Learn about Bailout 10: Moral Hazard Video

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Learn about Bailout 10: Moral Hazard

So now let's think about, I talked about what the feds bail out proposal is. It’s that they essentially want to take $700 billion and use that to buy some of these smelly assets. These CDOs that a lot of these banks have on their balance sheet which had been kind of the cause of why all of these banks are going under or at least why all of the banks aren't lending to each other. And we said, I kind of touched in the last video that in my mind maybe it’s also a problem, but if it does, even if it does all the problem we’ll address in this issue. But in this video, but it seems like a really horrible thing to do. Because if you are to buy these assets that are worth, let's say they worth 0. You pay $2 billion for them. You're essentially writing a check to the equity holders of this company, the shareholder of this company who bought. You know, they benefited from all the reward of the last 5 years. Gaining 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 tax payers bears the risk. And so you're writing $1 billion check to the equity holder and a $1 billion check to the liability holders or the people who lent to this company money. And you probably heard the word moral hazard bantered around. Moral hazard. And this is as good as 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 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 are to essentially buy out these CDOs, you're not penalizing them for making bad decision. They get to keep all their bonuses before. Maybe they get to keep their jobs still. And you're propping up their stock price. So that’s one element of moral hazard. The other element of moral hazards, and this is kind of a more new ones notion. But in some ways, the more important element of moral hazards. 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 got their reward already, but when the risk starts to hit, the government goes in and make sure that this people 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 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 out the private sector. So you create this moral hazard, well, 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, they have people lent money to this people who bought CDOs, they were leveled up. And the government even bail out these dudes. So I can take huge risks, I’ll get all the reward from them and in the future the government just going to bail me out. And that’s the other element of moral hazard. Well anyway, with that aside. And I wouldn’t argue that there's a lot of moral hazard with the government current bill proposal. Maybe that moral hazard is worth it if it prevents this chain in this cascade of events from happening. If somehow it allows people to start lending to each other and most importantly they 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, 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 been to have $5 trillion of these tax CDOs. So one, on all of these financial institutions balanced sheets. I don’t know if that’s the accurate number, but I do know for sure 700 billion is a relative small fraction of the total amount that’s out there. And Burnencky and Paulson, they're essentially arguing, no, 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 were hoping to do is by going out there with a large amount of money and starting to buy these CDOs. That we will hopefully create some type of a market in these CDOs. And they talked about doing a reverse auction, where we’ll say, okay were ready to buy 100 billion in CDOs. So whatever banks willing to give us $100 billion worth of CDOs at the best price, those are the ones we’ll going to buy from. That’s a reverse auction. You go and say I want to buy, who’s going to sell to me for the cheapest price. And so that what they said. By doing that, maybe they’ll create other private interest. Will say the government’s getting a good deal on this CDOs, I want to buy in to. And maybe other people will start buying these CDOs. The reason why I call that crap is because if other people where there to buy CDOs they would buy them already. And the bottom line is when you do all these type of reverse auction, when you say oh I have 100 billion, I want to spend in CDOs. Paulson and Burnencky, they're arguing that would somehow create some type of market price for these CDOs that these banks could then mark their assets and everyone what they worth. Two 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 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 this 2 billion CDOs even when the government does this reverse auction worth only. I don’t know, these are only worth 500 million. Right. That’s what people are willing to unload them for. 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 this 200 million down to 500 million. This 2 billion down to 500 million, 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 will actually create a real market price that anyone would believe. I don’t think it’s going to make anyone jump in to the market all of a sudden. Frankly, if someone thought these were good deals, there are a lot of very, very sophisticated investors out there who have a lot more knowledge about what these assets really mean than frankly the treasury does. And if they thought they were good deals, I guarantee 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 til 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 good deal, but these are most probably not worth much. They're probably worth nothing. So, what is another solution? This is something that a lot of people have bantered around a lot. They said, well why doesn’t the government just go in. instead of just buying out this CDOs, which is essentially just writing a check to the very people who got us in to this situation. Why not buy stock in these companies. So we talked about those situations with the Savern well funds, right. With the Savern well fund comes in, but in that example, they bought $3 billion worth of equity and they gave $3 billion worth of cash. And then the company can use those pay off instead. That frankly is not a horrible idea. The only reason why I say it’s still not a great idea is you're diluting these share holders. But what if this equity is worth 0? Right? What if there's actually negative equity here? If this is worth 0, these $2 billion are actually worth 0. And this is in an insolvent company. Right. You have 3 billion of assets, 4 billion of liabilities. This is actually minus 1 billion of equity. So really the stock has no value. The correct share price of the stock, if we didn’t have, limited liability of the corporations would be the correct market capitalization would be minus $1 billion. So why would you pay a positive price for those shares? So even in that situation, if this is really worth 0 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 may be having 2 billion shares. If you owned 100 percent of the company before, now you only owned 20 percent of the company. And that’s actually what happened with AIG. You might say, that’s a pretty good situation, but still. The government is taking a little bit of a hit. 