[MUSIC] We can't understand what happened in the housing crisis without getting a little deeper into understanding mortgages, the loans that are made so that people can buy houses. These loans, of course, when bundled together into securitized bonds, played a very large role in what eventually happened in the financial crisis. But, first the underlying mortgages themselves. In the United States, the standard mortgage has a 30 year term, fixed interest rates. So, every year, you pay interest on that loan, plus a tiny amortization. So if you have a 5% mortgage on a $300,000 mortgage, paying 5% fixed interest rate, you will pay every year in interest 5% of whatever the remaining principal is on the loan, plus some principal. So in the early years of the loan, in the very first year of the loan, you would need to pay $15,000 in interest. Plus you might pay about $3,000 off of the principal. So in total, you'd pay about $18,000. And if you keep paying $18,000 every year, eventually you will pay off all of the loan. And that takes 30 years. Now, there are alternative structures. And these alternative structures grew in popularity in the United States. They've always been popular in other countries, relatively more popular. The most common alternative is an adjustable rate mortgage. An ARM, or just pronounced arm or ARMs for the plural. An adjustable rate mortgage will be adjustable for some portion of the term. So it could be adjustable right from the beginning. So your interest rate will be pegged to some other interest rate that's in the market. Most commonly the London Interbank Offered Rate, the LIBOR. And you'll pay some amount relative to that. So that can start in the very first year. So as short term interest rates move around, your payment would move around as well. More common though is to have a rate that's fixed for some portion of the loan and then begins to float. By doing that, you will get a lower rate in the early years of the loan, but you're taking some risk that the rate will increase in the later years of the loan. So for example, a 5/25, sometimes just called 5/1, so 5/25 would mean it's fixed for five years, and then floating or adjustable for 25 years. The other way of saying Saying it is 5/1 which is it's fixed for five years, and then it adjusts every one year after that. So let's say that same loan that you could have taken out for 5% fixed rate on your $300,000 mortgage, you could get for perhaps 3.5% fixed rate for the first five years. But then after five years, it will adjust. Now this could be a good loan for you, especially if you're expecting there's no way you're gonna stay in your house for past five years. If you know for sure you're gonna be selling your house sometime in the next five years, why pay a higher interest rate in the first five years under a fixed rate when you don't need all of that safety over the last 25 years of the loan? 5/25, that's a very common type of loan, but so are 2/28, 3/27, 7/23, which in each case would mean fixed for two years for the 2/28, fixed for three years for the 3/27, or for seven for the 7/23. In those cases, you just get a shorter or a longer amount of time before the loan begins to adjust. Now sometimes, we will lower the fixed rate below even what the market might want us to do, for five years. So it could be that to borrow over 30 years, you would have to pay 5%. To borrow over five years, you would have to pay 3.5%. But to make it even more appealing to a potential buyer, we give you a very low rate over the first five years. Not three and a half percent, but let's say two and a half percent, even lower. Now why would we be able to do that? We would do that if when you refinance the loan, if you choose to refinance the loan after five years, you have to pay us a little bit of a penalty. Or, if after five years, when you refinance, the rate that you'll have to pay relative to whatever the reference rate is, has a bigger spread. So for example in the three and a half percent case for a five 5/25 mortgage, you might then pay let's say 100 basis points which is 1% over the LIBOR rate. If I give you a teaser rate, perhaps you have to pay 200 basis points above the LIBOR rate when there is an adjustment. Which of course, then gives you a pretty big incentive to refinance your loan after five years. But if you have to pay me a small penalty to do that, I'm getting some of the money back later. So that would be one way that we can fool around with a teaser rate on an adjustable rate mortgage. Alternative structures such as this are quite popular outside of the United States, and grew in popularity in the United States. You can get even more flexible structures. Instead of just saying the fixed rate mortgage, where it's the same payment every year. Or an adjustable rate mortgage, where you would make the same payment for the first X years of the mortgage, and then you would adjust thereafter. You can add in extra things. For example, negative amortization loans. Enable you in the early years of the mortgage, instead of paying off small piece of the mortgage, to actually be increasing the size of the mortgage. So, your payment is much lower in the first few years. This is similar to a teaser rate. What the lender would get in return is either the ability to charge you more in the later years of the mortgage, or to get some payment made to them, if you refinance before you have to make those larger payments. Similarly, instead of paying a small amortization every year, another way to keep your payments down is with a big balloon payment. A large payment after some part of the loan. So instead of paying off, say, approximately 1% of the principal every year for the first five years, you might make one payment of 5% of the principal after 5 years. All of these things, all of these extra little tweaks are ways that lenders and borrows often try to have a contract such that the payments are lower in the early years and higher in the later years. We'll talk a lot more today about why that might be an optimal thing to do in some instances. [MUSIC]