Bailout 8: Systemic risk

I think we're now ready to tackle the big picture and what has our government officials so worried right now. So what I've done is, I've just drawn the balance sheets for a bunch of banks. Obviously, this is simplified. And I made all of their balance sheets look the same. All of these banks, each of these kind of represents the balance sheet of a bank. And just to explain it, the left-hand side of this balance sheet, so this column right here-- and maybe I can, at least for the first bank, mark it a little bit. So what I'm squaring off in magenta, that's the assets of that bank. What I'm squaring off in blue, that's the liabilities of the bank. And what I wrote here is, it has $4 billion of liabilities. Its assets, I divided it between $3 billion of other assets and $2 billion of CDOs. Because we want to focus on the CDOs, because that's the crux of everything that's going on. And we have $5 billion in assets, $4 billion of liabilities, so you have $1 billion in equity. So that's what's left there. So this is just another visual representation that liabilities plus equity is equal to assets. Or assets minus liabilities is equal to equity. And I've just copied and pasted this one balance sheet a bunch of times. I don't know whether we're going to use all those. But let's just assume, for simplicity, that a ton of banks in the system have this identical balance sheet. Obviously, they don't have an identical balance sheet. But all of their balance sheets might have kind of similar properties. This isn't always the case, different banks have different exposures to CDOs. Some of them have a lot, some of them have a little bit. Some of them are valuing them more conservatively than others. But just for the sake of simplicity, I've just made all the banks in the situation where the book value of the CDOs that they have on their balance sheets is the larger than their equity value. And I did that for a reason. Because it leads to the issue of, are these banks facing just a liquidity issue or are they facing just a solvency issue? If you believe that these are worth $3 billion, these assets, these liabilities are worth $4 billion, then the crux of whether it's a liquidity or a solvency issue all falls down as to whether these are worth $2 billion or not. For example, if these are worth $2 billion, then you have $1 billion of equity. If these are worth $1.5 billion, well maybe they're being a little optimistic here, but you'll still have $0.5 billion of equity. So you're still solvent. And in that situation, in theory, one is just if they don't have the cash when some of their debt comes due, they should just be able to borrow some money and get past that hurdle. And then in the future maybe sell their assets and still have positive equity. However, if the true value of those CDOs, and this is kind of a philosophical question, what's the true value of anything? And the best thing that we as humans have been to be able to come up with is a market. The market value tends to be the best representation of the true value of something. Let's say the true value of this is $1 billion or less, then we have a situation. For example, if these are worth nothing, then we only have $3 billion of assets, $4 billion of liabilities, we have negative equity. This company is worth nothing. And to lend this bank or this company any money would just be throwing good money after bad. Because that money is just going to go into a black hole. Because one of the people who this company owes money to is probably not going to see their money. And if you are the most junior person lending the money-- which means that when all the money is distributed if they go into bankruptcy, you're the last person to see the money-- then you're just throwing good money after bad. So that's the issue. But I want you to see the big picture now. Because if it was just an issue with one bank it wouldn't be a big deal. If it was just Bear Stearns or if it was just Lehman Brothers, not a big deal, let the greedy bankers go bankrupt. And they probably are doing just fine with the bonuses they've collected after sourcing these CDOs for the past eight years or five years or however long. But what I want to show you in this video is what people are talking about when they say systemic risk. So these $4 billion in liabilities, these are loans, maybe from other banks. In fact, probably from other banks. And those loans from other banks, those are assets of other banks. For example, let's say this is Bank A, this is Bank B. Maybe a billion of these are a loan from bank B. And if this is a loan from Bank B, Bank B would have an asset called loan to Bank A. On Bank B's balance sheet we're calling this a loan to Bank A. This is one of its assets. And then one of its liabilities will be a loan from Bank B. So how can I say this? They took this money and they gave it to B. I'm sorry, B had money, gave it to A in the form of a loan. And so that cash ended up here. And they got an asset called loan to Bank A. And this is a liability, loan from Bank B. And they might have taken that money and they might have lent it to Bank C down here. I think you're starting to see how this gets pretty hairy very fast. So let's say that Bank A, one of its $3 billion in assets, is a loan to Bank C. And so on Bank C's balance sheet, it'll say loan from Bank A. Or so we owe A $1 billion. And A says, C owes me $1 billion, and that's all fine. And then you see that oh, we owe B $1 billion. And then we could keep doing this. Or I could just even make this into a circle already. So maybe Bank B has some money that it owes to someone else. And let's say that someone else, just for fun, just to make this interesting-- I think you