In the last several videos we
talked about the difference between the book value
and the market value of a company’s equity. And in this example here, where
I said this is some type of a financial institution. And these are its assets. And at least on its books, it
had $1 billion of government bonds. $10 billion of very
highly rated corporate bonds, so these are loans to
corporations that are very likely to pay back. $10
billion of commercial mortgages, those would be loans
for someone to buy an office building, or build
an office building, or something like that. And then we focused in a little
bit on this piece, this green piece here, residential
CDOs. And I explained what
those are. Those are essentially derivative
securities that are derived from mortgage
backed securities. Which are just a bunch
of mortgages that are packaged together. And we focused on that because
this is really the crux of everything that everyone’s been
focusing on since the credit crunch started. Although, I’ll throw it out
there, this is just the first wave. This is what’s
deteriorated so far. Housing prices have gone down,
you had all of these people with these liar loans where you
could make up your income and get a million-dollar loan
with no money down. So this was just
the first wave. But you can imagine, if the
economy gets bad enough, then a lot of these commercial
mortgages are going to to start looking not
so great either. And actually, there was an
article that I read this morning where they talked about
because of all of the turmoil in the financial system,
because of this piece, that the commercial vacancies
actually going up. And a lot of the people who
own commercial mortgages, they’re actually getting a
little bit worried right now because a lot office space
is going free. But anyway that’s not
the focus of this. What we should focus on now is
well, fine, this bank has a shady asset. And that makes it look a little
uncertain as far as what its equity is worth. If we said this asset was worth
$4 billion, we said we have $3 billion of
equity here. Because everything would have
added up to $26 billion. And we have $23 billion
in liabilities. And so liabilities plus equity
is equal to assets. Or assets minus liabilities
is equal to equity. So 26 minus 23 is equal to 3. And I gave you the example of
well what if the stock market is actually valuing this thing
at an equity of $1.5 billion. And the way you get that is,
they’re saying $3 a share and there are half a
billion shares. So what if the stock market is
saying no, I think that this company’s equity is only
worth $1.5 billion. And a rationale for that could
be that they just think that this asset right here is worth
$1.5 billion less. Anyway, I just wanted to make
that point because a lot of people often get confused
between book and market value. But now, let’s think about
why this matters. Why is Hank Paulson, and Ben
Bernanke and George Bush, and seemingly everyone
else, so scared? The logic goes, well if this
is just one bank and maybe these things are worth zero,
what’s the problem? If these things are worth zero,
this one bank declares bankruptcy, and it just
gets resolved in the bankruptcy process. And I’ll do another
video on how the bankruptcy process works. Or, there’s another scenario
where you say, oh well this one bank, maybe this
isn’t worth zero. Maybe this is worth
$4 billion. And as long as people just
continue to loan it money, it should be able to be fine and
it’ll weather out the storm. And that’s the crux
of the issue. Whether people will continue
to loan them money. So, corporate loans, or loans
to corporations or banks. Most of the loans we’re familiar
with in our personal lives, maybe a mortgage, where
it’s a fixed term, 30 years, at the end of it you’ve paid all
of the interest and you’ve completely paid off the loan. Corporate loans tend to be for
simplicity purposes, interest only loans. There might be a little bit
of paying down the equity. But for the most part they’re
interest only loans. So for example, this
Loan A over here. It’ll have some interest rate,
let me make something up, maybe it’s a 7% loan. And maybe its term, they’ll give
you the money for some period of time, let’s say
it’s for three months. So that says that whoever lent
this money to you, they’ll give you $10 billion. Every year you pay 7% but on I
guess a monthly basis, you’ll pay roughly 1/12. We know that that’s not the
exact math, but you’ll pay it’s actually 1.07 to the
1/12 power, but it’s roughly 1/12 of this. And then at the end of three
months, you pay that lender back the $10 billion. You might say, well that’s
a strange way of financing yourself. Because every three months
you’re going to have to go and get another loan. And that’s absolutely true. But in a normal credit
environment, most companies can say, OK I’ll borrow this $10
billion for three months at an annual rate of 7%. And then when three months pass,
I’ll just got another loan, maybe from the same
lender, maybe from another lender, that has maybe similar
terms. Pay off the old loan, and get a new loan. You can kind of say they keep
on renewing those loans. They’re able to keep keep
getting new loans that can replace the old ones. What’s happening now is you have
these short term loans, let’s say three months, and then
