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Bailout 14: Possible solution

A solution that is MUCH fairer that has a MUCH better chance of working! Created by Sal Khan.

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  • blobby green style avatar for user aespea
    thank you for your effort in explaining the crisis and other banking, finance videos. i truly do appreciated them.
    one question re: Todd's solution
    ( i assume you agree wholeheartedly )
    If we created new banks from the $700 B, what happens to the existing banks? if they fail, what happens to all the savings, CDs, etc. i don't think the FDIC can handle the "bank runs", right ? ( let me know, pls ) also, what other unintended consequences ??? if the Fed starts letting major US banks fail.
    (17 votes)
    Default Khan Academy avatar avatar for user
    • Aespea, I do not know the answer myself, but I believe Sal thinks it is better for these banks to go bankrupt, and then come back re-structured. He has mentioned this in some previous videos, saying they will eventually come back leaner and smarter, or something along those lines.

      As for your concerns about people not wanting to save their money in these banks, I think that would precisely be the point. A couple of the immediately foreseeable and more obvious consequences would likely be:
      (1) the existing banks cleaning up their act to regain people's trust
      (2) people transferring their money to the more trustworthy institutions, possibly the newly created banks or some of the smaller existing banks
      (3) people choosing to invest their money in other ways.

      I am in no way an expert on the matter, however. Think of me as just thinking out loud. :)
      (13 votes)
  • blobby green style avatar for user BrendanHulton
    I like your theory, but I think you are forgetting an important aspect. If we let all the irresponsible banks fail, the FDIC would've had to pay out a lot of insurance on the deposits of the defunct banks. B of America holds $1 trillion in U.S. deposits alone. JP Morgan holds $500B. There is no way the FDIC has this kind of money to pay out to people. Plus the banks are so over-leveraged, their equity may end up being negative. It probably would've cost us more money to let them fail, no?
    (15 votes)
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    • starky sapling style avatar for user Justin Helps
      All of my finance knowledge comes from this site, so forgive me (and please set me straight) if I'm wrong, but I think the FDIC would only have to pay that much if all of the banks' assets were worth zero. Even if a bank becomes insolvent, its assets will hopefully still cover a large percentage of its liabilities, and the FDIC would only have to make up the difference. Also, (I think) the FDIC only insures deposits, so stock and bond holders would still be left to bear much of the burden.
      (9 votes)
  • blobby green style avatar for user vicecitygrif
    Where is the bailout 13 video?
    (4 votes)
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  • hopper cool style avatar for user jphung2020
    What does Sal mean by a "too big to fail problem"? I don't see why that would be a bad thing.
    (3 votes)
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    • male robot donald style avatar for user Kelly Conley
      This is a good question and the term is a little misleading. The problem with "too big to fail" is that it encourages those institutions to take more risk than they should, because they believe they have a safety net (the government). Too big to fail doesn't mean they can't fail but that they are big enough that, if allowed to fail, the impact to the economy would be much larger than a single institution going out of business. It would be like pushing over the first domino in the line and would likely result in many other businesses going down with it.
      (1 vote)
  • purple pi purple style avatar for user Ong Hong Ming Teddy
    Your solution would never be enacted because it is political suicide and politicians will go paranoid and say it will kill all of us. but it is a good plan to refresh the economy but nobody wants to take the risk and everyone wants the benefit. Am i right?
    (3 votes)
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  • leaf green style avatar for user lizoneill128
    (1) With 50 banks, how would you prevent a monopoly within one state? Would it not make more sense to have 70+ banks, to make it clear that there are other options within a state?

    (2) How do you prevent the "oligarch" problem we see in Russia, where powerful people bought up the shares and ended up in control of state resources? With 300m people, some will not value them and some will hoover them up.
    (2 votes)
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  • leaf green style avatar for user bugspot
    But doesn't the current (2012) political climate tell the American people that the government should not be in the banking business? At the moment there is a 50/50 split on helping large interest or help the middle class. It seems to me that the bail out was premised on helping the big banks in return they would lend, honestly. Instead, they are not lending enough, still in 2012, to make industry happy enough to add jobs. The moral hazard problem has not been solved.
    Was the Auto bailout more like a direct loan? It seems that worked well.
    (2 votes)
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  • purple pi purple style avatar for user Ujjwal Vaish
    How come the assets of each bank is worth $140 bn ? What is that 10 :1 leverage concept ? at
    (2 votes)
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  • starky ultimate style avatar for user Sudhanshu Sisodiya
    What's the benefit of levering up?
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      When a company levers up, the equity gets a higher rate of return when the value of the assets increase, but also a higher risk. Say for instance that the assets are owned by 10% equity and 90% liabilities. If the value of the assets should increase by 5%, that would mean that, since the liabilities are fixed, the value of the equity increases by 50%. Of course, on the other side, should the value of the assets decrease by 5%, the value of the equity decreases by 50%.
      (2 votes)
  • blobby green style avatar for user ostinlt
    Hi.
    1. You didnt mention what happens to deposits in the TBTFs that fail when the 50 new banks are established with new capital? This is a HUGE point.

