Geithner plan 3 | Money, banking and central banks | Finance & Capital Markets | Khan Academy

In the second Geithner video,
I lay out a scenario where a bank could– let me draw
its balance sheet. Let’s say– oh, that’s not
how I wanted to do it. Let’s say this is a bank. It’s holding– let me draw its
assets and liabilities. So it’s holding some toxic
asset A right here. And that could be the bank’s
equity, that’s its liabilities, And this is the
other assets for the bank. So it could hold some toxic
asset A, and we lay out a scenario where, what the bank
could do, right now it has 100% exposure to A. What it could do is it could
take a little bit of cash, lend it to another party. Let’s say it could lend it to a
hedge fund, so this becomes a loan to the hedge fund. So now the hedge fund owes this
money to our bank and it now has the cash on
its balance sheet. So this would now, instead of
being cash, it’ll be called loan to hedge fund. Now this is the hedge fund’s
balance sheet. Its liability is
loan from bank. And now it has this cash, and
then it could use this cash to invest in essentially the Legacy
Loans Program, the public-private investor Legacy
Loans Program that Geithner talks about. And if they did this, they could
take this– let’s say this was $7. They could take this $7,
contribute it to the equity in the program. The Treasury would contribute
another $7. The Fed would contribute $84,
and then they would have $100, and I know this is kind of
messy, but they would have $100 that they can then use
to go buy these assets. And the net effect of this is
that this bank went from having 100% exposure to this
toxic asset to having only $7 exposure through this loan to
this hedge fund, or this special-purpose entity, or
whatever you want to call it. And I got a couple of emails,
even from some colleagues, to say, well, can this
really be done? And my kind of knee-jerk
reaction was, well, if this can’t be done, they’ll figure
out a way to do it, because there’s billions of dollars
at stake, and really, the incentive here is structured
to do it. And frankly, the Government
probably wants them to do it, because on some level, even
though this would be a massive transfer of exposure and wealth
from the taxpayers to the banks, it would on some
level solve the problem. And if people really aren’t
aware of it, everyone will be happy about it, because all of
these banks, Citibank and Bank of America, will just survive,
and they can just kind of say that all’s well. So what I wanted to do, just to
answer those questions, is get a little bit particular
about the wording. And I got an email. Leigh Logan actually emailed
me, and she highlighted one clause in the Legacy Loans
term sheet that seems to address what I talk about in
that second video there. And this is from the Legacy
Loans terms sheet. It says: “Private investors
may not participate in any PPIF”– so this is that
Private-Public Investment Fund– “that purchases assets
from sellers that are affiliates of such investors or
that represent 10% or more of the aggregate private
capital in the PPIF.” So the question is what’s
an affiliate? And I looked it up in the
Securities Exchange Act of 1934, and there are multiple
definitions. But this is probably
the best one. It says: “The term affiliate
means any company that controls, is controlled by, or
is under common control with another company.” And that’s an
area that I just outlined. This bank really
doesn’t control this hedge fund, right? They just essentially gave them
a loan with very little stipulations on it, and then the
hedge fund can go do it. But, you could say, oh, well,
you know, there’s nothing that this bank could do to force this
hedge fund to buy these assets, so maybe this
plan won’t work. And another thing is what’s
the definition of the private capital? You also can’t represent
10% more of the aggregate private capital. Frankly, when I think of private
capital, I think more in terms of equity investments,
but maybe the definition of private capital
also includes debt investments, although,
I doubt it. So in this video I want to
lay out a scenario that, essentially, it can do the same
thing economically, and in fact, the exact behavior
that they want in other parties without being in any
way an affiliate of the counterparty and in
no way giving capital directly to them. So what Bank A could do
instead– let me redraw it. Actually, not Bank A. The bank that’s holding
toxic asset A. And this is what I thought of
after kind of thinking about it for about five
or ten minutes. You could imagine what the banks
will come up with when they have billions of dollars
and careers on the line. So if you have a scenario where
you have this toxic asset A, and you economically
want to do what I describe, but you don’t want to be an
affiliate and you don’t want to give the appearance of
self-dealing, what you do is you sell credit defaults on A
that become supercheap, so you have essentially $7 exposure
of credit defaults. Let me do it this way. So what you do is you sell
credit default swaps. So let’s say you sell
$7 of exposure. So your liability right here,
is a seven-dollar CDS exposure, and I’ll go over
the economics of how this works in a second. And you actually get some
of the income stream. It wouldn’t even be accounted
this way. You normally just have to– if
you’re insuring $7 worth of credit default swaps, your
liability isn’t $7. You do the probability of
default and all that, so your liability will probably be– I
don’t know, $1.00, whatever it is, and you get some income
stream for it. But the general notion is that
