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Bailout 9: Paulson's plan

What Paulson wants to do and why I don't like it. Created by Sal Khan.

Video transcript

In the last video we saw that it's not just an issue of one bank failing. Because maybe one bank does fail, some of its loans come due. In this case, Bank A had some loans from Bank B that come due. It couldn't liquidate these assets. And then it couldn't liquidate these CDOs for enough money to pay for this loan. So Bank A had to go into bankruptcy. Then we saw that could create a whole chain of events. Then this loan that Bank B had made to Bank A, the one that actually precipitated the event, that had to be written down. Because then Bank A is going to go into bankruptcy and you don't know how much you're going to get back for that loan. And of course, everybody who had loans to Bank A, maybe Bank D had loans to Bank A. So maybe this asset right here was also a loan to Bank A. Everyone with loans to Bank A all of a sudden gets afraid. They might have to write down their assets. And now, on top of the CDO problem that we were all talking about, these smelly assets that no one wants to value correctly, on top of that you have this issue of these loans that I made to this other bank, now all of a sudden those are impaired assets. These are assets that probably aren't worth what I thought they were. And so you have this situation. One, Bank A was the last one to fall. But maybe everyone starts looking at Bank C next. And it's usually reflected in the stock price. People start shorting the stock, the stock go starts going down. And then Bank C has a situation where it has some loan to Bank F, it comes due. And because its stock price is going down, no one wants to lend it money because they say oh you're just another Bank A, I'm not going to lend you money. No one wants to jump in and give them equity, no sovereign wealth fund. Because you're just going to go to zero, why would I buy any stock for even $1 a share when it's going to go to zero because your liabilities are greater than your equity. So no one wants to save them either. And so now, you have this chain reaction occurring, this cascade of negative events. All the banks are afraid to lend to any other bank. And you've probably read articles that the Fed is injecting liquidity. What the Fed was doing was, they were saying, OK, we'll take some of these assets that Bank C has. We'll take them as collateral and we'll lend you money. And even if this was horrible collateral, the Fed just got very nervous and just started lending money to anybody. Anybody who was allowed to borrow from the Fed. And I don't know if you remember, but the Fed extended it. Normally, it's just commercial banks. But at the beginning of the credit crisis-- or actually after the Bear Stearns collapse, the Fed allowed investment banks and other people to start borrowing from the Federal Reserve directly. Normally, when the Federal Reserve lends money to someone, that person borrows that money, keeps some of it, and lends the rest to someone else. And so that money enters the system. And it allows the actual money supply to increase. But what's been happening now is when banks use this money to borrow from the Fed or to borrow any money, they used these assets as collateral, they just sit tight on that cash. Because they're like, I don't know what my assets are worth. I don't know what other of my assets are going to fail. When these loans come due that I owe, I better have some cash. Otherwise, I'm just going to be another Bank A. So people were borrowing from the Fed, or borrowing in general, but they weren't lending out again. So that money just kind of went into a black hole. So everyone was just sitting tight on top of their money. So what's the problem here? Well clearly, one bank failure can lead to multiple bank failures. Especially if no one's willing to lend them more money. So you can say, oh well the only problem is all of these banks just fail and who knows the world might be better off for that. Because you won't have all these people who frankly aren't making anything. Although, I don't want to say that. Because there is a use for the financial services sector. But to some degree a lot of what happened in the last five years, they weren't creating value, they were just leveraging up and increasing the risk in the system. But anyway, let's put that aside. So you might say, OK, worst case, these banks all go bankrupt. They get restructured. But they come back. The only negative of that will be that the current shareholders lose all their money. But that's OK, no risk no return. There was risk. And the risk was that your stock goes to zero. But then the banks will come back with new equity. And then they'll be back in five years under new ownership. You might say that's OK. What the problem is maybe all of these banks, there's just a cascade, they go under. But not all of these loans that they make out are to other banks. Some of these loans they make out to the real economy, what everyone is calling Main Street now. Some of these loans they're making out are to a company that makes tractors. Or company maybe it's an agricultural company that needs loans to buy seeds for the next year's crop. So these are loans that are actually funneled into the real economy. And if every bank is just sitting on their money, then these loans aren't going to be made into the real economy. Those real companies aren't going to be able to make investments, to buy seeds, or to make a loan to build a factory for a product that's actually doing quite well. And so everyone will be starved off. And we'll go into this massive recession. Because even though there is good uses of capital, if you were to give someone a loan, they could use that loan to actually create value by planting seeds, or by building a