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Bailout 10: Moral hazard

Alternate plans and moral hazard. Created by Sal Khan.

Video transcript

So now let's think about, I talked about what the Fed's bailout proposal is. They essentially want to take $700 billion and use that to buy some of these smelly assets, these CDOs that a lot of these banks have on the balance sheet. Which have been kind of the cause of why a lot of these banks are going under. Or at least why a lot of the banks aren't lending to each other. And I kind of touched on it in the last video that, in my mind, maybe its solves the problem, but even if it does solve a problem, we'll address that in this video, but it seems like a really horrible thing to do. Because if you were to buy these assets, let's say they're worth zero, you pay $2 billion for them. You're essentially writing a check to the equity holders of this company, the shareholders of this company, they benefited from all the reward of the last five years of getting the returns on that stock price and the dividends and whatever else. And now all of a sudden when things go bad, they don't bear the risk. The American taxpayer bears the risk. And so you're writing a $1 billion check to the equity holders and a $1 billion check to the liability holders, or the people who lent this company money. And you've probably heard the word moral hazard bantered around. And this is as good of a time as any to explain what people mean by moral hazard. Well there's a couple, there's one, just a superficial notion of, hey you are writing a check to the very same people who made bad decisions. The people who lent this company money made bad decisions and the equity holders of this company made bad decisions. One, the people who invested in this company, they didn't realize the risk. And also, a lot of the equity holders are the management of the company. And they're the very ones who invested in these CDOs. And if you were to essentially buy out these CDOs, you're not penalizing them for making bad decisions. They get to keep all their bonuses before. Maybe they get to keep their jobs still. And you're propping up their stock price. So that's one element of moral hazard. The other element of moral hazard, and this is a more nuanced notion, but it's in some ways the more important element of moral hazard. And that's if the government goes in every time that there's some type of financial stress. All these people took risk, they got their reward already. But when the risk starts to hit, the government goes in and make sure that these people don't have to deal with their consequences. The moral hazard there is in the future, people are going to say I'm going to take risk. Because if when times are good, I'm going to make the money. And when times are bad, we've seen it multiple times, the government, the U.S. government, is all too ready to come out and bail out the private sector. So you create this moral hazard of making these bubbles more likely to happen in the future. Because people are not going to be as concerned about risk, because they're, like, look at these idiots, they took all the risks in the world, they bought CDOs, there were people who lent money to these people who bought CDOs, they were levered up. And the government even bailed out these dudes. So I can take huge risk, I'll get all the reward from it, and in the future the government is just going to bail me out. And that's the other element of moral hazard. Well anyway, I would argue that there's a lot of moral hazard with the government's current bailout proposal. Maybe that moral hazard is worth it if it prevents this chain, this cascade, of events from happening. If somehow it allows people to start lending to each other and most importantly, start lending to the real world, like the guy who wants to build a factory or the farmer who wants to borrow money for seeds for next year's crop. What I've heard, and I don't know the exact numbers here, and I'm not an expert here, is that there's about $5 trillion of these toxic CDOs. On all of these financial institutions' balance sheet. So I don't know if that's the accurate number. But I do know for sure, $700 billion is a relatively small fraction of the total amount that's out there. And Bernanke and Paulson, they're essentially arguing, no we know $700 billion doesn't represent all the CDOs out there, even if you were to buy them at a discount. But what we're hoping to do is by going out there and with a large amount of money and starting to buy these CDOs, that'll hopefully create some type of a market in these CDOs. And they talk about doing a reverse auction. Where we'll say, OK we're ready to buy $100 billion in CDOs. So whatever banks are willing to give us $100 billion worth of CDOs at the best price, those are the ones we're going to buy from. That's a reverse auction. You go and you say, I want to buy, who's going to sell to me for the cheapest price? And by doing that, maybe it'll create other private interests. We'll say hey, the government's getting a good deal on these CDOs, I want to buy in too and maybe other people will start buying these CDOs. The reason why I call that crap is because if other people were there to buy CDOs, they would buy them already. And the bottom line is, when you do this type of reverse auction, when you say, oh I have $100 billion I want to spend on CDOs, Paulson and Bernanke are arguing that that would somehow create some type of market price for these CDOs that these banks can then mark their assets and everyone will know what they're worth. Two problems. That will not be a market price. Because you're creating artificial demand. Artificial demand from the government. If the government wasn't there, there wouldn't be this $100 billion entity wanting to buy assets. So the assets would go for less. And then the second thing is, what if the government does that and people realize that these $2 billion of CDOs, even when the government does this reverse auction, are actually worth only $500 million. That's what people are willing to unload them for. And it would probably the more solvent people who would do it. Because for them it won't make them go bankrupt. Well if they're really worth $500 million, then every other bank that holds the same thing will have to write this $2 billion down to $500 