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Current time:0:00Total duration:10:51

Video transcript

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 I said this is some type of a financial institution and these were its assets and at least on its books that you know had a billion dollars of government bonds 10 billion dollars of very highly rated corporate bonds so these are loans to corporations that are very likely to pay back 10 billion of commercial mortgages which would be loans for someone to be I could buy an office building or build an office building or something like that and then we we focus in a little bit on this piece this green piece here residential CDOs and I explain 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 focus 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 you know these these liar loans where you could make up your income and and get a million dollar loan with no money down so this was just the first way but you can imagine if the economy gets bad enough then a lot of these commercial mortgages are going to are going to start looking not so great either and actually there was an article that I read this morning where they talked about well you know because of all of the all of the turmoil in the financial system because of this piece that the that the commercial vacancy is actually going up and a lot of the people who owe commercial who owned commercial mortgages they're actually getting a little bit worried right now because a lot of office basically free but anyway that's not the focus of this what we should focus on now is well fine you know this Bank has a shady asset and that makes it look a little uncertain as far as what its equity is worth right if we said this asset was worth four billion dollars we said we have 3 billion of equity here right because everything would have added up to 26 billion and then 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 then I gave you the example of well but what if the stock market is actually valuing this thing at equity of 1.5 billion and the way you get that is you just say well they're saying $3 a share and they're half a billion shares so what if the what if the stock market is saying no I think that this company's equity is only worth a billion and a half and a rationale for that could be that they just think that this asset right here is worth a billion and a half less maybe I just wanted to make that point because a lot of people you know often get confused between book and market value but now let's think about let's think about why this matters why is why is Hank Paulson and Ben Bernanke and George Bush and it's seemingly everyone else so scared I mean the logic goes well if I just have you know this is just one bank and you know 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 you know this is this one Bank maybe this isn't worth zero maybe this is worth four 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 they tend not to be most of the loans we're familiar with in our personal lives or 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 are they tend to be they 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 their interest only loans so for example this loan a over here get my pen out this loan a it'll have some interest rate I don't know they make something up maybe it's a 7% loan and maybe its term so this alone is for you know they'll give you the money for some period of time let's say it's for three months three months three months so that says that whoever lent lent this money to you they'll give you ten billion dollars every year you you pay seven percent 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 some small you know roughly one it's actually seven 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 dollars you might say well that's a strange way of financing yourself because every every three months you're going to have to go and get another loan and that's absolutely true but in a normal in a normal credit environment most companies can say okay I'll borrow this 10 billion dollars for 3 months at an annual rate of 7% and then when 3 months pass I'll just get another loan may be from the same lender may be from another lender that has maybe similar terms pay off the old loan and get a new loan so they keep on you can kind of say they keep on renewing these those loans they're able to keep keep getting new loans that can replace the old ones what's happening now is you have this these short-term loans I'll say 3 months and then when it comes to renew the bank or whoever left you this money says huh I'm not so sure anymore because one your stock price has been tanking right your stock price has been tanking if if anything we know is that a lot of these you know maybe these hedge funds out there they're doing more homework than me the bank or whoever you know 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 I'll often say just like a big bucket of the column level 3 assets and those are assets that really the 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 bears turn to look look a lot like you I saw I saw Lehman Brothers go down and Lehman Brothers looks a lot or looked a lot like you look now you know what I just want my money back just pay me the ten billion dollar loan and then you go out if you're this Bank you say okay well let me look to find someone else and no one's willing to lend you the money because everyone's gotten a little bit irked so you say simple enough well why don't you just you know and and you know they go for they go for another guy for loans and they're like look I'm not gonna give you a loan but here's some advice if you really think these assets are worth enough you want you sell these assets and maybe some other assets and then you can you can you'd be good for your money right you don't even need the loan you don't you don't need to hold these assets and so if they say fine you know let me take out so what you do is when this comes due since you can't get any other loans let's say that you sell these right so you sell these triple-eight corporate bonds those are very valuable so you get 10 billion dollars for them so if you got ten billion dollars for them so now you have ten bout ten billion dollars in cash you got ten billion dollars in cash and you're able to pay off this loan and actually what what I've just described this is called D leveraging and so actually I'll probably save it to the next video on what leverage and D leverage 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 if someone has a lot of assets but they're controlling it with very little equity they have huge leverage if you're controlling ten dollars of assets and you only have one dollar of equity you have ten to one leverage now I just reduced my assets but I didn't change my equity so I've delivered I'll do that more in the next video but that's fine so I was able to cover 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 hey you know what I'm not prepared to get 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 okay 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 in a fire sale type of situation since you have to do it very quickly and ever a little squared Nana let's say you only get nine billion dollars for these right you they're worth ten billion or so you say and then when you actually try to sell them in the market you get nine billion dollars so you get nine billion from those that was nine billion and let's say you have to sell your government bonds as well so you another billion so that gives you ten billion dollars 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 ten billion of assets and I had to I had to essentially write them down to nine billion because that's what I got for them so let's let's actually recalculate our new book value so if I'm the company remember this four billion was what the company said it was worth the 2.5 billion was what the market said it was worth so they have four billion plus 1 billion so we have five billion now and assets and what's our liabilities we have three billion in loans so we have three billion of liabilities and now the book value of our equity is now going to be two billion and just to think about it why did our book value of equity go from three billion to two billion well because I actually I thought that these commercial mortgages were worth 10 billion but when I had to sell them really fast I only got nine 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 the book value of the equity is now two 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 four billion I shouldn't have crossed it out let me write it again four billion the two point five is what the market is saying which is larger than my total equity so if this is worth zero then actually have negative equity if this is what's 2 billion instead of 4 billion then I have zero equity so now I'm getting into a very interesting situation and and I wonder what's going to happen when loan C comes due and we'll explore that in the next video