    Thanks.
    (1 vote)
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    • old spice man green style avatar for user raymcgill
      700B directly into economy = another huge bubble due to lots of cash. Inflation = increase of available capital, so would this be a spark to hyperinflation? The Austrian Economists have it right. Read Meltdown.
      Oh, and your idea here is still the best I've heard.
      (1 vote)

Video transcript

I tried recording this possible solution to the bailout video just now, but apparently the sound went bad so I just restarted my computer, so hopefully I won't turn into slow motion man again. Well, anyway, the whole discussion so far has been focused on how did the credit crisis get started, and why the card bailout proposal, one, is wrong from just a moral hazard and fairness point of view, and why it probably won't work even to begin with. So, you know, why even go into it? And some of you all said, well, what could be a solution? And I've argued a little bit in the wealth destruction video that you really can't legislate against reality. That you kind of have to let things correct. You cannot create wealth just by passing bills. All you can kind of do is shuffle around who takes the losses. But in one of the videos, I argued that if the government was serious about helping Main Street, about loans to Main Street, why don't they lend directly to Main Street? And I kind of said it a little bit flippantly that if that was their intention, that's what they should do with the $700 billion. And I got an email from a friend from business school, a very intelligent fellow who I respect very much, and he has a solution that I think is essentially that. Loan directly to Main Street. Don't bail out these people who have already acted extremely irresponsibly and essentially write them checks from American taxpayers. And his suggestion is, instead of buying worthless assets, why not create new banks fully capitalized by the government-- but you might not even have to capitalize them-- and let those banks lend directly to Main Street? And he makes a very interesting point. He says -- let me make sure that I can fit all of this. And I don't know if you can read it. I want this to all fit. But he makes the interesting point. $700 billion of capital -- this is his email that he sent to me -- with $700 billion of equity, this is more book equity, and therefore more lending power, than Bank of America, J.P. Morgan, Citigroup, Washington Mutual, Wachovia, Goldman Sachs, and Morgan Stanley combined. So combine these institutions, which are really the pillars of our financial system, they represent $619 billion of book equity. And remember, this is their book equity. This is what they say is the book value of their assets. But we've already learned that they're probably being overstated, and that's why we have to go and buy them at prices more than what they're worth. But this -- just to get an idea how large of a dollar amount this is -- this $700 billion is more than what these banks say they're worth. It's probably several multiples of what they really are worth. Some of these banks probably aren't worth anything. And as it points out, the new bank would have no prior committed loans, so the incremental amount of lending available would be much larger. Which means you are not lending into a black hole. When you lend money or you essentially give money to one of these banks that have all of these other bad liabilities, your money's essentially just being poured into a black hole and there's no assurance that that bank is going to go and then lend that money to other people, and go to main street. But if you inject it into a bank with a completely pristine balance sheet, a new bank -- you could call it you know the Bank of Washington, the Bank of Jefferson. And I would actually recommend having multiple banks, just so you have competition and you don't have that too big to fail problem. But these banks, they would have pristine balance sheets, and they would go out and make loans, and they would go out and make loans wherever it is most prudent. And he says, you know, this accomplishes the goal of injecting lending capital into the system without creating the moral hazard problem, and at the end of a few years, the government will probably be able to IPO sell the bank for more than one times book value, which will include the original $700 billion, generating a substantial profit to the taxpayer. Exactly. In fact, they could either do that, the government could own it and then try to IPO it in five years or so, like Todd suggests, or another option is maybe each of these banks-- maybe the bank takes $700 billion and creates 10 banks that each have $70 billion in initial equity capital. And maybe the government issues 300 million shares of each of those banks, and every American man, woman, and child gets one share of each of those banks. I think that would have a very powerful political statement. And it actually would make economic sense. All of a sudden you would have the American people are now the owners of the banking system, instead of this concentrated wealth that's really formed over the past 150 years in the old banking system. And then, you know, he goes on to point out some other things. Sure, the more current banks would fail probably quicker, and we all know that's a good thing. What happened in Japan? What happened in Japan is we kept infusing capital into-- well, we didn't, the Japanese government kept infusing-- or either did it themselves or coaxed other people to infuse capital into banks that were essentially zombie banks, that were insolvent, and just slowed down. It slowed down the downfall, and essentially led to their lost decade. So he says, you know, more banks would fail, but many of them probably would be deserve to fail, and the financial system would be preserved. I agree with him completely. If the new bank wants to lend new money to new borrowers, it can. Or if it thinks it will make more money buying up old loans, like the CDOs or the residential mortgage backed securities, at a deep discount, it can do this too. But it will be making a clear economic profit decision. And I'd add-- just so that we make sure that the management of these new entities, so that they are aligned with profit-making as opposed to bailing out their own previous past bad decisions, or bailing out the people who they used to work with-- I would try to not put these banks in New York. Maybe you put them in Detroit and New Orleans and Stockton, California, which is the