If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Bailout 13: Does the bailout have a chance of working?

Can the bailout work? Created by Sal Khan.

Want to join the conversation?

  • blobby green style avatar for user bilal muzaffar
    how are CDOs so worthless? After all the are secured by houses and houses will not become completely worthless?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • starky tree style avatar for user Reed Rawlings
      The CDO's are broken up into tranches. Sal assumes in most of his videos that the banks hold the riskiest tranches in their assets. If everyone or most everyone in the riskiest tranche defaults then the CDO could be worth 0. The CDOs are backed by mortgages not houses. If someone defaults on their mortgage the house is sold and that money goes to the investors in the CDOs who were in the safer tranches. If half the homeowners default, and in a low real estate market, half the homes are only worth 60% then the total in the CDO won't be enough to cover the riskiest tranche (the part the bank owns) and is therefore worthless.
      (10 votes)
  • duskpin ultimate style avatar for user Theresa
    Will you make a similar series of bank bail out videos using a more recent example in 2019?
    (4 votes)
    Default Khan Academy avatar avatar for user
  • piceratops tree style avatar for user david r
    So - did the actual interest rate go up with less banks willing to give money? Also - usually the interest rate is set by the Fed. Res. - but that's just the basic interest rate - there's still an open market competition with loans between the added/premium interest they charge - is there any track of an "average" interest rate that regular banks charge (opposed to the basic Fed. Res. interest)? Does anyone ever do a survey of this every period of time?
    (2 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Chris Lovato
    I have watched all your videos now great job. But Why haven't you even mention the Feds role in all this? they have their claws in it from beginning to end! They distorted the interest rates by allowed banks to take more risk than they necessarily would have, They facilitated the bailouts by buying many stinky assets, they are also responsible for the quantitative easing for the next bubble we are about to have. also why don't you mention the Banks or IB ability to leverage 9 to 1?
    (1 vote)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Soh Jiaming
      The decision to execute the CDO is not determine by the FED. Nor the decision to loosen the Financing option is executed by the FED. The interest rate is not being determine by just one sector (in your case the housing sector) but instead it is adjusted according the the broader macroeconomics objective. 2) If the bailout is not done, people will still blame the FED for inaction when all their savings and deposits at the banks vanish due to the domino effect. 3) Quantitative easing is also done to prevent deflation from occurring, not mainly to enable the bank to create another bubble (that is why the execution of tighter regulation is going on). I am not trying to support the FED here, but from what I witness every action that the FED took was consistent with their economics objective.
      (2 votes)
  • blobby green style avatar for user Danny
    It is common for banks to lend money to other banks?
    (1 vote)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Ryan
      It is very common. At the end of the day a bank will always try to lend out excess cash it has on the overnight market. These loans will primarily go to other banks that need cash to settle transactions.
      (2 votes)
  • blobby green style avatar for user pdgrein
    At , Sal refers to CDO's backed by credit card debt. I understand that the collateral in a residential CDO is the house, itself. What is the collateral in a CDO backed by credit card debt? Is it just the assets of the credit debt holder? I know in the early 2000's, I was getting offers of ridiculous credit and as an 18-early 20-something at the time, I had zero assets (besides a car, which wasn't worth nearly what the credit I was being offered could've amounted to).
    (1 vote)
    Default Khan Academy avatar avatar for user
  • mr pants teal style avatar for user Wiebke Janßen
    At around : I didn't understand what Alt - A mortgages are.
    (1 vote)
    Default Khan Academy avatar avatar for user
  • leaf orange style avatar for user glauber.motta
    Hi, first of all, im sorry about my english, im from brazil, well, anyway, i would like to understand the credit risk management better, could you show us a litttle more about it, dont you?!

