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Geithner plan 2

More on the Geithner Plan. The problem of banks buying the assets from themselves. Created by Sal Khan.

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Video transcript

So just to get us back up to speed where I left off in the last video, we have a bank sitting on an asset that it maybe originally paid $100 for. Let's say it has $60 liability. $40 of equity. That's when they paid for it. So this is $100. This is $60 of debt. And they had $40 of equity. And these are the toxic assets. We're just assuming a world that only has one set of assets. And the problem that we said from the beginning of the banking crisis is, that the banks can't sell these assets to pay off its liabilities, its deposits, or other debtors, for the price that it wants to sell them at. Because obviously if they sell this for anything less than $60, the bank is bankrupt. So this is the bank, and it wants to sell for greater than-- I'll say $60. I won't say 60 cents on the dollar, but it's the same thing. Wants to sell for greater than $60. While the market is willing to pay less than $30 for this asset. And obviously if the bank went and sold this at the market price and only got $30 for this. If this whole thing became $30, then the liabilities become worth much more than the asset, than the $30. And the bank is bankrupt. And so as I outlined at the end of the last video, the current incarnation is for, you have a public private partnership. Let me draw their equity. And let me try to draw it a little bit better. So let's say that you have-- and I'll do the number slightly different-- so you have $5. from a private investor. This is a review of the last video. You have $5 from the Treasury. These are both the equity investors. And then you have $50 borrowed from the Fed. And I'm doing this a little bit differently, so the numbers match up exactly with what they're going to pay for the asset. So you have $50. Let me see. So if that's $10, $50 would be something that looks something like that. So you have $50 that you borrow from the Federal Reserve. And so, this entity will have $60 here. When it gets capitalized. We'll do that in green. And what they can now do, is they can give that $60 to the banks. Essentially paying a price that the banks are willing to part with the assets for. And then the banks are going to give them the assets. So now the bank has $60 of cash that it can use to keep its liabilities liquid. And now this entity right here has a toxic asset, we could call it. And I addressed it in the last video, you know, why is the investor doing this? Because they share disproportionately in the upside. They paid $60 for this thing. And just as a real quick review, if this thing ends up being worth-- let's say it ends up being worth $100. Then they owe $50 to the Federal Reserve. That's this loan right here. To the Fed. And then they split the equity with the Treasury. So, how much equity? There's a total of $50 of equity left. $25 for the Treasury. $25 for them, for the private investor. So their initial investment was $5, and it went to $25. That's awesome. Five times your money. And then in the down case. What's their down case? Their down case is-- let's say that toxic asset really is worth $30. Let me draw that. And this is a review of the last video. But it's important, because it really bears into what might happen. So let's say that this is optimistic. This is pessimistic. So let's say these assets end up being worth $30. Then you have this $50 loan from the Fed. And you have no equity left over. And the Fed essentially is left taking a loss on its loan. But the private investor, since there's no equity, is going to be left with zero. So you went from $5 to zero. But this is still a pretty good risk/reward. Depending on how you weight these probabilities. But a lot of people, if you thought that there's an equal chance of this and this happening, you would take this bet. If you had a 50% chance of making five times your money, and only a 50% chance of losing your money, the expected value here is, it would be 0.5 times 25 plus 0.5 times zero. It would be a $12 expected value. So I would pay $5 for something that has a $12 expected value. That's a great return. You're making 140% on your money. You don't see returns like that every day. Unfortunately, the probability of these two things happening aren't equally likely. Because obviously right now, the market's willing to only pay $30 for these things. The market, if they thought that there was any chance that these things are worth more than $60, any chance, they'd be trading at higher than $30. So given where the current market is, before government intervention, clearly no-one thinks that there's a really good chance of them being worth $60. There's a much higher probability of this scenario occurring than this. And you could do a spreadsheet. And you could weight the probabilities. And if you make this probability high enough relative to this one, then of course the expected value is still going to be less than $5. You're still expected to lose money. And so you might say, well, who would do that? Even though Paul Krugman is out there saying, you know, this is one of those heads I win, tails you lose type of scenarios. And that is true. In the positive scenario, the private investor makes the bulk of the money, alongside the Treasury. With the Fed just getting a very low interest rate back on this money. While in the negative scenario, most of the hit is going to be taken by the Federal Reserve with their loan, and then the Treasury who's an equity investor alongside them. So that is one of these things that Paul Krugman is talking about. But I'd say, that even if that, an