Geithner plan 2 | Money; banking and central banks | Finance & Capital Markets | Khan Academy Video Lecture | Geithner plan: How America revived from Financial crisis - Entrepreneurship

So just to get us back up to
speed where I left off in the
last video, we have a bank
sitting on an asset that it
maybe originally
paid $100 for.
Let's say it has
$60 liability.
$40 of equity.
That's when they paid for it.
So this is $100.
This is $60 of debt.
And they had $40 of equity.
And these are the
toxic assets.
We're just assuming
a world that only
has one set of assets.
And the problem that we said
from the beginning of the
banking crisis is, that the
banks can't sell these assets
to pay off its liabilities,
its deposits, or other
debtors, for the price that
it wants to sell them at.
Because obviously if they sell
this for anything less than
$60, the bank is bankrupt.
So this is the bank, and it
wants to sell for greater
than-- I'll say $60.
I won't say 60 cents
on the dollar, but
it's the same thing.
Wants to sell for greater
than $60.
While the market is willing
to pay less than
$30 for this asset.
And obviously if the bank went
and sold this at the market
price and only got
$30 for this.
If this whole thing became
$30, then the liabilities
become worth much more than
the asset, than the $30.
And the bank is bankrupt.
And so as I outlined at the
end of the last video, the
current incarnation is for,
you have a public private
partnership.
Let me draw their equity.
And let me try to draw it
a little bit better.
So let's say that you have--
and I'll do the number
slightly different--
so you have $5.
from a private investor.
This is a review of
the last video.
You have $5 from the Treasury.
These are both the
equity investors.
And then you have $50 borrowed
from the Fed.
And I'm doing this a little
bit differently, so the
numbers match up exactly
with what they're going
to pay for the asset.
So you have $50.
Let me see.
So if that's $10, $50 would
be something that looks
something like that.
So you have $50 that you borrow
from the Federal Reserve.
And so, this entity will
have $60 here.
When it gets capitalized.
We'll do that in green.
And what they can now
do, is they can give
that $60 to the banks.
Essentially paying a price that
the banks are willing to
part with the assets for.
And then the banks are going
to give them the assets.
So now the bank has $60 of cash
that it can use to keep
its liabilities liquid.
And now this entity right
here has a toxic asset,
we could call it.
And I addressed it in the last
video, you know, why is the
investor doing this?
Because they share
disproportionately in the upside.
They paid $60 for this thing.
And just as a real quick review,
if this thing ends up
being worth-- let's say it
ends up being worth $100.
Then they owe $50 to the
Federal Reserve.
That's this loan right here.
To the Fed.
And then they split the equity
with the Treasury.
So, how much equity?
There's a total of $50
of equity left.
$25 for the Treasury.
$25 for them, for the
private investor.
So their initial investment was
$5, and it went to $25.
That's awesome.
Five times your money.
And then in the down case.
What's their down case?
Their down case is-- let's
say that toxic asset
really is worth $30.
Let me draw that.
And this is a review
of the last video.
But it's important, because
it really bears
into what might happen.
So let's say that this
is optimistic.
This is pessimistic.
So let's say these assets
end up being worth $30.
Then you have this $50
loan from the Fed.
And you have no equity
left over.
And the Fed essentially
is left taking
a loss on its loan.
But the private investor, since
there's no equity, is
going to be left with zero.
So you went from $5 to zero.
But this is still a pretty
good risk/reward.
Depending on how you weight
these probabilities.
But a lot of people, if you
thought that there's an equal
chance of this and this
happening, you
would take this bet.
If you had a 50% chance of
making five times your money,
and only a 50% chance of
losing your money, the
expected value here is, it would
be 0.5 times 25 plus 0.5
times zero.
It would be a $12
expected value.
So I would pay $5 for something
that has a $12
expected value.
That's a great return.
You're making 140%
on your money.
You don't see returns
like that every day.
Unfortunately, the probability
of these two things happening
aren't equally likely.
Because obviously right now, the
market's willing to only
pay $30 for these things.
The market, if they thought that
there was any chance that
these things are worth more than
$60, any chance, they'd
be trading at higher than $30.
So given where the current
market is, before government
intervention, clearly no-one
thinks that there's a really
good chance of them
being worth $60.
There's a much higher
probability of this scenario
occurring than this.
And you could do
a spreadsheet.
And you could weight
the probabilities.
And if you make this probability
high enough
relative to this one, then of
course the expected value is
still going to be
less than $5.
You're still expected
to lose money.
And so you might say, well,
who would do that?
Even though Paul Krugman is out
there saying, you know,
this is one of those heads
I win, tails you
lose type of scenarios.
And that is true.
In the positive scenario, the
private investor makes the
bulk of the money, alongside
the Treasury.
With the Fed just getting a very
low interest rate back on
this money.
While in the negative scenario,
most of the hit is
going to be taken by the Federal
Reserve with their
loan, and then the Treasury
who's an equity investor
alongside them.
So that is one of these
things that Paul
Krugman is talking about.
