So now let's think about, I talked about what the Fed's
bailout proposal is.
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 the balance sheet.
Which have been kind of the cause of why a lot of these
banks are going under.
Or at least why a lot of the banks aren't
lending to each other.
And I kind of touched on it in the last video that, in my
mind, maybe its solves the problem, but even if it does
solve a problem, we'll address that in this video, but it
seems like a really horrible thing to do.
Because if you were to buy these assets, let's say
they're worth zero, you pay $2 billion for them.
You're essentially writing a check to the equity holders of
this company, the shareholders of this company, they
benefited from all the reward of the last five years of
getting 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 taxpayer bears the risk.
And so you're writing a $1 billion check to the equity
holders and a $1 billion check to the liability holders, or
the people who lent this company money.
And you've probably heard the word moral
hazard bantered around.
And this is as good of a time as any to explain what people
mean by 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.
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 were to essentially buy out these CDOs, you're not
penalizing them for making bad decisions.
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 hazard, and this is a more
nuanced notion, but it's in some ways the more important
element of moral hazard.
And that's if the government goes in every time that
there's some type of financial stress.
All these people took risk, they got their reward already.
But when the risk starts to hit, the government goes in
and make sure that these people don't have to deal with
their consequences.
The moral hazard there is in the future, people are going
to say I'm going to take risk.
Because if 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 U.S. government, is all too ready
to come out and bail out the private sector.
So you create this moral hazard of 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, there were people
who lent money to these people who bought CDOs, they were
levered up.
And the government even bailed out these dudes.
So I can take huge risk, I'll get all the reward from it,
and in the future the government is just going to
bail me out.
And that's the other element of moral hazard.
Well anyway, I would argue that there's a lot of moral
hazard with the government's current bailout proposal.
Maybe that moral hazard is worth it if it prevents this
chain, this cascade, of events from happening.
If somehow it allows people to start lending to each other
and most importantly, 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.
What I've heard, and I don't know the exact numbers here,
and I'm not an expert here, is that there's about $5 trillion
of these toxic CDOs.
On all of these financial institutions' balance sheet.
So I don't know if that's the accurate number.
But I do know for sure, $700 billion is a relatively small
fraction of the total amount that's out there.
And Bernanke and Paulson, they're essentially arguing,
no we know $700 billion doesn't represent all the CDOs
out there, even if you were to buy them at a discount.
But what we're hoping to do is by going out there and with a
large amount of money and starting to buy these CDOs,
that'll hopefully create some type of a
market in these CDOs.
And they talk about doing a reverse auction.
Where we'll say, OK we're ready to buy
$100 billion in CDOs.
So whatever banks are willing to give us $100 billion worth
of CDOs at the best price, those are the ones we're going
to buy from.
That's a reverse auction.
You go and you say, I want to buy, who's going to sell to me
for the cheapest price?
And by doing that, maybe it'll create
other private interests.
We'll say hey, the government's getting a good
deal on these CDOs, I want to buy in too and maybe other
people will start buying these CDOs.
The reason why I call that crap is because if other
people were there to buy CDOs, they would buy them already.
And the bottom line is, when you do this type of reverse
auction, when you say, oh I have $100 billion I want to
spend on CDOs, Paulson and Bernanke are arguing that that
would somehow create some type of market price for these CDOs
that these banks can then mark their assets and everyone will
know what they're 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 these $2 billion of CDOs, even
when the government does this reverse auction, are actually
worth only $500 million.
That's what people are willing to unload them for.
And it would probably the more solvent people
who would 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 thing will have to write this $2
billion down to $500 million.
And so their equity will get wiped out and the cascade will
start over again.
So I don't buy it on two counts.
One, I don't think it'll actually create a real market
price that anyone would believe.
I don't think it's going to make anyone jump into 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 you
there's capital out there where they would go and buy
these assets for what they thought is a good deal.
And hold them to 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 a good deal.
But these are most probably not worth much.
They're probably worth nothing.
So what is another solution?
And this is something that a lot of people have bantered
around a lot.
They said, well why doesn't the government just go in and
instead of just buying out these CDOs, which is
essentially just writing a check to the very people who
got us into the situation, why not buy
stock in these companies?
So we talked about those situations with the sovereign
wealth funds.
Where the sovereign wealth fund comes in, 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 to pay off its debt.
That frankly, is not a horrible idea.
The only reason why I would say it's still not a great
idea is, you're diluting the shareholders.
But what if this equity is worth zero?
What if there's actually negative equity here?
If this is worth zero, if these $2 billion are actually
worth zero, then this is an insolvent company.
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 with corporations, 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 zero, and
the government were to 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 maybe have 2 billion shares.
If you owned 100% of the company before, now you only
own 20% of the company.
And that's actually what happened with AIG.
You might say well that's a pretty good situation, but
still the government's taking a little bit of a hit.
And 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-- let me do the example.
Let's say there's 500 million shares now.
The government says, we're going to give
this company $4 billion.
So we're going to give it $4 billion in cash.
And let's say for those four billion shares, we want--
let's make it really intense.
Let's say the government wants ten billion shares.
So essentially they're paying $0.40 per share.
So then we're going to have 10 billion shares here.
So that's 10,000 million.
And 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, $3 billion
of other assets.
And now these CDOs maybe are worth nothing.
Now no matter what, this company cannot go bankrupt.
It has $4 billion of cash, $4 billion of liability, it could
pay off its liability with that equity infusion.
And the people who deserved to kind of take some downside,
did get downside.
Because the equity holders, they used to have 100% of the
company with their 500 million shares.
Now they own, what is this?
They own 1/21 of their company.
So they got diluted from owning 100% of the company to
owning less than 5% 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.
They lent money to an institution that they
should've known better than to lend money to.
They're holding all these toxic assets, they collected
interest on this institution.
Right when this institution was 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.
Because the government now owns 90-something percent of
the company.
And pays off the liability holders.
So I would still say that there's still some moral
hazard here.
Because in the future, you're still hurting the equity
holders, but you'd 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 equity.
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 actually, in my mind, if the government is really not
worried about the banks, and they really are worried about
this piece, the farmer who needs a loan, or the guy wants
to build a factory that needs a 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 don't they 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 everyone will get
punished appropriately.
So that in the next up cycle there won't be all of this
moral hazard.
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.
And it's going to get highly politicized.
Who do you lend to, et cetera?
Maybe then you still do a reverse auction.
But the bottom line is, if the government were genuine about
being concerned about Main Street, they wouldn't use this
$700 billion in this indirect way.
They would lend it directly to Main Street.
Anyway, see you in the next video.