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Video transcript
In the second Geithner video, I lay out a scenario where a bank could-- let me draw its balance sheet. Let's say-- oh, that's not how I wanted to do it. Let's say this is a bank. It's holding-- let me draw its assets and liabilities. So it's holding some toxic asset A right here. And that could be the bank's equity, that's its liabilities, And this is the other assets for the bank. So it could hold some toxic asset A, and we lay out a scenario where, what the bank could do, right now it has 100% exposure to A. What it could do is it could take a little bit of cash, lend it to another party. Let's say it could lend it to a hedge fund, so this becomes a loan to the hedge fund. So now the hedge fund owes this money to our bank and it now has the cash on its balance sheet. So this would now, instead of being cash, it'll be called loan to hedge fund. Now this is the hedge fund's balance sheet. Its liability is loan from bank. And now it has this cash, and then it could use this cash to invest in essentially the Legacy Loans Program, the public-private investor Legacy Loans Program that Geithner talks about. And if they did this, they could take this-- let's say this was $7. They could take this $7, contribute it to the equity in the program. The Treasury would contribute another $7. The Fed would contribute $84, and then they would have $100, and I know this is kind of messy, but they would have $100 that they can then use to go buy these assets. And the net effect of this is that this bank went from having 100% exposure to this toxic asset to having only $7 exposure through this loan to this hedge fund, or this special-purpose entity, or whatever you want to call it. And I got a couple of emails, even from some colleagues, to say, well, can this really be done? And my kind of knee-jerk reaction was, well, if this can't be done, they'll figure out a way to do it, because there's billions of dollars at stake, and really, the incentive here is structured to do it. And frankly, the Government probably wants them to do it, because on some level, even though this would be a massive transfer of exposure and wealth from the taxpayers to the banks, it would on some level solve the problem. And if people really aren't aware of it, everyone will be happy about it, because all of these banks, Citibank and Bank of America, will just survive, and they can just kind of say that all's well. So what I wanted to do, just to answer those questions, is get a little bit particular about the wording. And I got an email. Leigh Logan actually emailed me, and she highlighted one clause in the Legacy Loans term sheet that seems to address what I talk about in that second video there. And this is from the Legacy Loans terms sheet. It says: "Private investors may not participate in any PPIF"-- so this is that Private-Public Investment Fund-- "that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF." So the question is what's an affiliate? And I looked it up in the Securities Exchange Act of 1934, and there are multiple definitions. But this is probably the best one. It says: "The term affiliate means any company that controls, is controlled by, or is under common control with another company." And that's an area that I just outlined. This bank really doesn't control this hedge fund, right? They just essentially gave them a loan with very little stipulations on it, and then the hedge fund can go do it. But, you could say, oh, well, you know, there's nothing that this bank could do to force this hedge fund to buy these assets, so maybe this plan won't work. And another thing is what's the definition of the private capital? You also can't represent 10% more of the aggregate private capital. Frankly, when I think of private capital, I think more in terms of equity investments, but maybe the definition of private capital also includes debt investments, although, I doubt it. So in this video I want to lay out a scenario that, essentially, it can do the same thing economically, and in fact, the exact behavior that they want in other parties without being in any way an affiliate of the counterparty and in no way giving capital directly to them. So what Bank A could do instead-- let me redraw it. Actually, not Bank A. The bank that's holding toxic asset A. And this is what I thought of after kind of thinking about it for about five or ten minutes. You could imagine what the banks will come up with when they have billions of dollars and careers on the line. So if you have a scenario where you have this toxic asset A, and you economically want to do what I describe, but you don't want to be an affiliate and you don't want to give the appearance of self-dealing, what you do is you sell credit defaults on A that become supercheap, so you have essentially $7 exposure of credit defaults. Let me do it this way. So what you do is you sell credit default swaps. So let's say you sell $7 of exposure. So your liability right here, is a seven-dollar CDS exposure, and I'll go over the economics of how this works in a second. And you actually get some of the income stream. It wouldn't even be accounted this way. You normally just have to-- if you're insuring $7 worth of credit default swaps, your liability isn't $7. You do the probability of default and all that, so your liability will probably be-- I don't know, $1.00, whatever it is, and you get some income stream for it. But the general notion is that you sell credit default