20,000
We could do anything.

388
00:31:20,000 --> 00:31:25,000
So we could wage and win a war on poverty.

389
00:31:25,000 --> 00:31:27,000
We could do it.

390
00:31:27,000 --> 00:31:30,000
We had done, we're Americans, we can do anything.

391
00:31:30,000 --> 00:31:32,000
So he had that.

392
00:31:32,000 --> 00:31:37,000
And also, he was a fierce anti-communist.

393
00:31:37,000 --> 00:31:40,000
He hated commies, as it were.

394
00:31:40,000 --> 00:31:47,000
And so he embarked on sending military, quote unquote,

395
00:31:47,000 --> 00:31:56,000
advisors to this backwater shithole in Southeast Asia called Vietnam.

396
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Because he wanted to keep the communists from taking over that country

397
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because in his mind and in many other minds, it would be a domino effect.

398
00:32:04,000 --> 00:32:08,000
If Vietnam falls to communist China and to communist Soviets,

399
00:32:08,000 --> 00:32:13,000
then along will go Cambodia, Laos, and all those other countries,

400
00:32:13,000 --> 00:32:16,000
and we'll have communism across Asia.

401
00:32:16,000 --> 00:32:18,000
So he wanted to stop that.

402
00:32:18,000 --> 00:32:24,000
We were going to wage a war at home and a war abroad, guns and butter both.

403
00:32:24,000 --> 00:32:27,000
And the money would be spent.

404
00:32:27,000 --> 00:32:31,000
Now, at that time, tax rate, the top tax rate was 70%,

405
00:32:31,000 --> 00:32:37,000
which would be absolutely the evil from hell in today's world.

406
00:32:37,000 --> 00:32:39,000
But we had good tax revenues.

407
00:32:39,000 --> 00:32:41,000
We had a bustling economy.

408
00:32:41,000 --> 00:32:44,000
And so we could pay for this.

409
00:32:44,000 --> 00:32:53,000
And Camelot rode until a November day in 1963 in Dallas

410
00:32:53,000 --> 00:32:57,000
when a lone gunman, that's what they say anyway,

411
00:32:57,000 --> 00:33:04,000
a lone gunman ended Camelot with a headshot to Jack Kennedy.

412
00:33:04,000 --> 00:33:06,000
And that was the end of it.

413
00:33:06,000 --> 00:33:08,000
Well, you see, there was an interesting thing.

414
00:33:08,000 --> 00:33:11,000
Kennedy had on the table the war in Vietnam.

415
00:33:11,000 --> 00:33:14,000
He had on the table the social programs.

416
00:33:14,000 --> 00:33:20,000
And he was also working on something that was called a Civil Rights Act.

417
00:33:20,000 --> 00:33:24,000
And, oh, this was just setting off the conservatives in this country something fierce.

418
00:33:24,000 --> 00:33:29,000
So his vice president was a man named Lyndon Johnson.

419
00:33:29,000 --> 00:33:34,000
Now, Lyndon was an old blue dog southern Democrat.

420
00:33:34,000 --> 00:33:38,000
He probably had a white sheet hanging in his closet.

421
00:33:38,000 --> 00:33:41,000
And all of his friends were in Congress.

422
00:33:41,000 --> 00:33:46,000
He had been a senator before he was Kennedy's vice president.

423
00:33:46,000 --> 00:33:53,000
And everyone who was a conservative celebrated the rise of Johnson.

424
00:33:53,000 --> 00:34:00,000
As a matter of fact, in my town, church bells rang in celebration when Kennedy was murdered.

425
00:34:00,000 --> 00:34:02,000
It was that bad.

426
00:34:02,000 --> 00:34:06,000
So everyone, so all the conservatives in Congress figured,

427
00:34:06,000 --> 00:34:10,000
well, finally we're going to get things back to normal around here.

428
00:34:10,000 --> 00:34:14,000
But they didn't understand Johnson.

429
00:34:14,000 --> 00:34:17,000
Johnson said, we're going to do these things.

430
00:34:17,000 --> 00:34:19,000
We're going to go to the moon.

431
00:34:19,000 --> 00:34:21,000
We're going to prosecute a war in Vietnam.

432
00:34:21,000 --> 00:34:23,000
We're going to build the projects.

433
00:34:23,000 --> 00:34:27,000
And we are going to pass a Civil Rights Act.

434
00:34:27,000 --> 00:34:32,000
And, of course, the first one, Civil Rights Act, oh, that was just,

435
00:34:32,000 --> 00:34:35,000
those blue dog Democrats, they didn't want anything to do with that.

436
00:34:35,000 --> 00:34:37,000
And they thought Johnson would be on their side.

437
00:34:37,000 --> 00:34:40,000
But Johnson said, this is what Jack wanted.

438
00:34:40,000 --> 00:34:42,000
And we're going to do it.

439
00:34:42,000 --> 00:34:46,000
Now, you've got to understand Johnson as a politician.

440
00:34:46,000 --> 00:34:50,000
He was brought up in the hellfire of Texas politics.

441
00:34:50,000 --> 00:34:55,000
And he was as vicious as any politician could be.

442
00:34:55,000 --> 00:34:59,000
There's a story about him when he was running for the Senate.

443
00:34:59,000 --> 00:35:04,000
His opponent, he wanted to destroy his opponent.

444
00:35:04,000 --> 00:35:10,000
He told his campaign manager, I want you to start a rumor about my opponent

445
00:35:10,000 --> 00:35:14,000
that he's a pig fucker.

446
00:35:14,000 --> 00:35:17,000
Linda, early, no pig fucker.

447
00:35:17,000 --> 00:35:19,000
His wife's a little hefty.

448
00:35:19,000 --> 00:35:20,000
Oh, shut up.

449
00:35:20,000 --> 00:35:22,000
I don't care if he is or not.

