In the next series of videos,
I’m going to give my best attempt at trying to get a
handle on the bailout and the financial crisis. So I’m going to try to explain
different concepts in more than one way. Then I think hopefully
it’ll all sink in. But the big picture really is
that there’s a lot of fancy terminology being thrown around,
but the underlying concepts really aren’t
that fancy. So I think a good place to start
is just with the idea of the balance sheet. And you could watch some of the
videos that I did before the whole financial mess on the
balance sheet and that’ll give you good primer,
but it doesn’t hurt to review it here. So a balance sheet is just a
snapshot of what you have and what you owe and the difference
between, and the difference between is kind
of like your wealth. So if I just had a personal
balance sheet, I could write my assets. They mean what you
think they mean. These are things that will
give you future benefit. So let’s say I have
$1,000 cash. Let’s say I have a
$100,000 house. Let’s say I have
a $10,000 car. And let’s say everything else,
I’ll call it other, my furniture, my TV and everything else, is another $5,000. So those would be my assets. And so what are my
total assets? It’s $101,000, $111,000,
$116,000. Well, it would be great
if we lived in a world of only assets. But, unfortunately, let’s
say that I had liabilities as well. So liabilities. And a liability is what
you think it means. It means something that you have
to give future economic benefit for. You’re kind of on the
hook for something. And so let’s say, my
liabilities, I have a $20,000 student loan. And let’s say on that house,
unfortunately, I don’t own it outright. Let’s say that I have an $80,000
mortgage on that house, so essentially
I borrowed $80,000 from the bank. And let’s throw some credit
card debt in there. Just to make this realistic
relative to I think a lot of households out there, let’s
say that there’s $5,000 of credit card debt, although for
most households right now, this house is a lot more and
this mortgage is a lot more. But anyway, I won’t make
social commentary. This is just to explain what
a balance sheet is. So what is left over for me? What is my assets minus
my liability? Let’s calculate our
total liabilities. So this is total assets. I’ll use an A colon. So what are my total
liabilities? 20 plus 80 plus 5,
so it’s $105,000. $105,000 total liabilities. So the difference between these
two, my assets minus my liabilities, this is essentially
my net worth. If I just liquidated everything
tomorrow, if I sold all of this and paid off all
this, this is what I would be left standing with. That’s my net worth. Or you could view that
as that is my equity. You often hear equity in
the context of a house. In the context of a house, it’s
just the asset of the house minus the liability, but
I’m talking about in the context of my personal balance
sheet, not that these are the actual numbers. I don’t want to give away too
much about my life just yet. But anyway, so what is
that number here? So my equity, and I’ll do that
in green since if it’s positive it’s a good number. My equity is $116,000
minus is $105,000. So what is that? That’s $11,000. That’s my equity. So there’s a couple of things
to think about here. You’ll meet people with a
$100,000 house or a $1 million house, and they say, oh,
I am worth $1 million. And you’re like, well, you’re
not really worth $1 million unless you own that house
outright and you could actually sell that house
for $1 million. It’s not what you paid for it. It’s what the market is willing
to give for it. But your real net worth is your
assets minus all of your liabilities. So in this case, your net
worth is actually $11,000, not $116,000. And this is another important
thing to think about. Assets are always equal to
liabilities plus equity. That just comes out of the
definition of what equity is. Equity was assets minus
liabilities. If you take an MBA, they’ll
write it down, and it looks like an equation, but it’s
assets is equal to liabilities plus equity. But that’s almost by definition
that that’s going to be true. So what can we do with this? How does this help us? Well, there’s a couple of ways
that we can think about this. First of all, what happens
if my liabilities are larger than my assets? So if I owe the world more
than the world owes me? Well, then this number is
going to be negative. And if this number is negative,
then there’s no really good reason for me, maybe
to preserve my credit score, but other than that,
if we take that out of the equation, there’s no good reason
for me to continue living this existence. If my liabilities are greater
than my assets, let’s think about that situation. Let’s say that my house is only
worth $100,000, but for whatever reason, I owe
$120,000 to the bank. Let’s say maybe I originally
bought the house with a no-money down payment
for $120,000. And now I’m honest
with myself. I’m like the value
has gone down. It’s only worth $100,000 now. So I’m in the situation where
