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Wealth destruction 2

How bubbles destroy wealth. Created by Sal Khan.

Video transcript

So what happened in the previous video? We had a nice, simple neighborhood in 1995. Everyone prudently bought houses with 20% down, they bought it for a $100,000. And frankly, there were probably more people who wanted to buy houses then but they couldn't get financing. And that was in place for a reason; because you had to prove yourself worthy to get the financing. But anyway, 10 years go by, financing gets really cheap because you have this dynamic of rising home prices; people downplay risk; people are willing to give loans to more and more people. And they kind of do that, just to keep up with the other banks. And you have in 2005, at kind of the peak of the bubble, someone buys house number one for $1,000,000, with no money down, subprime loan. And then, a year later, they foreclose and the house is auctioned off and it only gets $300,000. But between the time that the house was bought for a million dollars and auctioned off for $300,000, let's say that that's in-- I don't know, let me do that in year, let me say this is 2008, now. So 2008, this house get's foreclosed, and auctioned for $300,000. And in the meantime, all of these people-- let's say all of them-- took $500,000 home equity loans, right? So they all have $500,000 of debt from the home equity loans, plus whatever they have left from the original $80,000 loan, so, maybe, $580,000; if they were only paying interest. It may be a little bit less than that. Let's just say, it's roughly $500,000. And at first, maybe in 2008, they all say, you know what, this is temporary, that was just a fire sale price, and these auctions don't really reflect a market reality. So we're just going to sit tight and wait for our housing prices to go up because this wasn't a real transaction. But let's say 2009 comes along, and this individual, house number two's owner either has to move, has a different job in a different city; or maybe they just get laid off and they can't pay their mortgage anymore and they need to sell their house. Well they try to sell their house a little bit and it's no coincidence that they sell for $600,000. And no one [? call ?] [? line ?] for awhile, and [UNINTELLIGIBLE] starting up, because you have a lot of people trying, at least, just be made whole on their loan when they sell their house. But no one's buying their house. So at some point, they give up. They go to the bank and they say, hey bank, can I do a short sale where if I sell it for less, then I don't owe you any debt. But the banks are still pretty confident then, and they're like, no. A short sale is when you sell something for less than what you owe on it. So a short sale would be like this guy has house number two, has let's say a $500,000 mortgage. And if he were to sell his house for $480,000 and the bank were to agree that $480,000 is all he has to pay back, then that would be a short sale. Right? But the bank says, no, you either sell your house or we're going to foreclo-- You either pay us for the debt, or we're going to foreclose on you. So the guy says, sure, you know what, I have nothing to lose. I've just lost my job. Here are the keys to the house, foreclose on it. And so the bank says, OK I foreclosed on it and the bank realizes in a few months that was a bad decision. Because now, when they auction the house, they don't get even $580,000; they don't get $480,000 for it; they get $250,000 for it. And all of this sounds like a very extreme example. Things not that different than what I'm describing happened in places like Modesto and Stockton, California, and parts of Miami and Nevada and Arizona. But anyway, so it auctions off for $250,000. Now everyone in the neighborhood gets scared because this guy, house number two, made an honest effort to sell; couldn't sell; tried to do a short sale; couldn't do a short sale; and when the bank auctioned, they actually auctioned it off for less than house number one, it was $250,000. So now, all these people say, what am I doing? I'm working three jobs to pay a $500,000 mortgage on a house that's probably worth $250,000. And if someone really were to be rational about it, $250,000 isn't some crazy lowball price. They paid $100,000 for it. Maybe, if you adjust that for GDP growth or inflation, that $100,000 in 2009 dollars might be $150,000 or $200,000. So $250,000 actually, isn't a crazy price. But anyway, all of these people said, why do I keep working so hard, being an indentured servant to this mortgage? I'm just going to give the keys back to the bank, that's called: jingle mail. So you give the keys back to bank. Let's say this guy gives the keys back to this bank. This bank that thought that they had made a prudent loan, this is house number three, I think. So they give the keys back to the bank instead of paying off the loan. And this bank says, oh boy, now I have this house. They auction it off; they get $250,000. So what happened to the bank? The bank had a $500,000 loan out, it got $250,000 back. And also, this person has also lost all of the equity in their house