450
00:35:22,000 --> 00:35:24,000
I know he ain't.

451
00:35:24,000 --> 00:35:27,000
But I want him to deny that he is.

452
00:35:27,000 --> 00:35:31,000
That's the kind of politician Johnson was.

453
00:35:31,000 --> 00:35:36,000
So when he met resistance from those blue dog Democrats in the Congress

454
00:35:36,000 --> 00:35:38,000
about the Civil Rights Act,

455
00:35:38,000 --> 00:35:41,000
he brought them in one by one and he told them what he was going to do

456
00:35:41,000 --> 00:35:44,000
if they didn't pass that Civil Rights Act.

457
00:35:44,000 --> 00:35:50,000
And it was on the weight of his political power and viciousness

458
00:35:50,000 --> 00:35:55,000
that we got the Civil Rights Act of 1964,

459
00:35:55,000 --> 00:36:00,000
the first time in American history that by law,

460
00:36:00,000 --> 00:36:06,000
we were forbidden from discriminating on the basis of race, national origin,

461
00:36:06,000 --> 00:36:10,000
creed, and a whole lot of other stuff.

462
00:36:10,000 --> 00:36:11,000
Why?

463
00:36:11,000 --> 00:36:14,000
Because Jack wanted it and Johnson was going to do it.

464
00:36:14,000 --> 00:36:17,000
He prosecuted the war in Vietnam.

465
00:36:17,000 --> 00:36:23,000
He laid iron on that country like nothing, even World War II.

466
00:36:23,000 --> 00:36:27,000
Carpet bombing of Dresden wasn't anything compared to how much tonnage

467
00:36:27,000 --> 00:36:30,000
we dropped on that lousy little country.

468
00:36:30,000 --> 00:36:34,000
And then he also, he had the projects built.

469
00:36:34,000 --> 00:36:37,000
That's where those are, those old towers.

470
00:36:37,000 --> 00:36:42,000
He had welfare, food stamps, Medicare, the whole nine yards,

471
00:36:42,000 --> 00:36:48,000
guns and butter, spending money hand over fist.

472
00:36:48,000 --> 00:36:52,000
Well, at first it worked,

473
00:36:52,000 --> 00:36:58,000
and the Fed could just print money at the real growth rate of the economy

474
00:36:58,000 --> 00:37:00,000
and everything would be stable.

475
00:37:00,000 --> 00:37:05,000
But as time went on, we had to start printing more money

476
00:37:05,000 --> 00:37:08,000
because we had budget deficits, we had to pay our bills.

477
00:37:08,000 --> 00:37:19,000
And so what happened was that if this is money and this is our subreal,

478
00:37:19,000 --> 00:37:25,000
we had the demand for money and we had a supply of money.

479
00:37:25,000 --> 00:37:30,000
We had an equilibrium, our subreal.

480
00:37:30,000 --> 00:37:36,000
But as the first thing that happened was we print money,

481
00:37:36,000 --> 00:37:43,000
so we go from S1 to S2, which brings down the real interest rate,

482
00:37:43,000 --> 00:37:47,000
which stimulates the economy and provides actual cash money

483
00:37:47,000 --> 00:37:54,000
to spend on the programs, the guns and butter.

484
00:37:54,000 --> 00:38:00,000
So if we put our subreal here

485
00:38:00,000 --> 00:38:06,000
and here we put the expected inflation premium here

486
00:38:06,000 --> 00:38:11,000
and we put the R here,

487
00:38:11,000 --> 00:38:16,000
we started to lower the real interest rate.

488
00:38:16,000 --> 00:38:21,000
Now, at first, expected inflation didn't respond.

489
00:38:21,000 --> 00:38:25,000
The money just soaked into the economy.

490
00:38:25,000 --> 00:38:29,000
It's like your first shot of tequila.

491
00:38:29,000 --> 00:38:31,000
I still feel sober.

492
00:38:31,000 --> 00:38:34,000
It's only a while later when you take your third drink,

493
00:38:34,000 --> 00:38:38,000
oh, God, why is this room moving?

494
00:38:38,000 --> 00:38:42,000
So expected inflation stayed pretty level.

495
00:38:42,000 --> 00:38:49,000
And so the real interest rate started, kept going down.

496
00:38:49,000 --> 00:38:50,000
The economy was stimulated.

497
00:38:50,000 --> 00:38:53,000
The war and all the social welfare programs

498
00:38:53,000 --> 00:38:56,000
really boosted the economy, did it good.

499
00:38:56,000 --> 00:38:57,000
Yeah?

500
00:38:57,000 --> 00:39:02,000
Going nowhere.

501
00:39:02,000 --> 00:39:13,000
Well, as time went on, we did it more.

502
00:39:13,000 --> 00:39:15,000
Our subreal fell more.

503
00:39:15,000 --> 00:39:20,000
But then something nasty began to happen.

504
00:39:20,000 --> 00:39:25,000
A little bit of expected inflation started to sneak in.

505
00:39:25,000 --> 00:39:36,000
But it was still the net effect was that the risk-free rate went down.

506
00:39:36,000 --> 00:39:40,000
And this was continued after Johnson left office.

507
00:39:40,000 --> 00:39:43,000
The next president was Richard Nixon.

508
00:39:43,000 --> 00:39:47,000
Now, Nixon is vilified, and I'm not going to do that in this class.

509
00:39:47,000 --> 00:39:57,000
The real story is, yes, he was harder conservative than Kennedy and Johnson, obviously.

510
00:39:57,000 --> 00:40:02,000
But in many ways, he was actually fairly progressive.

511
00:40:02,000 --> 00:40:07,000
He, for example, he was the one who appointed the Supreme Court justices

512
00:40:07,000 --> 00:40:11,000
that created the most liberal court in American history.

513
00:40:11,000 --> 00:40:17,000
He was the president who signed into law the Environmental Protection Act.

