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CNN: Understanding the crisis

Video of Sal on CNN on October 10th discussing the credit crisis and a potential solution to it. Created by Sal Khan.

Video transcript

Rick: Susan Liscovicz, thanks for that report. We'll be talking to you, obviously, throughout the course of this newscast. I want to bring somebody in now that I'm realy excited about having on this show. He's totally different from most of the people that we talk to. He's gained his fame on YouTube, of all places, where people to go to see how he explains things that many of us frankly don't understand, so let's start with the basics, Sal Khan, thanks so much for being with us from the Khan Academy, by the way. Basic question, explain to our viewers. Explain to the million people out there what is actually broken that we need to fix? Sal: Right, and right now, we have so many, you know, the stock market goes down every day, and people are having foreclosures, and banks are stopping lending and they're failing, so it's really hard for people to keep track of what is the problem. Are these just causes of the problem, or are they the actual problem? I think we need to take a step back, and I've drawn a little diagram, here. Rick: Let's put it up. Sal: Drew a little diagram here, and I think there's a basic fundamental question that we all have to ask, and what does the financial system do? They make a lot of money. Hopefully they add some value to our economy, and this diagram essentially explains what the financial system does, so in a capitalist economy, you have a lot of people with capital. That could be land. That could be gold. That could be, I don't know, animals. that could be cash, and what you need to do in order to make the economy grow is invest that capital into projects. Build factories, plow seeds, hire people. What the financial system does, the banks, and the markets, they take that capital and hopefully they allocate it on projects that actualy put people to work, hire people, grow our GDP. The problem right now is, as opposed to the financial system actually putting more capital into the real world, it's, for the most part, more concerned with self-preservation at the moment. They're kind of in survival mode, and because they're in survival mode, you don't have this flow of capital going from whoever has it to the financial system and then to the projects. You pretty much have everything just going back into the financial system because it's in essentially survival mode. Rick: So, I see the financial system in the middle. Why is that piece broken? Draw that one up for us. Sal: Sure, and here I'm going to attempt to give everyone a 5-minute MBA, but essentially, what I've drawn here is our balance sheets for some banks, and it might sound like a complicated term, but a balance sheet is, I think, something that most people are fairly familiar with when they talk about home equity. Rick: Mm-hmm. Sal: So, if I were to draw a balance sheet for someone's house, it would look something like this. So the asset would be your house, whatever it's worth, and then your liability, and I'll call that A for asset, and then your liability would be your mortgage. Your liability would be the loan. Rick: Mm-hmm. Now, if your house is worth $1 million, and your loan, let's say you owe 800,000 on your loan. Rick: Mm-hmm. Sal: Whatever's left over is your equity. Rick: Right. Sal: That's a balance sheet. That's a balance sheet that I think most people are fairly familiar with. For corporations, they have the exact same notion. And I think this is an important point to realize when people talk about the stock market and what does it mean for a company's stock to go to 0? When you buy a stock in a company, you're essentially, you're not buying a share in all of its assets. You're buying a share in its equity. So, if you look at, so I drew two banks here, and we'll talk a little bit more about what's broken, but a bank has assets, and a bank has liabilities. If you take the sum of the assets, and you subtract out the liabilities ... Rick: Mm-hmm. Sal: ... what's left over is essentially the equity. When you buy a stock in a bank or any company, you're essentially taking a share of that. So what's broken here is through the housing bubble, a lot of these banks, in order to facilitate this whole securitization, and I can go into more detail into what that is, they essentially accumulated these assets on their balance sheets. This has been, this has been the central focus of the entire bailout plan, and there's been a lot of talk about toxic CDOs and what are they worth, but I just want to show you what they do to a bank's balance sheet, and why it's so important that we figure out what these things are worth because you see here, I drew the, you can kind of view the height of this left-hand side as the assets. The height on the right-hand side is the liabilities. What's left over is the equity. If these toxic CDOs are worth nothing, if this disappeared, then all of a sudden, your assets are worth less than your liabilities. If your house is worth less than your mortgage, then you have no equity. In that situation, your stock would be worthless. In that situation, there's no reason why anyone should be lending to you, because you're essentially throwing good money after bad. Rick: So, essentially, the situation that the banks find themselves in is the same as the one that homeowners had found