that they originally had. House number three lost their house. So how much wealth is gone from each person's perspective? Well the bank had given $500,000 of real capital, real money that could have been used to build a factory; to plant some crops; to work on research and development that might have developed new materials or new technologies. That was real $500,000 of capital. And now, they got a house and they auctioned off that house and they got $250,000. Right? So they lost $250,000. And this individual, number one, what did they lose? Well, they lost, by entering into this transaction, essentially, they lost whatever equity they originally had in their house. And what equity would they have had in their house? Well, they had, let's just say, they had $20,000 of equity before they did this transaction, right? So they lost that $20,000 of equity. And frankly, they could've sold that $100,000 house for $250,000. We know, even in this quote, unquote, tough real estate market, they could have sold it for $250,000. So they really had, let's see, they had an $80,000 loan, a $250,000 asset, so they really had $250,000 minus $80,000, that's $170,000. So they really had $170,000 of lost equity, if I'm doing my math right. But I think you get the point. So they did build some equity through housing appreciation, just the house didn't go from $100,000 to a $1,000,000, it went from $100,000 to $250,000. So their equity was actually $20,000 plus the $150,000 that they got from just the increasing asset value-- if they didn't enter into this transaction. So they would've had a another $170,000 of equity that they lost. So the homeowner lost $170,000. So combined, these two parties, by entering into this transaction, how much did they lose? Let's see, 300,000, they lost $420,000. $420,000 was just wiped out. It just disappeared from the economy. And where did it go? It existed at some point, it must've gone someplace. Well, it was consumed. It went into these granite countertops and these hardwood floors and the vacation; the vacation is pure consumption. You could argue, maybe, some of it's investment if it helps you become more productive, but for the most part, that's pure consumption. Things like wood floors and the two more bathrooms and the granite countertops, there is some value there, but that value is definitely not equivalent to the amount of money that was spent on them. They were depreciating assets; they're luxury goods; they're probably according to the taste of the person who did it. But anyway, the whole point of this video is, is when you have these asset bubbles, like in real estate, and you have this downplaying of risk, and this psychology that an asset class can only go up. And then people start to have an inflated notion of what the assets are worth, and start to borrow against those and leverage up against those inflated notions, you have to have a misallocation of wealth and, essentially, a lot of resources end up getting destroyed. Resources that could have built factories, could have built schools, could have built roads, whatever, ended up building granite countertops and sending people on vacation and making them feel good to go start shopping at Williams-Sonoma or Neiman Marcus or whatever. And all of that is, essentially, just consumption that just destroys wealth. So it just disappears. And I want to make this point because we have a government now that somehow thinks that it can legislate away real wealth destruction. It thinks that, you know what, if we just somehow buy this loan from this bank, this $500,000 loan, and if we were to hold on to it long enough, maybe the underlying asset-- the house got foreclosed on, so we don't even have the loan anymore, we have the house. So maybe the government says, oh what if we just buy this house and hold it long enough, maybe it'll get back to a million dollars. It may get back to a million, if our population increases so much that, one day, that might become a productive asset again, or becomes a high demand asset. Or, it might not ever go up; it might be a house that was built in the middle of nowhere that's not really useful to anyone; and, if anything, it's going to become a place where squatters start to come and the whole place turns into an empty neighborhood. Who knows? But the bottom line is the government somehow thinks that once things get bad, it can step in and try to not let people realize that they have destroyed wealth. I call that legislating against reality. And reality is something it's very hard to do anything against, whether you want to legislate against it, or speak against it, or perceive a universe that's not in accordance with it. But anyway, this is the crux of the issue. But with that said, I don't want to seem like one of these defeatist people who says that there's no solution to the credit crunch. In particular, this banking crisis we're dealing with right now. In the next video, I'll give you a proposed solution that was actually suggested to me by a friend from business school. And I actually think it makes a lot of sense, if you think that the credit freeze that's going on is the crux of the issue.