514
00:40:17,000 --> 00:40:23,000
He was the president who opened dialogue with our arch enemies, Russia and China.

515
00:40:23,000 --> 00:40:28,000
He was, in those ways, not bad at all.

516
00:40:28,000 --> 00:40:30,000
He did things.

517
00:40:30,000 --> 00:40:39,000
But he also had faced a problem that was kind of unlike anything we'd seen before.

518
00:40:39,000 --> 00:40:45,000
Now, this requires that I reel back a minute back to 1947.

519
00:40:45,000 --> 00:40:53,000
After World War II, we had a whole lot of the world's population of Jews

520
00:40:53,000 --> 00:40:59,000
who had come out of the Shoah, which you know as the Holocaust.

521
00:40:59,000 --> 00:41:06,000
And we had other Jewish populations around the world who did not feel safe anymore.

522
00:41:06,000 --> 00:41:13,000
We established through the United Nations a nation called Israel, a small patch of land.

523
00:41:13,000 --> 00:41:19,000
And it pissed off the Arabs pretty bad, but we were going to defend this piece of territory

524
00:41:19,000 --> 00:41:30,000
that was a safe haven for the world's population that had just been nearly annihilated by a maniac

525
00:41:30,000 --> 00:41:35,000
that took a lot of money and years and lives to stop.

526
00:41:35,000 --> 00:41:38,000
So we had Israel, we had the Arabs.

527
00:41:38,000 --> 00:41:47,000
The Arabs kept attacking Israel, the Arab states did, trying to drive it into the sea and all of that.

528
00:41:47,000 --> 00:41:49,000
And it never worked.

529
00:41:49,000 --> 00:41:57,000
And so in 1973, the Arab nations got together with a massive military assault.

530
00:41:57,000 --> 00:42:05,000
Everything they had, from all directions surrounding Israel, they came at that small country.

531
00:42:05,000 --> 00:42:10,000
And in three days, that small country kicked their asses,

532
00:42:10,000 --> 00:42:19,000
destroyed well more than half of their military capability, and won.

533
00:42:19,000 --> 00:42:22,000
Well, that pissed off the Arabs.

534
00:42:22,000 --> 00:42:30,000
They said, how could such a small country win a war this fast against all of us?

535
00:42:30,000 --> 00:42:36,000
Oh, that's right, the United States, those are the ones who buy our oil.

536
00:42:36,000 --> 00:42:41,000
And so what they did was to punish us, they turned off the oil.

537
00:42:41,000 --> 00:42:47,000
It was the famous OPEC, oil producing and exporting countries, oil embargo.

538
00:42:47,000 --> 00:42:48,000
They just turned it off.

539
00:42:48,000 --> 00:42:51,000
You should have seen what was going on.

540
00:42:51,000 --> 00:42:57,000
The mines for gasoline, literally miles long out to the interstate from small towns.

541
00:42:57,000 --> 00:42:59,000
I was there and I saw it.

542
00:42:59,000 --> 00:43:04,000
It was ungodly, the effect.

543
00:43:04,000 --> 00:43:16,000
Well, in order to keep our economy from utterly collapsing into a dark pit and having social revolution in this mess,

544
00:43:16,000 --> 00:43:22,000
you should have seen the fights that were breaking out and the demonstrations and all that.

545
00:43:22,000 --> 00:43:29,000
Well, what the Fed did was it monetized the price shock.

546
00:43:29,000 --> 00:43:33,000
Now, madam, you're angry at me.

547
00:43:33,000 --> 00:43:36,000
You really, I've done something to wrong you.

548
00:43:36,000 --> 00:43:37,000
You're blaming me.

549
00:43:37,000 --> 00:43:39,000
You hate me.

550
00:43:39,000 --> 00:43:43,000
And then you're coming at me to shoot me.

551
00:43:43,000 --> 00:43:48,000
I pull out a big wad of cash and I say, here.

552
00:43:48,000 --> 00:43:53,000
Now, are you going to be as mad at me after I give you this massive wad of cash?

553
00:43:53,000 --> 00:43:54,000
Probably not.

554
00:43:54,000 --> 00:43:55,000
No.

555
00:43:55,000 --> 00:43:56,000
That's what it was.

556
00:43:56,000 --> 00:44:03,000
The Fed printed a large amount of money just to monetize that price shock.

557
00:44:03,000 --> 00:44:09,000
They spread a sector price spike across the economy.

558
00:44:09,000 --> 00:44:14,000
So as they did that, the supply of money came out.

559
00:44:14,000 --> 00:44:20,000
Real interest rates weren't going down as much because we got them awfully low.

560
00:44:20,000 --> 00:44:28,000
So real interest rates did come down a little bit, but then came the expected inflation.

561
00:44:28,000 --> 00:44:35,000
And there was a little blip upward, just a little blip upward in the risk-free rate.

562
00:44:35,000 --> 00:44:42,000
But you see, once you start that process, the expected inflation begins to push up the risk-free rate.

563
00:44:42,000 --> 00:44:54,000
And the only way the Fed could stop that from happening was to print more money to drive down the real rate.

564
00:44:54,000 --> 00:45:04,000
And then when the expected inflation goes higher, making the risk-free rate go higher,

565
00:45:04,000 --> 00:45:07,000
you do it again and again.

566
00:45:07,000 --> 00:45:14,000
Now, Mr. Nixon resigned in 1974, and the presidency was assumed by his vice president, Gerald R. Ford.

567
00:45:14,000 --> 00:45:23,000
Now, Ford was a very likable man, moderate, classic moderate Republican, kind of cast in the media as goofy.

568
00:45:23,000 --> 00:45:26,000
He was very tall, so he kept bumping his head on things.

569
00:45:26,000 --> 00:45:28,000
He didn't have a bandage on his head.

570
00:45:28,000 --> 00:45:35,000
He was sort of like a caretaker government.