you sell credit default swaps on this toxic asset, on
A, for really cheap. And just so you know what a
credit default swap is, I’ve made a couple of videos on it,
it is essentially an insurance policy on a loan or on a
company, and if that company or this loan defaults, you say
that you are going to pay up essentially the insurance
amount. So what you do is you sell $7 of
credit defaults swaps on A. And just so you know, most of
these toxic assets that these banks hold, these are assets
that they were the originators for, and so, they’re
very particular to the individual banks. So a bank can definitely say I’m
selling a credit default swap on A, and they know that,
in the end, when I kind of outline this whole thing,
they’ll be the main beneficiary of it. So if you sell $7 of credit
defaults swaps on A, what would I do? Well, I’m a hedge fund. What I do is I buy those credit defaults for really cheap. And then I invest in
the TALF, right? So let’s say I’m a hedge fund,
and I have two things. I have a $7 investment in the
TALF– sorry, in this Geithner Plan, and then I also have this
credit default swap, this insurance contract. And just so you know, depending
on the price, you pay a certain amount
every year. But the key here is that this
bank could sell it, if they wanted to, for almost free. They could essentially
give away these credit default swaps. So if that bank did it, then the
hedge fund’s assets would have the $7 investment in this
Geithner program, and then it’ll have $7 of credit default
swap protection. Now what happens to
this hedge fund? In the world where asset A is
worth a lot, they get all of the upside through their
investment in the Geithner Plan. That $7 investment gets
levered to $100. Let me actually draw
that again. So that $7 investment
is here, $7 capital, $7 from the Treasury. You have $86 from the Fed, and
they use this to give the cash here, and then that goes
back here, and you’re holding toxic asset A. Now if toxic asset A ends up
being worth a lot of money, then this is worth a lot, and
this is worth nothing, And that’s OK, because the hedge
fund essentially paid nothing for it or paid next to nothing
for it, in which case, everyone kind of works out
well in that scenario. On the other hand, let’s say
that this thing is worth zero. Let’s say that this
thing defaults. If that thing defaults, then
this investment is worth zero. But guess what? The hedge fund had an insurance
policy, where this guy was a counterparty. So he says, hey, this thing
here defaulted. I’m going to claim my insurance
policy, so this guy’s going to have
to send him $7. So it’s economically the exact
same thing that I outlined in the Geithner Two video, but in
this situation, these guys, it’s almost an arms-length
transaction. But this bank can make that
behavior happen by essentially going into the market and
selling credit default swaps for this exact asset for
really, really cheap. And this is just the first
way I thought about it. There’s other ways
you could do it. If you’re just a separate hedge
fund and you own enough of the shares in a bank, let’s
say you owned all of the shares of the bank or a good
percentage of the shares of the bank, then you would also
have an incentive to go out there and use the Geithner
Plan and lever up and buy these assets. Another thing is– I don’t want
to get too technical –if you kind of hold one of the
fulcrum pieces of debt, the pieces of debt that are trading
at a discount, because you’re afraid that this bank is
going to fail, if you hold a bunch of those assets,
you still would want to participate in the Geithner Plan
and funnel money and use the Government money to
essentially buy this asset A. I mean, the general theme here
is, if you have two people, if this is the private world and
you have a scenario where person A, if a transaction can
make $100 or he gets rid of $100 exposure, and person B
essentially has a potential loss of minus $7 of exposure,
there’s a net transfer of wealth here. You went from $100 of exposure
to $7 exposure for this guy. So someone is offloading the $93
of exposure to this stuff, and that’s the Government. The Government’s only taking
the down side. So this is a huge subsidy of
exposure, and it depends what these are really worth, if this
thing is really worth $30 and it’s a $63 exposure, but
any time you have this, the private sector is going to
figure out a way to make this subsidy happen. And everything I’ve outlined
so far is if A is the bank that has 100% exposure, all they
have to do is, through whatever back-door scheme or
financial product or insurance or whatever they want to do, or
loans that have very little stipulations on it, they just
have to give this guy essentially $7 of compensation
somehow that gets around the Government rules, and then this
transaction will occur. And I hope it doesn’t occur,
and it’s very possible it won’t, because maybe I’m missing
something here, but I’m just saying that everything
I understand about the Geithner Plan is that
there’s a huge incentive for this to occur, and this is
frankly the only reason why the plan would work. Because, as I outlined in the
other videos, for a private investor who’s not incentivized
in this way, the put option that the Government
is giving them still is not enough of a rationale to go from
paying $30 for an asset to going to pay $60 an asset. So it won’t work if this
behavior doesn’t occur. The only way that the plan quote
unquote will work and people will overpay for the
assets is if you have this type of action going on.


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