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Bailout 13: Does the bailout have a chance of working?

Can the bailout work? Created by Sal Khan.

Video transcript

Let's put all of the moral hazard issues and all the fairness issues aside. And just think hard about whether this bailout could work. Because frankly, if it doesn't work, then it's definitely not something that any of us should worry about. And even if it does work, then I think you should worry about the moral hazard issues. But let's say this is Bank A, shady Bank A. And it has-- and let's see, these are its assets on the left hand side. And these are its liabilities. And so it has, at least on its books, the book value of the CDOs that it has is $5 billion. And what the government is saying, is that right now, Bank B has lent Bank A this loan. Bank B has given them $8 billion that maybe has to be paid back next month. And the big fear is that Bank B is going to get scared, and then when this loan is due in a month's time, that Bank B won't give them a new loan or renew the loan. They're just going to want to take the money back, because they're afraid of keeping money with these guys, when you don't know what these CDOs are worth. And that's a legitimate fear, right? Because if these CDOs really are worth $5 billion, then you really do have $4 billion of equity here, right? Total assets are $12 billion minus $8 billion of liabilities means you have $4 billion of equity. Fair enough. But what happens if these CDOs are only worth $1 billion? And this is worth $1 billion, and these are worth $7 billion, then you only have $8 billion in assets. And $8 billion in liabilities, and there's no equity. Or even worse. What if this these CDOs are worth zero? Then you have negative equity. Then if these guys were to go bankrupt, if they were to be the next Lehman Brothers, then all this Lender B would get if they went bankrupt are these CDOs worth 0 and these $7 billion of assets. For every $8 they let lend to Bank A, it'll only get $7. So what the government is saying is, OK, to keep Bank B from pulling their money out of Bank A, let's buy out these CDOs at essentially at a price that keeps this bank solvent. Even if they really are worth 0, we're not the Fed or the Treasury-- the Treasury's the one doing it. The Treasury's not going to pay 0, because if they paid 0, this guy would just go bankrupt. It would be another Lehman Brothers. So the Treasury wants to essentially, maybe pay $5 billion for it. So that you take $5 billion-- buy these CDOs for $5 billion. And all of a sudden this doesn't become CDOs of $5 billion, this becomes cash. And their argument is, if you were to do this, no matter how unfair it might be, because this is essentially a check of $5 billion, if you assume these CDOs are worthless. This is essentially a check that's being written to the equity holders and the unsecured debt holders of this bank. But let's assume that-- Let's put all that aside. Let's assume that this works. That now Bank B will say, oh boy, I don't have to worry about those CDOs anymore. Those CDOs have been turned into cash. This company definitely has positive book value, and therefore, I will continue to loan to this company. But it isn't that simple. Because right behind these CDOs, there are other assets on this book. On most banks' books. So these were the subprime CDOs, the stinkiest of the stinky. Then you have other things that are a little bit less risky. They're Alt-A CDOs. These are loans that were given to people who aren't necessarily subprime. These are people who had decent credit scores. But they still put no money down, and they still were able to essentially fabricate their income on there loan applications. So these are the Alt-A loans. Then above that-- And these might be Alt-A CDOs. They've been sliced and diced, so some tranches are more risky, some tranches are less risky. Above that, you might have commercial real estate CDOs. So I'll call that commercial real estate CDOs. Then above that, you might have commercial loans. Just a regular companies. Or even better, these could be loans to private equity-- actually, that's even better. Let's put some private equity loans in there, because I wanted to show you that this isn't the only stinky thing on the balance sheets, these CDOs. That this is just the stinkiest of them all. A good way to think about it is, if you have a dead skunk in your house, you won't notice that the milk is going bad. And that is the situation. These CDOs, they seem really bad now, but you know what? Six months ago, or even a year ago. Six months ago, these CDOs looked a lot like-- these subprime CDOs look a lot like these Alt-A CDOs are starting to look. And the way these Alt-A CDOs looked six months ago is how a lot of these commercial real estate CDOs are starting to look right now. So this is just the tip of the iceberg, these CDOs. So you have an issue here. The government goes in. It spent $700 billion. It buys these assets that are of questionable value. And it's claiming to us that the problem will be solved. But Bank B isn't an idiot. Bank B isn't an idiot. They're probably more prudent than Bank A. They didn't buy these subprime assets. Subprime CDOs. But I wouldn't be surprised if Bank B probably has some of these less stinky things on their balance sheets. Alt-A. I mean, they definitely have something stinky, which is called a loan