I think we’re now ready to
tackle the big picture and what has our government
officials so worried right now. So what I’ve done is, I’ve just
drawn the balance sheets for a bunch of banks. Obviously, this is simplified. And I made all of their balance
sheets look the same. All of these banks, each of
these kind of represents the balance sheet of a bank. And just to explain it, the
left-hand side of this balance sheet, so this column right
here– and maybe I can, at least for the first bank,
mark it a little bit. So what I’m squaring off
in magenta, that’s the assets of that bank. What I’m squaring off
in blue, that’s the liabilities of the bank. And what I wrote here is, it has
$4 billion of liabilities. Its assets, I divided it between
$3 billion of other assets and $2 billion of CDOs. Because we want to focus on the
CDOs, because that’s the crux of everything
that’s going on. And we have $5 billion in
assets, $4 billion of liabilities, so you have
$1 billion in equity. So that’s what’s left there. So this is just another visual
representation that liabilities plus equity
is equal to assets. Or assets minus liabilities
is equal to equity. And I’ve just copied and pasted
this one balance sheet a bunch of times. I don’t know whether we’re
going to use all 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 all of their balance sheets
might have kind of similar properties. This isn’t always the case,
different banks have different exposures to CDOs. Some of them have a lot, some
of them have a little bit. Some of them are valuing
them more conservatively than others. But just for the sake of
simplicity, I’ve just made all the banks in the situation where
the book value of the CDOs that they have on their
balance sheets is the 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
or are they facing just a solvency issue? If you believe that these are
worth $3 billion, these assets, these liabilities are
worth $4 billion, then the crux of whether it’s a liquidity
or a solvency issue all falls down as to whether
these are worth $2 billion or not. For example, if these are worth
$2 billion, then you have $1 billion of equity. If these are worth $1.5 billion,
well maybe they’re being a little optimistic here,
but you’ll still have $0.5 billion of equity. So you’re still solvent. 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 past that hurdle. And then in the future maybe
sell their assets and still have positive equity. However, if the true value of
those CDOs, 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 to be able to come up with is a market. The market value tends to be the
best representation of the true value of something. Let’s say the true value of this
is $1 billion or less, then we have a situation. For example, if these are worth
nothing, then we only have $3 billion of assets, $4
billion of liabilities, we have negative equity. This company is worth nothing. And to lend this bank or this
company any money would just be throwing good money
after bad. Because that money is just going
to go into a black hole. Because one of the people who
this company owes money to 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. If it was just Bear Stearns
or if it was just Lehman Brothers, not a big
deal, let the greedy bankers go bankrupt. And they probably are doing
just fine with the bonuses they’ve collected after sourcing
these CDOs for the past eight years or five
years 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 these $4 billion in
liabilities, these are loans, maybe from other banks. In fact, probably from
other banks. And those loans from other
banks, those are assets of other banks. For example, let’s say this
is Bank A, this is Bank B. Maybe a billion of these
are a loan from bank B. And if this is a loan from Bank
B, Bank B would have an asset called loan to Bank A. On Bank B’s balance sheet
we’re calling this a loan to Bank A. This is one of its assets. And then one of its liabilities
will be a loan from Bank B. So how can I say this? They took this money and
they gave it to B. I’m sorry, B had money, gave it
to A in the form of a loan. And so that cash
ended up here. And they got an asset called
loan to Bank A. And this is a liability,
loan from Bank B. And they might have taken that
money and they might have lent 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
Bank A, one of its $3 billion in assets, is a loan
to Bank C. And so on Bank C’s balance
sheet, it’ll say loan from Bank A. Or so we owe A $1 billion. And A says, C owes me $1
billion, and that’s all fine. And then you see that oh,
we owe B $1 billion. And then we could
keep doing this. Or I could just even make this
into a circle already. So maybe Bank B has some money
that it owes to someone else. And let’s say that someone else,
just for fun, just to make this interesting– 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 lent money to Bank B. Fair enough. OK, so now we’re in an
