Geithner plan 5 | Money; banking and central banks | Finance & Capital Markets | Khan Academy Video Lecture | Geithner plan: How America revived from Financial crisis - Entrepreneurship

In the last video I constructed
a scenario where
we get all of the upside in an
investment and our downside
was limited to essentially
15% of our investment.
Or in that case it was $25.50.
I think I made a slide
math error.
I kept saying $24.50.
It was really $25.50.
And I also apologize, I
realize I had my sound
settings a little off.
But hopefully you'll be
able to still listen
to that last video.
But just to review what we did
is instead of putting $30--
let's say the asset
price was $30.
Instead of just going out there
and paying $30 for it,
what we did is we put
$25.50 aside.
And then we used $4.50 to
participate in Geithner's
project, or his plan.
And we put in $4.50.
The Treasury puts in $4.50.
Then the Fed lends us $51.
And then we're able to buy $60
worth of security, or twice as
many as we would've
otherwise bought.
But we're splitting
the upside.
So essentially we're getting
the upside on the security.
And we saw in the last video
what the payoff looked like.
And let me draw that here.
So hopefully this'll be a
slightly cleaner version than
I did in the last video.
So this is going to
be the eventual
price of the security.
And let me make the y-axis
the eventual value of my
investment.
Now if I just straight up
invested in the thing then the
value of my investment is the
value of the security.
So it would just look
something like that.
So let's say if the value of
the security ends up being
$30, then the value of my
investment ends up being $30.
This is the scenario
where I just
straight up buy the thing.
If the thing ends up being worth
nothing, then the value
of my investment's nothing.
If the thing ends up being worth
$60, then the value of
my investment is $60.
This is my investment value.
Not too fancy there.
But what we saw in the last
video is, if we do this
scenario where I put $25.50
aside, and I only put $4.50 at
risk in this type of reality,
what we had is that if the
value of the security is
anything less than $25.50,
then the equity holders
here get wiped out.
My $4.50 is worth nothing.
My $4.50 is worth nothing.
But I still have that $25.50
that I put aside, the cash.
So my losses were limited to
essentially $4.50 or the
capital that I put at risk.
So the payoff diagram then
looks like this.
In an upside scenario, with my
$4.50 investment I'm able to
capture all of the upside that
I would have normally gotten,
and then my downside is
essentially capped to $4.50.
No matter what happens to the
security, I'm going to be
sitting with $25.50.
So the worst case is that I
really just lose $4.50,
assuming that my original price
that I pay is $30 for
the security.
This'll be my loss.
And then this is obviously
my gain, just like that.
Now let's see, if there was no
Geithner Plan, let's see if we
could set up the same type of
payoff using more conventional
securities, I guess we
could call them.
And if we can do that, then we
can try to price those more
conventional securities, and
then we have a good sense of
the subsidy or essentially what
the government is giving.
So instead of the Geithner
Plan, let's say that we
invested straight up
in the security.
And I'll just say, we invest
in the security for $30.
And then we also buy an
insurance contract.
So we buy the security
for $30.
And then we also buy
a put option.
And that sounds fancy, but all
it is is an insurance contract
essentially on a security.
So we buy a put.
And the put gives us the right,
it's a contract that
says that we can sell.
We have the right to sell
our security for $25.50.
And we don't have to sell
our security for $25.50.
Let's say it ends up
being worth $60.
We're out here.
Then we're just going
to take our put
contract and rip it up.
It's worthless.
We don't want it.
We didn't need the insurance.
Our house didn't burn
down, right?
But let's say we're down here.
The thing we bought, this toxic
asset, really is worthless.
Then wow, we have
this contract.
We got into a contract with
someone else who said that
they would agree to buy
that thing for us
from $25.50, right?
We have the right to sell it to
them, or to put it to them,
for $25.50.
And just so you get a little
bit of the lingo, although
many of you all are probably
familiar with this, this is
the strike price of
the put option.
And what would the payoff
diagram look like?
Well, I have the security.
So in all of the scenarios where
the security is worth
more than $25.50, my payoff is
going to look like this.
It's going to be just
along this line.
Now, in these scenarios down
here, what is my payoff?
Well if the value of the
security ends up being
something less than $25.50, well
I have this thing here
saying, you know, the market's
saying that they're only
willing to pay I don't know,
$12 for my security.
But I have this contract with
somebody that says hey,
they're willing to pay $25.50
for my security.
So in any of these scenarios,
I'm just going to exercise my
put option, and I'm just
going to sell it to
this guy for $25.50.
So, no matter in all of these
downside scenarios, I still
get $25.50, because I have
that put option.
So essentially, as you see,
this payoff diagram is
identical to what the
government gave us.
So throughout this whole
structure, this public private
partnership, all the government
is essentially
doing is giving us a
put option with a
$25.50 strike price.
And so to figure out how large
of a subsidy that is, we
really just have to figure out
what is a put option with a
$25.50 strike price.
And people have Nobel-- It's
actually not that easy to
calculate this type of thing,
because you have to know about
the volatility of the security
and its dividends, and
actually the math to originally
come up with this
came out of-- People have won
Nobel Prizes for this.
But it's a known problem.
What I'm going to do here--
And it's a little bit
theoretical.
What a lot of people do in
reality is, they look at what
the market is paying for these
options, and then they figure
out what the implied assumptions
are, the
volatility.
And that's really the
big assumption.
But I just did a little
bit of a web search.
And just to give proper
credit, this is
math.columbia.edu.
And this is a little tilde sign
~smirnoff\options13.html
But what he has here is a
little bit of an options
calculator.
And I'll take my chances with
this guy, who's probably a
Ph.D student or a professor at
Columbia, that he knows how to
calculate options, and that
his JavaScript is correct.