intelligent investor, just because the risk soon. reward is disproportionately weighted to the other guy, they still wouldn't want to invest it, if this is the more likely scenario. So the question is, who is going to do this? And this is what I mentioned in the last video, could be troubling. The obvious thing is that the banks might want to buy it from themselves. So let me redraw everything. Because this is an important point to make. And frankly, I don't know how you can prevent this from happening. If this version of Geithner's plan ends up passing. So this is the bank's balance sheet. Kind of their before balance sheet. They paid $100 for these assets. They owe $60. All liabilities, deposits, whatever. And originally they have $40 in equity. What the bank does is it takes some extra money, and they could raise equity, or for all we know they could raise money. I mean, the government is giving them loans right now. This isn't fiction. So what you do is let's say you borrow $7 from the government. And this is happening. I mean, the government is giving loans to these major banks, to Citibank and Bank of America, et cetera. And they'll get $7 of cash right here. Now what the bank does is, they create a separate entity. They can call it whatever they want. They could put it in a hedge fund to do this. I mean, banks are great. Special purpose entities happen all the time. And there's nothing to stop a bank from putting this $7 into another entity. Another special purpose entity. Where the bank essentially owns the equity. And this cash went to that. And then taking this $7 and using this to participate in the plan. In this new Geithner plan. So the bank takes that $7 that they essentially might have just borrowed from the government. Participates in the plan as the private investor. And I'll put that in quotes. And they could put a bunch of layers here and obfuscate it. Or even get one of their hedge fund clients to do it, by giving them good terms on something else. I mean, there's a million and one ways you could set this up. And that's why I think it's impossible to legislate around, or legislate to prevent it. So they do that there. The Treasury will participate side by side as an equity investor. And then they'll borrow $86 from the Federal Reserve. That's from the Treasury. And now the bank is essentially the private investor. They're controlling this entity here. They're controlling entities that control that entity. It doesn't matter. But they essentially set the price for which this entity is going to pay for its own assets. So they could pay $100 for this thing. Even though everyone knows that these things are worth nowhere near $100. So they pay $100 for this. Take it off their balance sheet. And then they're sitting with $100 cash. And this is sitting there with a toxic asset. And why would a bank do this? Well, think about it. In this reality, before any of this happened, the banks had 100% exposure to these toxic assets. It had this whole thing right here, it had exposure to. And for all we know, they're only worth $30. But the bank never wanted to accept that reality. While in this reality, the bank only has $7 exposure to it. So even if this thing ends up blowing up, who's going to take the loss? The bank's just going to take a $7 loss here. And then the rest of the loss is going to go to the taxpayer; the Treasury and the Federal Reserve. So this is an awesome situation. Because in this reality when there was a hit, if this was worth $30 the bank would have to take a $70 hit. While in this reality, if this toxic asset now is only worth $30, the bank's only going to take a $7 hit. And the bank is going to stay solvent. So this investment right here is going to be wiped out. But still, the bank got $100 in cash. So my fear is, and frankly since there's nothing to prevent it, it's almost a self-fulfilling prophecy that's going to happen. You have this big question mark, why would a private investor ever participate in this? Even if the government is kind of giving you more of the upside than the downside. You wouldn't participate in it if you thought that the downside scenario is more likely. But you would participate in it, if you were the actual seller of the security. Because if you are the seller of the security, you are Citibank, you're going from 100% exposure to only 7% exposure, and you're going to be staying solvent. But the net effect of this is that the Treasury and the Federal Reserve, they got $100 for something. Or I guess, if you take out the $7, they essentially got $93. Because they had to spend $7 to make this thing happen. But they got $100. So they got $93 for something that's really worth $30. So the difference, the $63, it essentially would be a check that's being written from the U.S. taxpayer to these banks. And in the magnitude that we're talking about, it wouldn't be a $63 check. It would be a $630 billion check. So to me, this would be kind of the biggest travesty of capitalism. And it would be a sad day. It would frankly just make the AIG bonuses look trivial. The right answer is, you take that $630 billion, make the banks wipe out their shareholders, and then you recapitalize the banks with the money. And then you start, instead of writing the $63 or the $630 billion check directly to the management and the shareholders who got us into the mess, you essentially recapitalize the new banks. And I've written a paper about that, and there's a new bank plan. And distribute the shares to the American people. And you get the same effect without this hugely negative repercussion of providing a huge wealth transfer to the very same people who got us in the mess. Anyway, I hope people kind of get on this story, because it's got me pretty troubled. Anyway, see you