2008 Bank bailout
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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
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CNN: Understanding the Crisis
Bailout 11: Why these CDOs could be worth nothing Why a CDO could be worth nothing even though they are "collateralized".
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- The government has said a lot about the fact that this $700
- billion might not just be a blank check, that we're
- actually buying assets.
- And, who knows, maybe we'll even make a
- profit on the assets.
- And I've hinted and other people have hinted that, well,
- that's very unlikely because these assets, they're probably
- not worth what the government's
- going to pay for it.
- And one could argue that even some of these are worth 0.
- And I've gotten some letters and I've heard other people on
- the news actually say, well, how could they be worth 0?
- They're backed by mortgages, which are backed by houses,
- which are the collateral.
- That's where the collateral comes from, the collateralized
- debt obligations.
- So in this video I'm going to do, hopefully, a reasonably
- straightforward example to show you why some of these
- collateralized debt obligations could be worth
- very little or maybe even nothing.
- So let's do something simple.
- Let's not talk in terms of millions of homes, let's talk
- in terms of 10 homes.
- Let's say I were to create a very small
- mortgage-backed security.
- Essentially, I give out 10 mortgages.
- Right?
- Let's say each mortgage is $1 million.
- Let's say that's 10 times 1 million more.
- 10 times $1 million.
- And the people who I give those mortgages to buy ten $1
- million houses.
- Right?
- So, I create a corporation, a special purpose entity, for
- the sake of this mortgage-backed security for
- constructing these collateralized debt
- obligations.
- That's my company I create, the balance sheet of it.
- What are the assets?
- Well, I have 10 mortgages times a million so I have $10
- million in loans, essentially, $10 million in mortgages.
- And they're collateralized or they're backed by the
- underlying houses that these mortgages were used to buy.
- $10 million in mortgages, $10 million more, right?
- Now, how is this special purpose entity-- we'll call it
- an S.P.E.-- how is this S.P.E.
- funded?
- Well, it's essentially funded by the people who are buying
- the collateralized debt obligations.
- And collateralized debt obligations are essentially
- just debt that is used to fund these mortgages.
- And what's interesting about a collateralized debt
- obligation-- see in a mortgage-backed security, I
- would have just given these $10 million mortgages and
- then, in this corporation, I would have just issued a
- thousand shares.
- And so each share would hold 1/1000 of this value, right?
- That's a mortgage-backed security.
- But in a collateralized debt obligation, I
- split it into buckets.
- So what I do is, let's say I borrow three tranches.
- Just call that buckets.
- So I go to some people and I borrow, I don't know, of that
- $10 million that I said you lent out, I borrow-- I don't
- know-- let me say-- I'll make up a number-- $5 million.
- %5 million from these people, and these are
- the senior debt holders.
- So essentially, both this debt holder and this debt holder
- has to get wiped out before this guy gets impaired.
- Impaired just means that you get less money
- than you lent, right?
- So I borrow $5 million from somebody else and I'm going to
- pay them the lowest interest rate because this is the
- safest bucket.
- So think of it this way: let's say these 10 mortgages, let's
- say that I'm getting 8%.
- And let's say that I'm paying, let me draw, they're giving me
- $5 million.
- Let's say that I'll pay these guys 5%.
- And why are they willing to take a lower interest rate?
- Because essentially any default on this side will hit
- these two buckets before it hits these people.
- So this'll be an arguably very safe debt instrument.
- And I'll do more about that in a second.
- And let's say I borrow another $4 million
- from some other people.
- So they gave me $4 million.
- I have to pay a little bit higher interest to them.
- I have to pay 6% interest to them, right?
- And then, finally, I borrow another $1 million.
- I borrow $1 million from people who are willing to take
- the biggest risk.
- So if there's any defaults over here, these people are
- going to be wiped out before these people get touched.
- And actually, we can figure out the appropriate amount of
- interest, right?
- How much money is coming in per month before anyone starts
- defaulting?
- Let's see, I'm getting $800,000 in per month.
- That's the inflow.
- And then on the outflow, I have to pay these people 5
- million times 5%.
- That's $250,000.
- So that's how much I'm paying to that tranche.
- $250,000.
- And then four times 6%.
- That's $240,000, minus 240.
- So that's what, 800 minus 490.
- So then I have 310,000 left, right?
- So I can essentially pay this $310,000 per
- year to this tranche.
- So they're going to actually get a 31% interest. And that
- sounds great.
- That's why they call that the equity tranche normally in a
- CDO because those people get a lot of upside.
- But guess what: if there's any default, these people get
- wiped out first. And just to make this example clear, let's
- do it very simply because you could model this out and
- assume some type of prepayment et cetera, et cetera.