when it comes to renew, the bank or whoever lent you
this money says, I’m not so sure anymore. Because one, your stock price
has been tanking. And if anything, we know that a
lot of these hedge funds out there, they’re doing more
homework than me, the bank, or the lender is doing, or
at least these ratings agencies are doing. So maybe they see
something fishy. And I know that you have some
type of assets, you have some of these residential mortgage
backed securities, or you have some of these derivative
assets there. And you don’t really give a
lot of transparency to me. In fact, seldom you’ll actually
even see this much transparency on a company’s
balance sheet. They’ll often say just like a
big bucket of, they’ll call them level three assets. And those are assets that really
the management of this bank can decide what
they’re worth. So if I’m the person who lent
them the money, I’ll be like, you know what, I saw Bear
Stearns go down. And Bear Stearns looked
a lot like you. I saw Lehman Brothers go down
and Lehman Brothers looked a lot like you look now. You know what? I just want my money back. Just pay me the $10
billion loan. And then you go out, if you’re
this bank, you say, OK well let me look and find
someone else. And no one’s willing to lend
you the money because everyone’s gotten a
little bit irked. And they go for another
guy for loans. And they’re like look, I’m not
going to give you a loan, but here’s some advice. If you really think these assets
are worth enough, why don’t you sell these assets, and
maybe some other assets, and then you can be good
for your money? You don’t even need the loan. You don’t need to hold
these assets. So what you do when this comes
due, since you can’t get any other loans, let’s say
that you sell these. So you sell these AAA
corporate bonds. Those are very valuable. So you get $10 billion
for them. So now you have $10
billion in cash. And you’re able to pay
off this loan. And actually, what I’ve just
described, this is called deleveraging. Actually, I’ll probably save
it until the next video on what leverage and
deleverage is. But just think of it this way,
leverage is the ratio of how much assets you have over how
much equity you have. And so if you think about someone who
has a lot of assets, but they’re controlling it with very
little equity, they have huge leverage. If you’re controlling $10 of
assets and you only have $1 of equity, you have
10:1 leverage. Now, I just reduced my assets,
but I didn’t change my equity. So I’ve deleveraged. I’ll do that more in
the next video. But that’s fine, so I was
able to cover that. I didn’t have to declare
bankruptcy or anything. But let’s say when this
loan comes due, I’m in the same situation. This person, everyone’s a
little scared after Bear Stearns and Lehman Brothers and
they say, I’m not prepared to renew this loan to you. And you go out into the credit
markets and no one else is willing to give you this loan,
but you’re like, OK fine, I have these commercial
mortgages. And I can sell them. They’re fairly liquid
securities. Liquid securities means that
there’s a market in them and that you can find buyers who
are willing to buy them. But let’s say since you have
to kind of do it in a fire sale type of situation, since
you have to do it very quickly and everyone’s a little scared,
let’s say you only get $9 billion for these. They’re worth $10,
or so you say. But then when you actually try
to sell them in the market, you get $9 billion. And let’s say you have to sell
your government bonds as well. So you get another billion. So that gives you $10 billion. And then you could pay off
this guy right there. So now it’s getting
interesting. Notice, the book value of my
equity, well it might have changed a little bit. Because I had $10 billion
of assets. and I had to essentially write
them down to $9 billion, because that’s what
I got for them. So let’s actually recalculate
our new book value. So if I’m the company, remember
this $4 billion was what the company said it was
worth, the $2.5 billion was what the market said
it was worth. So they have $4 billion plus
$1 billion, so we have $5 billion now in assets. And what’s our liabilities? We have $3 billion in loans. And now the book value
of our equity is now going to be $2 billion. And just to think about it,
why did our book value of equity go from $3 billion
to $2 billion? Well, because I actually thought
that these commercial mortgages were worth $10
billion, but when I had to sell them really fast, I only
got $9 billion for them. So I essentially had to write
down those assets and then sell them and turn
them into cash. So that’s why the book
value of the equity is now $2 billion. And now notice something here,
the book value of this residential mortgage backed
security, at least what this bank management says the book
value is, is $4 billion. I shouldn’t have crossed it out,
let me write it again. $4 billion, the $2.5 is what
the market was saying. Which is larger than
my total equity. So if this is worth zero,
then I actually have negative equity. If this is worth $2 billion
instead of $4 billion, then I have zero equity. So now I’m getting into a very
interesting situation. And I wonder what’s going to
happen when Loan C comes due. And we’ll explore that
in the next video.