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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.