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Current time:0:00Total duration:14:02

Video transcript

we've gotten 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 know you have some Bank maybe a Citibank or somebody else instead of let's say they just 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 the crux of the issue they did that by let's say they used obviously a lot of them levered much more but let's say they used 40 dollars of equity 40 dollars of equity and then they borrowed the remaining $60 to get that asset they borrowed the remaining $60 and now of course these you know this this asset right here it's backed by toxic mortgages and it's you know 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 kind of all of the videos that we did on the on Paulson's original bailout plan because I talk about all the liquidity issues there the bottom line is that these you know 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 is if they offload these assets I mean let's say everyone they know it's not worth $100 right everyone knows it's really not worth $100 but these banks they don't want to offload these assets for anything less than $60 right because if they if they offload these assets for anything less than $60 then they have negative equity right then that means that the book value is here let's say if they offload let's say if that was the only asset they had then you would have this situation if they offloaded it for I don't know 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 dollars you owe $60 so there's nothing left for the equity and in fact you would go into bankrupt you bankruptcy you would be an insolvent bank so obviously just set the framework there's a huge incentive why the bank doesn't want to sell for anything less sell this asset for anything less than sixty cents on the dollar the problem is the most that anyone's willing to pay for it right now is not even the sixty cents on the dollar people are just willing to pay you know I've read reports and depends what asset you're looking on that that people are willing to pay thirty cents so let's let me write that down because this is important this is what banks want banks want greater than sixty cents on the dollar in this case there's a hundred dollars so sixty dollars in willing you know investors willing to pay investors paying my understanding is so far you know for the most part without any government intervention the investors are willing to pay thirty cents or less so there's this disconnect the banks like well I'm not willing to sell this for anything less than sixty cents because then I'm insolvent and the gigs up and investor saying well no 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 you know 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 the buyers willingness to pay is much lower than the sellers willingness to sell and nothing happens and so these toxic assets or you could say clogging up the system because they 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 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 different iterations of how can we somehow get get these assets off the banks balance sheets without causing the banks to get insolvent and you know the original version of tarp one is that the government will essentially buy these assets for who knows seventy cents on the dollar right 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 dollars and there would still be a little bit left of equity there would be $10 left but the important thing is is that the bank would be able to pay off its liabilities stay liquid and then you know be around for 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 this is kuitar one tarp one and the government pays 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 right and you know these are the very same people the management and the original investors a lot of these companies are the very same people who got us into this mess and why should 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 I'll do other videos on that so the new I duration that has come about let me scroll down a little bit is let me draw the original circumstance so you have this item here that was originally paid for $100 they borrowed they borrowed $60 to purchase them and then they have $40 of equity the new plan is the government saying you know we'll do what we don't you know we you're right the taxpayer we as a government we're not in a position to decide what things are worth you know we're not hedge fund managers or mutual fund managers we're just you know a bureaucrat and 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 essentially just a big subsidy from the taxpayer so the new plan the new Geithner plan is saying hey we're going to partner we're going to partner with the private and with the private investors and the way they're suggesting they do that is that I say a private investment these are numbers that I've been reading in some of the newspaper reports and you know the numbers might change over time because they do tend to but private investors will contribute this is an exhibit say $7 the treasure we can see this is from private investors the Treasury will contribute another we make a another box will kind of match that investment by the private investor so the trick the Treasury will contribute another $7 the Treasury and then the Fed is going to lend the balance so the Fed let's see if you want to get to $100 as 14 so the Fed has to lend $86 draw a box here the Fed is going to lend $86 it's going to look something like that so that's 86 dollars from the Fed and of course this entity when it's originally capitalized it's just going to be sitting on a hundred dollars of cash right on that's its assets it's going to have well I'm saying it has 100 dollars of cash it could be something less but let's say this is what it originally sets out to be Fed gave 86 lent $86 so this is a loan the Treasury made it 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 that you know 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 then in that case let's say let's just make it a loop let's say they pay let's say let's say I decide to pay $100 just to make the math easy so then this cash will go to this Bank right so then they'll have $100 of cash and then the asset so then you will have the toxic asset sitting here the toxic asset will be sitting here right and you might say hey Sal you know that that's crazy why would a private investor do it and you're right you're right I mean in a lot of circumstances they obviously wouldn't pay actually because of that let me not make hundred dollars a number let's say that they pay let's say that they pay $60 for because that's we remember the banks weren't even willing to part with them for less than $60 so for is this to even work someone's gonna 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 then they're gonna have $40 leftover right they have toxic asset and then they're going to have $40 leftover because they only paid $60 for the security the way I set it up although they're probably designed this thing so there isn't any any cash actually well yeah they probably sign it so there isn't any cash left over but let's just let's just use these numbers for the sake of convenience so now you might say well this was good you know the private s investors they made like a an educated decision and they've decided to price these things at 60 cents of the dollar and my question to you is why would the 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 the kind of naive answer is that the government takes the first hit or if if these things end up being worth 30 cents on the dollar let's say that you know 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 this the lender which is in case the Fed can't go after the equity holders all the lender can do is take the assets 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 right if this thing that they paid $60 for and being worth let's say it ends up being worth I'll draw it down here because it's call going to the equity holder if that asset they paid $60 for it if it ends up being worth $80 then that extra $20 a value is going to be split by the Treasury and the private investor right so let me give you that situation so what would the balance sheet look like they paid 60 now all of a sudden that asset is worth that asset is worth 80 right so this is a good scenario upsides in air remember we had $40 leftover cash just based on the way I had originally set it up you owe $86 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 - 86 so you have 34 dollars of equity right right because you have right six more here so this is 34 dollars of equity and it's going to be split 50-50 so it's going to be 17 dollars for the private investor and then you have 17 dollars for the Treasury this looks great in this situation the private investors original investment was $7 and it went to and it went to $17 so it's got a got a huge return on the investment so this is a positive scenario and then the negative scenario where the originated that original investment was actually ends up being worth let's say the envelope being worth $30 remember they had $40 of cash just the way I sat on I've set it up now all of a sudden the Federal Reserve you had a loan to the Fed from the Fed for $86 now your 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 right so this doesn't actually looked like that bad of a scenario that in an up go from I'll just eight hundred seventy you go from seven to seventeen dollars and in a bad case you go from seven to zero dollars right 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 really thinks that these things are worth 30 cents and that they're really there's no chance that they're worth more than 60 cents there's still 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 sub sub subsidizing hedge funds and other private investors but if they really thought that their that the value is closer to 30 then 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 and to some degree the next video you might find troubling see you soon