million. And so their equity will get wiped out and the cascade will start over again. So I don't buy it on two counts. One, I don't think it'll actually create a real market price that anyone would believe. I don't think it's going to make anyone jump into the market all of a sudden. Frankly, if someone thought these were good deals, there are a lot of very very sophisticated investors out there who have a lot more knowledge about what these assets really mean than frankly the Treasury does. And if they thought they were good deals, I guarantee you there's capital out there where they would go and buy these assets for what they thought is a good deal. And hold them to maturity. There is cash out there. And I think that's an important issue that people don't realize. A lot of people are out there holding cash, they're holding treasuries. They just don't want to invest in these because they are bad deals. People are looking for a good deal. But these are most probably not worth much. They're probably worth nothing. So what is another solution? And this is something that a lot of people have bantered around a lot. They said, well why doesn't the government just go in and instead of just buying out these CDOs, which is essentially just writing a check to the very people who got us into the situation, why not buy stock in these companies? So we talked about those situations with the sovereign wealth funds. Where the sovereign wealth fund comes in, in that example they bought $3 billion worth of equity, and they gave $3 billion worth of cash. And then the company can use those to pay off its debt. That frankly, is not a horrible idea. The only reason why I would say it's still not a great idea is, you're diluting the shareholders. But what if this equity is worth zero? What if there's actually negative equity here? If this is worth zero, if these $2 billion are actually worth zero, then this is an insolvent company. You have $3 billion of assets, $4 billion of liabilities, this is actually minus $1 billion of equity. So really the stock has no value. The correct share price of the stock, if we didn't have limited liability with corporations, the correct market capitalization would be minus $1 billion. So why would you pay a positive price for those shares? So even in that situation, if this is really worth zero, and the government were to buy a lot of shares and infuse this with capital, it would save the company. It would penalize the equity holders. Because all of a sudden instead of having 500 million shares, you maybe have 2 billion shares. If you owned 100% of the company before, now you only own 20% of the company. And that's actually what happened with AIG. You might say well that's a pretty good situation, but still the government's taking a little bit of a hit. And and frankly, if the government did that, I think the risk-reward might be reasonable there. Because if the government were to infuse capital into these banks-- let me do the example. Let's say there's 500 million shares now. The government says, we're going to give this company $4 billion. So we're going to give it $4 billion in cash. And let's say for those four billion shares, we want-- let's make it really intense. Let's say the government wants ten billion shares. So essentially they're paying $0.40 per share. So then we're going to have 10 billion shares here. So that's 10,000 million. And we're going to have 10.5 billion shares. This is actually not a bad situation for me. So the company now will have $4 billion of cash, $3 billion of other assets. And now these CDOs maybe are worth nothing. Now no matter what, this company cannot go bankrupt. It has $4 billion of cash, $4 billion of liability, it could pay off its liability with that equity infusion. And the people who deserved to kind of take some downside, did get downside. Because the equity holders, they used to have 100% of the company with their 500 million shares. Now they own, what is this? They own 1/21 of their company. So they got diluted from owning 100% of the company to owning less than 5% of the company. So this might be a fair situation. Although, I would still say even in this situation you are bailing out the people who lent this money to the bank. They lent money to an institution that they should've known better than to lend money to. They're holding all these toxic assets, they collected interest on this institution. Right when this institution was about to go belly up, the government does this huge equity infusion and essentially takes over the company. Makes it a part of the government. Because the government now owns 90-something percent of the company. And pays off the liability holders. So I would still say that there's still some moral hazard here. Because in the future, you're still hurting the equity holders, but you'd still be willing to lend to an American bank, because you'd say, when things get bad the American government goes in and bails out the bank by buying a bunch of equity. So you won't properly price and risk in the future. But if this does open up lending markets and people start lending to the farmer or to the guy who wants to build factories, then maybe this is worth it. And actually, in my mind, if the government is really not worried about the banks, and they really are worried about this piece, the farmer who needs a loan, or the guy wants to build a factory that needs a loan. Why don't they take that $700 billion and just create a fund to lend directly to the real world, to lend directly to Main Street? Why don't they just let all of these banks go bankrupt, go into bankruptcy? They'll come back and they'll come back leaner and more efficient with proper risk measures and everyone will get punished appropriately. So that in the next up cycle there won't be all of this moral hazard. And you have the $700 billion that is going directly to lend to farmers and companies that are building capital equipment and whatever. And of course, there still is moral hazard. And it's going to get highly politicized. Who do you lend to, et cetera? Maybe then you still do a reverse auction. But the bottom line is, if the government were genuine about being concerned about Main Street, they wouldn't use this $700 billion in this indirect way. They would lend it directly to Main Street. Anyway, see you in the next video.