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Bailout 6: Getting an equity infusion

The bank gets bailed out by an equity infusion from a sovereign wealth fund. Created by Sal Khan.

Video transcript

Welcome back. And I've made this balance sheet so messy I think it would make sense to redraw it cleaned up a little bit. So what's our new balance sheet, after we've unloaded a lot of those assets? All I have now, I have a little bit of cash, let me write that down, I had $1 billion of cash. I'll write the 'b' there so you know. And just so you know, a bank needs cash to operate. It can't just use all of its cash to pay off things. Because then it won't be able to even transact with its customers, or pay its rent, or send its executives on their Learjets, whatever it needs to do. But anyway, you have $1 billion of cash. So you might have been thinking, why not just use its cash to unload some of that debt? Well, you always have to keep some cash on line just to conduct business. And actually, that's called working capital. But anyway, back to the point of this video. So you have $1 billion in cash. And at least the management of this company thinks that it has $4 billion worth of residential CDOs. And this is the toxic stuff that's the focus of this government bailout, which is really historic in its proportions. And I'll talk more about that later. And on the liabilities side, what was left? I think I had called it Loan C. I'll write liabilities in red, just because they're bad. They're not bad, but they're something you owe, so they're not as pleasant. So Loan C, we said was $3 billion. And then what is the equity? I'll do that in yellow. So the total assets were $5 billion in assets. Total assets. You have $3 billion in liabilities. So if you believe what the accountants or the bank management has said about their assets, if you wanted to just liquidate everything. If you had $5 billion in assets, you liquidate them, got $5 billion, you paid off your $3 billion in loans, you'd be left with $2 billion. So that's the equity. And just as a reminder, how many shares where there? I think I originally set in the original video that we have 500 million shares. So each of those shares is one 500 millionth of this equity. So let's see, the book value per share is what? It's going to be the book value, $2 billion, divided by 500 million. So it's $4. Remember, it was $6 not too long ago. But we had to take those commercial mortgages that we thought were worth $10 billion, actually ended up being worth $9 billion. So we lost $1 billion of our book value. And $1 billion translates to $2 of the share price. Anyway, fair enough. And maybe at this point the market value of the share, so that's essentially the stock price if you were to look up this company's ticker price, let's say it's at $1. Because they're like, boy, after all this Bear Stearns and Lehman Brothers, this is all getting a little nerve racking. And they have this shady thing over here. So we have to be careful. So if the market value is $1, what are they saying about the assets? Or what are they saying about the equity? Well, what's the market cap? It's the share price times the number of shares. So they're saying essentially that the market cap, and that's equivalent to the market value of the equity, or what the market thinks the equity is worth, that's $1 times 500 million shares. So it's worth $500 million. Or $0.5 billion. So the market is actually saying, no, you don't have $2 billion of equity, you only have half a billion of equity. And it's probably because they think this is worth a billion and a half left. But anyway, we'll leave that aside for now. But now we're getting to the crux of the issue. Two of those other loans, they came due, no-one was willing to renew the loans, or give them new loans. So the company had to liquidate some of their assets in order to pay those loans down. Now, this is the endgame. We have Loan C. And let's say Loan C comes due. So they say, things are really shady, your assets they look very similar to Lehman Brothers and Bear Stearns, we're not going to renew your loan. You go out to the credit markets, you try to issue bonds, you try to do anything you can. No-one's willing to give you a loan, just because they're all a little bit scared. So what do you do? Well, you have to pay $3 billion of loans. You just have to. Because no-one's willing to give you $3 billion. Well you say, out of this cash I can't use all of it. If I just wanted to operate bare-bones, maybe I could give $0.5 billion in cash. But that's not going to help my situation at all. Because I still would have $2.5 billion left. So you're like, wow I'm in a situation where I have to sell these CDOs. So now, all my models and all my assumptions are going to see if they were even vaguely accurate. If these things are really worth $4 billion. So I go out there and I try to sell my CDOs. I try to sell them for whatever I can get for them, because I have to sell them. And one, there's no market for them. Because there's a lot of people who want to unload them, but there's not really anybody who's keen on buying it. So there there might not even be any market. But you're like, no I want to sell them. So you broadcast it out to every hedge fund and private equity fund and every bank out there. And you say, who wants to buy my CDOs? And some private equity firm comes and says, OK well, I think that those things