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Current time:0:00Total duration:12:07

Video transcript

so now let's think about I talked about what the feds bailout proposal is is that they essentially want to take 700 billion dollars and use that to buy some of these smelly assets these CDOs that have on that that a lot of these banks have on their balance sheet and that which which have been kind of the cause of why a lot of these banks are going under or at least why a lot of the banks aren't lending to each other and we said you know I kind of touched on the last video that yes in my mind maybe it solves a problem but if it does even if it does solve a problem we'll address that in this issue but in this in this video but it seems like a really horrible thing to do because if you were to buy these assets that are worth let's say they're worth zero you pay two billion dollars for them you're essentially writing a check to the equity holders of this company the shareholder this company who bought you know they benefited from all the reward and of the last five years of getting the returns on that stock price and the dividends and whatever else and now all of a sudden when things go bad they don't bear the risk the American taxpayer bears the risk and so you're writing a 1 billion dollar check to the equity holder and a 1 billion dollar check to the liability holders or the people who lent this company money and you've probably heard the word moral hazard bantered around moral hazard and this is as good of a time as any to explain what people mean by a moral hazard well there's a couple there's one just a superficial notion of hey you are writing a check to the very same people who made bad decisions right the people who lent this company money made bad decisions and the equity holders of this company made bad decisions one the people who invested in this company they didn't they didn't realize the risk and also a lot of the equity holders are the management of the company and they're the very ones who invested in these CDOs and if you were to essentially buy out these CDOs you're not penalizing them for making bad decisions they get to keep all their bonuses before maybe they get to keep their job still and you're propping up their stock price so that's one element of moral hazard the other element of moral moral hazards and this kind of this is a more nuanced notion but it's in some ways the more important element of moral hazard and that's if the government goes in every time that there's some type of financial stress right all of these people took risk they had they got the reward already but when the risk starts to hit the government goes in and make sure that these people don't have to don't have to deal with their consequences the moral hazard there is is in the future people are going to say you know what I'm going to take risk because if when times are good I'm going to make the money and when times are bad we've seen it multiple times the government the US government is all too ready to come out and bail that bail out the private sector so you create this moral hazard well even in the few you're making these bubbles more likely to happen in the future because people are not going to be as concerned about risk because they're like look at these idiots they took all the risks in the world they bought CDOs that people lend money to these people who bought CDOs they were levered up and the government even bailed out these dudes so I can take huge risk I'll get all the reward from them in the future the government's just going to bail me out and that's the other element of moral hazard well anyway with that the side and I would argue that there's a lot of moral hazard with the government's current bailout proposal maybe that moral hazard is worth it if it prevents this chain this cascade of events from happening if somehow it allows people to start lending to each other and most importantly start lending to the real world like the guy who wants to build a factory or the farmer who wants to borrow money for seeds for next year's crop now what I've heard and I don't know the exact numbers here and I'm not an expert here is that there's about I've heard the number better at five trillion dollars of these toxic CDOs so one the on all of these financial institutions bank balance sheet so I don't know if that's the accurate number but I do know for sure is 700 billion is is a is a relatively small fraction of the total amount that's out there and Bernanke and Paulson they're essentially arguing no no I we you know we know 700 billion it doesn't represent all of the CDOs out there even if you were to buy them at a discount but what we're hoping to do is by going out there and with a large amount of money and and starting to buy these CDOs that will hopefully create some type of a market in these CDOs and they talk about doing a reverse auction where we'll say okay we're ready to buy a hundred billion in CDO so whatever banks whatever banks are willing to give 100 the 100 billion dollars worth of CDOs that the best price those are the ones we're going to buy from that's a reverse auction you go and you say I want to buy who's going to sell to me for the cheapest price and so that's what they say and by doing that maybe it'll create other other other private interests will say hey the government's getting a good deal on these CDOs I want to buy into and maybe other people will start buying the CDOs the reason why I call that crap is because if other people were there to buy CDOs they would buy them already and when and the bottom line is when you do it with this type of reverse auction when you say oh I have 100 billion I want to spend on CDOs Paulson and Bernanke they're arguing that that would somehow create some type of market price for these CDOs that these that these banks could then mark their assets and everyone will know what they're worth to problems that will not be a market price because you're creating artificial demand artificial demand from the government if the government wasn't there there wouldn't be this 100 billion dollar entity wanting to buy assets so the assets would go for less and then the second thing is what if the government does that and people realize that these two billion dollars of CDOs even when the government does this reverse auction are actually worth only I don't know these are only worth 500 million right that's what people are willing to unload them for and and it's probably the more solvent people who do it because for them it won't make them go bankrupt well if they're really worth 500 million then every other bank that holds the same things will have to write these this 200 million down to five hundred million this two billion down to five hundred million and so their