571
00:45:35,000 --> 00:45:40,000
He probably knew what had to be done.

572
00:45:40,000 --> 00:45:43,000
We had to claw back that liquidity.

573
00:45:43,000 --> 00:45:44,000
We had to.

574
00:45:44,000 --> 00:45:49,000
We had to crush the money supply, but he didn't have the political capital to do it.

575
00:45:49,000 --> 00:45:56,000
So instead, he had a bunch of buttons printed that were, whip inflation now.

576
00:45:56,000 --> 00:45:58,000
When?

577
00:45:58,000 --> 00:46:01,000
You put this on, and that'll beat inflation.

578
00:46:01,000 --> 00:46:09,000
Of course, it doesn't, but that was what he could do.

579
00:46:09,000 --> 00:46:20,000
He was defeated in the 1976 election by a gentleman from Georgia named Jimmy Carter, who was a peanut farmer,

580
00:46:20,000 --> 00:46:22,000
but he was also a nuclear physicist.

581
00:46:22,000 --> 00:46:24,000
He understood the process.

582
00:46:24,000 --> 00:46:26,000
He knew what was happening.

583
00:46:26,000 --> 00:46:31,000
At first, he didn't choose to do it that way.

584
00:46:31,000 --> 00:46:42,000
Being of a very religious background, he described this fight against inflation as what he called the moral equivalent of war.

585
00:46:42,000 --> 00:46:45,000
Let me read that again.

586
00:46:45,000 --> 00:46:49,000
The moral equivalent of war.

587
00:46:49,000 --> 00:46:52,000
Oh, the press just had a party.

588
00:46:52,000 --> 00:46:57,000
Meow. Yeah, that's really going to stop inflation, meowing at it.

589
00:46:57,000 --> 00:46:59,000
Well, there was that.

590
00:46:59,000 --> 00:47:06,000
But he did know what had to be done, and he knew it was probably going to be his political death now.

591
00:47:06,000 --> 00:47:16,000
In 1979, he appointed a new chairman of the Federal Reserve, Paul Volcker.

592
00:47:16,000 --> 00:47:18,000
Paul Volcker.

593
00:47:18,000 --> 00:47:28,000
Six foot five, something like that, 250, 270 pounds of I don't care about anything.

594
00:47:28,000 --> 00:47:30,000
He smoked giant cigars.

595
00:47:30,000 --> 00:47:40,000
Rumor was, I never saw it happen, but he would blow cigar smoke in people's faces if they disagreed with him or if they annoyed him.

596
00:47:40,000 --> 00:47:42,000
And he just didn't care.

597
00:47:42,000 --> 00:47:45,000
He just said, crush the money supply.

598
00:47:45,000 --> 00:47:48,000
Just bring it clear back.

599
00:47:48,000 --> 00:47:54,000
Drain that liquidity overhang that had been building for years.

600
00:47:54,000 --> 00:47:58,000
Just claw it back all at once.

601
00:47:58,000 --> 00:48:06,000
Well, of course, what that did was that drove the real rate through the roof.

602
00:48:06,000 --> 00:48:11,000
Expected inflation still went up because no one believed him.

603
00:48:11,000 --> 00:48:13,000
The capital markets didn't believe him.

604
00:48:13,000 --> 00:48:16,000
The Fed chairman had been saying this all along.

605
00:48:16,000 --> 00:48:18,000
Yeah, we're going to get this inflation under control.

606
00:48:18,000 --> 00:48:25,000
Who was to believe that the latest lackey was going to actually do it?

607
00:48:25,000 --> 00:48:28,000
Expected inflation is nasty that way.

608
00:48:28,000 --> 00:48:34,000
It keeps going even after you have stopped doing what caused it in the first place.

609
00:48:34,000 --> 00:48:36,000
I'm a banker.

610
00:48:36,000 --> 00:48:43,000
I'm putting a massive expected inflation premium into my mortgage loan rates.

611
00:48:43,000 --> 00:48:45,000
Oh, no, no, you can quit that now.

612
00:48:45,000 --> 00:48:49,000
Paul Volcker said he's going to get rid of the inflation.

613
00:48:49,000 --> 00:48:51,000
I'm not going to believe him.

614
00:48:51,000 --> 00:49:03,000
It has to be one of those things where Volcker puts the giant hand of the Fed on the throat of the economy for month after month after month

615
00:49:03,000 --> 00:49:11,000
before the economy was willing to give the right answer to the question, who's your daddy?

616
00:49:11,000 --> 00:49:20,000
Well, Carter, the problem was that interest rates were stupid high, so the economy had slowed to a stall.

617
00:49:20,000 --> 00:49:25,000
We had massive inflation because the expectation of inflation was there.

618
00:49:25,000 --> 00:49:34,000
So we had what came to be known as a stagnant inflation.

619
00:49:34,000 --> 00:49:39,000
Well, we went into the 1980 election, and no one understood what was going on.

620
00:49:39,000 --> 00:49:48,000
They voted Carter out and elected the gentleman who had been a former governor of California.

621
00:49:48,000 --> 00:49:58,000
He had also been an actor in Western movies, and he was a spokesperson for advertisements for a cigarette brand.

622
00:49:58,000 --> 00:50:01,000
His name was Ronald Reagan.

623
00:50:01,000 --> 00:50:13,000
Well, of course, eventually, eventually, after, well, during the Reagan administration, they did a tax cut, which helped boost the economy too.

624
00:50:13,000 --> 00:50:24,000
But eventually, the expected inflation over a period of a couple of years finally began to drain out.

625
00:50:24,000 --> 00:50:37,000
And we finally, that was when Volcker could lay off contracting the money supply and ultimately open it back up again,

626
00:50:37,000 --> 00:50:40,000
increase the money supply, which lowered the interest rate.