interesting situation. Let’s say this loan, the
loan from Bank B to Bank A comes due. And we’ve studied this
multiple times. And let’s say for whatever
reason, all of these other loans, they’re not liquid. They’re not due yet. So Bank A can’t get rid
of these loans. So let’s say this comes due,
this is $4 billion. They can’t sell any of this. So Bank A has to come up with $1
billion 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
to the CDOs. So there’s a couple
of issues here. If you think it is just an issue
of illiquidity, if these are $2 billion of assets,
they’re really worth $2 billion, but Bank A just
can’t sell them. Because either there’s
quote-unquote nobody willing to buy. Although, I would argue if
no-one is willing to buy something, then its true
value is probably zero. But let’s just say Bank A says
no-one is willing to buy, we’re just illiquid, this is
really worth $2 billion. So one situation is they could
get a loan from someone. Maybe the Fed would be willing
to take this as collateral. So they would give this as
collateral to the Fed. Maybe the Fed will give them
a billion dollar loan. And then they can use
that to pay Bank B. Let’s say that’s off the table
because this is just smelly enough collateral that not even
the Fed, which we now realize is willing to do
anything to support the markets, not even the Fed is
willing to give them 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
wealth fund. And we covered that a couple
of videos ago. Where the sovereign
wealth fund will essentially inject some cash. It’ll dilute the shares and then
you know maybe we had 500 million shares before. Now we’ll have 2
billion shares. So the sovereign wealth fund
will take over roughly 80% of the company. And in exchange for 80% of the
company, would give maybe $2 billion and then you could use
that to pay off this loan. But let’s say that that’s not
on the table anymore either. Because the sovereign
wealth funds have gotten burned so much. So what happens? Well we learned what happens. If you can’t get a loan, a new
loan, to replace this loan, or if you can’t get an equity
infusion from kind of a greater fool, what happens? You go into bankruptcy. And this is what happened
to Lehman Brothers. Lehman Brothers went
into bankruptcy. No sovereign wealth fund, no one
else bought the company. And I should probably
do another video on that scenario. And they couldn’t get a loan. So they went bankrupt. I should call this Company
L actually. But I’ll call it Company
A for now. Because I don’t want
to impugn anyone. I actually don’t think Lehman
was any worse or better than any of the other players here. So when they go into bankruptcy,
something very interesting happens. Now, Bank B, they were already
worried about these CDOs. These CDOs were already
an issue. And they were probably thinking,
boy when when Loan C comes due, I’m going
to be in trouble. Or when Loan D, or F, or
whatever, I’m going to be in trouble 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 isn’t
getting paid off. And who knows? Bank A is going to go
into bankruptcy. Maybe in bankruptcy we realize
that these are worth nothing. And if those are worth nothing,
then maybe I’m very junior in 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 $1
billion and I have to write this down to $0.5 billion. So now I have two problems. I
have this and I have this. And once again, this is
a non liquid loan. Bank A is in bankruptcy. And if I wanted to somehow get
the value of this I have to wait for all of Bank A’s assets
to go into liquidation. And then whatever assets I get
I would have to sell it. So this is kind of
a frozen asset. So once again, I’m stuck holding
this non liquid asset. So now I have this non liquid
asset that’s probably not worth what I thought it was,
which was a loan to A. Then I also have these CDOs. And now, God forbid, let’s
say that I had another loan to Bank D. And now let’s say Bank
D goes bankrupt. And then I have another
loan that’s bad on top of these CDOs. But the CDOs were the
crux of the issue. That’s what caused
the situation. If Bank A could have only sold
this CDO for $2 billion, it wouldn’t have caused this
chain reaction. And Lehman Brothers really was
the thing that catalyzed this whole chain of events. And then you can imagine now
Bank C is worried because now Bank B has all of these illiquid
assets on top of these CDOs and it starts
to look bad. And you can imagine, now it’s
even less likely that when a bank, let’s say that Bank D is
the next one to go into a dire 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 banks are saying,
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 it’s 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
we’re in. And that’s the difficulty
that the Fed is somehow trying to unwind. And I realized I’m out
of time again. I will confront that issue
in the next video.