equity will get wiped out and the cascade will start all over again so I don't buy it on two counts one I don't think it'll actually create a real market price that anyone would believe I don't think it's going to make anyone jump into the market all of a sudden frankly if someone thought these were good deals are a lot of very very sophisticated investors out there who have a lot more knowledge about what these assets really mean then frankly the Treasury does and if they thought they were good deals I guarantee you there is capital out there where they would go in and buy these assets for what they thought is a good deal and hold them to maturity there is cash out there and I think that's an important issue that people don't realize a lot of people are out there holding cash they're holding Treasuries they just don't want to invest in these because they are bad deals people are looking for a good deal but these are most probably not worth much doubly worth nothing so what is another solution and this is something that a lot of people have have bantered around a lot they said well why doesn't the government just go instead of just buying out these CDOs which is essentially just writing a check to the very few the very people who got us into the situation why not buy stock in these companies so we we talked about those situations with the sovereign wealth funds right where the sovereign wealth fund comes in bought you know in that example they buy three billion dollars worth of of equity and they gave three billion dollars worth of cash and then the company can use those to pay off its debt that frankly is not a horrible idea the only reason why I would say it's still not a great idea is you're diluting the shareholders but what if this equity is worth zero right what if there's actually negative equity here if this is worth zero if these two billion dollars are actually worth zero then this isn't an insolvent company right you have three billion of assets four billion of liabilities this is actually minus 1 billion of equity so really this stock has no value the correct share price of the stock if we didn't have limited liability with corporations would be the correct market capitalization would be minus 1 billion dollars so why would you pay a positive price for that for those shares so even in that situation if this is really worth zero and the government were to buy shares buy a lot of shares and infuse this with capital it would save the company it would penalize the equity holders because all of a sudden instead of having 500 million shares you'd maybe have 2 billion shares if you owned a hundred percent of the company before now you only own 20% of the company and that's actually what happened with AIG you might say well that's a pretty good situation but still the government's taking a little bit of a hit and and frankly if the government did that I think the risk reward might be reasonable there because if the government were to infuse capital into these banks if they were to so let's say let me do the example let's say there's 500 million shares now the government says you know what we're going to give this company 4 billion dollars so we're going to give it 4 billion of cash 4 billion of cash and let's say for those 4 billion shares let's see if the current is for those 4 billion shares we want no we want another let's make it like really intense let's say the government wants 10 10 billion shares right so essentially they're paying 40 cents per share so then we're going to have 10 billion shares here that's 10,000 million we're going to have 10 point five billion shares this is actually not a bad situation for me so the company now will have four billion dollars of cash four billion dollars of cash 3 billion dollars of other assets and now the CDOs and maybe those CDOs are worth nothing now no matter what this company cannot go bankrupt because 4 billion dollars of cash 4 billion of liability it could pay office liability with that equity infusion and net and and and and the people who deserved to kind of take some downside did get downside because the equity holders they used to have a hundred percent of the company with their 500 million shares now they own what is this this is one they own one 21st of their company so they went they got diluted from owning a hundred percent of the company to owning what like yeah like less than 5% of the company so this might be a fair situation although I would still say even in this situation you are bailing out the people who lent this money to the bank right they they lent money to an institution that they should have known better than to lend money to they said they're holding all these toxic saat assets they collected interest on this institution right when the institution was about to go belly-up the government does this huge equity infusion and essentially takes over the company makes it a part of the government right because the government now owns 90 something percent of the company and pays off the liability holders so I would still say that there is still some moral hazard here because in the future people say oh I'm willing to lend maybe you know you're you you're still hurting the equity holders but you still be willing to lend to an American bank because you'd say when things get bad the American government goes in and bails out the bank by buying a bunch of equity so you won't properly price and risk in the future but if if if this does open up lending markets and people start lending to the farmer or to the guy who wants to build factories then maybe this is worth it and I'll actually you know in my mind if the government is really not worried about the bed and they really are worried about this piece right the farmer who needs a loan or the guy who wants to build a factory the needs alone why don't they take that 700 billion and just create a fund to lend directly to the real world to lend directly to Main Street why don't they just let all of these banks go bankrupt go into bankruptcy they'll come back and they'll come back leaner and more efficient with proper risk measures and the proper everyone will get punished appropriately so that in the next upcycle there won't be all of this moral hazard and you have the seven hundred billion dollars that is going directly to lend to farmers and and and companies that are building capital equipment or whatever and of course there still is moral hazard it's going to get highly politicized who do you lend to etc etc maybe then you still do a reverse auction but the bottom line is if the government were genuine about being concerned about Main Street they wouldn't do they wouldn't use the seven hundred billion in this indirect way they would lend it directly to Main Street anyway see you in the next video