627
00:50:40,000 --> 00:50:52,000
So finally, we got to the point where interest rates finally went back to about a normal level.

628
00:50:52,000 --> 00:50:58,000
Now, real forward. 2008, we had a terrible financial crisis.

629
00:50:58,000 --> 00:51:09,000
Most people don't know that we were about two hours away from an apocalypse, a financial apocalypse, in September, September 15th of 2008.

630
00:51:09,000 --> 00:51:13,000
The whole world almost came to a grinding financial halt.

631
00:51:13,000 --> 00:51:19,000
Fortunately, we got by it, but the after effects were staggering.

632
00:51:19,000 --> 00:51:24,000
It had been building for some years, but we staggered along.

633
00:51:24,000 --> 00:51:35,000
About 2011, we were pretty much back on track expansion of the economy, and the Fed was doing what it's supposed to do,

634
00:51:35,000 --> 00:51:40,000
grow the money supply at about the real growth rate of the economy.

635
00:51:40,000 --> 00:51:44,000
So the price levels would stay about constant.

636
00:51:44,000 --> 00:51:58,000
And we had that in effect, but then, unfortunately, in 2017, Mr. Obama had finished his two terms, and we elected President Donald Trump.

637
00:51:58,000 --> 00:52:08,000
And in 2017, the largest massive tax cut you could imagine was put into place.

638
00:52:08,000 --> 00:52:16,000
The one effect, as I've already told you, was the top corporate tax rate was cut from 39% to 21%.

639
00:52:16,000 --> 00:52:20,000
That just drained the coffers of the economy.

640
00:52:20,000 --> 00:52:24,000
The government was borrowing hand over fist.

641
00:52:24,000 --> 00:52:27,000
The Fed was not accommodating it, though.

642
00:52:27,000 --> 00:52:32,000
The Fed was not printing money to pay for these budget deficits.

643
00:52:32,000 --> 00:52:39,000
And then we came toward 2019, and the economy was showing signs of a recession,

644
00:52:39,000 --> 00:52:50,000
because the government was borrowing piles of money, which was starting to lift interest rates as the demand for capital from businesses and from the government was increasing,

645
00:52:50,000 --> 00:52:54,000
and we were drifting toward a recession.

646
00:52:54,000 --> 00:52:59,000
President Trump threatened to fire the Board of Governors, or at least the chairman.

647
00:52:59,000 --> 00:53:11,000
Legally, maybe he could, maybe he couldn't have, but that kind of got the Fed to start printing money to monetize the deficits

648
00:53:11,000 --> 00:53:15,000
and to monetize the economy so it wouldn't slide into a recession.

649
00:53:15,000 --> 00:53:18,000
Well, it did anyway, but it wasn't a major one.

650
00:53:18,000 --> 00:53:20,000
Pretty mild.

651
00:53:20,000 --> 00:53:30,000
But then President Trump lost the election to President Biden, and that COVID hit.

652
00:53:30,000 --> 00:53:38,000
The economy just went to a grinding halt, and the government just started printing checks hand over fist.

653
00:53:38,000 --> 00:53:48,000
COVID checks, PPP loans for businesses that couldn't raise, make money because they were locked down.

654
00:53:48,000 --> 00:53:51,000
We spent money hand over fist.

655
00:53:51,000 --> 00:54:01,000
Of course, what that did was, eventually, we were trying to keep interest rates low,

656
00:54:01,000 --> 00:54:10,000
but then the expected inflation premium started going up and up and up.

657
00:54:10,000 --> 00:54:21,000
We started getting, and we saw it in actual inflation, and it was starting to get embedded just like it was in the 1970s.

658
00:54:21,000 --> 00:54:26,000
The same process, the same effect.

659
00:54:26,000 --> 00:54:28,000
That's just how it happened.

660
00:54:28,000 --> 00:54:39,000
And surprisingly, the Fed at first looked like it was not going to do what needed to be done, but quite quickly it did.

661
00:54:39,000 --> 00:54:42,000
It crushed the money supply.

662
00:54:42,000 --> 00:54:52,000
It brought interest rates way up, and we were in that situation again where we had interest rates rising because the money supply was being crushed,

663
00:54:52,000 --> 00:54:58,000
expected inflation was rising, which made the risk-free rate and everything after it go up,

664
00:54:58,000 --> 00:55:13,000
and so we began this latest cycle, which we are now just finishing extraordinarily more quickly than we did during the 1960s, 70s cycle.

665
00:55:13,000 --> 00:55:22,000
We moved rapidly because we knew that if we put it off and put it off, that expected inflation premium would get embedded.

666
00:55:22,000 --> 00:55:24,000
It would metastasize.

667
00:55:24,000 --> 00:55:31,000
Instead of being a tumor that could be removed with a surgery, it would become a cancer that would sweep through the whole body

668
00:55:31,000 --> 00:55:38,000
and take drastic measures to deal with, as we did in 1979.

669
00:55:38,000 --> 00:55:41,000
Let me show you on these charts here.

670
00:55:41,000 --> 00:55:50,000
Let's go back here to 2022.

671
00:55:50,000 --> 00:56:01,000
Do you see how stupidly low the risk-free rate was, 0.40% at the beginning of 2022?

672
00:56:01,000 --> 00:56:05,000
Now look what happened as 2022 went along.

673
00:56:05,000 --> 00:56:07,000
Look at that yield. Look at that interest rate.

674
00:56:07,000 --> 00:56:09,000
Do you see it going up?

675
00:56:09,000 --> 00:56:17,000
That is the visual evidence of the Fed crushing the money supply backward.

676
00:56:17,000 --> 00:56:22,000
Expected inflation was still holding on tenaciously.

677
00:56:22,000 --> 00:56:29,000
So you had rising real interest rates because the money supply was being crushed, expected inflation gathering steam

678
00:56:29,000 --> 00:56:36,000
because no one believed that the Fed was going to correct the problem, claw back the liquidity overhang.

