Wealth destruction 2 | Finance & Capital Markets | Khan Academy

So what happened in the
previous video? We had a nice, simple
neighborhood in 1995. Everyone prudently bought houses
with 20% down, they bought it for a $100,000. And frankly, there were probably
more people who wanted to buy houses then but
they couldn't get financing. And that was in place for a
reason; because you had to prove yourself worthy to
get the financing. But anyway, 10 years go by,
financing gets really cheap because you have this dynamic of
rising home prices; people downplay risk; people are
willing to give loans to more and more people. And they kind of do that,
just to keep up with the other banks.

And you have in 2005, at kind
of the peak of the bubble, someone buys house number one
for $1,000,000, with no money down, subprime loan. And then, a year later, they
foreclose and the house is auctioned off and it
only gets $300,000. But between the time that the
house was bought for a million dollars and auctioned off for
$300,000, let's say that that's in– I don't know, let me
do that in year, let me say this is 2008, now. So 2008, this house get's
foreclosed, and auctioned for $300,000. And in the meantime, all of
these people– let's say all of them– took $500,000 home
equity loans, right? So they all have $500,000 of
debt from the home equity loans, plus whatever they have
left from the original $80,000 loan, so, maybe, $580,000;
if they were only paying interest.

It may be a little
bit less than that. Let's just say, it's
roughly $500,000. And at first, maybe in 2008,
they all say, you know what, this is temporary, that was just
a fire sale price, and these auctions don't really
reflect a market reality. So we're just going to sit tight
and wait for our housing prices to go up because this
wasn't a real transaction. But let's say 2009 comes along,
and this individual, house number two's owner either
has to move, has a different job in a different
city; or maybe they just get laid off and they can't pay
their mortgage anymore and they need to sell their house. Well they try to sell their
house a little bit and it's no coincidence that they
sell for $600,000.

And no one [? call ?] [? line ?] for awhile, and [UNINTELLIGIBLE] starting up, because you have
a lot of people trying, at least, just be made whole on
their loan when they sell their house. But no one's buying
their house. So at some point,
they give up. They go to the bank and they
say, hey bank, can I do a short sale where if I sell
it for less, then I don't owe you any debt. But the banks are still pretty
confident then, and they're like, no. A short sale is when you sell
something for less than what you owe on it. So a short sale would be like
this guy has house number two, has let's say a $500,000
mortgage. And if he were to sell his house
for $480,000 and the bank were to agree that $480,000
is all he has to pay back, then that would
be a short sale. Right? But the bank says, no, you
either sell your house or we're going to foreclo– You
either pay us for the debt, or we're going to foreclose
on you. So the guy says, sure,
you know what, I have nothing to lose.

I've just lost my job. Here are the keys to the
house, foreclose on it. And so the bank says, OK I
foreclosed on it and the bank realizes in a few months that
was a bad decision. Because now, when they auction
the house, they don't get even $580,000; they don't get
$480,000 for it; they get $250,000 for it. And all of this sounds like
a very extreme example. Things not that different than
what I'm describing happened in places like Modesto and
Stockton, California, and parts of Miami and Nevada
and Arizona. But anyway, so it auctions
off for $250,000. Now everyone in the neighborhood
gets scared because this guy, house number
two, made an honest effort to sell; couldn't sell; tried to do
a short sale; couldn't do a short sale; and when the bank
auctioned, they actually auctioned it off for
less than house number one, it was $250,000.

So now, all these people
say, what am I doing? I'm working three jobs to pay a
$500,000 mortgage on a house that's probably worth
$250,000. And if someone really were to be
rational about it, $250,000 isn't some crazy
lowball price. They paid $100,000 for it. Maybe, if you adjust that for
GDP growth or inflation, that $100,000 in 2009 dollars might
be $150,000 or $200,000. So $250,000 actually,
isn't a crazy price. But anyway, all of these people
said, why do I keep working so hard, being
an indentured servant to this mortgage? I'm just going to give the keys
back to the bank, that's called: jingle mail. So you give the keys
back to bank. Let's say this guy gives the
keys back to this bank. This bank that thought that they
had made a prudent loan, this is house number
three, I think.

