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Current time:0:00Total duration:11:24

Bailout 4: Mark-to-model vs. mark-to-market

Video transcript

so the last couple of videos we've been looking at the balance sheet of this what I called Bank a and we said you know it has these assets and the assets that I wanted to asset in particular we're going to focus on is this four billion dollars in residential CDOs right here but anyway its total assets for twenty six billion dollars at least it's telling us that its total assets are twenty six billion dollars according to its accounting on its balance sheet its liabilities are twenty three billion and so if you just subtract the twenty three from the twenty six billion you get a book value of its equity if you believe with every all of the numbers on the company's balance sheet the company is worth three billion dollars that's what the shareholders own they own this equity stake and if there are five hundred million shares that's six dollars for each of those shares in the last video we talked about well if if the market is actually trading at twelve dollars a share people are exchanging those shares between themselves remember the secondary markets the stock market most of that is between two people who are unrelated to the company trading the shares of the stock it's not a transaction with the company there are transactions every now and then with the with the company and that's why the stock price is important but for the most part what you see every day when you get a quote is just a transaction between two unaffiliated parties it could be between me and you I have my a trade account you have your Charles Schwab account we just traded the stock for that second we set the price for for whatever the value of bank a so I said if if the market value of that the market the value of the market is placing our shares twelve dollars per share that's a six billion dollar market cap the market at least for that moment or at least the person who just transacted or just traded those shares is saying that no I don't think that this company only has three billion of equity it actually has six billion of equity and it might be because they have some kind of great brand the equivalent of charisma and good looks that can't be quantified on a balance sheet or maybe one of these assets are worth more maybe they've appreciated since the last time that the bank wrote down their balance sheet or the last time that the bank kind of evaluated the assets worth and then we had another situation and this is very relevant to what's going on in the world today well what happens if the market price is below the book price so that was the case where the stock is trading at $3 per share and $3 per share times half a billion shares that's a 1.5 billion dollar market value of its equity and I think that's what I wanted to write here market value of equity and what is what is what is the market then saying or at least the person who's buying or selling the share right at that moment what are they saying well they're saying that okay i you know Bank a that's a nice you say that your assets - like your liabilities are worth 3 billion but I don't think that's true I think your assets - slider but - your liabilities are 1.5 billion and let's say that you know we can't read anyone's brain we don't know why they think that maybe they think there are fewer assets maybe they think there are more liabilities but let's say that we do read someone's brain they're like you know what we're I think you're doing a little bit of shading is I think you're doing it on this line right here I don't think that thing is worth four billion dollars I think that thing is worth two and a half billion dollars and if this is worth two and a half billion then your total assets are what their billion and a half left and so your assets are what 24 24 point five billion right well I know this is a little bit messy but if the market is saying that this is a three dollar stock $3 per share then that says your market value is 1.5 billion dollars and let's say we don't know why the market saying that blessed we can get their hand and they're saying that because they think that this thing is not worth 4 billion dollars they think it is worth 1 they think it is worth 2.5 billion so they think it's worth a billion and a half left if this is worth 2.5 billion then all of this will add up to if I did my math right 24 and a half billion - 23 billion and then so then that gets you to the market value of the equity so let's call that market equity the market value of the equity of 1.5 billion so this this raises a very interesting question how do people decide or how do especially the bank's themselves decide what some of these assets are worth and in particular these CDOs well there's a couple of ways to do it and they're they're all kind of different schools of economic philosophy you could you could put here what you paid for it right maybe the bank originally paid four billion dollars back when real estate could only go up or so people thought and and all of these CDOs look like these great high yielding instruments based on those assumptions the the bank says well you know I'll pay four billion dollars for it so they put it on their books for four billion and they never kind of reassessed it so they just put the four billion dollars at cost and then people would have every right to question that number they'll be like well you know that doesn't make sense since then we know that housing prices can go down we know that especially since this was the riskiest slice of the CDOs that these could be completely wiped out even if we only have a small number of defaults on mortgages and we know that you as a the CFO or the CEO of your bank have every incentive to not write the real value here because you want to prop up the stock because you have a lot of options in the company and you are evaluated on the stock price but anyway I'll maybe I'll make whole other video on on incentives so that's one way Olynyk my phone is ringing my phone is ringing out I'll answer it later this is I'm too worked up to answer the phone right now I need to channel this energy into this but anyway so that's one way of saying the cost basis another one and this is and now I'm going to introduce