swaps on this toxic asset, on A, for really cheap. And just so you know what a credit default swap is, I've made a couple of videos on it, it is essentially an insurance policy on a loan or on a company, and if that company or this loan defaults, you say that you are going to pay up essentially the insurance amount. So what you do is you sell $7 of credit defaults swaps on A. And just so you know, most of these toxic assets that these banks hold, these are assets that they were the originators for, and so, they're very particular to the individual banks. So a bank can definitely say I'm selling a credit default swap on A, and they know that, in the end, when I kind of outline this whole thing, they'll be the main beneficiary of it. So if you sell $7 of credit defaults swaps on A, what would I do? Well, I'm a hedge fund. What I do is I buy those credit defaults for really cheap. And then I invest in the TALF, right? So let's say I'm a hedge fund, and I have two things. I have a $7 investment in the TALF-- sorry, in this Geithner Plan, and then I also have this credit default swap, this insurance contract. And just so you know, depending on the price, you pay a certain amount every year. But the key here is that this bank could sell it, if they wanted to, for almost free. They could essentially give away these credit default swaps. So if that bank did it, then the hedge fund's assets would have the $7 investment in this Geithner program, and then it'll have $7 of credit default swap protection. Now what happens to this hedge fund? In the world where asset A is worth a lot, they get all of the upside through their investment in the Geithner Plan. That $7 investment gets levered to $100. Let me actually draw that again. So that $7 investment is here, $7 capital, $7 from the Treasury. You have $86 from the Fed, and they use this to give the cash here, and then that goes back here, and you're holding toxic asset A. Now if toxic asset A ends up being worth a lot of money, then this is worth a lot, and this is worth nothing, And that's OK, because the hedge fund essentially paid nothing for it or paid next to nothing for it, in which case, everyone kind of works out well in that scenario. On the other hand, let's say that this thing is worth zero. Let's say that this thing defaults. If that thing defaults, then this investment is worth zero. But guess what? The hedge fund had an insurance policy, where this guy was a counterparty. So he says, hey, this thing here defaulted. I'm going to claim my insurance policy, so this guy's going to have to send him $7. So it's economically the exact same thing that I outlined in the Geithner Two video, but in this situation, these guys, it's almost an arms-length transaction. But this bank can make that behavior happen by essentially going into the market and selling credit default swaps for this exact asset for really, really cheap. And this is just the first way I thought about it. There's other ways you could do it. If you're just a separate hedge fund and you own enough of the shares in a bank, let's say you owned all of the shares of the bank or a good percentage of the shares of the bank, then you would also have an incentive to go out there and use the Geithner Plan and lever up and buy these assets. Another thing is-- I don't want to get too technical --if you kind of hold one of the fulcrum pieces of debt, the pieces of debt that are trading at a discount, because you're afraid that this bank is going to fail, if you hold a bunch of those assets, you still would want to participate in the Geithner Plan and funnel money and use the Government money to essentially buy this asset A. I mean, the general theme here is, if you have two people, if this is the private world and you have a scenario where person A, if a transaction can make $100 or he gets rid of $100 exposure, and person B essentially has a potential loss of minus $7 of exposure, there's a net transfer of wealth here. You went from $100 of exposure to $7 exposure for this guy. So someone is offloading the $93 of exposure to this stuff, and that's the Government. The Government's only taking the down side. So this is a huge subsidy of exposure, and it depends what these are really worth, if this thing is really worth $30 and it's a $63 exposure, but any time you have this, the private sector is going to figure out a way to make this subsidy happen. And everything I've outlined so far is if A is the bank that has 100% exposure, all they have to do is, through whatever back-door scheme or financial product or insurance or whatever they want to do, or loans that have very little stipulations on it, they just have to give this guy essentially $7 of compensation somehow that gets around the Government rules, and then this transaction will occur. And I hope it doesn't occur, and it's very possible it won't, because maybe I'm missing something here, but I'm just saying that everything I understand about the Geithner Plan is that there's a huge incentive for this to occur, and this is frankly the only reason why the plan would work. Because, as I outlined in the other videos, for a private investor who's not incentivized in this way, the put option that the Government is giving them still is not enough of a rationale to go from paying $30 for an asset to going to pay $60 an asset. So it won't work if this behavior doesn't occur. The only way that the plan quote unquote will work and people will overpay for the assets is if you have this type of action going on.