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Finance and capital markets
Geithner plan 6: A better solution
A better way to solve the "liquidity" and "price discovery" problem. Created by Sal Khan.
Want to join the conversation?
- Is it possible (probable) that the transparency you advocate would expose corruption of a sort that would make potential buyers even less interested in these assets? Is the federal government covering up significant corruption to protect friends and even the reputation of the American economy?(13 votes)
- The video is solving the "liquidity" problem. Sal even put it in quotes in the title description above, because I think it's clear he's implying that it wasn't really a problem of illiquidity, but of insolvency.(2 votes)
This sounds like an excellent solution. Since it hasn't been implemented, there must be some resistance. What are the arguments agains it?(3 votes)- I think some of the resistance would be time frame it would take to organize such a federal operation. It doesn't necessarily give the banks the selling price (i.e .60 cents on the dollar) they require to be solvent. It would probably yield them a lesser amount. Thus, it doesn't halt the domino effect of bankruptcy within banking system but instead only shrink the financial industry. This action plan leaves the tax pay off the hook,however, would still create havoc just on a smaller prolong scale. The Economy would also recover slower since the banks capital wouldn't be free up as it would have been in the previous plans.(2 votes)
- How could the value of these CDOs be so obscured? If I am understanding the structure correctly, the CDOs were continually garnering interest depending on the default rates. If default rates reached a certain point, the entire CDO would become worthless and stop producing interest. Couldn't one just look at the interest coming in from the CDOs to determine their value? Or was this whole discussion in anticipation of future defaults (i.e. for the time being the CDOs were still behaving normally)?(1 vote)
- The CDOs have unknown values because the investment banks who hold them are the ones who declare their value. Sometimes they're honest and give the most likely value, and sometimes they want to make their bank seem stronger and more solvent than it is, so they claim a higher value than the market would.
Sal answers this question pretty well in #11 of the Paulson Bailout.
http://www.khanacademy.org/finance-economics/paulson-bailout/v/bailout-11--why-these-cdos-could-be-worth-nothing(2 votes)
- I do agree with you about letting the banks go bankrupt - they deserve it after all ! ! ! But I've got a question: if, instead of taking subsidies from the government, the bank decides to throw it's toxic asset to the market to let investors decide how much the asset is worth, would anyone bother, or consider, valuing it ? Due to Asymmetric Information - investors aren't fully aware of what's inside those CDOs - they would be reluctant to invest in such assets, therefore I think the solution is just like dumping waste into the river, which does only evil - poisoning the whole market and triggering a financial catastrophe.(1 vote)
- Sal, i'ts not a US concern only, those CDO were well coted by agencies, many nations bouth those toxics papers.
How can we protect our self ??? Buy gold ???(1 vote) - Comment: Brilliant. What you are really suggesting atand just before when you state that what the government should really do is make the "toxic" securities transparent - what you are really doing is calling their bluff. Well done! 04:08
Eric Davis(1 vote) - well if they would have let those banks be bankrupt, then the gov wouldnt need to have QE1, QE2 and so forth..(1 vote)
Video transcript
In the last couple of videos,
I've been dumping on the Geithner Plan. Arguably showing that if right
now the market is willing to rationally pay $30 for a
security, even with the free put option that the government's
willing to give, at most a rational investor who
was willing to pay $30 is now maybe willing to
pay $40 to $50. And that still won't meet the
hurdle that the banks need in order to clear these assets
off their books. Because, we've done it in a
bunch of videos even when I did the videos on the first
bailout, the TARP plan, that if they sell them for less than
$60, that's the number you hear in a lot of the popular
press, that the banks will essentially be insolvent. So they're not even willing
to sell for less than $60. So if this is the case then
the plan won't work. Right. It just won't work. It won't work. Now, there's the other scenario
where, let's say we do see a bunch of trades
where they are going for $60, $70, $80. And based on some of the
arguments I've given in the previous video, I'd say well,
the only rational person willing to pay $60-plus would
be the banks themselves by creating some type of off
balance sheet investor. There's tons of ways
they've done this. I've gotten some letters where
people said how can a bank sell to themselves? Well, you can give a
non-recourse loan to a hedge fund that you just created
and that hedge fund then invests in them. And to somehow have an audit
trail, almost every hedge fund in the world has some
relationship with one of these major banks. So it would be almost impossible
to disassociate the private investors from the major
banks that are trying to offload these assets. So I would argue that this
probably is the case. But in this video I like to give
Geithner and maybe even the plan a bit of a break, and
give some credence to one of the arguments that they make. Right now, because of all of
these assets going sour all at once, you have all of these
forced sellers, right? You have all of these banks and
they're all facing these liquidity issues. So you have this huge amount of
supply of these securities. And right now since all of the
natural buyers are distressed, all of these banks are forcing
to sell, all the hedge funds who used to own these things,
they're all going bust. And they're facing redemptions. And their investors want
their money back. So the actual demand for these
securities, the actual pool of money going after
is very small. So the demand is very small. And they're saying this is the
reason why you have this market disconnect. This is the reason why people
are only willing to pay $30, because you have this
illiquidity. You have all of these forced
sellers and you have very few buyers left in the market. And the few buyers that are left
in the market are able to get things at fire
sale prices. That's the argument that we've
heard time and time again about how $30 isn't
the real price. That anyone who actually looked
at what's in these, what have unfortunately been
called toxic securities, probably because that's
what they are. But anyone who looks at one of
these securities and really looks inside of them will
realize that these are worth way more than $30. That they're yielding a lot. That there will be some defaults
but maybe they're really only worth $80 or $70
or $0.70 on the dollar. My argument, if is really the
case, what the government should do instead of giving
free put options to hedge funds to essentially subsidize
the assets from banks. Or, even worse, allowing the
banks to do kind of that scheme that I talk about in the
