Learn about Bailout 9: Paulson's Plan Video

Get it off your chest – be the first to comment on this video!

Learn about Bailout 9: Paulson's Plan

In the last video we saw that it is 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 this CDO’s for enough money to pay for this loan, so bank A had to go in the bankruptcy. And then we saw that could create a whole chain of events than this loan that bank B had made to bank A the one that actually precipitated the event, that had to be written down because then bank A is going to go in the bankruptcy and you don’t know how much you're going to get back for that loan. And of course everybody who had loans to bank A maybe bank D have 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 it gets afraid. They might have to write down their assets. And now on top of the CDO problem that we are all talking about is you know this smelly asset that no one wants to value correctly. On top of that you have these issues of wow, this loans that I've made to this other bank, now all of sudden those are impaired assets. These are assets that probably aren’t worth what I thought they were. And so you have this 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 starts going down. And then bank C has this situation where it has some loan to bank F it comes due and because its stock price is going down, no one wants to lend 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 sudden wealth bond because like you're just going to go to zero, why would I buy any stock for even $1.00 share when it's going 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 in this cascade of negative events. So all of the banks are afraid to lend to any other bank. And the Fed was in—you probably read the articles that the Fed injecting liquidity. What the Fed was doing it was they were saying, “Okay, we’ll take some of these assets that, you know, what we say bank C, bank C that you have. We’ll take them as collateral and we’ll lend you money”. And even if this was horrible collateral the Fed that just got very nervous and just start lending money to anybody, anybody who is allowed to borrow from the FED and I don’t know if you remember but the Fed extended normally it’s just commercial banks but at the beginning of the credit crisis were actually after various turns, after the various turns collapse, the Fed allowed investment banks and other people to start borrowing from the Federal reserve directly. But all that was happening normally, when the Federal reserves lends money to someone that persons and borrows that money, keep some of it and lends the rest to someone else. And so that money enters the system, and it allows the actually money to supply the increase. But what's been happening now is when banks use this money to borrow from the Fed or for borrow any money, they use these assets as collateral they just sit tight on that cash because they 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 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 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 ones 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 these people who frankly aren’t making anything.” Although I don’t want to say that because there is a use or the financial services sector but to some degree, a lot of what happened it 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 comeback” the only negative of that would be that their current share holders lose all their money but that’s okay no risk, no return or there was risk and the risk was it your shareholder, your stocks goes to zero but then the banks will comeback with new equity and then they’ll be back in five years and then new ownership. You might say that’s okay but what happens—what's the problem is—maybe all of these banks are just the cascade they go under but not all of these loans that they make out are to other banks. Some of these loans they make out to the real economy whatever ones calling Main Street now, some these loans they're making it could be to a company that makes tractors or company that or maybe its an agricultural company that needs loans to buy seeds for the next years 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 make a loan to build the factory for product that actually doing quite well. And so everyone will be starved off and you will go in to this massive recession because even though there is good uses of capital, if you were to give someone a loan they could use that loan to actually create value by planting seeds or building a factory. Those loans aren’t available, those factories won't get build, those seeds won't get planted the farmers will layoff people, the factories will layoff people and you could imagine will go into this economic down cycle. So that’s what the polls and the Federal Reserve is concerned about but although some people would debates that they're more concerned about the banks than the real economy. And they're just using the real economy as a kind of side show or the rational. So what are they arguing that they want to do? Well, they say well you know the cracks of these issues is if these $2 billion in CDO’s whatever the CDO’s that any of the bank are holding. If only the people could realized the value, if only these $2 billion that they have on their books could be turn into $2 billion of cash this wouldn’t be a problem because when these loans come due, if you believe these $2 billion then all of these banks have positive net worth’s. They all have positive equity and then this whole chain reaction won't happen. So this is what the government actual—when the bail out plan first came out and they said, “Oh, we’ll create the $700 billion fund to buy some of these taxed assets.” At first they said, “Oh, we’ll buy them at a discount and we’ll hold them to maturity and then we’re 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 by the CDO’s you'd be an idiot to pay $2 billion for them if the market is only giving instead of $2 billion if they're giving a $100 million for them. Why would you pay $2 billion? In fact these $2 billion are actually based on assumptions from 2006 when housing prices can't go down and everyone was paying off their mortgages and everything was rosy. Those are maybe the assumptions that drove these $2 billion price. So if you paid $2 billion 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. So 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—let say this are only worth 10 cents on the dollar so ten cents on the dollar if they pay 10% of $2 billion if the Feds came in and paid $200 million for this and it’s not even clear that this worth $200 million maybe the markets only willing to pay a $100 million. But let say the Feds coming and paid $200 million for it. They would have to market this down to $200 million. So that’s $1.8 billion right off something that was worth $2 billion is not worth $200 million. So if you write out $1.8 billion then you're going to have minus $800 million of equity or $0.8 billion of equity. And then you would still go bankrupt and in fact it would just force the issue. If the Federal will go in and buy what their calling out fire sale prices but it’s actually probably an accurate price. Even if they were to by flatly above that but still other discount, it would force this bank to write down this asset, it might have to then realize a negative equity and it would still create this whole chain of events. And so this is what the Fed actually said, they're actually said, “No, we don’t want to buy it at fire sale prices with shows you that maybe there and I think Bernenky is exact words for that, we’re not going to buy a 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, “Hey Sal, that’s not a bad” you’ll say, “That’s a horrible idea” because if these are really worth a $100 million and you're paying $2 billion for it you're essentially writing a government check $1.9 billion, you're essentially—let say they really worth -0.8, you're writhing a 1. —let’s say they’re really worth zero, just to simplify things. Let say these are actually worth zero and the government pays $2 billion for it the government is essentially writing a $2 billion check to the equity holders of this company. The real equity is worth minus $1 billion but the government is going to essentially write them a $2 billion check so they can get their billion dollars back. And it also going to benefit the bond holders because if this is worth zero not only will these guys get wiped out because you're going to have, but then these guys are only going to be able to capture back some of these $3 billion, so these liabilities cannot be written down. These guys that are owed $4 billion are going to be able to get $3 billion back. So if the government were to paid $2 billion for this it essentially writing a billion dollar check to the share holders and a billion dollar check to the bond holders or the people who lent this company money. And essentially those are the worst people to be writing a check too because these are the people who essentially lent money that should haven’t lent. These are people who took risk, they took all the reward over the last five years and now when the risk hits, the government is essentially having welfare for the private sector. So that in my mind is the worst idea of the government just arguing but you know I know its bad and these are the people we don’t want to 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 lend to the guy who wants to build the factory. In the next video I want to show you one why that might not be the case and even if they were to do this as much as I disagree with it if it worth maybe its 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.

