Learn about Bailout 8: Systemic Risk Video

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Learn about Bailout 8: Systemic Risk

Learn about Bailout 8: Systemic Risk I think we are now ready to tackle the big picture and what has our government official so worried right now. So what I’ve done is I’ve just drawn the balance sheet for a bunch of bank obviously this is simplified and I made all of their balance sheets looks the same. All of these banks, each of this kind of represents the balance sheets of a bank and just to explain it, the left hand side of this balance sheets. So this column right here and maybe I can—at least for this first bank I can mark a little bit. So what I’m squaring off in magenta, that’s the assets of that bank. What I’m squaring of in blue that’s a liability of the bank and what I wrote here has 4 billion of liabilities. Its assets I divide it between three billion of other assets and two billion of CDO’s because we want to focus on CDO because the cracks of everything is going on and we have 5 billion in assets, 4 billions of liabilities so you have one billion in equity so that’s what left there. This is just another visual representation that liabilities plus equity is equal to assets or an asset minus liabilities is equal to equity. I just have copied and paste this in balance sheet a bunch of time so I don’t know how much were going to use all of those but let’s just assume for simplicity that a ton of banks in the system have this identical balance sheet. Obviously they don’t have an identical balance sheet but they kind all of their balance sheets might have kind of the similar properties where the part represent the CDO and I’m doing this—this isn’t always the case. Different bank have different exposure to CDO’s, some of them have a lots and have a little bit. Some of them are valuing them more conservatively than others but just for the sake of simplicity I just made all of the banks in a situation where the book value of the CDO’s if they have on their balance sheet is larger than their equity value. And I did that for a reason because it leads to the issue of—are these banks facing just a liquidity issue? Are they facing just a solve issue. If you believe that you know these are worth 3 billion this assets, this liabilities were 4 billion and then the cracks of whether it’s a liquidity or solvency issue all false down as to whether these are worth 2 billion or not. For example if these are worth 2 billion, then you have a billion dollars of equity. If these are worth 1.5 billion well maybe they’re being a little optimistic here but you’re still have .5 billion of equity. So you’re still solvent right and in that situation, in theory, one is just if they don’t have the cash when some of their debt comes due. They should just be able to borrow some money and get pass that hurdle and then in the future maybe sell their assets and still have positive equity. However, if the true value of those CDO’s and this is kind of a philosophical question, what’s the true value of anything and the best thing that we as humans have been able to come up with is a market value tends to be the best representation of the true value of something but if the market value or let’s say the true value, this is billion dollars or less then we have a situation. For example if these are worth nothing then we only have three billion of assets, four billion of liabilities we have negative equity. This company worth nothing and to lend to this bank or this company any money we’ll just be throwing good money after bad because you’re not that money just going to go into a black hole because one of the people who this company was money too is probably not going to see their money. And if you are the most junior person lending the money which means that when all the money is distributed if they go into bankruptcy you’re the last person to see the money then you’re just throwing good money after bad. So that’s the issue but I want you to see the big picture now because if it was just an issue with one bank it wouldn’t be a big deal but if its just a bearers turns or for just 0351 brothers not a big deal, let the greedy bankers go bankrupt then you know they probably are doing just fine with the bonuses they’ve collected after sourcing this CDO’s for the past 8 years or 5 year or however long. But what I want to show you in this video is what people are talking about when they say systemic risk. So this 4 billion and liabilities, these are loans maybe from other banks and that probably from other banks and those loans from other banks those are assets of other banks for example maybe a billion and let say this is bank A, this is bank B. Maybe a billion of these are a loan from bank B. So this is a loan from bank B and if this is a loan from bank B, bank B would have an asset called a loan to bank A. On banks B, balance sheet were calling this a loan to bank A, this is one of his asset and then one of his liabilities will be a loan from bank B. B had money gave it to A is form of a loan right and so that cash end it up here and that they got an asset called loan to bank A and this is liability loan from bank B and then the might have taken that money and they might have lend it to bank C down here. I think you’re starting to see how this gets pretty hairy very fast. So let’s say that the bank A one of its three billion of an assets, let’s say it has a loan to bank C. And so bank C’s balance sheet it will say loan from bank A or so we owe a billion dollars right and A says oh C owes me a billion dollar and that’s all fine and then you see that oh we owe B a billion dollar and then we could keep doing this so I can just even make this into a circle all ready so maybe bank B has some money that it owes to someone else and let say that someone else just for fun just to make this interesting and I think you can extrapolate