can extrapolate and think about how this gets complicated very fast. Bank B has borrowed money from Bank C. So Bank C will have an asset here that says, no I lent money to Bank B. Fair enough. OK, so now we're in an interesting situation. Let's say this loan, the loan from Bank B to Bank A comes due. And we've studied this multiple times. And let's say for whatever reason, all of these other loans, they're not liquid. They're not due yet. So Bank A can't get rid of these loans. So let's say this comes due, this is $4 billion. They can't sell any of this. So Bank A has to come up with $1 billion somehow for Bank B. So that's the situation we're dealing with. I'm just going to say that they can't sell any of these assets. So it all comes down to the CDOs. So there's a couple of issues here. If you think it is just an issue of illiquidity, if these are $2 billion of assets, they're really worth $2 billion, but Bank A just can't sell them. Because either there's quote-unquote nobody willing to buy. Although, I would argue if no-one is willing to buy something, then its true value is probably zero. But let's just say Bank A says no-one is willing to buy, we're just illiquid, this is really worth $2 billion. So one situation is they could get a loan from someone. Maybe the Fed would be willing to take this as collateral. So they would give this as collateral to the Fed. Maybe the Fed will give them a billion dollar loan. And then they can use that to pay Bank B. Let's say that's off the table because this is just smelly enough collateral that not even the Fed, which we now realize is willing to do anything to support the markets, not even the Fed is willing to give them a loan. Or enough of a loan to pay off that loan. The other situation is maybe they can get an equity infusion from a sovereign wealth fund. And we covered that a couple of videos ago. Where the sovereign wealth fund will essentially inject some cash. It'll dilute the shares and then you know maybe we had 500 million shares before. Now we'll have 2 billion shares. So the sovereign wealth fund will take over roughly 80% of the company. And in exchange for 80% of the company, would give maybe $2 billion and then you could use that to pay off this loan. But let's say that that's not on the table anymore either. Because the sovereign wealth funds have gotten burned so much. So what happens? Well we learned what happens. If you can't get a loan, a new loan, to replace this loan, or if you can't get an equity infusion from kind of a greater fool, what happens? You go into bankruptcy. And this is what happened to Lehman Brothers. Lehman Brothers went into bankruptcy. No sovereign wealth fund, no one else bought the company. And I should probably do another video on that scenario. And they couldn't get a loan. So they went bankrupt. I should call this Company L actually. But I'll call it Company A for now. Because I don't want to impugn anyone. I actually don't think Lehman was any worse or better than any of the other players here. So when they go into bankruptcy, something very interesting happens. Now, Bank B, they were already worried about these CDOs. These CDOs were already an issue. And they were probably thinking, boy when when Loan C comes due, I'm going to be in trouble. Or when Loan D, or F, or whatever, I'm going to be in trouble because I'm going to be in that situation that I'm essentially forcing Bank A into right now. But now I have a new problem. This loan to Bank A isn't getting paid off. And who knows? Bank A is going to go into bankruptcy. Maybe in bankruptcy we realize that these are worth nothing. And if those are worth nothing, then maybe I'm very junior in seniority in terms of where my loan is and maybe I get nothing. Or I get a few pennies on the dollar here. So maybe I thought this was $1 billion and I have to write this down to $0.5 billion. So now I have two problems. I have this and I have this. And once again, this is a non liquid loan. Bank A is in bankruptcy. And if I wanted to somehow get the value of this I have to wait for all of Bank A's assets to go into liquidation. And then whatever assets I get I would have to sell it. So this is kind of a frozen asset. So once again, I'm stuck holding this non liquid asset. So now I have this non liquid asset that's probably not worth what I thought it was, which was a loan to A. Then I also have these CDOs. And now, God forbid, let's say that I had another loan to Bank D. And now let's say Bank D goes bankrupt. And then I have another loan that's bad on top of these CDOs. But the CDOs were the crux of the issue. That's what caused the situation. If Bank A could have only sold this CDO for $2 billion, it wouldn't have caused this chain reaction. And Lehman Brothers really was the thing that catalyzed this whole chain of events. And then you can imagine now Bank C is worried because now Bank B has all of these illiquid assets on top of these CDOs and it starts to look bad. And you can imagine, now it's even less likely that when a bank, let's say that Bank D is the next one to go into a dire situation, it's even less likely that Bank D can get a loan from a third bank. Because all the banks are getting scared now. All the banks are saying, I'm not going to loan money to anyone. If I can get any cash from anybody I'm just going to keep it. So that when it's my turn, when the market starts looking at me, I at least have a little cash. So everyone is frozen. Everyone wants to collect their loans from everyone else and no one wants to give loans to anybody else. So that's the situation we're in. And that's the difficulty that the Fed is somehow trying to unwind. And I realized I'm out of time again. I will confront that issue in the next video.