Geithner plan 1 | Money; banking and central banks | Finance & Capital Markets | Khan Academy Video Lecture | Geithner plan: How America revived from Financial crisis - Entrepreneurship

We've got 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're proposing, and see
if we can come to any
conclusions.
So, just to simplify the
original problem,
you have some bank.
Maybe it's Citibank
or somebody else.
Let's say they 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'm
oversimplifying it.
But I think it'll get you
the crux of the issue.
They did that by-- obviously a
lot of them leveraged much
more-- but let's say they
used $40 of equity.
And then they borrowed
the remaining
$60 to get that asset.
And now of course, this
asset right here is
backed by toxic mortgages.
And it's 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, all
of the videos that we did on
Paulson's original
bailout plan.
Because I talk about all the
liquidity issues there.
The bottom line is that 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,
if they offload these assets--
let's say they know it's not
worth $100, dollars, right?
Everyone knows it's really
not worth $100.
But these banks don't want to
offload these assets for
anything less than $60.
Because if they offload these
assets for anything less than
$60, then they have
negative equity.
That means that the books values
here-- let's say if
that was the only asset
they had, then you
would have this situation.
If they offloaded for 50 cents
on the dollar, then they're
offloading it for $50.
So you'd be with this reality.
You would have $50.
And you owe $60.
So there's nothing left for the
equity, and in fact you
would go into bankruptcy.
You would be an insolvent
bank.
So just to set the framework.
There's a huge incentive why the
bank doesn't want to sell
this asset for anything less
than 60 cents on the dollar.
The problem is, the most that
anyone's willing to pay for it
right now is not even the
60 cents on the dollar.
People are just willing to pay--
I've read reports and it
depends on what asset you're
looking at-- that people are
willing to pay 30 cents.
So let me write that down,
because it is important.
This is what banks want.
Greater than 60 cents
on the dollar.
And in this case, it's
$100, so $60.
My understanding is so far, for
the most part, without any
government intervention, the
investors are willing to pay
30 cents or less.
So there's this disconnect.
The bank's 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 investors are saying, well
these are toxic assets.
Every day there's more
foreclosures.
It's even hard to get good
documentation on what backs up
these loans.
A lot of these were
these 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 slower than the
seller's willingness to sell.
And nothing happens.
And so, these toxic assets are,
you could say, clogging
up the system.
Because 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 were willing
to sell them at the market
price-- whether or not you agree
with this market price--
the banks will be bankrupt.
So the government all along
has been trying to come up
with different iterations of how
can we somehow get these
assets off the banks' balance
sheets without causing the
banks to get insolvent?
And the original version of TARP
1 is that the government
will essentially buy these
assets for, who knows, 70
cents on the dollar.
And in that reality, if you
bought those assets for 70
cents on the dollar,
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 that
the bank would be able to
pay off its liabilities, stay
liquid, and then be around for
a better day or a better
economy, where it could grow
the equity base again by
investing in all of that.
And everyone realized
that the TARP was a
fraud on some level.
Because when you do that, if the
market price really is 30
cents on the dollar, and
you're paying 70 cents.
Let me say, if this TARP 1.
And the government pays 70
cents on the dollar.
The government's overpaying
by 40 cents on the dollar.
In this case, the government
would be writing a $40 check
to the owners of this company.
In this case, the
stockholders.
And these are the very same
people the management and the
original investors in a lot
of these companies.
These are the very same people
who got us into this mess.
And why should we be rewriting
them billions of dollars of
checks 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-- and let me scroll
down a little bit-- is, and
let me draw the original
circumstance.
So you have this item
here that was
originally paid for $100.
They borrowed $60 to
purchase them.
And then they have
$40 of equity.
The new plan is, the
government's saying, you're
right, taxpayer.
We as a government, we're not
in a position to decide what
things are worth.
We're not hedge fund managers
or mutual fund managers.
We're just bureaucrats.
And you're right.
We would probably just end
up overpaying 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
overpaying, and it's just a
big subsidy from the taxpayer.
So the new Geithner plan is
saying, hey we're going to
partner with the private
investors.
And the way they're suggesting
they do that, is that let's
say a private investor-- 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, say, $7.
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.
And then the Fed is going
to lend the balance.
So the Fed-- let's see, if you
want to get to $100, that's
$14-- so the Fed has
to lend $86.
Let me draw a box here.
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 going to be
sitting on $100 cash.
That's its assets.
Well I'm saying it
has $100 of cash.
It could be something less, but
let's say this is what it
originally sets out to be.
Fed lent $86.
This is a loan.
The Treasury made 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 it's worth 70 cents
on the dollar.
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 that in that case-- 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
$100 of cash.
So then we'll have the toxic
asset sitting here.
And you might say, hey
Sal, that's crazy.
Why would a private
investor do that?
And you're right.
I mean, in a lot of
circumstances, they obviously
wouldn't pay.
Actually, because of that, let
me not make $100 the number.
Let's say that they
pay $60 for it.
Because, remember, the banks
weren't even willing to part
with them for less than $60.
So for this to even work,
someone's going to have to pay
at least $60 for this thing.
So let's say they
pay $60 for it.
And then they get the asset.
And they're going to
have $40 left over.
So they have toxic asset, and
then they're going to 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 left over.
But let's just use these
numbers for the sake of
convenience.
So now, you might say,
well, this was good.
The private investors, they made
an educated decision, and
they've decided to price
these things at 60
cents on the dollar.
And my question to you is, why
would these same people who,
before this plan, weren't
willing to pay any more than
30 cents on the dollar, now
be willing to pay 60
cents on the dollar?
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 dollar.
Let's say that we go to some
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
going to 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, the
lender-- which is in this case
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
essentially it's going to get
nothing back for its loan.
So in this situation, the
private investor would get all
of the upside.
If this thing that they paid $60
for ends up being worth,
let's say it ends up being
worth-- I'll draw it down here
because it's all going to 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.
So let me give you
that situation.
So what would the balance
sheet look like?
They pay $60 now.
All of a sudden that
asset is worth $80.
So this is a good scenario,
an upside scenario.
Remember, we had $40 left over
in cash, just based on the way
I had originally set it up.
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 here minus
$86 So you have
$34 of equity, right?
Because you have $6 more here,
so this is $34 of equity.
And it's going to be split
50-50, so it's 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
investor's original
investment was $7.
And it went to $17.
So it's got a huge return
on investment.
So this is the positive
scenario.
And then the negative scenario,
where let's say that
original investment actually
ends up being worth $30.
Remember they had $40 of cash
in the way I set it up.
Now all of a sudden the Federal
Reserve, you had a
loan from the Fed for $86.
Now your assets are worth less
than your liabilities.
Your equity is wiped
out, right?
So in this bad situation, the
private investor invested $7,
and it went to zero.
So this doesn't actually look
like that bad of a scenario.
That in an up case, you go from
$7 to $17, And in a bad
case, you go from $7
to zero dollars.
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 that these things
are worth 30 cents, and
that there's no chance that
they're worth more than 60
cents, 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
subsidizing hedge funds and
other private investors.
But if they really thought that
the value was closer to
30 than to 60, then the question
is, why would they
participate at all?
I mean, if you know you're
going to lose money, you
shouldn't do it to begin with.
And I realize I've
run out of time.
I'm going to cover that
in the next video.
And to some degree,
the next video
you might find troubling.
See you soon.