and think about how this gets complicated very fast. Bank b has borrowed money from bank C. So bank C will have an asset here that says no I lend money to bank B. So they lend money to bank B, fair enough. Okay so now we’re in interesting situation. Let’s say this loan, loan from bank B to loan A comes due and we’ve studied this multiple times. Let’s say that this comes due and let say for whatever reason all of these other loans they’re not liquid you know, they’re not due yet so bank A can't get rid of these loans so the situation here is that they would either have to get some type of—so let’s say this is comes due this $4 billion. They can't sell any of this so they have to come up, bank A has to come up with the billion dollar somehow for bank B. So that’s the situation we’re dealing with. I'm just going to say that they can't sell any of these assets so it all comes down at CDO’s. So there’s a couple of issues here. If you think it is just an issue of a liquidity, if these are $2 billion of assets they really worth 2 billion but bank A just can't sell them because either there’s couldn’t got known willing to buy although I would argue if no one is willing to buy something that’s true value is probably zero but let’s just say bank A is unknown willing to buy, were just a liquid, this is really worth 2 billion. So one situation is they could get a loan from someone maybe the fed it would be willing to take this as collateral so they would give this collateral to the fed, maybe the fed will give them a billion dollar loan and then they can use that to pay bank B. So let’s say that’s off the table because this is just taxes, million of collateral than not even the fed which we now realize is willing to do anything to support the markets. To not even the fed is willing to give a loan or enough of a loan to pay off that loan. The other situation is maybe, they can get an equity infusion from a sovereign well fund and we cover that a couple of videos ago. Were the sovereign well fund will essentially inject some cash, it will dilute the shares and that you know maybe we have 500 million shares before now we’ll have 2 billion shares so the sovereign well fund will take over roughly was 2 billion over80% of the company and in exchange of 80% of the company would give me $2 billion and then you could use that to pay off this loan. But let say that that’s not on the table anymore either because the sovereign well funds have gotten burned so much right so what happens, well we learned what happens if you can't get a new loan to replace this loan or if you can't get an equity infusion from kind of a greater full, what happens you go into bankruptcy and this is what happen to Liman brothers. Liman brothers went to bankruptcy, no sovereign well fund, no one else both the company and I should probably do a video on that scenario and they couldn’t get a loan so they went bankrupt. I should call this company L actually but I call it company A for now because I don’t want impute anyone. Actually I don’t think Liman was any worst or better than any of the other players here. So when they go into bankruptcy, something very interesting happens. Now bank B, you know they are all worried about these CDO’s right. These CDO’s were all ready an issue and they are probably thinking when loan C comes do I’m going to be in travel or when loan D or F or whatever—I’m going to be in travel because I’m going to be in that situation that I’m essentially forcing bank A into right now but now I have a new problem. This loan to bank A is in getting paid off right. This loan to bank A isn’t getting paid off and who knows bank A is going to go into bankruptcy, bank A is going to bankruptcy maybe in bankruptcy we realized that these are worth nothing and if those worth nothing then maybe you know I’m very junior and seniority in terms of where my loan is and maybe I get nothing or I get a few pennies on the dollar here. So maybe I thought this was a billion dollars and I have to write this down to point 5 billion dollars. So now I have two problems, I have this and I have this and once again this is non liquid loan right, bank A is in bankruptcy and if I want it to somehow get the value of this I have to wait for all of bank As assets to go into liquid vision and the I would have to—whatever assets I get out, I have to sell out so this is kind of a frozen assets. So once again I’m stuck holding this non liquid assets and I have this one liquid assets is probably not worth when I thought it was which was a loan to A, then I also have these CDO’s and now God forbid, let say that I had another loan to bank D and now let say bank D goes bankrupt and then I have another loan that’s been on top of this CDO’s but the CDO’s were the cracks of issue right that’s what causes the situation if bank A could have only sold to this CDO for $2 billion it would not cause this chain reaction and this Liman brothers really was a thing that catalyzed this whole chain of events. And then you could imagine now bank C is wired because now bank B has all of this liquid assets on top of the CDO’s so start to look bad and you can imagine. Now it’s even less likely that when a bank let say that bank D is the next one to go into a dying situation, it’s even less likely that bank D can get a loan from a third bank because all the banks are getting scared now. All the bank—I’m not going to loan money to anyone if I can get any cash from anybody I’m just going to keep it so that when its my turn when the market starts looking at me I at least have a little cash. So everyone is frozen. Everyone wants to collect their loans from everyone else and no one wants to give loans to anybody else. So that’s the situation running and that’s the difficulty that the fed is somehow trying to unwind and I realize I don’t have enough time again. I will confront to that issue in the next video.

