Geithner plan 1

We've got 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 have some bank. Maybe it's Citibank or somebody else. Let's say they 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 crux of the issue. They did that by-- obviously a lot of them leveraged much more-- but let's say they used $40 of equity. And then they borrowed the remaining $60 to get that asset. And now of course, this asset right here is backed by toxic mortgages. And 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, all of the videos that we did on Paulson's original bailout plan. Because I talk about all the liquidity issues there. The bottom line is that 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, if they offload these assets-- let's say they know it's not worth $100, dollars, right? Everyone knows it's really not worth $100. But these banks don't want to offload these assets for anything less than $60. Because if they offload these assets for anything less than $60, then they have negative equity. That means that the books values here-- let's say if that was the only asset they had, then you would have this situation. If they offloaded for 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. So there's nothing left for the equity, and in fact you would go into bankruptcy. You would be an insolvent bank. So just to set the framework. There's a huge incentive why the bank doesn't want to sell this asset for anything less than 60 cents on the dollar. The problem is, the most that anyone's willing to pay for it right now is not even the 60 cents on the dollar. People are just willing to pay-- I've read reports and it depends on what asset you're looking at-- that people are willing to pay 30 cents. So let me write that down, because it is important. This is what banks want. Greater than 60 cents on the dollar. And in this case, it's $100, so $60. My understanding is so far, for the most part, without any government intervention, the investors are willing to pay 30 cents or less. So there's this disconnect. The bank's like, well I'm not willing to sell this for anything less than 60 cents, because then I'm insolvent and the gig's up. And investors are saying, well 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 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 buyer's willingness to pay is much slower than the seller's willingness to sell. And nothing happens. And so, these toxic assets are, you could say, clogging up the system. Because 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 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 iterations of how can we somehow get these assets off the banks' balance sheets without causing the banks to get insolvent? And the original version of TARP 1 is that the government will essentially buy these assets for, who knows, 70 cents on the dollar. 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. And there would still be a little bit left of equity. There would be $10 left. But the important thing is that the bank would be able to pay off its liabilities, stay liquid, and then be around for a 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, if this TARP 1. And 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. And these are the very same people the management and the original investors in a lot of these companies. These are the very same people who got us into this mess. And why should we 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 do other videos on that. So the new iteration that has come about-- and let me scroll down a little bit-- is, and let me draw the original circumstance. So you have this item here that was originally paid for $100. They borrowed $60 to purchase them. And then they have $40 of equity. The new plan is, the government's saying, you're right, taxpayer. We as a government, we're not in a position to decide what things are worth. We're not hedge fund managers or mutual fund managers. We're just bureaucrats. 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 just a big subsidy from the taxpayer. So the new Geithner plan is saying, hey we're going to partner with the private investors. And the way they're suggesting they do that, is that let's say a private investor-- and these are numbers that I've been reading in some of the newspaper reports, and the numbers might change over time because they do tend to. But private investors will contribute, say, $7. This is from private investors. The Treasury will contribute another-- let me make another box-- will kind of match that investment by the private investors. So the Treasury will contribute another $7. And then the Fed is going to lend the balance. So the Fed-- let's see, if you want to get to $100, that's $14-- so the Fed has to lend $86. Let me draw a box here. It's going to look something like that. So that's $86. from the Fed. And of course, this entity, when it's originally capitalized, is going to be sitting on $100 cash. That's its assets. Well I'm saying it has $100 of cash. It could be something less, but let's say this is what it originally sets out to be. Fed lent $86. This is a loan. The Treasury made 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 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 that in that case-- let's say they decide to pay $100, just to make the math easy. So then this cash will go to this bank. So then they'll have $100 of cash. So then we'll have the toxic asset sitting here. And you might say, hey Sal, that's crazy. Why would a private investor do that? And you're right. I mean, in a lot of circumstances, they obviously wouldn't pay. Actually, because of that, let me not make $100 the number. Let's say that they pay $60 for it. Because, remember, the banks weren't even willing to part with them for less than $60. So for this to even work, someone's going to 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 they're going to have $40 left over. So they have toxic asset, and then they're going to have $40 left over, because they only paid $60 for the security. The way I set it up. Although, they probably designed this thing so there isn't any cash left over. But let's just use these numbers for the sake of convenience. So now, you might say, well, this was good. The private investors, they made an educated decision, and they've decided to price these things at 60 cents on the dollar. And my question to you is, why would these 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 kind of naive answer is that the government takes the first hit. Or if these things end up being worth 30 cents on the dollar. Let's say that 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, the lender-- which is in this case the Fed --can't go after the equity holders. All the lender can do is take the asset. 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. If this thing that they paid $60 for ends up being worth, let's say it ends up being worth-- I'll draw it down here because it's all going to the equity holder-- if that asset they paid $60 for, it if it ends up being worth $80 then that extra $20 of value is going to be split by the Treasury and the private investor. So let me give you that situation. So what would the balance sheet look like? They pay $60 now. All of a sudden that asset is worth $80. So this is a good scenario, an upside scenario. Remember, we had $40 left over in cash, just based on the way I had originally set it up. 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 minus $86 So you have $34 of equity, right? Because you have $6 more here, so this is $34 of equity. And it's going to be split 50-50, so it's going to be $17 for the private investor. And then you have $17 for the Treasury. And this looks great. In this situation, the private investor's original investment was $7. And it went to $17. So it's got a huge return on investment. So this is the positive scenario. And then the negative scenario, where let's say that original investment actually ends up being worth $30. Remember they had $40 of cash in the way I set it up. Now all of a sudden the Federal Reserve, you had a loan from the Fed for $86. Now 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. So this doesn't actually look like that bad of a scenario. That in an up case, you go from $7 to $17, And in a bad case, you go from $7 to zero dollars. 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 that these things are worth 30 cents, and that there's no chance that they're worth more than 60 cents, 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 subsidizing hedge funds and other private investors. But if they really thought that the value was closer to 30 than 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 to some degree, the next video you might find troubling. See you soon.