679
00:56:36,000 --> 00:56:43,000
So interest rates just kept going up and up and up all through 2022.

680
00:56:43,000 --> 00:56:58,000
And we'll go down here to the end of 2022, and then we get to 2023, and we will see...

681
00:56:58,000 --> 00:57:02,000
Now the Fed is in the holding period.

682
00:57:02,000 --> 00:57:07,000
They crushed it again just to convince the markets they meant business.

683
00:57:07,000 --> 00:57:17,000
And you see how the interest rates are moving with the Fed's efforts to claw back all that liquidity overhang from the COVID lockdown.

684
00:57:17,000 --> 00:57:21,000
And then they've eased that back and gone up.

685
00:57:21,000 --> 00:57:27,000
But right now they've fallen back. The Fed has stopped clamping down.

686
00:57:27,000 --> 00:57:35,000
And it's beginning to let up a little bit on the money supply as we come into 2024 a few months ago.

687
00:57:35,000 --> 00:57:40,000
And you can see here in 2024, the Fed hasn't finished.

688
00:57:40,000 --> 00:57:52,000
It sees that we are now out of the worst part, but it still has a policy right now of not letting the interest rates start to fall.

689
00:57:52,000 --> 00:57:58,000
Not printing money, again, like it would normally do.

690
00:57:58,000 --> 00:58:10,000
So the net effect here is that you're seeing in these tables this time we did it a lot better than we did the last time.

691
00:58:10,000 --> 00:58:24,000
And that was in part because the Fed was not letting politics govern its decisions for as long as it did in the 1960s and 1970s.

692
00:58:24,000 --> 00:58:33,000
So we got out of it without getting a stagflation, without getting interest rates up there into insane territory.

693
00:58:33,000 --> 00:58:42,000
We got out of it this time because we trusted the process and we did it right this time.

694
00:58:42,000 --> 00:58:49,000
Now some would say, well, we should never have done it wrong to begin with. We shouldn't have sent COVID checks out and all of that.

695
00:58:49,000 --> 00:58:57,000
There's a point where you can follow the rules, but if you follow the rules too sharply, don't print too much money,

696
00:58:57,000 --> 00:59:02,000
well, you're going to cause so much suffering that you'll have social revolution out of it.

697
00:59:02,000 --> 00:59:08,000
So there you are with that.

698
00:59:08,000 --> 00:59:13,000
That is the history of where you stand now.

699
00:59:13,000 --> 00:59:26,000
And to a very large extent, you know more from one lecture about an hour than the vast overwhelming majority of people in our country know.

700
00:59:26,000 --> 00:59:37,000
You understand that this is an evil, it's a conspiracy, it's politics and physics of equations that make this all happen.

701
00:59:37,000 --> 00:59:49,000
Now I want to show you something here just to make sure that you understand what interest rates do to an economy.

702
00:59:49,000 --> 00:59:58,000
First of all, and you can do this for yourself, you can see it for yourself with that Excel sheet.

703
00:59:58,000 --> 01:00:05,000
As interest rates go up, the present value of future expected cash flows goes down.

704
01:00:05,000 --> 01:00:13,000
As interest rates go up, the present value of future expected cash flows goes down.

705
01:00:13,000 --> 01:00:27,000
And I will even show you right here, right now, in that stupid little Excel sheet that I provided to you.

706
01:00:27,000 --> 01:00:36,000
See this one here? We got an annuity of $200 for seven years compounded quarterly.

707
01:00:36,000 --> 01:00:41,000
And it has a present value of $4,865.

708
01:00:41,000 --> 01:00:51,000
Watch what happens if I increase the interest rate.

709
01:00:51,000 --> 01:00:59,000
Let's increase it again.

710
01:00:59,000 --> 01:01:04,000
Do you see how the present value is going down?

711
01:01:04,000 --> 01:01:12,000
Interest rates cause future expected cash flows to, as interest rates go up,

712
01:01:12,000 --> 01:01:18,000
you discount those future expected cash flows at a harder and harder rate.

713
01:01:18,000 --> 01:01:26,000
And so the present value of those future expected cash flows goes down.

714
01:01:26,000 --> 01:01:32,000
Now the next part of this, and you can do this for yourself, try different interest rates.

715
01:01:32,000 --> 01:01:35,000
Now watch what happens if I bring interest rates down.

716
01:01:35,000 --> 01:01:38,000
Let's bring them down to 3.09%.

717
01:01:38,000 --> 01:01:47,000
We go from present value of $4,547 to $5,018.

718
01:01:47,000 --> 01:01:49,000
They work in opposite directions.

719
01:01:49,000 --> 01:01:52,000
Interest rates go up, present values go down.

720
01:01:52,000 --> 01:01:56,000
Interest rates go down, present values go up.

721
01:01:56,000 --> 01:02:00,000
There is an inverse relationship.

722
01:02:00,000 --> 01:02:02,000
But it's even worse than this.

723
01:02:02,000 --> 01:02:07,000
So in other words, if I'm calculating the present value of the future expected cash flows from a project,

724
01:02:07,000 --> 01:02:15,000
as interest rates go up, those future expected cash flows have a lower present value.

725
01:02:15,000 --> 01:02:18,000
But let me show you something here.

726
01:02:18,000 --> 01:02:27,000
Suppose that I have a company and it's considering three projects.

727
01:02:27,000 --> 01:02:37,000
And each of those projects has a return on investment, an ROI.

728
01:02:37,000 --> 01:02:41,000
Projects A, B, and C.

729
01:02:41,000 --> 01:02:45,000
Now Project A has an ROI of 6%.

730
01:02:45,000 --> 01:02:49,000
Project B has an ROI of 10%.

731
01:02:49,000 --> 01:02:58,000
And Project C has an ROI of 15%.

