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Geithner plan 5
Quantifying the value of the put option. Created by Sal Khan.
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- So what actually happened (in hind-sight)? Did we see investors offering (the equivalent of) $70-$80?(10 votes)
- Heh.
We can't even sell them. Go look at the trillions in MBSs that the Fed has sitting on their balance sheet.(3 votes)
- QE is Quantitative Easing. We are in QE3 because the the Federal Reserve (aka the Fed) has done this twice before, and we are in the third round of QE. The Fed buys bonds from banks. Each month the Fed buys around $45 billion dollars worth of bonds from banks. They do this for two reasons.
First, this ensures banks have cash on hand. The hope is that if banks have a lot of cash they'll want to loan it out. This will help stimulate the economy, because when banks loan out money, businesses start up and increase production, farmers buy tractors, families buy cars and homes, etc.
The second reason the Fed is buying huge quantities of bonds is to drive the interest rate of bonds down. The interest rate is essentially the cost of borrowing money. The lower the interest rate, the cheaper it is to borrow money. This is meant to reinforce the first reason, above. Money is cheaper than ever, so the Fed is hoping more people will buy things with borrowed money, thus stimulating the economy.(8 votes)
- Sal, the news media now reports Geithner making claims that the treasury has recovered more money than spent on the TARP bailouts. Could you review what the Treasury/Fed ended up finally doing to unfreeze the credit markets (if different from the proposed plans), and assess whether taxpayers have really made money or have been short-changed?(4 votes)
- Is it correct to say that the Geithner plan as described here would actually be more valuable than an American put? The 25.50 strike price is, so to speak, in your pocket from the very beginning, so you can invest/lend it throughout the 3650 days.(3 votes)
- Wouldn't this be more similar to a call option with a subsidy attached to it? As when the price of the security increases your profit increases. Therefore, wouldn't it be considered paying for the right to buy at $30? Similar to a call debit spread without a cap on the amount of money you can make? Or am I thinking of this wrong?(1 vote)
- When the value of the asset is less than $25.50, you say some one in the market would be wiling to buy those asset. Is that "someone" the government, which also granted you the right to sell the asset at $25.50 ? I ask this question because I'm skeptical about if somebody would want to purchase what is considered toxic asset but the government in order to stabilize the situation. But, with this Put Option not working once the value is above $30, does the price charged to investors buying the Options go to the Government's Revenue ?(1 vote)
- The government isn't really giving a put option though. Can't you still go and invest that $25.50 in other stuff? And with the put option that money is "stuck" in the toxic asset. Please let me now if I am right or wrong. Thank you in advance.(1 vote)
- so all of this complicated manuevering, but I still dont fundementally understand, the government has to somehow let an investor pay 30 and have the bank receive 60, so they increase the value by taking the liability, or giving a subsidy. What's the value of all of this wrangling, if in the end it comes to the same thing essentially, just in a way that most concstituents wont understand?(1 vote)
- is this based on the formula used by LTCM?(1 vote)
Video transcript
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.