More on balance sheets and equity

welcome back where we left off in the last video I had just purchased a million dollar house to do it I went to the bank and I said Bank can you give me $750,000 and they said sure Sal you have an excellent credit rating and you look like an all-around great guy so we'll give you $750,000 and so I took that $750,000 and the $250,000 that I had saved up through through a lifetime of hard work and I went and I bought that house so after that transaction this is what my my personal well this might not involve everything but this could be my personal balance sheet but it looks like my whole world is this house which in a lot of cases it is for a lot of people so in this situation what are my assets I have a million dollar house on my balance sheet I have one asset in the world you know I guess you can't quantify charisma and good looks so the only real tangible asset I have is a million dollar house and what are my liabilities well I owe $750,000 to the bank and so we we learned in the last video and and it you shouldn't review this as a formula at all it should start to make a little bit of intuitive sense that assets are equal to liabilities plus equity or the other way to view it is asset minus liabilities is equal to equity right just subtract the liabilities from both sides and you know that well if I have a million dollar assets I owe 750 thousand if I were to resolve everything what I'd have left over at the end is $250,000 and I could make that happen I could sell the house for a million dollars hopefully and then pay the bank back and I would have two hundred fifty thousand left so that's what equity is just what you have left after you resolve everything or another way I mean and this makes sense to you if you talk about all of the things you own - all the things you owe to other people equity is what's left over or that could be owner's equity so now let's play with some scenarios of what happens maybe when the price when the value the market value of the house changes so let's say what happens when oh and one important thing to notice note this this Bank they're not just going to give me $750,000 you know just to do anything with it they're not going to say hey set Sal here $750,000 I know you'll pay it back to me but you can go gamble it in Monaco they want to know that they have a good getting at least the money that they give the loan amount and that's also often referred to as the principle they want to know that they're going to be able to get that principle back one day so what they say Sal we're only going to give you this loan but this loan has to be backed or it has to be collateralized by some asset and so what I say is okay well you know I'm I'm taking this loan out to buy a house just you know a million dollar house if for whatever reason I lose my job or you know I disappear somehow or whatever happens if I can't pay you the $750,000 you get the house you'll get this million dollar house and right now that looks like a pretty good deal to the bank right they almost hope that I'll default because they gave me $750,000 if after a day I just say you know what bank I can't pay this loan I I don't have the income when I lost my job I can't afford the mortgage they get a million dollar house overnight they would have made $250,000 right they would essentially gotten all my my equity for free so in that situation the bank works out pretty good and that's why they make sure that there's something that they can grab onto if you can't pay the loan and that's why back in the good old days and I think the good old days are going to come back again and I think they already are that the bank wants you to put some down payment in a house because there's a situation where let's say that I do this I borrow the money and I buy the house and I lose my job or you know whatever I just drink away all of my money whatever for whatever the case may be and so the bank and they foreclose foreclose means that Sal isn't paying on his paying his debt so we're going to take the collateral back that he gave for the loan so in that situation the bank says Sal can't pay we're taking that house well when they take that house there's a situation where you know maybe they're not going to get a million dollars for that house they don't want to sit and wait for months and months and months while a real estate agent tries to sell it so the bank might just auction off the house and when it auction off the house actually I think there are laws that it can't get more than the mortgage or anything more than the mortgage it gets it actually has to pay taxes or we won't bring all of that little auction off the house and maybe can only auction off the house for $800,000 right so the million dollar asset would really become an $800,000 asset and so the bank keeps this equity cushion right that if they loan $750,000 for a million dollar house and then the million dollar house only sells for 800 the bank still gets all of their money back that's why in the good old days the banks want you to put 20 or 25 percent down because they know even if the how how the value of the house drops by 20 or 25 percent it'll all come from your equity and maybe I should draw a diagram to see that situation let's say let's say that for whatever reason I have to sell this house in a fire sale or let's say I can't sell the house and the bank is forcing me to liquidate my assets the bank says well then I want that house back so in that situation well actually that's not a good situation because the bank will just I'll just get wiped out let's just do the situation where let's say a neighbour's house sells for the neighbor's house that is identical an identical neighbor's house sells for $800,000 right so in that situation if I want to be honest with myself and if I want to be honest with the balance sheet and actual you know real companies have to do this I'll say you know what this asset I have to revalue it I cannot in all honesty say that this is now worth this is a $1,000,000 asset so I would revalue the asset and this is actually called marking to market you've probably heard of the heard this concept marking the market means I have an asset and every now and then maybe every few months every quarter a quarter is just 1/4 of a year I have to figure out what that asset is worth and the best way to figure out what that asset is worth is to see what identical assets like that are going for in the market and very few houses are completely identical well there are kind of a few suburbs but very few assets are completely identical but let's just say that I know for a fact that an identical house just sold for $800,000 so I have to be honest and I have to mark it to mark it and then say that my assets are now an eight hundred thousand dollar house eight hundred thousand house my same house nothing really happened but the market value has dropped by two hundred thousand dollars for whatever reason maybe maybe the car factory nearby has has gone out of business so in this situation what happens what is my new balance sheet well has my liabilities changed because my neighbor's house sold for less well no I still owe as far as the bank is concerned I still owe $750,000 to the bank I still owe 750 thousand this is a liability I still owe $750,000 this is assets of course so what's my left over what would be the leftover if I were to liquidate at the market price if I were to sell the house at the market price well I would have 50k left over so my essentially when the market price of my asset dropped all of that value came out of my equity right and this is I'll do actually a whole other video on on the benefits and the risks of leverage because that's very relevant to what's happening the world world today but I think you get a sense what's happening equity kind of takes all of the risk so in this situation this is why the bank wants you to put some down payment because the bank if you can't pay this loan right here they're going to take your house and even in the situation where the value of the house went down if you can't pay the loan the bank will still be able to get its 750k right if you just if you just leave town or lose your job and you just tell the bank I can't pay anymore they're just going to take this house sell it hopefully for 800 K because that's what your neighbor sold it for and they're going to get the money back for their loan so that's why the bank wants you to put some down payment and then there's the other situation which is maybe you know a more positive situation and this is what happened in much of a much of the world and especially in areas like California and and Florida and Nevada over the last five years or so and I'll do a whole video on why it happened but let's say your neighbor's house a year later didn't sell for $800,000 let's say the identical neighbor's house sold for 1.5 million dollars and you say gee whiz that's great now my house is also worth for 1.5 million because I'm marking to market so now my asset nothing has really changed it's still the same house but I guess in someone else sold it for 1.5 million I guess I could too so my asset is now 1.5 million dollar what are my liabilities will your liability still haven't changed I still owe I still owe $750,000 $750,000 to bank this is liabilities so what's left over what's my equity what's my equity well assets minus liabilities so I have seven hundred and fifty thousand dollars of equity that's awesome even though the house appreciated by 50 percent right it went from a million to one point five my equity grew 3 fold it it appreciated by it appreciated by 200% and this is I think you're starting to get the benefits of you know what happens when you do leverage leverage is when you use debt to buy an asset but when you use leverage your the value of your the return that you get on your asset gets multiplied when you go to the return on your equity hope I'm not confusing you but in this situation almost and I have a ton of equity and I'm running out of time but in the next video I'm going to talk about how this happened because you saw a lot of neighborhoods a lot of houses a lot of houses appreciated over the last from about 2001 to 2005 and people all of a sudden just sitting on their house ended up with a lot of equity and they felt that wow I just went from having 250,000 net wealth to 750,000 of wealth without doing anything just by my neighbor's house selling for more I'll see in the next video