foreclosure capital of the world, of the country. Put them in places that are separate from Wall Street. Hire very intelligent people who have some distance from what has happened the last five, six years in Michigan. And I'll tell you, there are tons and tons of very competent, very intelligent managers who understand these issues deeply in this country. Unfortunately, a lot of them haven't been heads of banks lately. And they would be happy to work for something less than $20 million a year. In fact, I think many of them would do it out of patriotic duty. But you could pay them $100 thousand a year, and then you could say, you know what? You, as the new employees of these new American banks that are owned by the American people-- and they can be traded on an exchange, so it's essentially immediately privatized. It's never owned by the government. It's immediately owned by the private sector, by the American people, not by the government. When I say American people, it's literally owned by private individuals, not by the government. But you can actually create an incentive structure, that whatever the equity value of your company is five years out, you all, as the employees, share 1% of the benefit. And that's actually a huge number, that actually might be too much. But you'll be able to hire excellent managers, especially considering how many people are getting laid off right now, very intelligent people because of bad, risky decisions made by others. But then he finishes up, I recognize this will be less politically popular among banking lobbyists, but see it as a much better way to, one, protect the financial system-- I agree with him completely-- two, minimize the risk, maximize the reward to the U.S. government. And he welcomes any comments, criticisms. And I think it's interesting, he started off the idea, he says, "The problem is this sort of plan would be political suicide, with key financial donors to political campaigns." And that's true. Unfortunately-- I think this is a good idea, but I think the current old banking system has a much more receptive ear of our government unfortunately, than I, or Todd, or frankly the American people seem to have right now. But anyway, I was kind of parsing Todd's email. Let me actually draw out a plan of what this would be. So you take $700 billion-- and let me write that out-- 700, that's thousand, that's million, that's billion. You take that $700 billion, and you-- I don't know, I think the more banks the better. You want competition. You don't want to have this too big to fail problem. So you take that $700 billion, and the first time I recorded this video, I said you put it in 10 banks. But, I don't know, let's put it in-- let's see, 700 divided by 10 banks would be $70 billion each. If you do what? If you do 70 banks, you would have $10 billion each. So let's do that. Put it in 70 different banks. 70 different banks. Or maybe do it in 50 different banks, one bank for each state of the country. 70 different banks. I mean, that sounds crazy, but when you think about what the government was originally-- Actually, let's do 50 banks. I like the sound of that. One bank in every state, right? And they're not all concentrated in New York, and they're not, you know, so you get fresh thought, fresh blood in them. And they might actually hire people that are getting laid off in the manufacturing sector or the real estate sector or whatever. You take 50 different banks. You capitalize them each with what? 50 goes into 700 billion 14 times? Right. 14, let's see, 15 -- right, goes in 14 times. So you capitalize them each with $14 billion, so their balance sheets are going to look like this. Equity-- this is each bank-- $14 billion of initial equity. And they're going to have 300 million shares, one for every American. And if they don't like the holding shares, they can sell them. They'll all IPO on the exchanges. And then these will be member banks of the Fed. And so they'll be regulated, but they can lever up 10 to one. So they can, let's say with $14 billion of assets, each of these banks can control $100-- with $14 billion of equity, each of these banks can control $140 billion of assets. Which, essentially, that's $140 billion that they can lend out to the world. If they see good returns, good economic investment in Main Street, they'll do it there. If they think that some of the existing banks are actually good credit risks, that they could lend maybe to J.P. Morgan, or Bank of America, they'll do it. Maybe they won't do it at 6% like the Fed wants them to, or at 2%, or whatever, they'll say that's a little risky, or maybe I'll do it at 10% or 12%. And this is another side note I'd like to say, it seems like the Fed is getting frustrated that it wants to dictate that banks have to lend to each other at 2%, but they're willing to only lend to each other at 6%. And so it's losing control over that notion of what banks lend to each other at. 6% is still low. If I have to lend money to someone who could go under next week, I want at least 12% or 15%. And I don't think that's a crazy interest rate. That's what people were paying in the early '80s, and they weren't talking about financial Armageddon back then. But anyway, each of these banks would have $140 billion in assets, and then-- I don't know, how much in liability? Let's see, 140 minus 14 is $124 billion in liabilities. And they would be very easy to borrow money. These banks would have an easy time borrowing money from a bunch of different people. And why is that? Well, one, they have completely pristine balance sheets. No one worries about what kind of stinky things they have on this side, because it's all new investments. And then if the government really wants to make sure that these banks get off the ground running, they can make them a temporary government back stop on it. So essentially, they could be government-sponsored enterprises, but not indefinitely. We don't want a Fanny Mae, Freddie Mac again. You could say five year government back stop. Which essentially says, if you lend to these banks over the next five years, anyone lending to these banks over the next five years, if for whatever reason these banks were to go under you will be made whole. So there's literally no risk to investing in these banks. And frankly, frankly, if just this five year government back stop on these banks, I think will encourage people to invest equity in these banks, and the government might not even have to put these $14 billion in each bank. But anyway, I've run out of time. I'll continue this in the next video.