Credit Crisis
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The housing price conundrum
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Housing price conundrum (part 2)
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Housing Price Conundrum (part 3)
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Housing Conundrum (part 4)
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Mortgage-Backed Securities I
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Mortgage-backed securities II
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Mortgage-backed securities III
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Collateralized Debt Obligation (CDO)
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Credit Default Swaps
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Credit Default Swaps 2
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Wealth Destruction 1
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Wealth Destruction 2
Wealth Destruction 2 How bubbles destroy wealth.
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- So what happened in the previous video?
- We had a nice, simple neighborhood in 1995.
- Everyone prudently bought houses with 20% down, they
- bought it for a $100,000.
- And frankly, there were probably more people who
- wanted to buy houses then but they couldn't get financing.
- And that was in place for a reason; because you had to
- prove yourself worthy to get the financing.
- But anyway, 10 years go by, financing gets really cheap
- because you have this dynamic of rising home prices; people
- downplay risk; people are willing to give loans to more
- and more people.
- And they kind of do that, just to keep up
- with the other banks.
- And you have in 2005, at kind of the peak of the bubble,
- someone buys house number one for $1,000,000, with no money
- down, subprime loan.
- And then, a year later, they foreclose and the house is
- auctioned off and it only gets $300,000.
- But between the time that the house was bought for a million
- dollars and auctioned off for $300,000, let's say that
- that's in-- I don't know, let me do that in year, let me say
- this is 2008, now.
- So 2008, this house get's foreclosed, and
- auctioned for $300,000.
- And in the meantime, all of these people-- let's say all
- of them-- took $500,000 home equity loans, right?
- So they all have $500,000 of debt from the home equity
- loans, plus whatever they have left from the original $80,000
- loan, so, maybe, $580,000; if they were only paying
- interest. It may be a little bit less than that.
- Let's just say, it's roughly $500,000.
- And at first, maybe in 2008, they all say, you know what,
- this is temporary, that was just a fire sale price, and
- these auctions don't really reflect a market reality.
- So we're just going to sit tight and wait for our housing
- prices to go up because this wasn't a real transaction.
- But let's say 2009 comes along, and this individual,
- house number two's owner either has to move, has a
- different job in a different city; or maybe they just get
- laid off and they can't pay their mortgage anymore and
- they need to sell their house.
- Well they try to sell their house a little bit and it's no
- coincidence that they sell for $600,000.
- And no one [? call ?]
- [? line ?]
- for awhile, and [UNINTELLIGIBLE]
- starting up, because you have a lot of people trying, at
- least, just be made whole on their loan when they sell
- their house.
- But no one's buying their house.
- So at some point, they give up.
- They go to the bank and they say, hey bank, can I do a
- short sale where if I sell it for less, then I
- don't owe you any debt.
- But the banks are still pretty confident then, and
- they're like, no.
- A short sale is when you sell something for less than what
- you owe on it.
- So a short sale would be like this guy has house number two,
- has let's say a $500,000 mortgage.
- And if he were to sell his house for $480,000 and the
- bank were to agree that $480,000 is all he has to pay
- back, then that would be a short sale.
- Right?
- But the bank says, no, you either sell your house or
- we're going to foreclo-- You either pay us for the debt, or
- we're going to foreclose on you.
- So the guy says, sure, you know what, I
- have nothing to lose.
- I've just lost my job.
- Here are the keys to the house, foreclose on it.
- And so the bank says, OK I foreclosed on it and the bank
- realizes in a few months that was a bad decision.
- Because now, when they auction the house, they don't get even
- $580,000; they don't get $480,000 for it; they get
- $250,000 for it.
- And all of this sounds like a very extreme example.
- Things not that different than what I'm describing happened
- in places like Modesto and Stockton, California, and
- parts of Miami and Nevada and Arizona.
- But anyway, so it auctions off for $250,000.
- Now everyone in the neighborhood gets scared
- because this guy, house number two, made an honest effort to
- sell; couldn't sell; tried to do a short sale; couldn't do a
- short sale; and when the bank auctioned, they actually
- auctioned it off for less than house
- number one, it was $250,000.
- So now, all these people say, what am I doing?
- I'm working three jobs to pay a $500,000 mortgage on a house
- that's probably worth $250,000.
- And if someone really were to be rational about it, $250,000
- isn't some crazy lowball price.
- They paid $100,000 for it.
- Maybe, if you adjust that for GDP growth or inflation, that
- $100,000 in 2009 dollars might be $150,000 or $200,000.
- So $250,000 actually, isn't a crazy price.
- But anyway, all of these people said, why do I keep
- working so hard, being an indentured
- servant to this mortgage?
- I'm just going to give the keys back to the bank, that's
- called: jingle mail.
- So you give the keys back to bank.
- Let's say this guy gives the keys back to this bank.
- This bank that thought that they had made a prudent loan,
- this is house number three, I think.
