Geithner Plan I - Khan Academy
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Geithner Plan I - Khan Academy<br>Overview of the Geithner Plan and the problem it is supposed to solve.
We've got like a few more details today from Geithner and the Obama Administration about their plan for "Saving the banks".
So I figured that this is a good time to analyze what they are proposing and see if we can come to any conclusions.
So just to simplify the original problem, you know you have some bank, maybe Citibank or somebody else...
Instead of... Let's say they just have one big bad asset that they originally paid 100$ for.
So that was the original book value for the asset.
And they were able to do that... and obviously these banks have a bunch of assets so I am over-simplifying it.
But I think it will get you the crux of the issue.
They did that by, let's say they used... obviously a lot of them leveraged much more, but lets say they used 40$ of equity.
40$ of equity.
And then they borrowed the remaining 60$ to get that asset.
They borrowed the remaining 60$.
And now of course these... you know this asset right here, it's backed by toxic mortgages
And it's you know the equity tranche on these mortgages.
And I encourage you to watch the videos on collateralized debt obligations and mortgage backed securities...
and even the whole thing... um kind of all of the videos that we did on the... on Paulson's original bail-out plan, because I talk about all the liquidity issues there.
The bottom line is that these you know... some of these debts are coming due for these banks.
So they need to offload these assets to get cash.
And the whole problem here is... is if they offload these assets... I mean let's say everyone they know it's not worth a 100$ right.
Everyone knows it's really not worth a 100$.
But these banks, they don't want to offload these assets for anything less than 60$. Right?
Because if they, if they offload these assets for anything less than 60$, then they have negative equity.
Right. And that means that the book value is zero. Let's say if they offload... let's say if that was the only asset they had.
Then you would have this situation. If they offloaded it for, I don't know, 50 cents on the $.
Then they are offloading it for 50$. So you'd be with this reality... you'd have 50$ and you owe 60$
You owe 60$, so there's nothing left for the equity, and in fact into bankrupt(sic)... bankruptcy. You'd be an insolvent bank.
So obviously... just to set the framework, there's a huge incentive why the bank doesn't want to sell for anything less... sell this asset for anything less than 60 cents on the $.
The problem is, the most that anyone's willing to pay for it, right now, is not even the 60 cents on the $.
People are just willing to pay, you know I've read reports and depends what asset you're looking at, that that people are willing to pay 30 cents...
So this is... let me write that down... because this is important. This is what banks want.
Banks want greater than 60 cents on the $. And this case, this is 100$, so 60$
Willing... you know... Investors willing to pay. Investors paying... my understanding is so far you know for the most part, without any government intervention, the investors are willing to pay 30 cents or less.
So there's this disconnect. The banks are like "well I'm not willing to sell this for anything less than 60 cents, because then I'm insolvent and the gig's up."
And investor's saying "Oh no, these are toxic assets. Everyday there's more foreclosures. It's even hard to get good documentation on what backs up these loans."
A lot of these were these you know NINJA loans, no-income no-job loans, or these liar loans, or stated income loans, where people can just fill out with anything they want and there's all this fraud.
So people are discounting a lot of risk into these assets, so essentially the market isn't functioning.
The buyer's willingness to pay is much lower than the seller's willingness to sell. And nothing happens.
And so... these toxic assets are you could say clogging up the system. Because they... the banks... I won't say that they can't sell them
It's just they're not willing to sell them. Because if they are willing to sell them, at the market price, whether or not you agree with this market price, the bank's will be bankrupt.
So, the government all along, has been trying to come up with different um different iterations of how can we somehow, get these assets off the banks' balance sheets without causing the banks to get insolvent.
And you know the original version of TARP 1 is that the government will essentially buy these assets for who knows 70 cents on the $.
Right? and in that reality if you bought those assets for 70 cents on the $ then those assets... You'd have 70$ here, the bank would owe 60$.
And there would still be a little bit left of equity. There would be 10$ left.
But the important thing is, is that the bank would be able to pay off it's liabilities, stay liquid, and in the end...
you know be around for a better day or a better economy where it can grow the equity base again by investing and all of that.
And everyone realized that the TARP was a fraud on some level.
Because when you do that if the market really is 30 cents on the $ and you are paying 70 cents...
Let me just say this is TARP1... TARP1... and the government pays... the government pays 70 cents on the $, the government's over-paying by 40 cents on the dollar...
In this case the government would be writing a 40$ cheque to the owner's of this company, in this case the stockholders ... Right?
And you know these are the very same people... the management and the original investors in a lot of these companies... are the very same people who got us into this mess.
And why should we rewriting them billions of dollars of cheques to essentially just bail them out...why don't you just take them into receivership and all that and I'll do other videos on that.
So the new iteration that has come about... let me scroll down a little bit... is let me draw the original circumstance...
So you have this item here that was originally paid for 100$, they borrowed... they borrowed 60$ to purchase them and then they have 40$ of equity.
The new plan is... the government's saying "You know we'll do ... we don't you know we... you're right the tax payer... we as a government we're not in a position to decide what things are worth."
"We... we know...we're not you hedge fund managers or mutual fund managers... we're just you know bureaucrats. And you're right we would probably just end up over-paying for things."
"Because these guys are smart. And if they're not willing to pay more than 30 cents, and we're paying 70, we're over-paying. And ... And it's essentially just a big subsidy from the tax payer.
So the new plan... the new Geithner plan is saying "Hey we're gonna partner... we're gonna partner with the private en... uh with the private investors".
And the way they're suggesting they do that, is that .. see a private investors... and these are numbers that I've been reading in some of the newspaper reports and the numbers might change over time... because they do tend to.