732
01:02:58,000 --> 01:03:06,000
So suppose that we start with a cost of capital of 5%.

733
01:03:06,000 --> 01:03:12,000
Well, capital cost is 5%. We can make 15% on it.

734
01:03:12,000 --> 01:03:15,000
Sure, we'll take that project.

735
01:03:15,000 --> 01:03:19,000
Money costs 5% and we can make 10%.

736
01:03:19,000 --> 01:03:20,000
Well, yeah.

737
01:03:20,000 --> 01:03:23,000
Even the project that returns 6%.

738
01:03:23,000 --> 01:03:28,000
If capital cost is 5%, absolutely.

739
01:03:28,000 --> 01:03:35,000
We have a nice range of projects with different risk levels going up and all that from A to C.

740
01:03:35,000 --> 01:03:44,000
But what happens if we go to a cost of capital of 12%?

741
01:03:44,000 --> 01:03:45,000
Well, we'll...

742
01:03:45,000 --> 01:03:50,000
No, let's do 8% to start with. 8%.

743
01:03:50,000 --> 01:03:55,000
Yeah, we'll take the 15% project because it costs us only 8% of the capital does.

744
01:03:55,000 --> 01:03:57,000
So yeah.

745
01:03:57,000 --> 01:04:00,000
The 10% project, well, we pay 8%.

746
01:04:00,000 --> 01:04:02,000
We get 10%, sure.

747
01:04:02,000 --> 01:04:06,000
But the 6% project is gone.

748
01:04:06,000 --> 01:04:08,000
The money costs us 8%.

749
01:04:08,000 --> 01:04:09,000
We get only 6%.

750
01:04:09,000 --> 01:04:11,000
That project's gone.

751
01:04:11,000 --> 01:04:13,000
We reject it.

752
01:04:13,000 --> 01:04:15,000
Now let's do one more.

753
01:04:15,000 --> 01:04:20,000
Suppose that the rate goes to 12%.

754
01:04:20,000 --> 01:04:25,000
Well, we'll still take the 15% project, sure.

755
01:04:25,000 --> 01:04:29,000
12% capital for 50% return, sure.

756
01:04:29,000 --> 01:04:34,000
But we're not going to take the 10% because the capital costs us 12%.

757
01:04:34,000 --> 01:04:35,000
We reject it.

758
01:04:35,000 --> 01:04:40,000
And of course, that 6% project A is gone.

759
01:04:40,000 --> 01:04:47,000
Do you see what's happening to business activity as interest rates go up?

760
01:04:47,000 --> 01:04:48,000
Two things.

761
01:04:48,000 --> 01:04:52,000
One is we're rejecting more projects.

762
01:04:52,000 --> 01:04:55,000
And that means fewer jobs.

763
01:04:55,000 --> 01:04:59,000
That means lower revenues for the companies.

764
01:04:59,000 --> 01:05:08,000
So rising interest rates saps the strength of an economy, the driving force, innovation, new projects.

765
01:05:08,000 --> 01:05:11,000
And then there's a subtler effect if you look.

766
01:05:11,000 --> 01:05:16,000
Remember that risk and return, the greater the risk, the greater the expected return.

767
01:05:16,000 --> 01:05:20,000
Do you see what's happening from the beginning to the end there?

768
01:05:20,000 --> 01:05:26,000
The company is getting rid of its lower risk projects.

769
01:05:26,000 --> 01:05:30,000
It's being backed into a corner of high risk projects.

770
01:05:30,000 --> 01:05:37,000
And that is where the dramatic problem happens, is that one of the reasons we have more bankruptcies

771
01:05:37,000 --> 01:05:44,000
is because companies can't afford to do those low risk projects to counterbalance the high risk projects.

772
01:05:44,000 --> 01:05:51,000
It has to do the high risk projects because those are the only ones that pay enough for the capital

773
01:05:51,000 --> 01:05:57,000
that we are using to do those projects.

774
01:05:57,000 --> 01:06:07,000
So now, let's go back over here and finish this piece.

775
01:06:07,000 --> 01:06:18,000
We have this ginormous piece that is called the risk-free rate is where every interest rate starts.

776
01:06:18,000 --> 01:06:30,000
But then we have this three-part piece called the risk premium.

777
01:06:30,000 --> 01:06:39,000
Now, the risk premium has three parts, and they are greater or lesser depending upon what interest rate we're talking about.

778
01:06:39,000 --> 01:06:44,000
The first one is called the default premium.

779
01:06:44,000 --> 01:06:53,000
This is the extra interest you pay because you might not pay off the bill, pay off the loan.

780
01:06:53,000 --> 01:07:00,000
Now, the default premium on a home mortgage would be very low because it's backed by an asset.

781
01:07:00,000 --> 01:07:08,000
So that if you stop paying on that loan, you still, the bank will still be able to make it whole.

782
01:07:08,000 --> 01:07:13,000
That's why the default premium on a credit card is stupid high.

783
01:07:13,000 --> 01:07:16,000
That's why credit card interest rates are insane.

784
01:07:16,000 --> 01:07:18,000
There's nothing to back it.

785
01:07:18,000 --> 01:07:23,000
So if you stop paying, they lose everything.

786
01:07:23,000 --> 01:07:25,000
And in the middle are car loans.

787
01:07:25,000 --> 01:07:28,000
Now, car loans have a back in the car.

788
01:07:28,000 --> 01:07:31,000
But as soon as you pull a new car off the lot, it loses some value.

789
01:07:31,000 --> 01:07:36,000
So you would still have some default premium in there.

790
01:07:36,000 --> 01:07:40,000
The next one is a little more complex.

791
01:07:40,000 --> 01:07:45,000
This is the maturity premium.

792
01:07:45,000 --> 01:07:56,000
You see, if I'm making a loan, I make a loan to you at, let's say, 6% for 30 years.

