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## Finance and capital markets

# Geithner plan 4

Constructing an investment where an investor gets the same upside while the program limits the downside. Created by Sal Khan.

## Want to join the conversation?

- I dont understand how any of this is supposed ot be changing the value of the asset, essentially the government is incurring risk for free and taking an unfiarly bad deal on these assets, in other words the federal reserve and the taypayers are writing them a big check in the form of a put option. Am I missing something?(4 votes)
- Why does Sal divide the original 30 dollars?(2 votes)
- Sal only invests 15% of the $30 because the Federal Reserve is supplying the other 85% of the money in the form of a loan.(3 votes)

- Why doesn't the treasury get paid half of upside as a private investor?(3 votes)
- They do.

Sal explains it at https://www.youtube.com/watch?v=_ka1HZS-Egc#t=432 that when each asset is worth $40, two assets would be worth $80. The fed would take their $51, leaving $29 to be spread to both the treasury and the private investor, giving them each $14.50!(1 vote)

- What exactly is a non-recourse loan (1:20) ?.

The debtors can't go after the equity holder's personal assets for any loan given to a corporation/LLC is'nt it?

Then how is a non-recourse loan different from ordinary loans given to companies?(2 votes)- A non-recourse loan is any loan where the lender can't do anything to collect except ask for the money. They can't repossess anything, there's no collateral, they can't come after your other assets.(2 votes)

- 3rd video about the same thing. It's kinda pointless to talk about profit for private investor without knowing probabilities of those scenarios. What if getting to the point 20 is almost impossible? In totalizator there are all kind of ratios. There are cases when you put one dollar and can win 100 dolars, but it gets much smaller chances so you can't just say that1:100 is much better then 2:1.

It doesn't mean I disagree with moral hazard of whole story.(1 vote)- except that your chances of not losing your initial investment are basically nill. It is paid by the government. If you invest (according to Sal's scenario) you can only ever lose $4.50, but you may gain any amount.

Think of it like a lottery. You can invest a very little bit, but the (remote) possible payoff is very large.(2 votes)

- To be fair, why is this opportunity (if we see it as such) limited to banks and investment houses? Can a plain vanilla, average investor apply and get the Treasury co-invest and the Fed "loan" ... beats my 401 K money sitting in Certificates of Deposit at 1.5% ...?(1 vote)
- No, individuals cannot bank with the Fed. The Fed is not a commercial bank that makes loans to people. The Fed regulates the banks, and has a series of massive vaults where most commercial banks keep their money. The Fed also loans money to commercial banks.(1 vote)

