Bailout 2: Book Value Hypothetical bank balance sheet. What book value means.
Bailout 2: Book Value
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- In the last video I just discussed a personal balance sheet
- and what illiquidity or what insolvency means.
- And if you understood that, I think we're now ready to tackle
- what a balance sheet of some of these
- potentially troubled banks might look like.
- And I'm not going to, you know, go into the details,
- but I'm going to give you the big picture and I think that's essentially what matters.
- So essentially, these banks have a bunch of assets.
- And I'm going to talk about banks very generally right now
- both commercial and investment banks.
- In a future video I'll tell you the difference between the two
- and what regulation means and what leverage means and all that.
- Maybe I'll touch on that in this video.
- But let's just kind of think about a generic balance sheet for a bank.
- So its assets.
- So assets.
- So, I don't know, I'm just going to make up some things.
- Let's say that it has, I don't know, $1 billion -- $1 billion in government bonds,
- U.S. government bonds.
- I'm just throwing that in there just as filler just to show you that
- there could be a lot of different types of assets in there.
- Let's say that it has another, I don't know, $10 billion in AAA corporate bonds.
- So you know these -- these are loans to really solvent or very creditworthy companies.
- So AAA corporate bonds.
- Companies that have really good cash flow.
- There's very little chance of them defaulting on their loans.
- And what is a bond?
- Well, a bond is just a loan to another entity, right?
- If you loan me money, I could give you an IOU, right?
- saying that Sal owes you whatever, $10.
- And that IOU, you could call that a Sal bond.
- So $1 billion of government bonds, that's an asset that says
- the government owes me a billion dollars.
- And in the meantime, it's going to pay me interest.
- Similarly, corporate bonds, that's saying that these corporations,
- whoever these bonds are issued by,
- they owe me collectively $10 billion dollars
- and in the meantime, they're going to pay me interest.
- So that's all it is.
- And all an asset is, is something that has some future economic value.
- And that's what these are.
- These bonds have some future economic value.
- They have the value of the interest payments,
- plus eventually, they're going to pay you the $10 billion back.
- Or maybe it's something less than that.
- So the $10 is the interest payments plus what they're going to pay you back, which might be $9.9 billion.
- I'm making up numbers.
- But that's not the issue here.
- The crux of the issue is that there's this stinky asset here.
- Actually, let me draw a couple more assets here just to show you this is the stinkiest of them all.
- So let's say I have another group of assets.
- Let's say it's um -- let's say its $10 billion of commercial mortgages.
- Commercial mortgages.
- So this is, essentially, I lent money to companies to buy land or develop land
- or buy buildings that they're going to go rent out to other people.
- So once again, it's just a loan to someone else.
- And a loan to someone else that I've given is an asset.
- Because they owe me interest,
- and eventually they're going to pay the money back to me.
- And then finally I'm going to throw, and I'm not being comprehensive here,
- I'm going to throw in the crux of the issue here.
- Let's say that I have
- two -- Let me see, I have 21 right now, let me just make it an even number.
- Let's say that I have $4 billion, so it all adds up to 25.
- I have $4 billion in residential CDOs,
- collateralized debt obligations.
- And I've done a video on CDOs, but just to kind of have review,
- CDOs are a derivative instrument.
- I know that sounds complicated,
- but that just means they are derived from another instrument.
- Which probably,you know, that's a sign
- that the stink is starting to emerge from this part of the balance sheet.
- What does it mean, derivative?
- Well, you take a bunch of mortgages.
- So I'll just draw it down here.
- You take a bunch of mortgages,
- so you know, these are house mortgages.
- Maybe you take a million of them.
- You group them all together.
- And you end up with a mortgage backed security.
- Mortgage backed security.
- All a mortgage backed security is a loan to a big group of people
- and you put them all together so that you can kind of, you know, be able to statistically give it properties.
- Because if you lend to any one person, that's hard to trade.
- but if you lend to a bunch of people,
- it starts to become something that you could trade with other people
- because they can understand it.
- and, you know, in aggregate, you could say 8% of people are going to are going to default and all of that.
- But anyway, this isn't the crux of it either.
- I have a whole video on mortgage backed securities.
- CDOs, collateralized debt obligations, are derived from mortgage backed securities.
- And that's why they are called derivative instruments.
- What CDOs are, you take these mortgage backed securities,
- you know, they're loans to some people in some region of the country,
- or maybe they're diversified across regions, then you slice and dice them.
- So what you do is,
- you slice them into tranches.
- And I go into a lot more detail on this in the other videos.
