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Current time:0:00Total duration:11:05

Video transcript

in the last video we saw that it's not just an issue of one bank failing because maybe one bank does fail some of its loans come due in this case Bank a had some loans from Bank B that come due it couldn't liquidate these assets and then it couldn't liquidate these CDOs for enough money to pay for this loan so Bank a had to go into bankruptcy and then we saw that could create a whole chain of events then this loan that Bank B had made Bank a the one that actually precipitated the event that had to be written down because then you know Bank a is gonna go into bankruptcy and no ha you don't know how much is your going to get back for that loan and of course everybody who had loans to Bank a maybe Bank D had loans to bank a so maybe this asset right here was also a loan to bank a right everyone with loans to Bank a all of a sudden gets afraid they might have to write down their assets and now on top of the CDO problem that we were all talking about this you know these these smelly assets that no one wants to value correctly on top of that you have this issue of wow these loans that I made to this other Bank now all of a sudden those are impaired assets these are assets that probably aren't worth what I thought they were and so you have the situation one bank a was the last one to fall but maybe you know that everyone starts looking at Bank C next and it's usually reflected in the stock price people start shorting the stock the stock got starts going down and then Banksy has in a situation where you know it has some loan - I don't know Bank F it comes due and because its stock price is going down no one wants to lend it money because they say oh you're just another Bank a I'm not going to lend you money no one wants to jump in and give them equity no sovereign wealth fund because like you're just going to go to zero why would I buy any stock for even one dollar share when it's going to go to zero because your liabilities are greater than your equity so no one wants to save them either and so now you have this chain reaction occurring this cascade of negative events so all the banks are afraid to lend to any other Bank and the Fed was and you've probably read articles that the Fed is injecting liquidity well the Fed was doing it was they were saying okay well we'll take some of these assets that you know say Banksy Banksy that you have well we'll take them as collateral and we'll lend you and even if this was horrible collateral though the Fed just got very nervous and just started lending money to anybody anybody who was allowed to borrow from the Fed end and if you remember but the Fed extended normally it's just commercial banks but at the beginning of the credit crisis or actually after Bear Stearns after the Bear Stearns collapse the Fed allowed investment banks and other people to start borrowing from from the Federal Reserve directly but all that was happening normally when the Federal Reserve lends money to someone that person borrows that money keep some of it and lends the rest to someone else and so that money enters the system and it it allows the the actual monies of supply to increase but what's been happening now is when banks use this money to borrow from the Fed or for to borrow any money they use this these assets as collateral they just sit tight on that cash because they're like well you know what I don't know what my assets are worth I don't know what other of my assets are going to fail when these loans come due that I owe I better have some cash otherwise I'm just going to be another Bank a so people were borrowing from the Fed or borrowing in general but they weren't lending out again so that money just kind of went into a back black hole and so everyone was just sitting tight on top of their money so what's the problem here well clearly one bank failure can lead to multiple bank failures especially if no one's willing to lend them more money so you could say oh well you know the only problem is all of these banks just fail and who knows the world might be better off for that because you won't have all of these people who frankly aren't making anything although I don't want to say that because there is a a use for the financial services sector but to some degree a lot of what happened in the last five years they weren't creating value they were just leveraging up and increasing the risk in the system but anyway let's put that aside so you might say okay worst-case these banks all go bankrupt they get restructured but they come back the current the only negative of that will be that their current shareholders lose all their money but that's okay no risk no return well there was risk and the risk was that your shareholder your stock goes to zero but then the banks will come back with new equity and then they'll be back in five years under new ownership you might say that's okay but what happens what the problem is is maybe all of these banks is just a cascade they go under but not all of these loans that make out are two other banks some of these loans they make out to the real economy whatever one's calling Main Street now right some of these loans they're making out or to you know it could be to a company that makes tractors or company that or maybe it's an agricultural company that needs loans to buy seeds for the next for the next next year's next year's crop so these are loans that actually funneled into the real economy and if every bank is just sitting on their money then these loans are going to be made into the real economy those real companies aren't going to be able to make investments to buy seeds or to buy make a loan to build a factory for a product that's actually doing quite well and so everyone will be starved off and you will go into this massive recession because even though there is good uses of capital if you were to give someone alone they could use that loan to actually create value by planting seeds or by building a factory those loans aren't available those factories won't get built those seeds won't get planted the farmers will layoff people the factories will lay off people and you can imagine will go into this economic down down cycle so that's what