- So they give the keys back to the bank instead of
- paying off the loan.
- And this bank says, oh boy, now I have this house.
- They auction it off; they get $250,000.
- So what happened to the bank?
- The bank had a $500,000 loan out, it got $250,000 back.
- And also, this person has also lost all of the equity in
- their house that they originally had.
- House number three lost their house.
- So how much wealth is gone from each person's
- perspective?
- Well the bank had given $500,000 of real capital, real
- money that could have been used to build a factory; to
- plant some crops; to work on research and development that
- might have developed new materials or new technologies.
- That was real $500,000 of capital.
- And now, they got a house and they auctioned off that house
- and they got $250,000.
- Right?
- So they lost $250,000.
- And this individual, number one, what did they lose?
- Well, they lost, by entering into this transaction,
- essentially, they lost whatever equity they
- originally had in their house.
- And what equity would they have had in their house?
- Well, they had, let's just say, they had $20,000 of
- equity before they did this transaction, right?
- So they lost that $20,000 of equity.
- And frankly, they could've sold that
- $100,000 house for $250,000.
- We know, even in this quote, unquote, tough real estate
- market, they could have sold it for $250,000.
- So they really had, let's see, they had an $80,000 loan, a
- $250,000 asset, so they really had $250,000 minus $80,000,
- that's $170,000.
- So they really had $170,000 of lost equity, if I'm doing my
- math right.
- But I think you get the point.
- So they did build some equity through housing appreciation,
- just the house didn't go from $100,000 to a $1,000,000, it
- went from $100,000 to $250,000.
- So their equity was actually $20,000 plus the $150,000 that
- they got from just the increasing asset value-- if
- they didn't enter into this transaction.
- So they would've had a another $170,000 of equity that they
- lost. So the homeowner lost $170,000.
- So combined, these two parties, by entering into this
- transaction, how much did they lose?
- Let's see, 300,000, they lost $420,000.
- $420,000 was just wiped out.
- It just disappeared from the economy.
- And where did it go?
- It existed at some point, it must've gone someplace.
- Well, it was consumed.
- It went into these granite countertops and these hardwood
- floors and the vacation; the vacation is pure consumption.
- You could argue, maybe, some of it's investment if it helps
- you become more productive, but for the most part, that's
- pure consumption.
- Things like wood floors and the two more bathrooms and the
- granite countertops, there is some value there, but that
- value is definitely not equivalent to the amount of
- money that was spent on them.
- They were depreciating assets; they're luxury goods; they're
- probably according to the taste of the
- person who did it.
- But anyway, the whole point of this video is, is when you
- have these asset bubbles, like in real estate, and you have
- this downplaying of risk, and this psychology that an asset
- class can only go up.
- And then people start to have an inflated notion of what the
- assets are worth, and start to borrow against those and
- leverage up against those inflated notions, you have to
- have a misallocation of wealth and, essentially, a lot of
- resources end up getting destroyed.
- Resources that could have built factories, could have
- built schools, could have built roads, whatever, ended
- up building granite countertops and sending people
- on vacation and making them feel good to go start shopping
- at Williams-Sonoma or Neiman Marcus or whatever.
- And all of that is, essentially, just consumption
- that just destroys wealth.
- So it just disappears.
- And I want to make this point because we have a government
- now that somehow thinks that it can legislate away real
- wealth destruction.
- It thinks that, you know what, if we just somehow buy this
- loan from this bank, this $500,000 loan, and if we were
- to hold on to it long enough, maybe the underlying asset--
- the house got foreclosed on, so we don't even have the loan
- anymore, we have the house.
- So maybe the government says, oh what if we just buy this
- house and hold it long enough, maybe it'll get back to a
- million dollars.
- It may get back to a million, if our population increases so
- much that, one day, that might become a productive asset
- again, or becomes a high demand asset.
- Or, it might not ever go up; it might be a house that was
- built in the middle of nowhere that's not really useful to
- anyone; and, if anything, it's going to become a place where
- squatters start to come and the whole place turns into an
- empty neighborhood.
- Who knows?
- But the bottom line is the government somehow thinks that
- once things get bad, it can step in and try to not let
- people realize that they have destroyed wealth.
- I call that legislating against reality.
- And reality is something it's very hard to do anything
- against, whether you want to legislate against it, or speak
- against it, or perceive a universe that's not in
- accordance with it.
- But anyway, this is the crux of the issue.
- But with that said, I don't want to seem like one of these
- defeatist people who says that there's no solution to the
- credit crunch.
- In particular, this banking crisis we're
- dealing with right now.
- In the next video, I'll give you a proposed solution that
- was actually suggested to me by a friend
- from business school.
- And I actually think it makes a lot of sense, if you think
- that the credit freeze that's going on is
- the crux of the issue.
Be specific, and indicate a time in the video:
At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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