Geithner Plan
Geithner Plan IV Quantifying the value of the put option
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- 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.
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