the Federal Reserve that's what Paulson and the Federal Reserve is concerned about although some people would debate that they're more concerned about the banks then then the real economy and they're just using the real economy as as a as a it's kind of a sideshow or the rationale so what what are they arguing what are they arguing that they want to do well they said well you know the crux of this issue is if these two billion dollars in CDOs or these two billion dollars in CDOs whatever the CDO is that any of the banks are holding if only the people could realize the value if only this two billion that they have on their books could be turned into two billion dollars of cash this wouldn't be a problem right because when these loans come due if you believe this two billion dollars then they all of these banks have positive net worths they all have positive equity and then this whole chain reaction won't happen so this is what the government actually went when the bailout plan first came out and they said oh we'll create the seven hundred billion dollar fund to buy some of these toxic assets and and at first they said oh we'll buy them at a discount and you know we'll hold them to maturity and then we might even make a profit I said well that might sound good but how is that going to solve the situation because if you were to go to this bank and say buy the CDOs you'd be an idiot to pay two billion dollars for them if the market is only giving you know instead of two billion if they're only giving a hundred million dollars for them why would you pay to play in fact these two billion are actually based on assumptions from 2006 when housing prices can't go down and everyone was paying off their mortgages and you know all everything was rosy those are maybe the assumptions that drove this 2 billion dollar price so if you paid 2 billion dollars for this asset sure you would save Bank C but you would essentially be buying something that's worth a lot less and even if you held it to maturity you're not going to ever see a present value of 2 billion dollars so the friend when I first read the bailout proposal I said oh they're going to pay some discount on that but that's not going to help the situation because if they pay if they pay let's say these are only worth 10 cents on the dollar so 10 cents on the dollars they pay 10 percent of 2 billion if the if the feds came in and paid 200 million for this and it's not even clear that it's worth 200 million maybe maybe the markets only willing to pay 100 million but let's say the feds come in and pay 200 million for it they would have to mark this down to two hundred million two hundred million so that's a one point eight billion dollar write-off right something that was worth 2 billion is now worth 200 million so if you write out 1.8 billion then you're going to have minus 800 million of equity or point 8 billion of equity and then you would still go bankrupt and in fact it would just force the issue right if you if the Fed were to go in and buy what they're calling out fire sale prices but it's actually probably an accurate price even if they were to buy slightly above that but still at a discount it would force this bank to write down this asset it might have to then realize negative equity and it would still create this whole chain of events and so this is what the Fed actually said they actually said that no we don't want to buy it at fire sale prices which shows you that maybe there and I think Bernanke's exact words were that we're not going to buy it fire sale prices we're going to buy it hold to maturity prices so to me that's what the Fed is saying we're going to pay enough money for these assets so that these banks still have positive equity and so that these banks can still pay off any liabilities that come due well you might say well hey Sal that's not about it you also that's a horrible idea because if if these are really worth a hundred million dollars and you're paying two billion for it you're essentially writing a government check one point nine billion dollars you're essentially let's say this is really worth - point eight you're writing a 1-point let me if these are really worth let's say they're really worth zero right just to simplify things let's say these are actually worth zero and the government pays two billion dollars for it the government is essentially writing a two billion dollar check to the equity holders of this company right the real equity is worth minus 1 billion but the government is going to essentially write them a two billion dollar check so they can get their billion dollars back and it's also going to benefit the bondholders because this is worth zero not only will these guys get wiped out right because you're going to have but then these guys are only going to be able to capture back some of these three billions so these liabilities are going to be written down right these guys that are owed four billion are only going to be able to get three billion back so if the government were to pay two billion for this it's essentially writing a billion dollar check to the shareholders and a billion dollar check to the bondholders or the people who lent this company money and essentially those are the worst people to be writing a check to because these are the people who essentially lent money that shouldn't have been lent these are people who took risks they took all the reward over the last five years and now when the risk hits the government is essentially having you know welfare for the for the private sector so that in my mind is the worst idea the government is arguing is oh but you know I know it's bad and these are the people we don't want a reward but by doing this we save the real economy because by doing this we prevent this cascade from happening and hopefully these banks will still lend to the farmer and still land lend to the lend to the the guy who wants to build a factory in the next video I want to show you one why that might not be the case that even if they were to do this as you know as much as I disagree with it if if it worked maybe it's worth it but one I'll argue that it probably won't work and two there are better ways to do this more equitable more fair ways to do this and we'll show you that in the next video