you could say I’m upside down in my mortgage. Well, one, you could say there’s
no incentive for me to continue paying this house. An even bigger picture, if I now
look at my balance sheet, what are my liabilities now? My liabilities would
be $145,000. And my equity would be my assets
minus my liabilities. So $116,000 minus $45,000,
what is that? Minus $29,000. I’ll do that in red. That’s a bad number
for your equity. So in this situation, there’s
really no reason for me to continue living like the way
I am, at least financially. As long as you’re breathing,
there’s no reason not to continue breathing. But you wouldn’t want to live
like this financially anymore, so there’s no reason not to go
seek bankruptcy protection. And bankruptcy protection is
admitting I am insolvent, which means that there’s no way
that I’m going to be able to unwind all of
my liabilities. Courts protect me. My lenders can’t come
back after me. Everything is going
to be erased. They’re going to take all my
assets, all my liabilities, and they’re essentially going to
take these and divide them up amongst the people
that I owe stuff to. So that’s bankruptcy. That’s insolvency. And I want to highlight the word
insolvency because that’s a word that we’re going touch on
when we actually talk about the credit crisis. And that is opposed
illiquidity. So what is illiquidity? So insolvency means there’s no
reason for you to continue with this type of a financial
situation. You’re bankrupt. You go get bankruptcy
protection. That’s insolvency. Illiquidity is a different
situation. Illiquidity says no,
I actually do have positive equity. So let me go back to the
original circumstance. It really was I only owe $80,000
on the house, so my liabilities really are
only $105,000. So I really do have a positive
equity of $11,000. So this isn’t insolvency
anymore. So I’m going to describe what
illiquidity means to you. Or to me, in this case,
because this is my balance sheet. So let’s say that my wife comes
to me and says we need to pay our child’s tuition. It is $5,000 for the
upcoming year. I need to pay $5,000
in tuition. Actually, let me take a better
situation because if I’m talking about tuition, it
should have shown up on liabilities. Let’s say that I have to
make a $5,000 payment on my student loan. So I have some kind of weird
student loan, where $5,000 comes due all of a sudden. So I have to make a $5,000
payment on the student loan. Let me do that in red. Make $5,000 payment. And it could be for anything,
but let’s say it’s to satisfy part of one of these
liabilities. So if you look at my equity, if
you look at my assets minus my liabilities, I clearly
have $11,000. I’m worth $11,000. And if I could liquidate all
my assets and all my liabilities overnight, I would
have $11,000 in cash, and then I could pay that $5,000. In fact, in the process of doing
it, I would have paid that $5,000. But in this circumstance, if I
just look at my situation, let’s say that student loan
payment is due tomorrow. I only have $1,000 of cash. I only have $1,000
maybe sitting in my checking account. So I can’t make that $5,000
payment just with my cash. And then I look at everything
else, and I’m like, boy, can unload any of these
assets overnight? Well, a house, absolutely not. There’s no way I’m going
to be able to unload my house tomorrow. Maybe I could find someone who
would buy it for $50,000 tomorrow, but that wouldn’t
help my situation. Then my equity would
go negative again. So that won’t help. I can’t sell my car overnight. Maybe I could sell it at a super
low price for $4,000, just to kind of make this
payment, but I don’t want to do that either. And same thing, your furniture,
you’d have to go on Craigslist and take
pictures of it. You couldn’t do it. So this is a situation
where you are having a liquidity crisis. You are illiquid, but you’re
not insolvent. You have a positive net worth,
assuming that you’re not lying about what’s going on in
your balance sheet. And that’s another issue. So how do you get past a
liquidity crisis like this? Well, someone has to give
you– we could call it a bridge loan because they’re
giving you a financial bridge from here to where
you need to go. Or they’re giving you
a bridge that essentially buys you time. Let’s say your dad says, OK,
Sal, or my dad, I guess, I’ll give you a $5,000 loan for
the next two months. And over the next two months,
I expect you to find some other source of cash. Maybe sell your car, buy a
cheaper car, sell some of your furniture or something. So that is a loan to prevent
a liquidity crisis. And that loan wouldn’t be a
bad idea because if this person isn’t lying about their
balance sheet, or I’m not lying about my balance sheet,
then I actually am good for the money. On the other hand, that loan
be a bad idea if I had insolvency because it would
just be throwing good money after bad. I’m not able to pay my current
loans, and you’re just giving me another loan that I wouldn’t
be able to pay. Anyway, I’m out of time. I’ll see you in the
next video.