But I'd say, that even if that,
an intelligent investor,
just because the risk soon.
reward is disproportionately
weighted to the other guy, they
still wouldn't want to
invest it, if this is the
more likely scenario.
So the question is, who
is going to do this?
And this is what I mentioned
in the last
video, could be troubling.
The obvious thing is that the
banks might want to buy it
from themselves.
So let me redraw everything.
Because this is an important
point to make.
And frankly, I don't
know how you can
prevent this from happening.
If this version of Geithner's
plan ends up passing.
So this is the bank's
balance sheet.
Kind of their before
balance sheet.
They paid $100 for
these assets.
They owe $60.
All liabilities, deposits,
whatever.
And originally they have
$40 in equity.
What the bank does is it takes
some extra money, and they
could raise equity,
or for all we know
they could raise money.
I mean, the government is giving
them loans right now.
This isn't fiction.
So what you do is let's say
you borrow $7 from the
government.
And this is happening.
I mean, the government is giving
loans to these major
banks, to Citibank and Bank
of America, et cetera.
And they'll get $7 of
cash right here.
Now what the bank does is, they
create a separate entity.
They can call it whatever
they want.
They could put it in a hedge
fund to do this.
I mean, banks are great.
Special purpose entities
happen all the time.
And there's nothing to stop a
bank from putting this $7 into
another entity.
Another special purpose
entity.
Where the bank essentially
owns the equity.
And this cash went to that.
And then taking this $7
and using this to
participate in the plan.
In this new Geithner plan.
So the bank takes that $7 that
they essentially might have
just borrowed from
the government.
Participates in the plan as
the private investor.
And I'll put that in quotes.
And they could put a bunch of
layers here and obfuscate it.
Or even get one of their hedge
fund clients to do it, by
giving them good terms
on something else.
I mean, there's a million
and one ways you
could set this up.
And that's why I think it's
impossible to legislate
around, or legislate
to prevent it.
So they do that there.
The Treasury will participate
side by side
as an equity investor.
And then they'll borrow $86
from the Federal Reserve.
That's from the Treasury.
And now the bank is
essentially the private investor.
They're controlling
this entity here.
They're controlling entities
that control that entity.
It doesn't matter.
But they essentially set the
price for which this entity is
going to pay for
its own assets.
So they could pay $100
for this thing.
Even though everyone knows that
these things are worth
nowhere near $100.
So they pay $100 for this.
Take it off their
balance sheet.
And then they're sitting
with $100 cash.
And this is sitting there
with a toxic asset.
And why would a bank do this?
Well, think about it.
In this reality, before any of
this happened, the banks had
100% exposure to these
toxic assets.
It had this whole thing right
here, it had exposure to.
And for all we know, they're
only worth $30.
But the bank never wanted
to accept that reality.
While in this reality,
the bank only has
$7 exposure to it.
So even if this thing ends up
blowing up, who's going to
take the loss?
The bank's just going to
take a $7 loss here.
And then the rest of the loss
is going to go to the
taxpayer; the Treasury and
the Federal Reserve.
So this is an awesome
situation.
Because in this reality when
there was a hit, if this was
worth $30 the bank would
have to take a $70 hit.
While in this reality, if this
toxic asset now is only worth
$30, the bank's only going
to take a $7 hit.
And the bank is going
to stay solvent.
So this investment right here
is going to be wiped out.
But still, the bank
got $100 in cash.
So my fear is, and frankly
since there's nothing to
prevent it, it's almost a
self-fulfilling prophecy
that's going to happen.
You have this big question
mark, why would a private
investor ever participate
in this?
Even if the government is kind
of giving you more of the
upside than the downside.
You wouldn't participate in
it if you thought that the
downside scenario
is more likely.
But you would participate in
it, if you were the actual
seller of the security.
Because if you are the seller
of the security, you are
Citibank, you're going from
100% exposure to only 7%
exposure, and you're going
to be staying solvent.
But the net effect of this is
that the Treasury and the
Federal Reserve, they got
$100 for something.
Or I guess, if you take
out the $7, they
essentially got $93.
Because they had to spend $7
to make this thing happen.
But they got $100.
So they got $93 for something
that's really worth $30.
So the difference, the $63, it
essentially would be a check
that's being written from the
U.S. taxpayer to these banks.
And in the magnitude that
we're talking about, it
wouldn't be a $63 check.
It would be a $630
billion check.
So to me, this would be kind
of the biggest travesty of
capitalism.
And it would be a sad day.
It would frankly just make the
AIG bonuses look trivial.
The right answer is, you take
that $630 billion, make the
banks wipe out their
shareholders, and then you
recapitalize the banks
with the money.
And then you start, instead of
writing the $63 or the $630
billion check directly to
the management and the
shareholders who got us into
the mess, you essentially
recapitalize the new banks.
And I've written a paper
about that, and
there's a new bank plan.
And distribute the shares
to the American people.
And you get the same effect
without this hugely negative
repercussion of providing a huge
wealth transfer to the
very same people who
got us in the mess.
Anyway, I hope people kind of
get on this story, because
it's got me pretty troubled.
Anyway, see you