## Video transcript

Let's try to construct a
situation where I participate in the new Treasury Public
Private Program. And I get all of the upside
I would have gotten in a traditional just straight up
investment in these toxic securities. But then I'm able to offload
some of the downside. And so just as a review, what
the program entails is that if I want to make an investment
in something. Let's say I want to make a
$100 or 100% investment. It doesn't matter. Either way. That's 100. The Fed is going to give us
a loan for 85% of it. And then the remainder, the
equity, is going to be split half, or 50-50, between myself
and the Treasury. And then this is the
private investor. So what happens here? And we talked a lot about it in
the last couple of videos. Is that the upside, if this
thing is worth more than 100, it's split between the Treasury and the private investor. And then the downside is split
between the private investor and the Treasury. Until the asset becomes
worth less than 85% of its original value. And then the Fed takes
the hit, right? Because this loan won't
be worth anything. And all this loan can go
after is this asset. It's a non recourse loan. The Fed can't say, oh, this
thing is only worth 84. Private investor and Treasury,
you guys owe me a dollar. The Fed is just left with this
asset that might be worth something less than that. But how could we use this
program to get the same upside we would have otherwise gotten,
if we had just bought the toxic security outright? So let's say that the toxic
security, in a before-this program world that Geithner
has come up with. Let's say that I'm willing to
pay $30 for a security. And obviously if the security
is worth $40, I'll make $10. If it's worth $50,
I'll make $20. And so forth and so on. That's obvious. Now what I can do is, instead
of just, with this plan-- I mean, before I would have to
take my $30 that I have in the bank, and use it to buy some
asset, if one of these banks were willing to sell it to me. But what I can do now is, I
could say, well, let me just take 15% of this. So what's 15% of $30? It's $4.50. And use that to invest
in this program. And essentially get the same
upside as I would if I invested the whole $30. And then put the rest of the
cash away essentially safe, so that my worst case is that I
just lose what I invest. So let's do that. And we'll see that the numbers
do all work out. So instead of just doing $30
all for the investment, I'm going to set aside 15%. So I'm going to put $4.50 to
participate in the plan. And then I'm going to set
aside what's left. $25.50 in cash. And using this $4.50 in the
plan, I'll show you that I'll get all of the upside that I got
if I had originally had to use all $30 by myself. And obviously my downside
is limited. My downside is limited to the
$4.50, because I'm still going to have the $25.50 in
cash on the side. So how is this going to work? I'm going to put in $4.50. That's from me, the
private investor. The Treasury is going to
match my investment. $4.50. That's the Treasury. Now I have $9 of equity. And this is going to be 15% of
the total equity, so the debt that the Fed will lend me
is going to be $51. And I did the math before I did
the video, but you could work it out yourself. $51 loan from the Fed. And so what's our total capital
that we've raised now? So if you add $51 plus
$9, we have $60. Let me do this in a
different color. We now have $60. And we could use that $60. If someone was willing to sell
me one, I guess we could say one of the units, or one of the
securities for $30, now with $60, we can buy
two of the units. So we could buy two
of them for $30. And why did I end up making the
math work so we'd get two securities? Because we split the
upside, right? We split the upside
with the Treasury. So in order to set up a
situation where I get all of the upside that I would have
gotten with a $30 security, I essentially have to set up a
configuration where we buy twice as many securities. I buy twice as many securities,
and then I split the upside 50-50 with the
Treasury, then I'm just going to get the upside. You could almost view
it on one security. Let's see how the math
works out now. Let's do a bunch of scenarios. So in the world where-- maybe
I should do a table. Yeah, let's say that the
eventual value of the security, let's say it's worth--
I'm going to make a bunch of numbers up. 0, 10, 20, 30, 40, 50, 60. That's good enough. So let's say that these
securities end up being worth nothing. How much am I left with? What's the total value of
my total investment? Well if these are worth
nothing, then I get wiped out here. We all get wiped out here. In fact, everyone gets
wiped out here. So how much did I lose? Well my $4.50 is gone. This goes to 0. But what is my total investment
left with? I still have my $25.50 that
I put to the side, right? So I still have my
$25.50 in cash. If each of these securities
are worth $10, this is eventual value of each
of the units. So if each of these is worth
$10, then the whole asset side of this balance sheet is worth
$20, and once again, the Fed is going to take a $31 hit. And these two guys
are wiped out. So my investment is
worth nothing. But I still have that money
I set aside in the bank. $25.50. If these securities are worth
$20, then this whole asset side is worth $40, because
there's going to be two of them. The Fed is still taking a hit. Doesn't get all its
money back. And these two guys still
get wiped out. My $4.50 is gone. I still have my money
in my bank. $25.50. If this security is worth $30,
which is essentially the price that we're paying for it. Then this is what the balance
sheet is going to look like. So my equity is worth $4.50. But I have $4.50 plus
the money that I had set aside, right? I have $4.50 plus this
$25.50 that I'd put aside in the bank. Because I didn't have
to invest that. I just had to invest the
$4.50 initially. So I have my $4.50 here,
plus $25.50. So the value of all of my
investments is $30. What Happens if each of these
units are worth $40. If each of these are worth $40,
then we have $80 on the left-hand side of the
balance sheet. So let me draw that
really small here. So then we'll have two units
that are worth $40. That's $80. We owe $51 to the Fed. So we're going to have $29
to split between the Treasury and ourselves. $29 divided by 2 is $14.50. We're each going to
split that $29. So my equity is now
worth $14.50. So my total investment is going
to be the cash that I put aside-- so that's,
let's say, $25.50. Plus the value of my equity
investment now. So that's plus $14.50. And so it's worth $40. I think you see the
pattern here. In all of these kind of downside
scenarios, the most I lost was $4.50. And now in all of these upside
scenarios, we're going to see that I get the value of
the actual security. Now let's do it for $50, but I
think you know how the math's going to work out. If each of these ends up being
worth $50, then this whole left-hand side is $100. We owe the Fed $51. So this is going to be $49. And if you split that,
it's $24.50. The money we set aside in
the bank is $25.50. And so this is worth $50. And, likewise, if these are each
worth $60, this is going to turn out to be $60. So what you see here,
and I'm going to draw a payoff diagram. Let me draw a line here. Let's see if I can
do this right. So if this is the eventual
value of the asset. When we pay something in the
market, we're hoping we're buying it for less than its
real value, but we really don't know 100% what the
eventual value is. But this x-axis is the
eventual value. So it could be 10, 20,
30, 40, 50, 60, and so on and so forth. So depending on this eventual
value, what is the value of my investment? So we figured out if it's 0, 10,
20, all the way really up to-- The value of my investment
is going to be-- I didn't have to draw this stuff
down here-- let's say that this is $24.50. So in all of these scenarios--
whoops, trying to draw a line-- so 20, and
then at $25.50. If this thing is worth--
We could figure out the break-even, right? If these assets are worth
anything more combined than $51, then we start to have
value to the equity. So what's that value? That's this divided
by 2 is $25.50. So after $25.50 some value
starts going to the equity. And we know at $30-- let me draw
those points, actually. I'll do it in a different color
when we're in the money. So at $30, the value of
our security is 30. At $40, the value of
our security is 40. And so on and so forth. And let me draw a line now. That's not what I
wanted to do. I'll just draw a regular line. Our payoff would look
something like this. This is a good visualization
for what the government is giving us. And I'll show you that what
they're giving us is essentially insurance, or
a put option for free. And then we can talk in the
next video about how we can value it. And then we have a real sense
of what the government is handing over to the investor. Now, you might say that it's
handing it to the investor, but if because of this the
investor overpays for the asset, that subsidy is
really going to the person selling the asset. And we'll talk about
that a little bit more in the next video. But let me just finish
this up a little bit. So we said that the point
at which we start making money is here. Because this is what we
paid for the security. We're paying $30 for
the security. So these are all the scenarios
where we start making money. Where the security's worth
more than that. But the equity's actually worth
something above $25.50, but we're still taking
a slight loss. But the cool thing is, if we are
the private investor here, even if the thing is worth very
little, we don't take that much of a loss here. And this is much better. What would the payoff diagram
have looked like if we were just a straight-up investor? Let me just draw that in
a different color. Well then it would've looked
something like this. We would have had
the same upside. But our downside would've
gone all the way to 0. If the asset is worth 0, we
would have been worth-- well, these lines were supposed to
be on top of each other. But I think you get the idea
that the government is saving us from these losses
right here. Oh, I think you can't see it. I'm off the screen. The government's saving us from
these losses right there. And so I'm out of time
in this video. In the next video, I'm going to
actually analyze what that subsidy or what that insurance
or that option that the government is giving us,
what it might be worth. And then we could think about
whether now people are willing to actually overpay
for these things. See you in the next video.