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 or 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, I'm going to give this company $4 billion. So were going to give it 4 billion of cash. 4 billion of cash. And let's say, for those 4 billion shares, let's see. The current is, for those 4 billion shares, we want, I don’t know, we want another. Let's make it really intense, let's say the government wants 10 billion shares. Right. So essentially they're paying 40 cents per share. So then were going to have 10 billion shares here. Just 10,000 million. We’re going to have 10.5 billion shares. This is actually not a bad situation for me. So the company now will have $4 billion of cash. $4 billion of cash. $3 billion of other assets. And now these CDOs and maybe those CDOs are worth nothing. Now no matter what, this company cannot go bankrupt. Because $4 billion of cash, 4 billion of liability. It can pay off this liability with that equity infusion. And the people who deserve that kind of takes some downside did get downside. Because the equity holders, they use to have 100 percent of the company with their 500 million shares. Now they own, what is this, this is 1/21st of their company. So they got diluted from owning 100 percent of the company to owning, what, like less than 5 percent 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 lent money to an institution that they should known better than to lend money to. They said, they're holding all these taxes, that assets. They collected interest in this institution. Right when the institution is 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 97 percent of the company and pays off the liability holders. So I would still say that there still some moral hazard here. Because in the future, people say, oh, I'm willing to lend. Maybe you're still hurting the equity holders, but you're 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 equities. So you won't properly price and risk in the future. But 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 banks. And they really are worried about this piece, right, the farmer who needs the loan. Or the guy who wants to build a factory that needs the loan. 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 they don’t 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 be get punished appropriately. So that in the next up cycle, there won't be all these moral hazards. And you have the $700 billion that is going directly to lend, to farmers, and companies that are building capital equipment and whatever. And of course, there still is moral hazard. It’s going to get highly politicize. Who do you lend to et cetera, et cetera. Maybe then you still do reverse auction, but the bottom line is that if the government were genuine about being concern about Main Street. They wouldn’t use the 700 billion indirectly. They would lend it directly to Main Street. Anyway. See you in the next video.

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So now let's think about, I talked about what the feds bail out proposal is. It’s that they essentially want to take $700 billion and use that to buy some of these smelly assets. These CDOs that a lot of these banks have on their balance sheet which had been kind of the cause of why all of these banks are going under or at least why all of the banks aren't lending to each other. And we said, I kind of touched in the last video that in my mind maybe it’s also a problem, but if it does, even if it does all the problem we’ll address in this issue. But in this video, but it seems like a really horrible thing to do. Because if you are to buy these assets that are worth, let's say they worth 0. You pay $2 billion for them. You're essentially writing a check to the equity holders of this company, the shareholder of this company who bought. You know, they benefited from all the reward of the last 5 years. Gaining 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 tax payers bears the risk.
And so you're writing $1 billion check to the equity holder and a $1 billion check to the liability holders or the people who lent to this company money. And you probably heard the word moral hazard bantered around. Moral hazard. And this is as good as 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 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 are to essentially buy out these CDOs, you're not penalizing them for making bad decision. They get to keep all their bonuses before. Maybe they get to keep their jobs still. And you're propping up their stock price.
So that’s one element of moral hazard. The other element of moral hazards, and this is kind of a more new ones notion. But in some ways, the more important element of moral hazards. 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 got their reward already, but when the risk starts to hit, the government goes in and make sure that this people 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 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 out the private sector.
So you create this moral hazard, well, 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, they have people lent money to this people who bought CDOs, they were leveled up. And the government even bail out these dudes.
So I can take huge risks, I’ll get all the reward from them and in the future the government just going to bail me out. And that’s the other element of moral hazard.
Well anyway, with that aside. And I wouldn’t argue that there's a lot of moral hazard with the government current bill proposal. Maybe that moral hazard is worth it if it prevents this chain in this cascade of events from happening. If somehow it allows people to start lending to each other and most importantly they 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, 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 been to have $5 trillion of these tax CDOs. So one, on all of these financial institutions balanced sheets. I don’t know if that’s the accurate number, but I do know for sure 700 billion is a relative small fraction of the total amount that’s out there.
And Burnencky and Paulson, they're essentially arguing, no, 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 were hoping to do is by going out there with a large amount of money and starting to buy these CDOs. That we will hopefully create some type of a market in these CDOs. And they talked about doing a reverse auction, where we’ll say, okay were ready to buy 100 billion in CDOs. So whatever banks willing to give us $100 billion worth of CDOs at the best price, those are the ones we’ll going to buy from. That’s a reverse auction.