But private investors will contribute.. this isn't ex.. say 7$, the treasu... let me see this is from private investors...
The treasury will contribute another... let me make another box... will kind of match that investment by the private investors... so the treasury will contribute another 7$.
... The treasury... And then the fed is going to lend the balance. So the fed... let's see if you wanna get to a 100$, that's 14, so the fed has to lend 86$
Drop box here. The fed is going to lend 86$, it's going to look something like that.
So that's 86$ from the fed.
And of course this entity when it's originally capitalized, is just going to be sitting on a 100$ of cash.
Right?.. That's it's assets... It's going to have... well I'm saying it has a 100$ of cash. It could be something less.
But let's say this is what it originally sets out to be... fed gave 86 lent 86$ of it... this is a loan.
The treasury made it a direct equity investment of 7$... and private investors make a direct investment of 7$
And then this entity can then go and buy these assets. And what the government.... at least my reading of it is... is that the private investors are going to set the price.
So the private investors are going to say... you know what I think that this thing right here is worth... I don't know I think its worth um 70 cents on the $.
And let's say that they are the winning bid.They are the people willing to pay the most.
Because that's my reading, is that there will be an auction and the private investor in partnership with the treasury that's willing to pay the most will get the assets.
So then in that case, let's say.. let's just make ... let's say they pay... let's say.. let's say they decide to pay 100$, just to make the math easy.
So then this cash will go to this bank, so then they'll have a 100$ of cash.
And then the asset, so then we'll have the toxic asset sitting here.
The toxic asset will be sitting here. Right?
And you might say "Hey Sal, you know, that's crazy, why would a private investor do it." And you're right, you're right.
I mean in a lot of circumstances they obviously wouldn't pay, actually because of that, let me not make 100$ a number. Let's say that they pay, let's say that they pay 60$ for it.
Because that's remember, the banks weren't even willing to part with them for less than 60$, so for this to even work, someone's gonna pay at least 60$ for this thing.
So let's say they pay 60$ for it, and then they get the asset, and then they're gonna have 40$ left over.
Right? They have toxic asset and then they're gonna have 40$ left over.
Because they only paid 60$ for the security.
The way I set it up, although they probably designed this thing so there isn't any cash.
Actually look... well yeah they probably designed it so that there isn't any cash left over.
But let's just let's just use these numbers for the sake of of convenience.
So now you might say this was good, you know the private investors they made like an educated decision, and they've decided to price this thing at 60 cents of the dollar.
And my question to you is "Why would the same people who before this plan, weren't willing to pay any more than 30 cents on the $, now be willing to pay 60 cents on the $?"
Now they're willing to pay this much for the asset. And there's a couple of answers here.
I mean the kind of naive answer is that the government takes the first hit.
Or if these things end up being worth 30 cents on the $, let's say that you know we go to a future state and these really are worth only 30 cents.
The most that the private investor loses in this situation is his 7$, the rest of the loss is gonna be borne by the fed and the treasury.
This loan by the federal reserve is a non-recourse loan.
Which means that if for whatever reason this entity can't pay back the loan, this the lender, which in this case is the fed, can't go after the equity holders.
All the lender can do is take the asset. So if this asset is worth nothing...
The fed all it can do is just take the asset, and is essentially is going to get nothing back for the loan.
So in this the private investor will get all of the upside.
Right? If this thing that they paid 60$ for, ends up being worth... let's say it ends up being worth...
Um I'll write down here because it's [not clear] with the equity holder.
If that asset they paid 60$ for it, if it ends up being worth 80$, then that extra 20$ of value...
is going to be split by the treasury and the private investor. Right? So let me give you that situation.
So what would the balance sheet look like. They paid 60 now... all of a sudden that asset is worth... that asset is worth 80...Right? so this is a good scenario... an upside scenario
Remember where we had 40$ left over in cash just based on the way I had originally set it up. You owe 86 $.
You owe 86$ to the fed. The federal reserve which is officially separate from the treasury, separate entity.
And then the equity is split between the treasury and the private investor.
So how much equity is there. You have 120$ minus 86, so you have 34$ of equity right?
Right so you have 6 more here so this is 34$ of equity. And its going to be split 50/50, so its going to be 17$ for the private investor...
And then you have 17$ for the treasury, and this looks great.
In this situation the private investors original investment was 7$ and it went to 17$, so it's got a... got a huge return in investment, so this is a positive scenario...
And then the negative scenario, where the.. where let's say that the original investment actually ends up being worth... let's say ... actually ends up being worth 30$. Remember they had 40$ of cash.
Just the way I set it up. Now all of a sudden the federal reserve, you had a loan to the fed, from the fed for 86$. Now your assets are less than the liabilities. Your equity is wiped out right.
So in this bad situation, the private investor invested 7$ and it went to zero right? So this doesn't look actually that bad of a scenario.
That in an up case you go from um (that's a 170 [corrects to 17]) You go from 7 to 17$, and in the bad case you go from 7 to 0$ right?
And actually this could be magnified a lot more depending on how these things work out.
But this still begs the question. If an investor really thinks... really thinks that these things are worth 30 cents. And that there really there's no chance they're worth more than 60 cents.
There's still... even though they disproportionately can participate in the upside relative to the downside, which I think in of itself is wrong.
That the government shouldn't be subsidising hedge-funds and other private investors.
But if they really thought that the value was close to the 30 than the 60...
Then the question is why would they participate at all. I mean if you know you're gonna lose money, you shouldn't do it to begin with.
And I've realized I've run out of time, I'm gonna cover that in the next video and ... and to some degree the next video you might find troubling. See you soon.

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