And the numbers make sense.
But let's say the security
in our case is $30.
The strike price is $25.50.
Let me make this larger.
The interest rate.
So this is the risk free
interest rate.
It could also be the interest
on the debt.
It depends.
But you know, it's
something small.
Interest is low right now.
Say 2%.
The dividend yield-- We're
buying these toxic assets that
essentially have a pretty
high yield.
And if you're buying it at
$0.30 on the dollar, your
yield's probably in the range
of 30% or something.
But you can play with
these assumptions.
I'm trying to be as favorable
as possible to this, to kind
of see how large the
subsidy could be.
And maybe we'll come
up a range.
And you could play with
this in your own time.
Volatility per year.
I think 30% is pretty fair.
That in any given year, the
perceived value of this could
fluctuate by 30%.
And the time to expiration.
These are long lived assets.
A lot of mortgage assets, their
average maturity is
around 10 years.
So instead of 365 days, let's
make it 10 years.
3,650 days.
And let's calculate it.
All right, and what we want
to worry about is
the American put.
In future videos, I'll talk
about the difference between a
European put and an
American put.
But an American put means you
can essentially exercise it at
any time you want
to exercise it.
While a European put just has an
exercise date, where that's
the only time where you can
exercise your option.
But the American put says that
the value of this, for the
assumptions we gave,
is about $19.50.
So it's a pretty big subsidy.
And of course, the numbers
change a good bit depending on
if we make the yield on
the security less and
we calculate it.
Whoops, I made a mistake here.
It becomes something less.
But no matter how you play with
the assumptions, you get
something in the
$15-$20 range.
So that option calculator told
us that the correct price or
the theoretical price for
something like this, for a put
option for a security like this,
with 30% volatility that
maybe has a 30% yield
on it, because it's
paying a lot of dividends.
People are paying their
mortgage payments.
That the option value of this
put, if you had to go buy it
on the market.
You know, it's a range.
It's maybe $15 to $20.
So a rational investor who would
have paid $15 to $20 for
the option, how much are they
willing to pay for the
security plus the option?
Well, that same rational
investor, we're saying was
willing to pay $30 for
the security before.
And now they're getting the
security and the option.
So now, if they had had to go
buy the option by themselves,
they'd have to pay $15 to $20.
So in theory, they would be
willing to pay up to $30 plus
the value of the option.
So they'd be willing to
pay up to $45 to $50.
Now I want to be
clear on this.
If the investor with this option
is, let's say they end
up paying $50, who
is benefiting?
If the private investor here
ends up paying $50 for the
security, because the government
is essentially
giving them a free option, if
they pay $50 they're actually
paying for the what the
government is giving them.
They're paying for the option.
So the real benefit is the
person selling the toxic
assets, which are these
banks that I'd argue
are probably insolvent.
So the subsidy wouldn't be
to the private investor.
It would be to the banks.
Only if the private investor
pays the same prices that they
would have already
paid, the $30.
And the bank's willing
to sell it for $30.
Then you could say that the
subsidy is going to that
private investor.
But this begs the
whole question.
The whole point of this exercise
was that the bid in
the market right now,
or what people are
willing to pay, is $30.
While the banks, essentially,
they can't sell for anything
less, because if they did then
the gig would be up.
People would know they're
bankrupt.
The offer is $60.
So even with this option that
the government is giving them,
and even if this investor were
to pay up for the entire price
of the option, we're kind of
getting that maybe they'll be
willing to pay up
to $45 or $50.
In which case the private
investor is really getting no
value from this whole gig.
So even then, you don't
get to this point.
And obviously if the private
investor's only paying in the
$30, range, then that's no
different than the reality
we're already into.
And so this goes back to
that Geithner 2 video.
That even with this option, a
rational investor is only
willing to pay up to maybe
$40 or $50, how
could this plan work?
Well it either won't work.
Because a rational investor
still won't pay the magic
number that the banks need
in order to be solvent.
Or the scenario that I described
in the Geithner Plan
2 video will happen, where the
banks have this huge incentive
to buy these for themselves.
They just create these kind
of shill hedge funds.
And maybe I'll do a bunch of
videos on all of the different
ways they can do that.
And banks are experts at this.
At creating kind of off-balance
sheet entities
that they really do control.
And then those things
participate with the
government and buy the
assets off of them.
So my general take on it is,
if when we see this program
start to happen, if we see
bids that are above $60.
If we see bids at $0.70 on the
dollar or $0.80 on the dollar,
then these bids are actually
coming from the banks
themselves.
Because there's no rational
reason, even with the put
option, why a regular investor
would pay in
excess of $40 or $50.
And then there is a whole
liquidity argument here, that
Geithner has made, that oh well
it's not just the subsidy
we're giving.
It's just also the
buying power.
That right now, you have all
these distress sellers, and
you don't have that
many buyers or
dollars that are buying.
And by kind of leveraging things
up, you're increasing
the buying power out there.
And in the next video, I'll kind
of address that question.
If that is the real problem that
Geithner wants to solve,
there's a much better way to
solve it than doing this
public private partnership.
And essentially allowing
the banks to
potentially set the price.
You're either letting the banks
set the price, which
would be a direct transfer of
wealth from taxpayers to banks
that made mistakes.
Or you're giving a put option,
which has a pretty good value,
to a bunch of hedge funds and
investors, who maybe aren't
the reason why we got into the
mess, but there's no reason
why you should be transferring
money from
taxpayers to hedge funds.
So in the next video, I'll
address that, and hopefully
this gave you a good sense of
what exactly the government is
doing, and how you
can value it.
See you in the next video.