Khan Academy

The Khan Academy is a not-for-profit organization with the mission of providing a high quality education to anyone, anywhere.

http://www.khanacademy.org/

In the last video we saw that it is 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 this CDO’s for enough money to pay for this loan, so bank A had to go in the bankruptcy.

And then we saw that could create a whole chain of events than this loan that bank B had made to bank A the one that actually precipitated the event, that had to be written down because then bank A is going to go in the bankruptcy and you don’t know how much you're going to get back for that loan. And of course everybody who had loans to bank A maybe bank D have 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 it gets afraid. They might have to write down their assets. And now on top of the CDO problem that we are all talking about is you know this smelly asset that no one wants to value correctly. On top of that you have these issues of wow, this loans that I've made to this other bank, now all of sudden those are impaired assets. These are assets that probably aren’t worth what I thought they were. And so you have this 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 starts going down. And then bank C has this situation where it has some loan to bank F it comes due and because its stock price is going down, no one wants to lend 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 sudden wealth bond because like you're just going to go to zero, why would I buy any stock for even $1.00 share when it's going 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 in this cascade of negative events. So all of the banks are afraid to lend to any other bank. And the Fed was in—you probably read the articles that the Fed injecting liquidity. What the Fed was doing it was they were saying, “Okay, we’ll take some of these assets that, you know, what we say bank C, bank C that you have. We’ll take them as collateral and we’ll lend you money”.

And even if this was horrible collateral the Fed that just got very nervous and just start lending money to anybody, anybody who is allowed to borrow from the FED and I don’t know if you remember but the Fed extended normally it’s just commercial banks but at the beginning of the credit crisis were actually after various turns, after the various turns collapse, the Fed allowed investment banks and other people to start borrowing from the Federal reserve directly.

But all that was happening normally, when the Federal reserves lends money to someone that persons and borrows that money, keep some of it and lends the rest to someone else. And so that money enters the system, and it allows the actually money to supply the increase. But what's been happening now is when banks use this money to borrow from the Fed or for borrow any money, they use these assets as collateral they just sit tight on that cash because they 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 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 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 ones 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 these people who frankly aren’t making anything.” Although I don’t want to say that because there is a use or the financial services sector but to some degree, a lot of what happened it 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 comeback” the only negative of that would be that their current share holders lose all their money but that’s okay no risk, no return or there was risk and the risk was it your shareholder, your stocks goes to zero but then the banks will comeback with new equity and then they’ll be back in five years and then new ownership.