some words that you might have heard on the news mark - Marta I was going to say mark the model and then my brain was going to say mark - mark it mark - model so what this says is I'm going to mark these assets I'm going to value these assets based on a model that I have I hired a bunch of PhDs from the best schools in the country they they can you know these are rocket scientists and some of them actually are they can you know put the man on the moon and and I'm going to they're going to make fancy computer models with some assumptions and those are going to spit out what these things are worth so they're going to model the behavior how many of these mortgages you into fall to all that and those numbers spit out a number and you know maybe they say that they are worth three billion dollars right and if that happened in any period the company would actually have to restate this they would actually have to say oh this wasn't four billion we're going to have to restate that we're going to take a write down and you've heard this a lot when banks report the earnings we took a write down with thought we had a four billion dollar asset maybe that's what we paid for it originally we reran our model based on new assumptions so we're marking to model now we have a three billion dollar asset according to our assumptions or our new assumptions in our model so we are doing a 1 billion dollar write-off right to go from 4 billion what we originally had on the books maybe that was our old assumptions in our model to our new model and immediately you should be suspicious of that because once again you're being dependent on on the banks to report on themselves you're you know sure these might be well maybe there were even well intentioned but at the end of the day this value is being set by a model where the assumptions into that model and frankly I don't care how fancier your model is and how many PhDs the people who made the model have at the end of the day you can always rig this number based on the assumptions you make and frankly the market has no transparency as far as what assumptions you did make so it's very hard to believe but you know it's it's probably a better guess than the four billion right especially when they're taking it down and you also have to and I'll do a whole video on this later on you also have to question why they keep taking right downs right why you know why their models keep having to make more pessimistic scenarios maybe they're just buying time maybe the first time they run their model they actually say it's worth zero in which case they have zero equity right because if if this was worth zero they'd only have twenty two billion dollars in assets and 23 billion in liabilities which means they have negative assets which means that they're insolvent which means that they should go bankrupt but they don't want to do that right they don't want to be responsible for running the company in the ground so they don't want to admit all at once that these are worth zero maybe they'll they'll admit that's worth you know not for it's worth three but then they'll go to the market and they'll try to raise more money and I'll explain that in a little bit because I know that can get very complicated so this is Mark to model you've heard a lot about it it's not a fancy concept the models might be fancy but it's just like I am going to make my own assumptions to figure out what they're worth and as you can imagine there aren't the most credible assumptions of the value of this the other idea is mark-to-market mark-to-market mark-to-market and this essentially says well if this is an instrument that is traded in some market right let's say that these CDOs and they at least they used to be let's say that they are traded in some market that you actually assign the market price so let's you know maybe I have a I don't let's say I have a billion of these CDOs and the market price of those CDOs is a dollar fifty per CDO I'm just making up numbers in which case the market value of them would be a billion and a half so if you did mark-to-market you would have to make this into a billion and a half and you would have to do another write down now why do why doesn't everyone do that well I actually think that's a very good question I'll tell you why the banks don't want to do that they are making the argument that people are destroyed well first of all some of these markets since no one wants to buy these things because maybe they think they're actually worth zero the markets have disappeared and the few people that are selling them they're usually selling them when they are you know they're distressed in some way so that you know they're quote-unquote it's a fire sale so people are arguing that the market price is not reflective of the true value of these securities they're arguing that the few people who have transacted did it out of desperation so that you know that 1.5 billion value of these CDOs the market value Studios is not truly accurate so these companies saying no no I cannot I cannot admit what the market what capitalism is telling me what the price is even though these people are the same people who have been for the last thirty years saying the Martlet the market determined everything you know I I make twenty million dollars a year because I am a capitalist and because I have taken risk and that you know I deserve that money and now these are the same people now that they they're they're they're very adamant that says oh don't believe the market price because those people they the market is wrong now our PhDs are correct and you know if you think about it that's a very communist way of thinking because the in communist government they didn't believe in markets they believed in hiring the smartest people that they could find ie the PhDs of their relative countries to essentially engineer their markets to determine what things are worth without letting the markets at the price of anyway I'm not going to that this is supposed to instruct you as opposed to make you angry although I think just by learning about this you might get angry but anyway that's what mark-to-market means and I just realized I'm out of time again because of my rant so I will see you in the next video and we'll continue to learn the nuance of everything that's going on see you soon