So they give the keys back
to the bank instead of paying off the loan. And this bank says, oh boy,
now I have this house. They auction it off;
they get $250,000. So what happened to the bank? The bank had a $500,000 loan
out, it got $250,000 back. And also, this person has also
lost all of the equity in their house that they
originally had. House number three
lost their house. So how much wealth is gone
from each person's perspective? Well the bank had given $500,000
of real capital, real money that could have been used
to build a factory; to plant some crops; to work on
research and development that might have developed new
materials or new technologies. That was real $500,000
of capital. And now, they got a house and
they auctioned off that house and they got $250,000. Right? So they lost $250,000. And this individual, number
one, what did they lose? Well, they lost, by entering
into this transaction, essentially, they lost
whatever equity they originally had in their house. And what equity would they
have had in their house? Well, they had, let's just
say, they had $20,000 of equity before they did this
transaction, right? So they lost that $20,000
of equity.

And frankly, they could've
sold that $100,000 house for $250,000. We know, even in this quote,
unquote, tough real estate market, they could have
sold it for $250,000. So they really had, let's see,
they had an $80,000 loan, a $250,000 asset, so they really
had $250,000 minus $80,000, that's $170,000. So they really had $170,000 of
lost equity, if I'm doing my math right. But I think you get the point. So they did build some equity
through housing appreciation, just the house didn't go from
$100,000 to a $1,000,000, it went from $100,000
to $250,000. So their equity was actually
$20,000 plus the $150,000 that they got from just the
increasing asset value– if they didn't enter into
this transaction. So they would've had a another
$170,000 of equity that they lost. So the homeowner
lost $170,000. So combined, these two parties,
by entering into this transaction, how much
did they lose? Let's see, 300,000, they
lost $420,000. $420,000 was just wiped out. It just disappeared
from the economy. And where did it go? It existed at some point, it
must've gone someplace. Well, it was consumed. It went into these granite
countertops and these hardwood floors and the vacation; the
vacation is pure consumption.

You could argue, maybe, some of
it's investment if it helps you become more productive, but
for the most part, that's pure consumption. Things like wood floors and the
two more bathrooms and the granite countertops, there is
some value there, but that value is definitely not
equivalent to the amount of money that was spent on them. They were depreciating assets;
they're luxury goods; they're probably according to
the taste of the person who did it.

But anyway, the whole point of
this video is, is when you have these asset bubbles, like
in real estate, and you have this downplaying of risk, and
this psychology that an asset class can only go up. And then people start to have an
inflated notion of what the assets are worth, and start to
borrow against those and leverage up against those
inflated notions, you have to have a misallocation of wealth
and, essentially, a lot of resources end up getting
destroyed. Resources that could have built
factories, could have built schools, could have built
roads, whatever, ended up building granite countertops
and sending people on vacation and making them feel
good to go start shopping at Williams-Sonoma or Neiman
Marcus or whatever. And all of that is, essentially,
just consumption that just destroys wealth. So it just disappears. And I want to make this point
because we have a government now that somehow thinks that
it can legislate away real wealth destruction. It thinks that, you know what,
if we just somehow buy this loan from this bank, this
$500,000 loan, and if we were to hold on to it long enough,
maybe the underlying asset– the house got foreclosed on, so
we don't even have the loan anymore, we have the house.

So maybe the government says,
oh what if we just buy this house and hold it long enough,
maybe it'll get back to a million dollars. It may get back to a million, if
our population increases so much that, one day, that might
become a productive asset again, or becomes a
high demand asset. Or, it might not ever go up; it
might be a house that was built in the middle of nowhere
that's not really useful to anyone; and, if anything, it's
going to become a place where squatters start to come and the
whole place turns into an empty neighborhood. Who knows? But the bottom line is the
government somehow thinks that once things get bad, it can
step in and try to not let people realize that they
have destroyed wealth. I call that legislating
against reality.

And reality is something it's
very hard to do anything against, whether you want to
legislate against it, or speak against it, or perceive a
universe that's not in accordance with it. But anyway, this is the
crux of the issue. But with that said, I don't want
to seem like one of these defeatist people who says that
there's no solution to the credit crunch. In particular, this banking
crisis we're dealing with right now. In the next video, I'll give you
a proposed solution that was actually suggested
to me by a friend from business school. And I actually think it makes
a lot of sense, if you think that the credit freeze
that's going on is the crux of the issue..

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