factory. Those loans aren't available. Those factories won't get built. Those seeds won't get planted. The farmers will lay off people. The factories will lay off people. And you could imagine, we'll go into this economic down cycle. So that's what Paulson and the Federal Service are concerned about. Although, some people would debate that they're more concerned about the banks than the real economy. And they're just using the real economy as kind of a sideshow or the rationale. So what are they arguing that they want to do? Well they said the crux of this issue is, if these $2 billion in CDOs, whatever the CDOs at any of the banks are holding, if only the people could realize the value. If only this $2 billion that they have on their books could be turned into $2 billion of cash, this wouldn't be a problem. Because when these loans come due, if you believe this $2 billion, then all of these banks have positive net worth. They all have positive equity. And then this whole chain reaction won't happen. So when the bailout plan first came out and they said we'll create this $700 billion fund to buy some of these toxic assets. and at first they said we'll buy them at a discount and we'll hold them to maturity and then we might even make a profit. I said, well that might sound good, but how's that going to solve this situation? Because if you were to go to this bank and buy the CDOs, you'd be an idiot to pay $2 billion for them if the market is only giving, instead of $2 billion, only $100 million for them. Why would you pay $2 billion? In fact, these $2 billion are actually based on assumptions from 2006 when housing prices can't go down and everyone was paying off their mortgages. And everything was rosy. Those are maybe the assumptions that drove this $2 billion price. So if you paid $2 billion for this asset, sure, you would save Bank C. But you would essentially be buying something that's worth a lot less. And even if you held it to maturity, you're not going to ever see a present value of $2 billion. So when I first read the bailout proposal, I said they're going to pay some discount on that, but that's not going to help the situation. Because let's say these are only worth $0.10 on the dollar. If they paid 10% of $2 billion. If the the Fed came in and paid $200 million for this. And it's not even clear that it's worth $200 million, maybe the market is only willing to pay $100 million. But let's say the Fed comes in and pays $200 million for it. They would have to mark this down to $200 million. So that's $1.8 billion writeoff. Something that was worth $2 billion is now worth $200 million. So if you write out $1.8 billion, then you're going to have minus $800 million of equity. Or $0.8 billion of equity. And then you would still go bankrupt. In fact, it would just force the issue. If the Fed were to go in and buy at what they're calling now fire sale prices, but it's actually probably an accurate price. Even if they were to buy slightly above that, but still at a discount, it would force this bank to write down this asset. It might have to then realize negative equity. And it would still create this whole chain of events. And so this is what the Fed actually said. They actually said no we don't want to buy it at fire sale prices. I think Bernanke's exact words were that, we're not going to buy at fire sale prices, we're going to buy at hold to maturity prices. So to me, what the Fed is saying, we're going to pay enough money for these assets so that these banks still have positive equity. And so the these banks can still pay off any liabilities that come due. Well you might say, well hey Sal, that's not a bad idea. And I say, that's a horrible idea. Because if these are really worth $100 million, and you're paying $2 billion for it, you're essentially writing a government check, $1.9 billion. Let's say this is really worth minus $0.8. Let's say that they're really worth zero, just to simplify things. Let's say these are actually worth zero and the government pays $2 billion for it. The government is essentially writing a $2 billion check to the equity holders of this company. The real equity is worth minus $1 billion. But the government is going to essentially write them a $2 billion check so they can get their billion dollars back. And it's also going to benefit the bond holders. Because if this is worth zero, not only will these guys get wiped out, but then these guys are only going to be able to capture back some of these $3 billion. So these liabilities are going to be written down. These guys that are owed $4 billion are only going to be able get $3 billion back. So if the government were to pay $2 billion for this, it's essentially writing a $1 billion check to the shareholders and a $1 billion check to the bond holders or the people who lent this company money. And essentially, those are the worst people to be writing a check to. Because these are the people who essentially lent money that shouldn't have been lent. These are people who took risk. They took all the reward over the last five years and now when the risk hits, the government is essentially having welfare for the private sector. So that in my mind is the worst idea. The government is arguing, I know it's bad, and these are the people we don't want to reward, but by doing this, we save the real economy. Because by doing this, we prevent this cascade from happening. And hopefully, these banks will still lend to the farmer and still lend to the the guy who wants to build a factory. In the next video I want to show you one, why that might not be the case. That even if they were to do this, as much as I disagree with it, if it worked maybe it's worth it. But one, I'll argue that it probably won't work. And two, there are better ways to do this. More equitable, more fair ways to do this. And we'll show you that in the next video.