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Learn about Bailout 8: Systemic Risk

I think we are now ready to tackle the big picture and what has our government official so worried right now. So what I’ve done is I’ve just drawn the balance sheet for a bunch of bank obviously this is simplified and I made all of their balance sheets looks the same. All of these banks, each of this kind of represents the balance sheets of a bank and just to explain it, the left hand side of this balance sheets. So this column right here and maybe I can—at least for this first bank I can mark a little bit. So what I’m squaring off in magenta, that’s the assets of that bank. What I’m squaring of in blue that’s a liability of the bank and what I wrote here has 4 billion of liabilities.

Its assets I divide it between three billion of other assets and two billion of CDO’s because we want to focus on CDO because the cracks of everything is going on and we have 5 billion in assets, 4 billions of liabilities so you have one billion in equity so that’s what left there. This is just another visual representation that liabilities plus equity is equal to assets or an asset minus liabilities is equal to equity. I just have copied and paste this in balance sheet a bunch of time so I don’t know how much were going to use all of those but let’s just assume for simplicity that a ton of banks in the system have this identical balance sheet. Obviously they don’t have an identical balance sheet but they kind all of their balance sheets might have kind of the similar properties where the part represent the CDO and I’m doing this—this isn’t always the case. Different bank have different exposure to CDO’s, some of them have a lots and have a little bit. Some of them are valuing them more conservatively than others but just for the sake of simplicity I just made all of the banks in a situation where the book value of the CDO’s if they have on their balance sheet is larger than their equity value. And I did that for a reason because it leads to the issue of—are these banks facing just a liquidity issue? Are they facing just a solve issue.

If you believe that you know these are worth 3 billion this assets, this liabilities were 4 billion and then the cracks of whether it’s a liquidity or solvency issue all false down as to whether these are worth 2 billion or not. For example if these are worth 2 billion, then you have a billion dollars of equity. If these are worth 1.5 billion well maybe they’re being a little optimistic here but you’re still have .5 billion of equity. So you’re still solvent right and in that situation, in theory, one is just if they don’t have the cash when some of their debt comes due. They should just be able to borrow some money and get pass that hurdle and then in the future maybe sell their assets and still have positive equity.

However, if the true value of those CDO’s and this is kind of a philosophical question, what’s the true value of anything and the best thing that we as humans have been able to come up with is a market value tends to be the best representation of the true value of something but if the market value or let’s say the true value, this is billion dollars or less then we have a situation. For example if these are worth nothing then we only have three billion of assets, four billion of liabilities we have negative equity. This company worth nothing and to lend to this bank or this company any money we’ll just be throwing good money after bad because you’re not that money just going to go into a black hole because one of the people who this company was money too is probably not going to see their money. And if you are the most junior person lending the money which means that when all the money is distributed if they go into bankruptcy you’re the last person to see the money then you’re just throwing good money after bad. So that’s the issue but I want you to see the big picture now because if it was just an issue with one bank it wouldn’t be a big deal but if its just a bearers turns or for just 0351 brothers not a big deal, let the greedy bankers go bankrupt then you know they probably are doing just fine with the bonuses they’ve collected after sourcing this CDO’s for the past 8 years or 5 year or however long.

But what I want to show you in this video is what people are talking about when they say systemic risk. So this 4 billion and liabilities, these are loans maybe from other banks and that probably from other banks and those loans from other banks those are assets of other banks for example maybe a billion and let say this is bank A, this is bank B. Maybe a billion of these are a loan from bank B. So this is a loan from bank B and if this is a loan from bank B, bank B would have an asset called a loan to bank A. On banks B, balance sheet were calling this a loan to bank A, this is one of his asset and then one of his liabilities will be a loan from bank B.

B had money gave it to A is form of a loan right and so that cash end it up here and that they got an asset called loan to bank A and this is liability loan from bank B and then the might have taken that money and they might have lend it to bank C down here. I think you’re starting to see how this gets pretty hairy very fast. So let’s say that the bank A one of its three billion of an assets, let’s say it has a loan to bank C. And so bank C’s balance sheet it will say loan from bank A or so we owe a billion dollars right and A says oh C owes me a billion dollar and that’s all fine and then you see that oh we owe B a billion dollar and then we could keep doing this so I can just even make this into a circle all ready so maybe bank B has some money that it owes to someone else and let say that someone else just for fun just to make this interesting and I think you can extrapolate and think about how this gets complicated very fast.