You might say that’s okay but what happens—what's the problem is—maybe all of these banks are just the cascade they go under but not all of these loans that they make out are to other banks. Some of these loans they make out to the real economy whatever ones calling Main Street now, some these loans they're making it could be to a company that makes tractors or company that or maybe its an agricultural company that needs loans to buy seeds for the next years 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 make a loan to build the factory for product that actually doing quite well.

And so everyone will be starved off and you will go in to this massive recession because even though there is good uses of capital, if you were to give someone a loan they could use that loan to actually create value by planting seeds or building a factory. Those loans aren’t available, those factories won't get build, those seeds won't get planted the farmers will layoff people, the factories will layoff people and you could imagine will go into this economic down cycle.

So that’s what the polls and the Federal Reserve is concerned about but although some people would debates that they're more concerned about the banks than the real economy. And they're just using the real economy as a kind of side show or the rational. So what are they arguing that they want to do? Well, they say well you know the cracks of these issues is if these $2 billion in CDO’s whatever the CDO’s that any of the bank are holding. If only the people could realized the value, if only these $2 billion that they have on their books could be turn into $2 billion of cash this wouldn’t be a problem because when these loans come due, if you believe these $2 billion then all of these banks have positive net worth’s. They all have positive equity and then this whole chain reaction won't happen.

So this is what the government actual—when the bail out plan first came out and they said, “Oh, we’ll create the $700 billion fund to buy some of these taxed assets.” At first they said, “Oh, we’ll buy them at a discount and we’ll hold them to maturity and then we’re 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 by the CDO’s you'd be an idiot to pay $2 billion for them if the market is only giving instead of $2 billion if they're giving a $100 million for them.

Why would you pay $2 billion? In fact these $2 billion are actually based on assumptions from 2006 when housing prices can't go down and everyone was paying off their mortgages and everything was rosy. Those are maybe the assumptions that drove these $2 billion price. So if you paid $2 billion 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.

So 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—let say this are only worth 10 cents on the dollar so ten cents on the dollar if they pay 10% of $2 billion if the Feds came in and paid $200 million for this and it’s not even clear that this worth $200 million maybe the markets only willing to pay a $100 million. But let say the Feds coming and paid $200 million for it. They would have to market this down to $200 million. So that’s $1.8 billion right off something that was worth $2 billion is not worth $200 million.

So if you write out $1.8 billion then you're going to have minus $800 million of equity or $0.8 billion of equity. And then you would still go bankrupt and in fact it would just force the issue. If the Federal will go in and buy what their calling out fire sale prices but it’s actually probably an accurate price. Even if they were to by flatly above that but still other discount, it would force this bank to write down this asset, it might have to then realize a negative equity and it would still create this whole chain of events.

And so this is what the Fed actually said, they're actually said, “No, we don’t want to buy it at fire sale prices with shows you that maybe there and I think Bernenky is exact words for that, we’re not going to buy a 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, “Hey Sal, that’s not a bad” you’ll say, “That’s a horrible idea” because if these are really worth a $100 million and you're paying $2 billion for it you're essentially writing a government check $1.9 billion, you're essentially—let say they really worth -0.8, you're writhing a 1. —let’s say they’re really worth zero, just to simplify things. Let say these are actually worth zero and the government pays $2 billion for it the government is essentially writing a $2 billion check to the equity holders of this company.

The real equity is worth minus $1 billion but the government is going to essentially write them a $2 billion check so they can get their billion dollars back. And it also going to benefit the bond holders because if this is worth zero not only will these guys get wiped out because you're going to have, but then these guys are only going to be able to capture back some of these $3 billion, so these liabilities cannot be written down.

These guys that are owed $4 billion are going to be able to get $3 billion back. So if the government were to paid $2 billion for this it essentially writing a billion dollar check to the share holders and a billion dollar check to the bond holders or the people who lent this company money. And essentially those are the worst people to be writing a check too because these are the people who essentially lent money that should haven’t lent.

These are people who took risk, they took all the reward over the last five years and now when the risk hits, the government is essentially having welfare for the private sector. So that in my mind is the worst idea of the government just arguing but you know I know its bad and these are the people we don’t want to 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 lend to the guy who wants to build the factory.

In the next video I want to show you one why that might not be the case and even if they were to do this as much as I disagree with it if it worth maybe its 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.

Transcription by: Scribe4you Transcription Services