- Let me scratch this out right here.
- Let's say that one year out, half of the mortgages, I don't
- know, the people refinance or they move or they sell their
- house or whatever.
- So they just prepay the mortgage.
- So let's say in one year.
- Let me redraw this balance sheet in one year.
- So in one year, let's say five of those borrowers-- so this
- is a year later.
- Magenta is my color for a year later.
- A year later, half of those borrowers just refinance or
- they sell their house.
- And so they just pay us back $5 million, right?
- So we get $5 million.
- I'll put that on the asset side of the
- balance sheet, right?
- This is assets.
- There's a bunch of videos on assets and liabilities and
- balance sheets if this confuses you.
- And there's no equity in this company, right?
- Because assets minus liability is equity.
- And I did that because these are special purpose entities.
- Their whole purpose is to structure these securities.
- Their purpose really isn't to be an ongoing operation that
- has net income in and of itself, although there
- probably was equity in the bank who constructed this
- probably took at all.
- OK, so we said half the people refinance.
- Those people were great.
- They were worth giving the money to because they paid off
- their loans in whole.
- But guess what?
- The other half of the people, the title of subprime was
- deserving of them, and they default.
- And we have to foreclose on them a year later, right?
- But all is not lost, right?
- We don't lose that $5 million that we lent those other 5
- million people because they had homes, right?
- These are collateralized debt obligations.
- We are able to take their houses.
- Unfortunately, it's a really weak real estate market and
- let's say, just for the sake of argument, we take those
- five houses from the people who didn't pay, right?
- Five paid, five didn't pay.
- We take the five who didn't pay houses.
- And let's say, when we sell them, let's say we're only
- able to get, I don't know, 60% on those houses, right?
- So 60% of $5 million.
- We're essentially only able to get $3 million for the houses
- we've foreclosed on.
- So a year later, what are all of our assets?
- We get the $5 million in cash from the people who are good
- and paid off their mortgages.
- And then we get the $3 million from the people who
- foreclosed.
- And then we only got 60% of the original purchase
- price of the homes.
- We only got that on the foreclosure.
- That makes sense because credit's getting tighter, and
- it's a tough mortgage market, and all these houses were in
- South Florida or Las Vegas or whatever.
- But what happens now?
- There's really no purpose for this entity to even exist
- anymore because everyone's paid off.
- There's no income streams coming in or out.
- So essentially we will just dissolve the corporation and
- give everyone what they're due.
- Well, this guy, he gets first dibs on it, right?
- He took the lowest interest rate in exchange for having
- the lowest risk.
- So that guy right there, I'll draw him in green because he's
- good to go.
- This tranche right here, he gets a full $5 million.
- That's great.
- He got 5% interest and he got all of his money back.
- Sounds great.
- The CDOs look safe so far.
- But what about this next tranche, this $4 million guy.
- He didn't do so good, right?
- The $4 million guy, that's what he was owed, that's what
- he essentially lent the special purpose entity.
- This $4 million tranche of CDOs.
- He's owed $4 million, but guess what?
- After you pay this guy $5 million, there's only $3
- million left.
- So this guy only gets $3 million.
- So for every $4 he lent, he only gets $3.
- So this guy gets $0.75 on the dollar.
- That's a seven, right there.
- I write my sevens like a European.
- But what happens to that equity
- tranche, this guy up here?
- This $1 million, right?
- He thought he was a genius.
- He lent this money and he was getting a 31% interest.
- Sounded good and, frankly, the bank probably wasn't able to
- unload this to anyone because pension funds and a lot of
- these foreign governments, they only buy the safer
- assets, right?
- So this is the stuff that's probably sitting on a lot of
- these investment bank balance sheets.
- These are the smelly, toxic, stinky assets that people are
- talking about.
- And guess what?
- There's nothing left to pay this $1 million to this guy.
- You pay $5 to this guy.
- This guy only got $0.75 on the dollar, right?
- He was impaired by $1 million here.
- And then this last tranche up here: he gets nothing.
- So the question is: these CDOs that are on banks's balance
- sheets, are they these CDOs?
- Are they a share in that tranche of debt, in which
- case, they're very safe.
- But I would argue in which case the banks probably aren't
- looking to unload them as quickly, or they can probably
- find buyers.
- Are they this tranche, in which case maybe they're worth
- $0.75, but you know even at $0.75, you're just going to
- break even?
- Maybe they're worth, at $0.60 on the dollar, maybe
- they're a good deal.
- Or are they this stuff?
- And if they're this stuff, then they really, really,
- really are worth nothing, at least in the
- example I just gave.
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At 5:31, how is the moon large enough to block the sun? Isn't the sun way larger?
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