793
01:07:56,000 --> 01:08:01,000
If interest rates go down on that home loan, you're going to refi.

794
01:08:01,000 --> 01:08:09,000
And what I thought was going to be 6% for 30 years, I get the money back and all I can do is lend it out at the lower rate.

795
01:08:09,000 --> 01:08:17,000
On the other hand, if interest rates go up, I'm screwed as well because usually people sell a home in about seven years.

796
01:08:17,000 --> 01:08:22,000
But if you've got a 6% loan and current mortgage rates are 12%, you're not going to sell that lot.

797
01:08:22,000 --> 01:08:24,000
You're not going to sell that.

798
01:08:24,000 --> 01:08:25,000
You're going to keep it.

799
01:08:25,000 --> 01:08:32,000
And so I can't, I'm getting 6%, and I'd really like to have you give that money back to me so I could lend it out at 12%.

800
01:08:32,000 --> 01:08:37,000
So whichever way interest rates go, I'm harmed.

801
01:08:37,000 --> 01:08:47,000
The maturity premium is simply the chance that interest rates will go up or down increases with the length of the loan.

802
01:08:47,000 --> 01:08:49,000
It's actually a physics principle.

803
01:08:49,000 --> 01:09:00,000
If you have a smoke coming out of a small pipe, at first there's very little chance that it will be far from the diameter of the pipe.

804
01:09:00,000 --> 01:09:06,000
But as it gets farther and farther out, there's more and more chance that smoke will be farther away.

805
01:09:06,000 --> 01:09:08,000
That's what interest rates are.

806
01:09:08,000 --> 01:09:13,000
If a loan is only a couple of years, interest rates are probably going to move very much in a couple of years.

807
01:09:13,000 --> 01:09:20,000
But in 30 years, there's a large chance that they'll move a lot.

808
01:09:20,000 --> 01:09:24,000
And either way they move is adverse to me as the lender.

809
01:09:24,000 --> 01:09:29,000
So that's where the maturity, it becomes bigger the longer the loan.

810
01:09:29,000 --> 01:09:39,000
So in other words, the maturity premium on a home mortgage is higher than the maturity premium on a car loan.

811
01:09:39,000 --> 01:09:46,000
Because there's more chance that over 30 years interest rates are going to do something weird than there is over 5 years.

812
01:09:46,000 --> 01:09:51,000
And finally the last one, the illiquidity premium.

813
01:09:51,000 --> 01:09:54,000
There's kind of a myth.

814
01:09:54,000 --> 01:09:58,000
You get a home loan from a bank.

815
01:09:58,000 --> 01:10:02,000
The bank has that loan for the 30 years, 25 years, whatever.

816
01:10:02,000 --> 01:10:03,000
No it doesn't.

817
01:10:03,000 --> 01:10:08,000
That bank gets rid of that loan within a day or two.

818
01:10:08,000 --> 01:10:16,000
Because the bank can sell that loan to what's called a secondary mortgage market.

819
01:10:16,000 --> 01:10:19,000
Ginny May, Fannie May, Freddie Mac.

820
01:10:19,000 --> 01:10:25,000
All they'll do then is collect a fee for taking your payments or something like that.

821
01:10:25,000 --> 01:10:28,000
So home loans are highly liquid.

822
01:10:28,000 --> 01:10:33,000
Remember the efficiency with which an asset can be converted to another asset.

823
01:10:33,000 --> 01:10:36,000
The bank collects loans in some cases.

824
01:10:36,000 --> 01:10:42,000
It takes the loans that it makes in one day, packages them up, and it sells them to Ginny May.

825
01:10:42,000 --> 01:10:45,000
This massive secondary mortgage market.

826
01:10:45,000 --> 01:10:47,000
Trillions of dollars.

827
01:10:47,000 --> 01:10:50,000
And they do what they will with them.

828
01:10:50,000 --> 01:10:56,000
So there is a very low liquidity premium on home loans.

829
01:10:56,000 --> 01:11:03,000
However, banks making car loans, they're pretty much stuck with those.

830
01:11:03,000 --> 01:11:07,000
They could probably unload them, but they'd have to unload them at a discount.

831
01:11:07,000 --> 01:11:16,000
And so that's why there would be a higher illiquidity premium on a home loan, on a car loan, than on a home loan.

832
01:11:16,000 --> 01:11:20,000
A personal loan, they're stuck with it.

833
01:11:20,000 --> 01:11:22,000
They're not going to get rid of that thing.

834
01:11:22,000 --> 01:11:27,000
Just on a loan that they make to you for something, like a vacation or something.

835
01:11:27,000 --> 01:11:30,000
So that would have a high illiquidity premium.

836
01:11:30,000 --> 01:11:37,000
They would charge you extra interest for the fact that they can't get rid of it if they want to.

837
01:11:37,000 --> 01:11:39,000
It's like a promissory note.

838
01:11:39,000 --> 01:11:45,000
I will charge you a higher interest rate because if you give me a written piece of paper,

839
01:11:45,000 --> 01:11:48,000
I owe you $100, I'm stuck.

840
01:11:48,000 --> 01:11:51,000
If I need that money right away, no one's going to buy it from me.

841
01:11:51,000 --> 01:11:54,000
So that's what the illiquidity premium does.

842
01:11:54,000 --> 01:12:05,000
It is the combination of those three for a given type of borrowing that determines what interest rate would be charged.

843
01:12:05,000 --> 01:12:09,000
The R sub F will be the same for all of them, or about the same.

844
01:12:09,000 --> 01:12:18,000
But it's those three, large, small, not there, that would be what would cause the interest rate you see

845
01:12:18,000 --> 01:12:22,000
to be different from another interest rate you would see.

846
01:12:22,000 --> 01:12:26,000
I'll finish this topic up on Monday, but that's all I have for you today.

847
01:12:26,000 --> 01:12:40,000
I thank you.