are pretty toxic, but they're probably worth maybe something. I'm pretty optimistic about the real estate market. And maybe in 10 years they might come back. So I'm willing to give you $1 billion for those CDOs. So essentially, what's the market price of something? It's the best price that someone's willing to give you for something. So the market price of this, because you've shopped it around, you've gone to the market, you've gone to everyone you can, the market price for this is, essentially, the market is offering you $1 billion for this CDO. So what do you do? Well, if you sell it for $1 billion, does that help your situation? If you sell this for $1 billion, you get $1 billion here, you have $1 billion of cash, you have a total of $2 billion, that still won't pay your loan. You're still going to be bankrupt. And even more, the company management is very stubborn. They say, if I sell it I'm going to go bankrupt. And I think that that's some kind of fire sale price, quote-unquote. That's not the real price. All of a sudden for the first time in my career when I was getting $30 million a year bonuses, I heavily believed in the market. But now I'm in denial of the market. I say, the only reason why I'm only getting $1 billion for this is because everyone is afraid. And these things, if someone were to just hold them to maturity, if someone were to just hold these assets for the 30 years over which the underlying mortgages will just pay out, someone's going to collect roughly $4 billion. Or maybe at worst, $3.5 billion. So I'm not going to do this. But really, you have no choice. So what you try to do is you say, well can someone give me some type of a loan? Just lend me some money in the short term just so that I could get this paid off. And I'll be willing to give this as collateral. Collateral on a loan is you give me a loan, and you take this as collateral, and if I don't pay the loan, you just keep the asset. And that's essentially what the Fed was doing. The Fed traditionally only gives loans if you give something really nice as a collateral, like treasuries, essentially just treasuries. And they'll still take a little discount of your collateral. Like if you give the Federal Reserve $1 of treasuries, they might give you $0.80 of loans. But over this whole credit crunch, the Fed has gotten looser and looser in terms of what it's willing to accept as collateral. So actually, the Fed, I don't know the details of how toxic of an asset they were willing to take as collateral, but they started loosening it up to pretty toxic assets. So maybe you could get a loan. But let's just put that aside right now. But this is the situation we're facing. You have a bank, and it's essentially being forced, or it perceives it, forced into bankruptcy. Even though, it thinks that it has positive equity. So you could get a loan from the Fed or someone else if they're willing to take this kind of toxic stuff as collateral. Let's assume that they're not for now. The other option is you can recapitalize. You can get someone to invest in the firm. You can sell equity in the firm and get some more cash to pay off this loan. If you can convince someone that no, your firm is really in the future going to be worth a lot more. This is just a stressful situation. So you go to some sovereign wealth fund, and that's just a way of saying some foreign government that's been collecting dollars because they've been selling us oil or cheap manufactured goods. So you go those and say, look, we are Goldman Brothers or we're Lehman Sachs. We are this great brand in the banking industry, wouldn't you like to have a piece of this thing that represents American capitalism? And they say sure, we'll be interested in investing. So they say, well the market price is $1 and I think that's probably a little distressed, so we'll be willing to pay $1.50 per share. And we'll buy, how much do you need? We'll buy 2 billion shares at $1.50 per share. So what happens? So let's say the sovereign wealth fund, they're going to buy 2 billion shares at $1.50 per share. So now what does the balance sheet look like? So 2 billion, $1.50 per share, that is equal to $3 billion. So now you get $3 billion more in cash, so this becomes $4 billion. But you can't get something for free, so what happened? Are our liabilities increasing? Well no, our liabilities didn't increase. They didn't give us a loan. They invested in us. They essentially bought shares of the company. They bought 2 billion shares. So how does that get accounted for? Well instead of our share account being 500 million shares, this is how many shares we had before, the company essentially created 2 billion new shares. So now the company has 2.5 billion shares. And it's something interesting here. What is the new book value of the shares? So what are our total assets? $4 billion plus $4 billion, it's $8 billion of assets. Our liabilities are still $3 billion. Now the the value of our share after the investment, and you can kind of call this the post money valuation or book value, is $5 billion. $8 billion minus $3 billion. And now what's the book value of our shares? $5 billion divided by $2.5 billion, it's $2 per share. And that's interesting. It's someplace in between our old book value and the price that the company paid, or the sovereign wealth fund paid, $1.50 per share. But anyway, I just realized I'm out of time again, I'll continue this in the next video.