    So, thank you so much becouse of you share your knowledge.

    regards,
    Glauber
    (1 vote)
    Default Khan Academy avatar avatar for user
  • leaf green style avatar for user Palfi Andras
    What are CDO-s backed by credit card debt?
    (1 vote)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user SarahChayaRoth
    Is this bailout referring to TARP or some other package? Because TARP was an infusion of capital via the purchase of preferred stock and was not related to CDO's in the best of my knowledge... Am I missing something? Thanks.
    (1 vote)
    Default Khan Academy avatar avatar for user

Video transcript

Let's put all of the moral hazard issues and all the fairness issues aside. And just think hard about whether this bailout could work. Because frankly, if it doesn't work, then it's definitely not something that any of us should worry about. And even if it does work, then I think you should worry about the moral hazard issues. But let's say this is Bank A, shady Bank A. And it has-- and let's see, these are its assets on the left hand side. And these are its liabilities. And so it has, at least on its books, the book value of the CDOs that it has is $5 billion. And what the government is saying, is that right now, Bank B has lent Bank A this loan. Bank B has given them $8 billion that maybe has to be paid back next month. And the big fear is that Bank B is going to get scared, and then when this loan is due in a month's time, that Bank B won't give them a new loan or renew the loan. They're just going to want to take the money back, because they're afraid of keeping money with these guys, when you don't know what these CDOs are worth. And that's a legitimate fear, right? Because if these CDOs really are worth $5 billion, then you really do have $4 billion of equity here, right? Total assets are $12 billion minus $8 billion of liabilities means you have $4 billion of equity. Fair enough. But what happens if these CDOs are only worth $1 billion? And this is worth $1 billion, and these are worth $7 billion, then you only have $8 billion in assets. And $8 billion in liabilities, and there's no equity. Or even worse. What if this these CDOs are worth zero? Then you have negative equity. Then if these guys were to go bankrupt, if they were to be the next Lehman Brothers, then all this Lender B would get if they went bankrupt are these CDOs worth 0 and these $7 billion of assets. For every $8 they let lend to Bank A, it'll only get $7. So what the government is saying is, OK, to keep Bank B from pulling their money out of Bank A, let's buy out these CDOs at essentially at a price that keeps this bank solvent. Even if they really are worth 0, we're not the Fed or the Treasury-- the Treasury's the one doing it. The Treasury's not going to pay 0, because if they paid 0, this guy would just go bankrupt. It would be another Lehman Brothers. So the Treasury wants to essentially, maybe pay $5 billion for it. So that you take $5 billion-- buy these CDOs for $5 billion. And all of a sudden this doesn't become CDOs of $5 billion, this becomes cash. And their argument is, if you were to do this, no matter how unfair it might be, because this is essentially a check of $5 billion, if you assume these CDOs are worthless. This is essentially a check that's being written to the equity holders and the unsecured debt holders of this bank. But let's assume that-- Let's put all that aside. Let's assume that this works. That now Bank B will say, oh boy, I don't have to worry about those CDOs anymore. Those CDOs have been turned into cash. This company definitely has positive book value, and therefore, I will continue to loan to this company. But it isn't that simple. Because right behind these CDOs, there are other assets on this book. On most banks' books. So these were the subprime CDOs, the stinkiest of the stinky. Then you have other things that are a little bit less risky. They're Alt-A CDOs. These are loans that were given to people who aren't necessarily subprime. These are people who had decent credit scores. But they still put no money down, and they still were able to essentially fabricate their income on there loan applications. So these are the Alt-A loans. Then above that-- And these might be Alt-A CDOs. They've been sliced and diced, so some tranches are more risky, some tranches are less risky. Above that, you might have commercial real estate CDOs. So I'll call that commercial real estate CDOs. Then above that, you might have commercial loans. Just a regular companies. Or even better, these could be loans to private equity-- actually, that's even better. Let's put some private equity loans in there, because I wanted to show you that this isn't the only stinky thing on the balance sheets, these CDOs. That this is just the stinkiest of them all. A good way to think about it is, if you have a dead skunk in your house, you won't notice that the milk is going bad. And that is the situation. These CDOs, they seem really bad now, but you know what? Six months ago, or even a year ago. Six months ago, these CDOs looked a lot like-- these subprime CDOs look a lot like these Alt-A CDOs are starting to look. And the way these Alt-A CDOs looked six months ago is how a lot of these commercial real estate CDOs are starting to look right now. So this is just the tip of the iceberg, these CDOs. So you have an issue here. The government goes in. It spent $700 billion. It buys these assets that are of questionable value. And it's claiming to us that the problem will be solved. But Bank B isn't an idiot. Bank B isn't an idiot. They're probably more prudent than Bank A. They