# Geithner plan 2 | Money, banking and central banks | Finance & Capital Markets | Khan Academy

To repeat where we left off last time. We have a bank that owns assets for which originally paid \$ 100. Let's say he has \$ 60 in liabilities. And \$ 40 in equity. They paid so much. Here's \$ 100. Here's \$ 60 debt. They also had \$ 40 in equity. And these are toxic assets. Suppose it exists only one set of assets. An issue we've been pointing out from the beginning banking crisis is that banks cannot sell these assets, to repay their liabilities, pay out deposits or others borrowers at the price at which the bank is willing to sell the assets. Because if they sell this for less than \$ 60, the bank goes bankrupt. We have a bank here and it wants to sell for more than, say, \$ 60. I'm not going to say 60 cents on the dollar, but it's the same.

The bank wants to sell for more than \$ 60. While the market is willing to pay for this asset less than \$ 30. Of course, if the bank now sold this asset on the market price, she would only get \$ 30 for this. If this only became \$ 30, then there would be liabilities they were much higher than the value of the asset than those \$ 30. The bank will go bankrupt. And as I indicated at the end of the last video, the current version is that we have a public-private partnership sector. I will draw their capital. I'll try to draw it a little better. Let's say you have … and I'll do the number a little different … You have \$ 5 from a private investor. This is just a repetition of the last video. You have \$ 5 from the Treasury Department. Both of these investors invest in capital. And you also borrowed \$ 50 from the Fed.

I'll do it a little differently, so that the numbers correspond exactly to how many they will be pay for assets. You have \$ 50. Wait. If this is \$ 10, then \$ 50 will be look something like this. You have \$ 50 to borrow from the Federal Reserve System. So this entity will have \$ 60, until it is capitalized. I'll draw it in green. What they can do now is give those \$ 60 to the banks. In essence, they will pay the price that banks are willing to do sell assets. Banks are willing to give them the assets. The bank now has \$ 60 in cash that it can use to maintain liquidity of its liabilities. This entity now has a toxic asset which we might call that. I did this in the last video, why does an investor do something like that? Because disproportionately they share a positive aspect. They paid \$ 60 for this thing. And now really just a short repetition. Let's say this thing in the end will be valued at \$ 100. Then he owes \$ 50 to the Fed This is the loan. It owes the Fed. And then he shares the capital with the Ministry of Finance.

How much capital will they receive? A total of \$ 50 of capital remains. \$ 25 for the Treasury Department. \$ 25 for them, for a private investor. Their initial investment was \$ 5 and they received a total of \$ 25. That's great. They gained 5 times more than they invested. Now what would it look like in a bad case. What is the bad case for them? It's … Let's say the value of that toxic asset is actually only \$ 30. I'll draw it.

We are still just repeating the last video. But it is important because it has consequences for potential future developments. Let's say this is an optimistic option. This pessimistic. Let's say that in the pessimistic variant, the value of the assets will be only \$ 30. You have \$ 50 borrowed from the Fed. And you have no capital left. The Fed will basically end with a loss on his loan. A private investor, because he no longer has any capital, ends at zero. From \$ 5, you ended up at zero. But this investment still has a pretty good risk-benefit ratio, It depends on what weights you assign to the probabilities of the individual variants. Most people, if they thought it was the same chances for a good and bad variant, so she would go to that store.

If you have a 50% chance of making 5 times your money and a 50% chance of losing your money, the expected value would be 0.5×25 plus 0.5×0. The expected value would be \$ 12. I would pay \$ 5 for something he has expected worth \$ 12. That's a great return. Your investment earns 140%. You don't see such a return every day. Unfortunately, the probability that these variants will occur not the same, not 50:50. This is because the market is now willing to pay for these assets only \$ 30. If the market thought the value of these assets is more than \$ 60, they would trade for more than \$ 30. Given the market situation before the government interventions, obviously no one thinks that there is a good chance that the value of the assets would be \$ 60. There is a much better chance that this variant will occur, than this optimistic. You could create a table. And assign weights to the probabilities. And if you give this probability a high enough weight given this, then of course the expected value will still be less than \$ 5. You are still expected to make money. And you might ask, who would do that? Paul Krugman tells us this is one from those situations where you win, whatever happens.

