Bailout 2: Book value

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 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. I'm just going to make up some things. Let's say that it has $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 $10 billion in AAA corporate bonds. So you know these are loans to really solvent or very creditworthy companies. Companies that have really good cash flows. There's very little chance of them defaulting on their loans. And what is a bond? A bond is just a loan to another entity. If you loan me money, I could give you an IOU saying that Sal owes you $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, wherever these bonds are issued by, they owe me collectively $10 billion 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 $10 billion of commercial mortgages. So this is, essentially, I lend 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, and I'm not being comprehensive here, I'm going to throw in the crux of the issue here. 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 is 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. 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. 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 be able to statistically give it properties. Because if you lend to any one person, that's hard to trade. 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 in aggregate, you could say 8% of people 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, 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 and 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. So any payments immediately go to this very senior tranche. 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. 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. 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 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 obligation 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. 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. Well let's just say it has a bunch of loans. So let's say it has loan A for $10 billion. 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 back. 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, it's another $10 billion. And let's say it has loan C. Loan C is, just to make it interesting, 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, it's a publicly traded company, what is its shareholders' equity? Let's figure it out. Well, its assets are $21, $25, $26 billion in assets. 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. Actually, let's just write it out. Let's call this Yachovia Bank. Actually, I shouldn't, that's too close. Let's call this Bank A. And let's say that Bank A has, let me make up something, let's say that it has 500 million shares. 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 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.