second video where they can buy things from themselves
and offload things on the taxpayer. What the government should
do is really increase the transparency on these securities
so that this pool of buyers becomes larger. Right now these securities,
these are either collateralized debt obligations
or mortgage backed securities. They're bonds of some kind. And the pool of people who can
buy bonds is not a large one. It's essentially a bunch of
professional investors, most of whom have blown up in
this credit debacle. Let me draw a little
balance sheet. You take those toxic assets,
let's say this is a random bank's balance sheet. That's its assets, liabilities,
equity. And it has one of these toxic
assets sitting on it. Right. This is a toxic asset. What you do is you take the
toxic assets, stick them in a company-- this is some
corporation-- so then the toxic assets go there. That's the assets. And the corporation will just
have a bunch of shares. If all the toxic assets came
from this bank, give these shares back to the bank. And notice this isn't any
sketchy accounting. The banks still have the assets
on their balance sheet, but instead of having the assets
directly they have the shares in this company. And the whole reason I'm doing
this is and you can then take this company and float it on
a traditional exchange. I mean we're talking about the
government, The U.S. Treasury. They could force this thing to
be listed on the New York Stock Exchange. So just by doing that, that
significantly increases the pool of investors who could
invest in it, right? Right now the only people who
could invest in it are people who are essentially
bond investors. And it's not a trivial matter
to start investing in bonds. You have to invest in $1,000
increments at minimum. Usually it's much larger
block sizes. And some of these are
collateralized debt obligations. They're just hard to invest
in even if you wanted to. Now, the second problem. That would solve just the pool
of people who could invest. So that'll make it a
little larger. But the second problem, this is
frankly the bigger problem with these assets, is that
there's no transparency. No-one knows what's in
these toxic assets. Right? The problem that happened over
this last real estate boom is, not only did they give loans to
people that they shouldn't have given loans to, but they
sliced and diced them. And I've done this in a bunch
of the videos in the past. They'll take a bunch of
mortgages, they'll take millions of mortgages, put them
in a corporate structure. And then they slice and dice
them into different tranches. And I explained this in the
collateralized debt obligations. Where this tranche gets paid off
first, this tranche gets paid off second, and this
tranche gets paid off last. So any losses on this, this group
takes it first. And for the most part these are the
toxic securities. But some of these have
also gone toxic. The problem with these things is
that the way that they sold them is that they went to
Moody's or S&P and they said, hey, Moody's, give us
a rating on these securities right here. And Moody's would say oh that's
a AAA-- and, well they wouldn't call that AAA,
but they would say that's a B security. And we just took Moody's
word for it that that's a B security. Or that this right here
is a AAA security. And everyone now knows that the
only reason why Moody's gave the rubber stamp on it is
because the same people who were structuring these things
and making all the money off of these things were
the same people who were paying Moody's. So what we need to do is disintermediate the rating agencies. So the government, not only
should it create these corporations so that you could
essentially buy these assets without being a bond trader, you
can just buy them on any exchange, what the government
should do is hire a big team. And we're talking about billions
or trillions of dollars here, so to hire a team
that essentially puts up a website and lets us know
what's in each of these securities. So let's say that this company
that I just created, its sticker symbol is ABCD. So what we can do is we can go
to a website, type in ABCD, and it'll tell me exactly what
is in that toxic security. I know a lot of people who are
professional investors who are in a position, if they wanted
to, to pull the trigger and even buy them in their
current form. And they're afraid to because
they don't know what's in these toxic securities. They don't know whether they're
completely fraudulent, only somewhat fraudulent. To some degree it's even hard
to tell where a lot of the assets are sitting, in which
of the tranches. So what the government should
do is just make these as transparent as possible. They should have a map of the
United States and they should say this security is for houses
that are in upstate New York and in Florida,
and its 30% upstate New York and X% Florida. It should have charts that tell
me what percentage is defaulting. So I as an investor maybe
I can extrapolate things, I can do models. But the crux of the issue here
is that instead of having some opaque 800-page document that
only a few people have access to and once they decide to parse
through that thing they have to go to their local bond
trader and invest in it that way, what you do is you put it
into a company, list that company on the NYSE, and then
make it completely transparent what's in that toxic security so
that anybody watching this video can say, you know what, I
think this thing is actually worth $0.40 on the dollar,
not $0.30 on the dollar. And you won't have to commit
millions of dollars. You could just go buy 1,000
shares for $400. It wouldn't be a major
up-front investment. And if they did this,
this would solve the liquidity problem. This would solve the
liquidity problem. This pool of buyers would then
become much, much larger. And then the government wouldn't
be able to make this argument, and the banks wouldn't
be able to make this argument that somehow that these
are distressed sales. That these $30 sales are way
below the actual value. Because you would have a
lot of people with real information, with real access
to actually trading them, being able to price
these securities. And then when you're forced to
do a mark to market -- First of all since each of these
shares in this security will be trading on the New York Stock
Exchange, you'll much more volume of the
transactions. You'll have continuous
trading. And then the mark to market that
you'll be forced to do on these, essentially shares now,
but it's the same thing right? It's shares in your
toxic asset. But the mark to market on
those will be much more accurate because you'll have
much more volumne. You'll have much better market
information as far as what they're worth. And then frankly if it turns out
that these things really are worth $30, then we can let
the banks fail and move on with our lives. And I've argued you could
arguably start new banks or do something else. But we won't be kind of playing
this charade of what are these assets worth? Wait, maybe we should
subsidize the banks. Maybe we should be writing
free put options to hedge funds and making
it all opaque. The solution is just expose
everything to sunshine. And then let the market price
really reflect a true reality. And if that reality is that
these banks are bankrupt, well then, you let them
go bankrupt.