And it is true. In a positive scenario, the private investor gains most of the money together with the Ministry of Finance. The Fed will receive only very low interest for borrowed money. In the negative scenario the biggest blow gets the Federal Reserve System with his loan and then with him the Ministry of Finance as a capital investor. So that's one of the things we care about Paul Krugman speaks. But I would say that a smart investor, just because the reward for risk is disproportionate inclined to the other party, he still will not want Invest if this is a more likely scenario. The question is, who will invest? And as I mentioned in the last video, the answer may be worrying. The obvious thing is that banks may want to buy assets by themselves. I'll redraw everything now. Because it is important to emphasize this. I honestly don't know how to prevent to make this happen. If this version of Geithner's plan eventually passes.

This is the bank's balance sheet. Basically a balance sheet "before". The bank paid \$ 100 for these assets. He owes \$ 60. Here are liabilities, deposits and so on. And the bank originally had \$ 40 in equity. The bank will now take some extra money, it can need to increase equity or get more money. The government is even currently lending to banks. This is not fiction. What you do is borrow \$ 7 from government. This is really happening. The government provides loans to these large banks such as Citibank or Bank of America, etc. Banks will receive \$ 7 in cash. And the bank will now create a separate entity. They'll call her whatever they want. For example, it may be part of a hedge fund.

Banks are great. Special purpose companies are constantly being established. And there's nothing to stop the bank from putting that \$ 7 into other companies. Other special purpose companies where the bank is essentially equity. And the cash went to this company. And she then took that \$ 7 and used it to participation in the plan. On this new Geithner plan. So the bank will take \$ 7, which you just feel free to she could just borrow from the government. He participates in the plan as a "private investor". I put that in quotes. The bank can create several layers with an unclear structure here.

Or even get one of her hedge fund clients to do it, by giving him good conditions and so on. There are an infinite number of ways how to do it. That's why I think it's impossible to regulate it by law, to prevent this. This is happening here. The Ministry of Finance will participate as a capital investor. And then he borrows \$ 86 from the Federal Reserve. This is from the Ministry of Finance.

The bank is now essentially a private investor. He controls this company. Or it controls the companies that control that company. It does not matter. In essence, however, they determine the price that this company will pay pay for their own assets. So they could pay \$ 100 for this. Although everyone knows that these things are far from over worth \$ 100. He'll pay \$ 100 for this. Let's take it off their balance sheet. And then they have \$ 100 cash and a toxic asset. Why would a bank do that? Think about it. In this case, before any of this happened, the bank was 100% exposed to these toxic assets.

She had the thing right here and it was exposed to her. And as we know, these assets are only worth \$ 30. However, the bank did not want to accept this fact. In this case, the bank issues against toxic assets only \$ 7. If in the end the value of the assets falls to zero, who will he make a loss? The bank will only lose \$ 7. And he will pay the rest of the loss taxpayer, Treasury and Fed. It's a great situation. Because in this case, if the value of assets were only \$ 30, the bank would realize a \$ 70 loss. While in this case, if the toxic asset has value only \$ 30, the bank will realize only a \$ 7 loss. And it will remain solvent. This investment will therefore be deleted. But the bank still has \$ 100 in cash.

My concern is and honestly, because there is nothing what would prevent this is, in fact, self-fulfilling prophecy, which occurs. You ask why it would be private did the investor want to participate in this plan? Even if the government gives you more advantages than disadvantages, you wouldn't participate anyway if You would think that a negative scenario is more likely. But you would participate if you would were a seller of a security. Because if you sell a security and you are Citibank, instead of 100% you are exposed to only 7% and you remain solvent. But the net effect is that the Ministry of Finance and The Fed got \$ 100. If you write off the \$ 7, they got it actually only \$ 93.

Because they had to spend that \$ 7 to make it happen. But they got \$ 100. So they got \$ 93 for something that was actually worth \$ 30. The difference of \$ 63 is basically a check, which the American taxpayer charges to banks. And to the extent that we are really talking about, it wouldn't be a check for \$ 63. It would be a check for \$ 630 billion. It would be a huge mockery for me capitalism. It would be a sad day. Honestly, the AIG bonuses would look insignificant in comparison.

It would be right to take the \$ 630 billion force banks to get rid of shareholders and then recapitalize banks with this money. Instead of writing a check for \$ 63 or \$ 630 billion directly to management and to the shareholders who got us into this mess, you would recapitalised new banks. I wrote an article about it. There is a new plan for banks who wants to distribute shares to American citizens. You get the same effect without the negative consequence in the form of providing a huge transfer of wealth the same people who got us in trouble. I hope people find their way around this story because I was very concerned about it personally. See you soon..