Finance and capital markets
How bubbles destroy wealth. Created by Sal Khan.
Let's do an example of how a housing bubble can lead to wealth destruction. And I really just want to hit the point home that once wealth is destroyed, all legislation can do is redistribute who takes the losses. That you can't create wealth, all of a sudden, out of legislation. You can maybe create incentives for investment et cetera, et cetera, but we'll talk about that in a future video. So let's say, in year one, I have a neighborhood and Toll Brothers goes out and builds a new development and they build five houses. Let me draw those five houses. House one, house two, house three, house four, and house five. And let's say, that this was a normal home buying environment. This could have been 1995. Let's just say, for the sake of argument, this is 1995. Although, I want this to be an abstract example, so we could call that year one. But in 1995, these people find five new families that go buy the house. They pay $100,000 each, for the houses. These were conforming loans, there wasn't this whole CDO and mortgage-backed security market. So essentially, these people have to put 20% down, and they had good credit scores, and all the rest. So immediately, they have $20,000 equity and an $80,000 loan. It's my code, E for equity. Now, we have this whole securitization, lending becomes a lot easier, becomes easier and easier every year because housing prices go up, so people stop taking risk into consideration. And let's say, we get to the year 2005. This could be an abstract example, it could be year two. In 2005, all of a sudden everyone is getting access to funding. The people who have houses actually don't want to sell the houses because they're convinced that their housing prices are going up so fast, that it's only a matter of time before they're millionaires just with the housing wealth, and then they could maybe retire off of it. But there's so much funding and anyone can get a loan. And let's say, that these first homeowners, maybe they have to move, or maybe they just want to move to a cheaper location, or maybe their kids have gone to college, so they just want to downsize. They decide to sell their house. And because there's so much demand out there, anyone can get a loan, frankly, the person who's going to be able to give the highest bid on the house, is a person, to some degree, who's most reckless or most prudent. And anyway, I won't go into that. But let's say, they pay $1 million for the house. They have no money down, $1 million loan, subprime, negative amortization, they had no credit rating, et cetera, et cetera. They pay $1 million. Now, that was the purchase price of the house. And we could just say, that they have zero equity. And of course, this guy's great now. He probably did build equity over that ten years from 1995 to 2005, but even if he didn't, even if all he did was pay the interest on this $80,000 loan. This guy, he had $20,000, now he gets $1,000,000, pays off the $80,000, so he essentially, gets $920,000 plus the $20,000 had before. So he moves to Costa Rica with $940,000 and lives like a king. Although, I've heard Costa Rica has also become expensive. But anyway, what happens now in the neighborhood? These people didn't sell their houses. They didn't find some subprime individual that was willing to bid up the house. Nothing happened, no money changes hands, but all of a sudden, these people say, well you know what, our houses are just as nice as this first house that sold. Maybe it's even better. So our houses are also worth $1 million. So we all have this kind of you could say, paper wealth here of $1 million. Just from one transaction. And actually, this is a five house neighborhood, this could happen in a 500 house neighborhood. You just to find one person to overpay for a house and then everyone in the neighborhood, all of a sudden, feels at their house is worth that much. And just out of thin air, just by one person getting cheap credit and overpaying for something, everyone in the neighborhood thinks that they just got $900,000 of wealth, or at least in this example. You never see a nine-fold increase in property prices but it wasn't crazy to see a two-fold increase in a year. Well, we have seen nine-fold increases over ten years, it's the example here, it's actually not that crazy. Anyway, that's all of their notional wealth. But all these people don't want to sell. One, they like their house, their kids are still there. And they say, wow, in ten years my house went from $100,000 to $1 million and in another ten years, my house is going to go from $1 million to $10 million. Why would I sell it; I can then retire off the house. They don't think, who could buy a $10 million house in ten years. The only people who could-- well anyway, I'll do another video on that, I just don't want to run out of time. But they can still monetize this. They could say, well when I go to my financial planner, they said, oh, it's so inefficient for you to have all of that equity sitting in your house. How much equity do they have? They had $20,000 before and even if they didn't build any equity while they paid their mortgage, they now have another $900,000 of equity. So these people, their financial planner, and their siblings, and their friends at work say, oh, your balance sheet is so inefficient, why don't you take some of that equity and invest it or put it to work. So they say, that's a good idea. I'll go get a home equity loan. So let's say, this person goes to a bank. A bank says, OK, sure, I'll give you a $500,000 home equity loan, and in exchange, get 8% interest on that loan. So this is the bank. And the bank thinks it got a great deal. Because this $500,000 loan is not an unsecured loan. It's not as if this person can't pay, they just file bankruptcy and there's nothing that the bank can get ahold of. This home equity loan is secured by the house. So the bank says, well if this person doesn't pay that $500,000 loan, if they default, for whatever reason, I get their house. And their house is worth $1 million. And why do I think it's $1 million? Because a house in the neighborhood sold for $1 million and frankly, that's how, unfortunately, housing was assessed. People would just say, oh, another house in this neighborhood sold for $1 million, this one must be worth $1 million because it's a very similar or maybe even a better house. So this banker thinks they have a great deal. This is better than buying treasuries. I'm getting 8%, maybe treasuries are giving me 3% or 4%. And if they default on it, I actually get an asset that's probably worth more than the loan amount, and I can auction that off and easily get my $500,000 back. So the risk managers within the bank think they have a great deal. And they probably sliced and diced these things and sold it to other people and got it rated as triple-A and all of that. But what happens next? Well let's say, 2005, in our imaginary universe was the peak of the credit cycle. That was the year that credit was the loosest. And as soon as some of these people who had no jobs and got these $1 million loans, they probably couldn't even pay the mortgage on their loan, not to speak of continuing it, or even pay the low rate on the original teaser loan. So maybe, they start to default, credit starts getting tighter, and let's say, this guy actually gets foreclosed. And so he gives the house back to the bank. The bank auctions it off and let's say, when the bank auctions it off, it only gets $300,000 for the house. And in the meantime, what did all of these people do with the $500,000 that they had? Well their intention was to take these home equity loans and put that money to work, invest it in some way. And they say, well what's a better investment than doing home improvements? Because we all know a house is the best investment. So unfortunately, a lot of that $500,000 it gets quote-unquote invested in granite countertops, two more bathrooms per house, hardwood floors, and you can imagine. They wanted to treat themselves too, so they did a little vacation. So it was invested quote-unquote in their house. Because they said, oh well, this will increase the value of my house. And oh, as a side benefit, I will really look good, relative to the neighbors and live it up. I can live beyond, essentially, what my income would predict. And I've done some videos on investment versus consumption, but I'd argue that this wasn't real investment, that $500,000. That this was consumption because it's not making the world more productive in any way; it's not increasing the total economic pie for the world, so it's not investment. It may be an investment if it somehow makes your asset more emotionally appealing to some greater fool to pay more for it. You didn't build a factory or you didn't invent some new technology that will make all of us richer, you just poured some money into something that's going to make your lifestyle a little bit better, and maybe the next person who buys your house. But anyway, this house got foreclosed upon. It gets auctioned off for $300,000, maybe this is the year 2006. Now, all of a sudden, all of these people, probably all of whom who took these home equity loans, let's say all of them did it. They all say, gee, I'm paying a $500,000 loan. Actually, I'm paying $500,000 plus my original $80,000 loan, so, I have $580,000 of debt on an asset that just sold for $300,000. So what do you think they're going to do? And I just realized I'm out of time, so I will continue this in the next video.