- And you say, this group of the CDOs,
- they'll get the first payments.
- or if any payments that go, immediately go to this very senior tranche, right?
- And then the next payments go to this one.
- And then this top tranche, you could call it the most junior tranche.
- it's sometimes called the equity tranche.
- This tranche, they're going to get whatever is left over.
- So if everyone pays, they get made whole,
- but if a lot of people default, all the defaults are going to hit this tranche, right?
- And to kind of make up for the fact that this is the riskiest tranche,
- or essentially these people are taking on all of the risk,
- or essentially these tranches are giving all the risk to this tranche.
- And a tranche is just a layer, just a slice, ok?
- I don't want to use too fancy words.
- But in return for taking on all of the risk, this person is going to get a higher yield.
- So while this person might be getting 6%,
- this person might be getting 7% on their money,
- maybe this person gets 12% on their money.
- This is another interesting thing.
- Because this person is the most secure,
- the ratings agency, which I'll probably do another whole series of videos on,
- They might give it, I don't know, a AAA rating.
- And maybe they give this tranche,
- and I'm making up things, but maybe they give it a AA rating.
- But this equity tranche, it will get a junkier rating.
- And because it's a junkier rating, no one is going to want to buy it.
- So the person who constructed this whole collateralized debt obligations
- and who sold these tranches to the public markets,
- and this process by the way is called securitization,
- because you're creating securities out of these assets that you sell to everyone,
- maybe the Chinese, or whoever, sovereign wealth funds.
- But people only want to buy these tranches.
- So the banks have to figure out what to do with this tranche,
- which is the stinky equity tranche.
- So most of them just kept it on their balance sheet.
- They said, oh it looks like housing never goes down,
- we get a really high yield on this,
- so we are going to keep this tranche for ourselves.
- And that's what these residential CDOs are, that are the crux of the issue.
- But anyway, that was just an aside.
- And so I wanted to show you this because these aren't just any residential CDOs.
- These aren't the AAAs.
- These, they might be, some of them.
- But just for the sake of argument, let's say that these are junky ones
- or smelly.
- So anyway, that's my example bank, the asset side of its balance sheet.
- Let's think about its liabilities.
- So liabilities.
- We'll just say it has a bunch of loans, right?
- So let's say it has loan A.
- Loan A for, I don't know, $10 billion dollars
- Let me actually throw some cash in here.
- Let's say it has a billion dollars of cash.
- A bank always has to keep some cash.
- Just in case someone asks for their money immediately.
- That's in the context of a commercial bank, but anyway,
- let's say it has some cash just for immediate liquidity needs.
- So the liability side has loan A. It owes someone $10 billion.
- It has loan B, I don't know, let's say it's another $10 billion.
- And let's say it has loan C.
- Loan C is, just to make it interesting, loan C is... let's say it's for $3 billion.
- So in this example right now, if we assumed that all of these asset values are correct
- and all of these liability values are correct, what is this bank's equity?
- And in this case, if it's a publicly traded company,
- what is its shareholders' equity?
- Let's figure it out.
- It's equity.
- Well, its assets are -- let's see one plus 21, $25, $26 billion in assets
- and its liabilities are $23 billion.
- So $26 billion of assets minus $23 billion of liabilities
- means that we have $3 billion of equity -- of shareholders' equity.
- And just to make it clear, what this equity is,
- let's say this is a publicly traded company.
- If you own a share of the company, you own a share of this equity.
- So lets --actually, let's just write it out.
- Let's say this company has --um, you know, let's call this, I don't know, Yachovia Bank.
- No, actually, I shouldn't, that's too close.
- Let's call this Bank A.
- And let's say that Bank A
- Bank A.
- has, I don't know, let me make up something, let's say that it has
- a, I don't know, a billion -- let's say it has 500 million shares.
- 500 million shares.
- Right? If go into Yahoo Finance, you said how many shares are outstanding?
- It has 500 million shares.
- So, each share price, or the book value of each share price,
- essentially should be this $3 billion of equity based on the balance sheet.
- And that's why they call it book equity.
- Because the balance sheet is often called the company's books.
- So this is this $3 billion of equity divided by the number of shares.
- So each share should be worth, let's see, $3 billion divided by 500 million,
- it should be $6 of book equity -- of book equity -- equity -- per share.
- And that's something important to realize
- because a lot of people think that if a stock price goes to zero,
- that means that you're getting the company for nothing.
- No, that's not true.
- That just means that the equity is worth zero.
- And I just realized that I'm out of time.
- I'm going to continue this in the next video.
- And we'll explore this a little bit more.
- See you soon.
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