themselves in as a result of this. Sal: Pretty much. Homeowners, you have an asset that's worth less than your liabilities, what do you do? Do you try to get someone to bail you out and buy your asset for more than it's worth or do you just declare bankruptcy? Rick: Let's hold off right there. We're gonna come back in just a little bit, and we're gonna continue that conversation, and we're also gonna be bringing you something today that's an exclusive to this particular hour on CNN. The story of Curveball. Who is Curveball? He may just be the only person that the Bush Administration used as their source for going to war in Iraq, or certainly as much as anyone else. Was he right? No. Who is he? No one's known, up to now. An exclusive interview with Curveball. Stay with us. We'll be right back. (upbeat music) twitter.com/ricksanchezcnn So many of you, 23,000, I believe when we last checked are talking to us, watching this newscast as well as on MySpace and Facebook. In fact, there's somebody on MySpace right now. She's watching our show and she just wanted us to know this. She says, "My son is 17 years old "and excited about college. "I'm worried that we won't be able to get a loan "to send him now. "My husband's hours have been cut back from work "as well. "This absolutely affects all of America." And that's why we're doing what we're trying to do for you. Let's go back now and bring in Sal, if we can. Sal Khan. He explained to us moments ago what it is that is actually the problem. What it is that is broken. Now, let's take the next step. Let's try and understand because everyone seems to be wondering. I don't understand this bailout / rescue plan that the government's been in. What is it? What is the government actually doing? Explain that to us so we could understand it like a 5th grader. Sal: Right. The main problem, just to take the big picture, was that no one's lending to each other. What the government at least said that they wanted to do is try to get the lending started again. Their bailout plan was essentially, let's buy out these toxic CDOs, because if I'm, let's say I'm a good bank that didn't get involved in this. If Bank A is holding these toxic CDOs, I'm not sure if Bank A should be bankrupt, if the toxic CDOs are worth nothing, or maybe they are good for the money. There's a lot of uncertainty on what these are worth. The government, at least what they said they would do is if they went in and essentially did these reverse auctions and bought these assets, then that, all of a sudden, would give confidence in these banks. People wouldn't, there wouldn't be uncertainty as to whether you can loan them money and maybe that'll free up the credit, the whole system again. Rick: Will it work? Sal: Probably not. If you think about what's going to happen, psychologically, so Bank A, if you were to, let's say that, you know, if you were to just switch these toxic CDOs, and if you were to just turn that back into cash because the government just bought it, for exactly what Bank A says it's worth. If you just turn this into cash, the question is, is Bank A all of a sudden going to start lending? And there's a couple of things to think about because besides that toxic CDO, there were other things on its balance sheet, and frankly, a lot of these things are starting to starting to get a little bit toxic. No one's really talking about them right now because if you have a dead skunk in your house, you're not going to notice the milk's gone bad, so essentially, you have a lot of assets on your balance sheet right here, that if you're a prudent bank manager, you're going to see, you're going to say, "Boy, I should just keep that cash "because if these turn toxic "because the economy might be turning south "or for whatever reason, "I should just hold onto that cash "so that I don't go bankrupt." So everyone is in complete survival mode, even the good banks. If somehow you were to give them capital and Paulson's new version of the plan is that essentially, they'll inject equity, so buy stocks. If you buy stock, you'll essentially make this pie bigger and put some cash here, but even this guy, the good bank, it's not so clear to me that he'll actually start lending. Everyone is in survival mode. This isn't a time to make new loans and take on new risks. Rick: So it seems like the government went in, and they had decided, "You know what we're gonna do? "We're gonna go in there and help these guys out, "and as soon as we help them out, "everybody will realize that now they have "the government's backing, "so other people will be interested in helping them. "More people will give them their money." That hasn't worked. The people and other investors haven't bought into that. When we come back, I want to hear your idea of what, perhaps, the government should have done or could still do to rescue this. It's unique. It's different. You and I had talked about it earlier, but I want you to be able to share it with our viewers. Also, Curveball, the story that we've been telling you about. This is gonna be a CNN exclusive to this hour about one particular individual who no one has ever talked to before. He only speaks German and Arab. You'll hear his conversation here in the next 10 minutes. Stay with us. We'll be right back. (lively music) All right, so we understand now what actually is broken. We've got a sense of what the government tried to do to fix it, but it doesn't seem to be working because enough people / investors and regular folk don't seem to be buying into it. Let's bring in Sal Khan once again from the Khan Academy and talk about what may be done. Either A, would have been the original plan that would have worked a lot better, or something we could still do now, and that is ... Sal: So the big picture, just quick, going back to the big picture is that the financial system no one's lending through, right? Rick: Right. Sal: And every bailout plan so far, the government is just, it just keeps injecting money in either through loans, either through buying assets for maybe more than they're worth or now buying stock. and the logic here is maybe that'll start up the lending, but most probably any new money that you put into the system, to a large degree, is just going to go into survival mode or it's gonna go to essentially make up mistakes that have already been made. So, one idea, and this actually came from a friend of mine, Todd Plutsky, and I actually think it sounded crazy when he first said it, but it actually sounds like a really good idea is take that 700 billion, and remember, the problem isn't, you're not trying to save the financial system. You're trying to save the pipe that goes from the capital to the project. So why not take the 700 billion and capitalize a brand new financial system? Rick: Hmm. Sal: And one thing that Todd had pointed out, 700 billion. It's an astronomical amount of money. That's more than the book value of the equity, book equity is this piece right here on the balance sheet, than JP Morgan, Morgan Stanley, Goldman Sachs, Washington Mutual, Wachovia, and Bank of America combined. So the government could overnight create banks bigger than those banks, although I don't think they should concentrate it all in five or six banks. They should start up ... Rick: So in other words, you're saying why try and put money into something that is so absolutely messed up? If they're half dead, let 'em die. Create a new system all together. But wouldn't that be a problem too? Because then wouldn't those banks be owned by the government? Do we want that? Sal: No, and this is a solution. First of all, just to make a point clear, Paulson's current solution involves government ownership. This plan, what you could do is, the government could capitalize the banks, maybe 20 or 30 banks around the country with the $700 billion, and then each of those banks could have 300 million shares, and they could give one share to every American. Rick: New banks. New, totally new banks. Interesting. Sal Khan, thanks so much. We'll keep you on. We're gonna be talking about this throughout the hour, obviously. We're trying to get people to explain some of these things for us, and what's the market doing right now? Let's put that, let's make that as big as we can possibly can. Down 71, a lot better than we were looking at an hour ago. Maybe you've helped, Sal, in some ways, hopefully. All right. We're gonna come back to that in just a little bit, but obviously one of the key stories that we've been saving for you today, the story of Curveball, the man who seemed to have been the source, so the influence in the invasion of Iraq. As we expected, Sal Khan is a bit of a hit. Does things kind of differently, doesn't he? and, a lot of you have a lot of comments, a lot of questions for him, including this one. Let's go ahead and take a Twitter board, if we possibly can. This one comes in from sanchfan. Yeah, he watches this show a lot, like every day. He says, "Keep Khan talking! "Look, the market is going up!" Apparently, it had been. I hadn't even noticed that. I was so engaged in the conversation. Let's do this real quick. I want to just step away from this for a moment. Wolf Blitzer, thanks so much. Sal Khan standing by. Sal, tell us, if you could, I guess bring us back to basics. How are we being affected by what we're seeing in the news every day, the credit crunch and the situation with the market. Sal: Sure. If we don't unclog the credit system, we know that everyone's gonna unlever their debt, so we're gonna have deleverage. Rick: Mm. Sal: That's essentially everyone unwinding their loans. Deleverage, and this is, I think, a critical point because I think there's been a lot of misinformation out there. That actually contracts the money supply. So, a lot of people out there are worried about inflation, these deficits that lead to inflation, but when you have deleverage, and this is what happened in Japan. This is what happened in the '30s, the money supply contracts. That's our printing press. Leverage is our printing press in a fractional reserve system. That's going to lead to deflation. So, i think a lot of people are worried about are we going to see inflation, are we going to see deflation, and if we don't fix the problem, we're going to see what Japan saw, and we're going to see deflation, and so ... Rick: And deflation, deflation means what? Concretely, to me and you. Sal: Things get cheaper, the opposite of inflation, so unfortunately, maybe salaries will go down, but on the plus side, a lot of assets, you know, people buying a house, they'll get cheaper, even. Rick: Got it. Sal: I know that probably won't be a good thing in the short term. Rick: Yeah, exactly. Not with what the situation is right now. Thanks so much. Sal Khan, you've been a great guest. What an original way of being able to explain things. We're gonna be right back with the closing bell, which looks to be somewhere in the middle of ...