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Finance and capital markets
Course: Finance and capital markets > Unit 10
Lesson 4: Paulson bailout- CNN: Understanding the crisis
- Bailout 1: Liquidity vs. solvency
- Bailout 2: Book value
- Bailout 3: Book value vs. market value
- Bailout 4: Mark-to-model vs. mark-to-market
- Bailout 5: Paying off the debt
- Bailout 6: Getting an equity infusion
- Bailout 7: Bank goes into bankruptcy
- Bailout 8: Systemic risk
- Bailout 9: Paulson's plan
- Bailout 10: Moral hazard
- Bailout 11: Why these CDOs could be worth nothing
- Bailout 12: Lone Star transaction
- Bailout 13: Does the bailout have a chance of working?
- Bailout 14: Possible solution
- Bailout 15: More on the solution
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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.
Want to join the conversation?
- 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)
- 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)
- Where is the bailout 13 video?(4 votes)
- What does Sal mean by a "too big to fail problem"? I don't see why that would be a bad thing.(3 votes)
- 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)
- 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)
- (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) - 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) - How come the assets of each bank is worth $140 bn ? What is that 10 :1 leverage concept ? at10:03(2 votes)
- I believe it's what he explains here and the video after; except instead of gold in the below example, he is leveraging the initial setup funding. http://www.khanacademy.org/economics-finance-domain/core-finance/money-and-banking/banking-and-money/v/banking-7--giving-out-loans-without-giving-out-gold(1 vote)
- With $14B of equity how can they create $140B of assets? 10:02(1 vote)
- They also create $126 billion of liabilities. That's what financial instituions do. They borrow from people to lend to other people.(2 votes)
- Sal mentions creating new banks as possible solution, but what happens to the saving accounts / checking accounts in the one of the existing banks if the government allows the current set of banks to collapse.(1 vote)
- What's the benefit of levering up?(1 vote)
- 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)
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.