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Current time:0:00Total duration:10:52

Video transcript

in the last video I just discussed a personal balance sheet and what liquidity 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 gonna you know go into the details but I'm gonna give you the big picture and I think that's that's essentially what what matters so essentially these banks they have a bunch of assets and I'm gonna 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 and what regulation means and what leverage means and all of 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 gonna make up some things let's say that it has I don't know 1 billion 1 billion in government bonds US government bonds I'm just throwing that in there just as kind of filler just to show you that there could be a lot of different types of assets in there let's say that they it has another I don't know 10 billion in triple a corporate bonds so you know these are these are loans to really solvent or really high credit were very credit worthy companies so triple-a corporate bonds so companies that have really good cash flows there's very little chance of them defaulting on their on their on their loans so and what is a bond well a bond is just a loan to another entity right if if if if you loaned me money I could give you an IOU right saying that Sal owes you whatever $10 and that I owe you you could call that a Sal bond so you know 1 billion dollars of government bonds that's an asset that says the government owes me a billion dollars and in the meantime is going to pay me interest similarly corporate bonds that's saying that you know 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 interest payments Plus eventually they're going to pay you the ten billion dollars back or maybe there's something less than that so the 10 billion is the interest payments plus what they're gonna pay you back which might be I don't know nine point nine billion I'm making up numbers but that's not the issue here what's the the crux of the issue is that there's this stinky acid here I actually let me let me let me let me draw a couple more assets here just to show you that this is the stinkiest of them all so let's say I have another another group of assets I don't know let's say it's um let's say it's I would say I have a ten billion dollars of commercial mortgages commercial mortgages so this is essentially I lend money to companies to you know 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 alone to someone else and alone to someone else that I've given it as an asset because they owe me interest and eventually they're gonna have to pay the money back to me and then finally I'm going to throw and I'm not being comprehensive here I'm gonna throw the the crux of the issue here let's say that I have to but let me see I have twenty one right now let me just make it an even number let's say that I have four billion dollars so it all adds up to twenty five I have four billion dollars in residential CDOs collateralized debt obligations residential CDOs and I've done a video on CEOs but but just to kind of have a review see CDOs are a derivative instrument and I know that sounds complicated but that just means that derive from another instrument which probably you know that's that's a sign that the stink is starting to emerge from from 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 the mortgage-backed security is is a loan to a ton a big group of people and you put them all together so that you can kind of you know be able to 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 you can it starts to become something that you could trade with other people because they can understand it and you know in aggregate you can say oh eight percent of the people are gonna default and all of that but anyway that 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 that their loans to some people in some region of the country or maybe they're diversify it across regions and 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 and the other videos right 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 tranches sometimes called the equity tranche this tranche they're gonna get whatever is left over so if everyone pays they get made whole but if a lot of people default all the defaults are gonna hit this tranche right and to kind of make up the fact that this is the riskiest tranche or essentially these people are ticking on all of the risk and or essentially these tranches are giving all the risk to this tranche and a tranche is just a layer it's just a slice okay 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 you know while this person might be getting 6% this person might be getting 7% on their money maybe this person gets 12% on their money and this is another interesting thing because this person is the most secure the ratings agency which I'll probably do a whole nother series of videos on they might give it it like I don't know a triple-a rating and maybe they give this tranche and I'm making up things but maybe they gave it a double-a rating but this equity tranche it'll get a junky rating and because it's a junky rating no one is gonna want to buy it so the person who constructed this whole collateralized debt obligation and who were 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 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 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 triple A's these they might be some of them but just for the sake of argument let's say that these are junky ones or smelly smelly so anyway that's my example Bank asset the asset side of its balance sheet let's let's think about its liabilities so liabilities liabilities well let's just say it has a bunch of loans right so let's say it has loan a loan a for I don't know ten billion dollars let me let me throw 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 it's their money right immediately but that's in the context of a commercial bank but anyway let's say it has some cash just for immediate liquidity needs so and the liability side has loan a and own someone you know someone ten billion dollars it has loan B I don't know let's say it's another ten billion dollars and let's say it has loan C loans C is just to make it interesting loan C is let's say it's four three billion dollars so in this example right now if we assume that all of these asset values are correct and all of these liability values are correct what R's this bank's equity and in this case it's a publicly traded company what is its shareholders equity let's figure it out its equity well it's assets r1 plus let's see 21 25 26 billion in assets all right and it's 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 let's actually let's just write it out let's say that this company has you know let's call this I don't know Yakko via bank no I shouldn't that's too close let's just call this bank a right 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 you went to 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 three billion dollars of equity based on the balance sheet and that's why they call it book equity because the balance sheet it's often called up the company's books so this is three billion dollars of equity divided by the number of shares so each share should be worthless III billion divided by 500 million it should be $6 of book equity book equity equity per share and that's something important to realize because a lot of people think that you know if a stock price goes to zero that you know 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 gonna continue this in the next video and we'll explore this a little bit more see you soon