didn't buy these subprime assets. Subprime CDOs. But I wouldn't be surprised if Bank B probably has some of these less stinky things on their balance sheets. Alt-A. I mean, they definitely have something stinky, which is called a loan to A. That's one of their assets. And then they might have loans to private equity, private equity loans. Then they might have some commercial real estate CDOs. They might have CDOs that are backed by credit card debt. The bottom line is that this bank can look into its own assets, and it can see that the fundamental value behind these assets are deteriorating. Anyone who talks to anyone in the real economy right now knows that the economy's slowing. That consumers can't spend any more money. In fact, last year consumers had negative savings, which means that they had to borrow money to fuel their consumption. And the only way that you can have consumption growth in that type of environment is if either salaries increased, which isn't happening, or people are able to borrow more money. And we already know that credit is getting tightened. So if you're Bank B, will the government buying out this asset, irregardless of how fair it is, will that make you confident in loaning to Bank A? Well, no, because you see in your own balance sheet that things are deteriorating. And frankly, you have loans to other people too, right? You have loans to Bank C. That's a loan to Bank E. That's a loan to some sovereign wealth fund. And then you have your equity here. So you have a double conundrum, right? You have all of these guys. These loans might come due, so you're going to need some cash for that in the future. And you see the trend. You're not an idiot. You aren't as risk-taking as this guy, and you see that this wasn't the only stinky thing out there. That there are other assets classes, other types of CDOs, and just loans in general, that are starting to deteriorate. That's starting to deteriorate. That's starting to deteriorate. That's starting to deteriorate. So maybe this credit crunch isn't just because of these CDOs. Maybe it's because this banker is actually being prudent. Maybe this banker's actually saying, you know what, I need to be careful. I see the left hand side of my balance sheet deteriorating. I need to pull this money, just in case, just really in the best interest of my equity holders. Of my shareholders, or even of my bond holders. So even on this first cut, even if there wasn't all of this controversy, and even if George Bush didn't go up, and do a primetime speech telling us that we're about to reach financial armageddon, if I was a prudent banker I would still be wary of loaning to Bank A, even if the government were able to pull this buyout. Now on top of that, I work in the financial industry. Bankers were prudent. They see reality. They see things are deteriorating. So they want to be cautious. But frankly, when Bush, and Paulson and Bernanke go up on TV and say, tell the world that you have to pass this bill and if not, we're essentially on-- they use words like "preicipice." These are the real precipice. And they use "financial armageddon." It's either their words, or some of the other words that I've heard out there. Financial armageddon. And days away from the precipice. So my question is to you, regardless of whether the government buys this out, is this type of language going to instill any type of sense of confidence in Bank B? If I'm the chairman or CEO of Bank B, I'm like, you know what, I thought things were bad. And that's why I was trying to, instead of charge 2 percent for a loan, I was going to charge 6 percent for a loan. But now the President of the United States, the Treasury Secretary, and the Chairman of the Federal Reserve have frankly used language that no elected or unelected official has ever used before. Days away from financial armageddon? We're on the precipice? Hell, I'm definitely not going to lend right now. I don't care even if they do buy assets. And then I'm going to throw another monkey wrench into the picture. The plan calls for a reverse auction, where the essentially the Fed says, hey everybody, I have $1 billion. Who wants to sell me their mortgages for the lowest price? Well, guess what? The people who are willing to sell their CDOs for the lowest price are probably the most desperate out there. And if anyone participates in those auctions and sells at a discount, those are the people that are going to be on my red flag list. Those are the banks that I'm going to be the least likely to lend to, because I knew that they were desperate. That they were just covering up their balance sheet for as long as they could. They were waiting for the government bailout. And if they're willing to take the government bailout, those are the very banks that I don't want to lend to. Anyway, I'll leave you there. But I just want to give you the point that everyone-- that George Bush and then the rest of his gang is trying to scare the world and say, oh, we are trying to save the economy. They don't mention the fact that even with their bailout, regardless of how unfair it is, we're probably going to end up in the same situation. And frankly, it might even make the situation worse. And that's something I really want to hit home with people. It's like when they started banning short selling in a small number of stocks. When they said, oh you can't short Banks A, B, and C. Immediately that made everyone's ears go up and say, oh the government knows something that we don't know. I'm not going to deal with Banks A, B, and C. Because those are probably the stinkiest of them all. Anyway, see you in the next video.