Bank b has borrowed money from bank C. So bank C will have an asset here that says no I lend money to bank B. So they lend money to bank B, fair enough. Okay so now we’re in interesting situation. Let’s say this loan, loan from bank B to loan A comes due and we’ve studied this multiple times. Let’s say that this comes due and let say for whatever reason all of these other loans they’re not liquid you know, they’re not due yet so bank A can't get rid of these loans so the situation here is that they would either have to get some type of—so let’s say this is comes due this $4 billion. They can't sell any of this so they have to come up, bank A has to come up with the billion dollar somehow for bank B. So that’s the situation we’re dealing with.

I'm just going to say that they can't sell any of these assets so it all comes down at CDO’s. So there’s a couple of issues here. If you think it is just an issue of a liquidity, if these are $2 billion of assets they really worth 2 billion but bank A just can't sell them because either there’s couldn’t got known willing to buy although I would argue if no one is willing to buy something that’s true value is probably zero but let’s just say bank A is unknown willing to buy, were just a liquid, this is really worth 2 billion. So one situation is they could get a loan from someone maybe the fed it would be willing to take this as collateral so they would give this collateral to the fed, maybe the fed will give them a billion dollar loan and then they can use that to pay bank B. So let’s say that’s off the table because this is just taxes, million of collateral than not even the fed which we now realize is willing to do anything to support the markets. To not even the fed is willing to give a loan or enough of a loan to pay off that loan.

The other situation is maybe, they can get an equity infusion from a sovereign well fund and we cover that a couple of videos ago. Were the sovereign well fund will essentially inject some cash, it will dilute the shares and that you know maybe we have 500 million shares before now we’ll have 2 billion shares so the sovereign well fund will take over roughly was 2 billion over80% of the company and in exchange of 80% of the company would give me $2 billion and then you could use that to pay off this loan.

But let say that that’s not on the table anymore either because the sovereign well funds have gotten burned so much right so what happens, well we learned what happens if you can't get a new loan to replace this loan or if you can't get an equity infusion from kind of a greater full, what happens you go into bankruptcy and this is what happen to Liman brothers. Liman brothers went to bankruptcy, no sovereign well fund, no one else both the company and I should probably do a video on that scenario and they couldn’t get a loan so they went bankrupt. I should call this company L actually but I call it company A for now because I don’t want impute anyone. Actually I don’t think Liman was any worst or better than any of the other players here.

So when they go into bankruptcy, something very interesting happens. Now bank B, you know they are all worried about these CDO’s right. These CDO’s were all ready an issue and they are probably thinking when loan C comes do I’m going to be in travel or when loan D or F or whatever—I’m going to be in travel because I’m going to be in that situation that I’m essentially forcing bank A into right now but now I have a new problem. This loan to bank A is in getting paid off right. This loan to bank A isn’t getting paid off and who knows bank A is going to go into bankruptcy, bank A is going to bankruptcy maybe in bankruptcy we realized that these are worth nothing and if those worth nothing then maybe you know I’m very junior and seniority in terms of where my loan is and maybe I get nothing or I get a few pennies on the dollar here. So maybe I thought this was a billion dollars and I have to write this down to point 5 billion dollars.

So now I have two problems, I have this and I have this and once again this is non liquid loan right, bank A is in bankruptcy and if I want it to somehow get the value of this I have to wait for all of bank As assets to go into liquid vision and the I would have to—whatever assets I get out, I have to sell out so this is kind of a frozen assets. So once again I’m stuck holding this non liquid assets and I have this one liquid assets is probably not worth when I thought it was which was a loan to A, then I also have these CDO’s and now God forbid, let say that I had another loan to bank D and now let say bank D goes bankrupt and then I have another loan that’s been on top of this CDO’s but the CDO’s were the cracks of issue right that’s what causes the situation if bank A could have only sold to this CDO for $2 billion it would not cause this chain reaction and this Liman brothers really was a thing that catalyzed this whole chain of events. And then you could imagine now bank C is wired because now bank B has all of this liquid assets on top of the CDO’s so start to look bad and you can imagine.

Now it’s even less likely that when a bank let say that bank D is the next one to go into a dying situation, it’s even less likely that bank D can get a loan from a third bank because all the banks are getting scared now. All the bank—I’m not going to loan money to anyone if I can get any cash from anybody I’m just going to keep it so that when its my turn when the market starts looking at me I at least have a little cash. So everyone is frozen. Everyone wants to collect their loans from everyone else and no one wants to give loans to anybody else.

So that’s the situation running and that’s the difficulty that the fed is somehow trying to unwind and I realize I don’t have enough time again. I will confront to that issue in the next video.

Transcription by: Scribe4you Transcription Services