Paulson Bailout
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CNN: Understanding the Crisis
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Bailout 1: Liquidity vs. Solvency
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Bailout 2: Book Value
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Bailout 3: Book value vs. market value
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Bailout 4: Mark-to-model vs. mark-to-market
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Bailout 5: Paying off the debt
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Bailout 6: Getting an equity infusion
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Bailout 7: Bank goes into bankruptcy
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Bailout 8: Systemic Risk
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Bailout 9: Paulson's Plan
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Bailout 10: Moral Hazard
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Bailout 11: Why these CDOs could be worth nothing
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Bailout 12: Lone Star Transaction
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Bailout 13: Does the bailout have a chance of working?
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Bailout 14: Possible Solution
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Bailout 15: More on the solution
Bailout 10: Moral Hazard Alternate plans and moral hazard.
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- 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.
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