to A. That's one of their assets. And then they might have loans to private equity, private equity loans. Then they might have some commercial real estate CDOs. They might have CDOs that are backed by credit card debt. The bottom line is that this bank can look into its own assets, and it can see that the fundamental value behind these assets are deteriorating. Anyone who talks to anyone in the real economy right now knows that the economy's slowing. That consumers can't spend any more money. In fact, last year consumers had negative savings, which means that they had to borrow money to fuel their consumption. And the only way that you can have consumption growth in that type of environment is if either salaries increased, which isn't happening, or people are able to borrow more money. And we already know that credit is getting tightened. So if you're Bank B, will the government buying out this asset, irregardless of how fair it is, will that make you confident in loaning to Bank A? Well, no, because you see in your own balance sheet that things are deteriorating. And frankly, you have loans to other people too, right? You have loans to Bank C. That's a loan to Bank E. That's a loan to some sovereign wealth fund. And then you have your equity here. So you have a double conundrum, right? You have all of these guys. These loans might come due, so you're going to need some cash for that in the future. And you see the trend. You're not an idiot. You aren't as risk-taking as this guy, and you see that this wasn't the only stinky thing out there. That there are other assets classes, other types of CDOs, and just loans in general, that are starting to deteriorate. That's starting to deteriorate. That's starting to deteriorate. That's starting to deteriorate. So maybe this credit crunch isn't just because of these CDOs. Maybe it's because this banker is actually being prudent. Maybe this banker's actually saying, you know what, I need to be careful. I see the left hand side of my balance sheet deteriorating. I need to pull this money, just in case, just really in the best interest of my equity holders. Of my shareholders, or even of my bond holders. So even on this first cut, even if there wasn't all of this controversy, and even if George Bush didn't go up, and do a primetime speech telling us that we're about to reach financial armageddon, if I was a prudent banker I would still be wary of loaning to Bank A, even if the government were able to pull this buyout. Now on top of that, I work in the financial industry. Bankers were prudent. They see reality. They see things are deteriorating. So they want to be cautious. But frankly, when Bush, and Paulson and Bernanke go up on TV and say, tell the world that you have to pass this bill and if not, we're essentially on-- they use words like "preicipice." These are the real precipice. And they use "financial armageddon." It's either their words, or some of the other words that I've heard out there. Financial armageddon. And days away from the precipice. So my question is to you, regardless of whether the government buys this out, is this type of language going to instill any type of sense of confidence in Bank B? If I'm the chairman or CEO of Bank B, I'm like, you know what, I thought things were bad. And that's why I was trying to, instead of charge 2 percent for a loan, I was going to charge 6 percent for a loan. But now the President of the United States, the Treasury Secretary, and the Chairman of the Federal Reserve have frankly used language that no elected or unelected official has ever used before. Days away from financial armageddon? We're on the precipice? Hell, I'm definitely not going to lend right now. I don't care even if they do buy assets. And then I'm going to throw another monkey wrench into the picture. The plan calls for a reverse auction, where the essentially the Fed says, hey everybody, I have $1 billion. Who wants to sell me their mortgages for the lowest price? Well, guess what? The people who are willing to sell their CDOs for the lowest price are probably the most desperate out there. And if anyone participates in those auctions and sells at a discount, those are the people that are going to be on my red flag list. Those are the banks that I'm going to be the least likely to lend to, because I knew that they were desperate. That they were just covering up their balance sheet for as long as they could. They were waiting for the government bailout. And if they're willing to take the government bailout, those are the very banks that I don't want to lend to. Anyway, I'll leave you there. But I just want to give you the point that everyone-- that George Bush and then the rest of his gang is trying to scare the world and say, oh, we are trying to save the economy. They don't mention the fact that even with their bailout, regardless of how unfair it is, we're probably going to end up in the same situation. And frankly, it might even make the situation worse. And that's something I really want to hit home with people. It's like when they started banning short selling in a small number of stocks. When they said, oh you can't short Banks A, B, and C. Immediately that made everyone's ears go up and say, oh the government knows something that we don't know. I'm not going to deal with Banks A, B, and C. Because those are probably the stinkiest of them all. Anyway, see you in the next video.