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.