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Current time:0:00Total duration:10:40

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 $100,000 and frankly you know there was there was probably more people who wanted to buy houses then but they couldn't get financing and that that that was in place for a reason because you had to prove yourself worthy to get the financing but anyway ten years go by financing gets really cheap because you have this dynamic of rising home prices people downplay risk people are willing to give a loans to more and more people and they kind of do that just to keep up with the other banks and you have at in 2005 at kind of the peak of the bubble someone buys house number one for a million dollars you know without no money down subprime loan and then a year later they foreclose for 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 in auctioned off for three hundred thousand let's say that that's in I don't let me do that in year let me say this is 2008 now so 2008 this house gets foreclosed and auctioned for $300,000 and in the meantime all of these people I say all of them took five hundred thousand dollar home equity loans right so they all have five hundred thousand dollars of debt from the home equity loans plus whatever they have left from the original eighty thousand dollar loan so you know maybe it's five hundred eighty thousand if they were only paying interest it's maybe a little bit less than that let's just say it's roughly five hundred thousand dollars and at first maybe in two thousand eight they all say you know what this is temporary that was just a fire sale price on you know these auctions don't really reflect a market reality so you know we're just going to sit tight and wait for our housing prices to go to go up because this wasn't a real transaction but let's say 2009 comes along 2009 comes along and this individual house number two's owner house number two's owner I don't know you know either has to move has a different job in a different city or maybe they just get you know that they get laid off and and they can't pay them or get any more they need to sell their house well they try to sell housed a little bit and it's no coincidence that they try house for I don't know six thousand dollars they'd sell for six hundred thousand dollars and no one caught lying for a while and the Ettore 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 and you know I don't know you any dad but the banks are still pretty confident then they're like no you know if you have a short sale a short sale is when you pay when you when you sell something for less than what you owe on it so a short sale would be like this guy has a five house number two let me say number two house number two has a five let's say a five hundred thousand dollar mortgage and if he were to sell his house for four hundred eighty thousand dollars and the bank were to agree that four hundred eighty thousand 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 gonna [ __ ] all you either pay us at the debt or we're gonna 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 okay 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 five hundred eighty they don't get four hundred eighty thousand dollars for it they get two hundred and fifty thousand dollars for it and although this sounds like a very extreme example things not that not that different than what I'm describing happened in places like Modesto and Stockton California and and parts of Miami Nevada and Arizona but anyway so auction is off for two hundred fifty thousand dollars now everyone in the neighborhood gets scared because this guy made house number two been an honest effort to sell couldn't sell try to do a short sale couldn't do a short sale and when the bank auctioned they actually auctioned it off less than house number one was two hundred fifty thousand so now all of these people say what am i doing I'm working three jobs to pay a five hundred thousand dollar mortgage on a house that's probably worth two hundred fifty thousand dollars and if someone really were to be rational about it two hundred fifty thousand isn't some crazy lowball price they paid a hundred thousand for it and maybe if you in just adjust that for GDP growth or inflation that hundred thousand and two thousand nine dollars might be 150 or 200 thousand dollars so 250 thousand actually isn't a crazy price anyway all these people said wow I'm why do I keep you know 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 the 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 was 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 right so what happened to the bank the bank had a five hundred thousand dollar loan out it got $250,000 back and also this person has also lost all of their equity in their house that they originally had right house number three lost their house so how much how much wealth is gone from each person's perspective well the bank had given five hundred thousand dollars of real capital real money that could have been used to build a factory - I don't know plant some crops - to work on research and development that might have developed you know new materials or new technologies that was real five hundred thousand dollars of capital and now they have they got a house and they auctioned off that house and they got $250,000 right so they got they lost two hundred fifty thousand dollars lost two hundred fifty thousand dollars and this individual number one what did they lose well they lost by entering into this transaction essentially they lost that 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 twenty thousand dollars of equity before they they did this transaction right so they lost that twenty thousand dollars of equity and frankly they could have sold that hundred thousand dollar house for 250 right we know even in this quote/unquote tough real estate market they could have sold it for 250 so they really had let's see they had an $80,000 loan a $250 asset so they really had let's see that's a - 50 - 80 that's one second 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 a hundred thousand to a million it went from a hundred to two fifty so their equity was actually twenty thousand plus the one hundred fifty that they got from from just the increasing asset value if they didn't enter into this transaction so they would have had another hundred seventy thousand of ech of equity that they lost so the homeowner lost one hundred seventy thousand so combined these two parties by entering into this transaction how much did they lose to see three hundred they lost four hundred and twenty thousand dollars four hundred twenty thousand dollars was just wiped out it would just disappeared from the economy and where did it go I mean you know you say well you know that existed at some point it must have gone someplace well it was consumed it went into these granite countertops and these hardwood floors and these Vicky I mean the vacation is pure consumption I mean you could argue maybe some of its investment if it helps you become more productive but for the most part that's pure consumption things like wood floors in 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 their 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 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 you have a misallocation of wealth and essentially a lot of resources end up getting destroyed resources that could have built fact that could have built factories could have built schools could have built roads whatever they ended up building granite countertops and sending people on vacation and you know making them feel good to go you know stop start shopping at williams-sonoma or or an even marcus or whatever and all of that is essentially just consumption that just destroys wealth so this this 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 if we buy it from that and if we were to hold long enough maybe the underlying asset does or you know that the house gets foreclosed on so we don't even have the loan anymore we have the house so maybe the government says oh well what if we just buy this house and hold it long enough maybe it'll get back to a million dollars it may it may get back to a million if we if our population increases so much that one day that might become a productive asset again or become a high-demand asset or it might not ever go it might be a house that was built in the middle of nowhere that's not really useful to anyone and if anything is going to become a you know a a it's going to be a place where a squatter start to come and the whole place is going to turn into a this you know 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 I don't know not let people realize that they have destroyed wealth and and and you know 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 or or perceive a universe that's not in 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's that that was actually suggested to me from by a friend from business school I actually think it makes a lot of sense if you think that that the the credit freeze is going on is the crux of the issue