You go and say I want to buy, who’s going to sell to me for the cheapest price. And so that what they said. By doing that, maybe they’ll create other private interest. Will say the government’s getting a good deal on this CDOs, I want to buy in to. And maybe other people will start buying these CDOs.
The reason why I call that crap is because if other people where there to buy CDOs they would buy them already. And the bottom line is when you do all these type of reverse auction, when you say oh I have 100 billion, I want to spend in CDOs. Paulson and Burnencky, they're arguing that would somehow create some type of market price for these CDOs that these banks could then mark their assets and everyone what they worth.
Two 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 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 this 2 billion CDOs even when the government does this reverse auction worth only. I don’t know, these are only worth 500 million. Right. That’s what people are willing to unload them for. 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 this 200 million down to 500 million. This 2 billion down to 500 million, 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 will actually create a real market price that anyone would believe. I don’t think it’s going to make anyone jump in to the market all of a sudden. Frankly, if someone thought these were good deals, there are a lot of very, very sophisticated investors out there who have a lot more knowledge about what these assets really mean than frankly the treasury does. And if they thought they were good deals, I guarantee 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 til 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 good deal, but these are most probably not worth much. They're probably worth nothing.
So, what is another solution? This is something that a lot of people have bantered around a lot. They said, well why doesn’t the government just go in. instead of just buying out this CDOs, which is essentially just writing a check to the very people who got us in to this situation. Why not buy stock in these companies.
So we talked about those situations with the Savern well funds, right. With the Savern well fund comes in, but in that example, they bought $3 billion worth of equity and they gave $3 billion worth of cash. And then the company can use those pay off instead. That frankly is not a horrible idea. The only reason why I say it’s still not a great idea is you're diluting these share holders. But what if this equity is worth 0? Right? What if there's actually negative equity here? If this is worth 0, these $2 billion are actually worth 0. And this is in an insolvent company. Right.
You have 3 billion of assets, 4 billion of liabilities. This is actually minus 1 billion of equity. So really the stock has no value. The correct share price of the stock, if we didn’t have, limited liability of the corporations would be the correct market capitalization would be minus $1 billion. So why would you pay a positive price for those shares?
So even in that situation, if this is really worth 0 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 may be having 2 billion shares. If you owned 100 percent of the company before, now you only owned 20 percent of the company. And that’s actually what happened with AIG.
You might say, that’s a pretty good situation, but still. The government is taking a little bit of a hit. 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 or 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, I'm going to give this company $4 billion. So were going to give it 4 billion of cash. 4 billion of cash. And let's say, for those 4 billion shares, let's see. The current is, for those 4 billion shares, we want, I don’t know, we want another. Let's make it really intense, let's say the government wants 10 billion shares. Right. So essentially they're paying 40 cents per share. So then were going to have 10 billion shares here. Just 10,000 million. We’re going to have 10.5 billion shares.
This is actually not a bad situation for me. So the company now will have $4 billion of cash. $4 billion of cash. $3 billion of other assets. And now these CDOs and maybe those CDOs are worth nothing. Now no matter what, this company cannot go bankrupt. Because $4 billion of cash, 4 billion of liability. It can pay off this liability with that equity infusion. And the people who deserve that kind of takes some downside did get downside. Because the equity holders, they use to have 100 percent of the company with their 500 million shares. Now they own, what is this, this is 1/21st of their company. So they got diluted from owning 100 percent of the company to owning, what, like less than 5 percent 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 lent money to an institution that they should known better than to lend money to. They said, they're holding all these taxes, that assets. They collected interest in this institution. Right when the institution is 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 97 percent of the company and pays off the liability holders.
So I would still say that there still some moral hazard here. Because in the future, people say, oh, I'm willing to lend. Maybe you're still hurting the equity holders, but you're 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 equities. So you won't properly price and risk in the future.
But 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 banks. And they really are worried about this piece, right, the farmer who needs the loan. Or the guy who wants to build a factory that needs the loan. 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 they don’t 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 be get punished appropriately. So that in the next up cycle, there won't be all these moral hazards. And you have the $700 billion that is going directly to lend, to farmers, and companies that are building capital equipment and whatever.
And of course, there still is moral hazard. It’s going to get highly politicize. Who do you lend to et cetera, et cetera. Maybe then you still do reverse auction, but the bottom line is that if the government were genuine about being concern about Main Street. They wouldn’t use the 700 billion indirectly. They would lend it directly to Main Street.
Anyway. See you in the next video.

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