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Bailout 7: Bank goes into bankruptcy

What happens when there is no equity infusion and the bank goes in to bankruptcy. Created by Sal Khan.

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  • blobby green style avatar for user lorliche
    So, what does Sal say at ? Is that "Lehman Brothers assets might be greater than its liabilities, which means that its equity is actually worse negative...?" Did I misheard it or does it mean something different?
    (19 votes)
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  • leaf green style avatar for user bbmhmmad
    Could someone please explain how the original shareholders' shares became worthless? Is it because it became a new corporate entity? Thanks.
    (5 votes)
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    • blobby green style avatar for user cmiddleman8
      When a company goes into bankruptcy the bond holders (owners of "loan C") have seniority (priority) to the equity holders (share holders) of the company. Since the liquified assets aren't enough to cover even all of loan C, it means that all of the equity holders get nothing because they were lower on the priority list. Now that the company has no more liability it has 2B in both assets and equity that belongs to the former owners of loan C who now have become the equity holders. The former owners of loan C could have decided to liquify the $2B and walk away, but since they think "Goldman Brothers" will bounce back they reinvest the $2B into the company, and are therefore the owners of the new equity and stock. I know it's a bit confusing, but he covers this in some of the earlier videos in the finance section although I don't remember specifically which one.
      (32 votes)
  • blobby green style avatar for user Julian
    This is a simple question, but how does bank just conjure up new shares? Wouldn't the original investors lose because they once had 1/500million of the bank but now they only have 1/2.5 billion of the bank?
    (4 votes)
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    • leaf green style avatar for user Rocky
      Hi, Julian. What happens to the original investors is known as 'dilution'. Essentially your question describes what happens to them - they go from owning 1/500 millionth of the company to owning 1/2.5 billionth of the company. The original investors, however, may actually be in a better position after the dilution than they were before if the new investment improves the company balance sheet (as was the case in Sals' example). Nonetheless, the process for issuing new shares for a public company is regulated by the Securities and Exchange Commission and is more common than you might think - especially in times of financial stress. Often times warrants or options are issued in lieu of actual shares which bequeath to the owner a right to purchase additional shares at a given price at a later date or within a window of time. Warren Buffett's $5B investment in Goldman-Sachs in 2009 included warrants such as I described.
      (5 votes)
  • spunky sam blue style avatar for user Hur Ozan Cerrahoglu
    Company just issued shares to bail out. To me basically they just did this out of thin air. Isn't this action similar to central bank's money printing attitude whenever they need to regulate the interest rates?
    (2 votes)
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  • mr pink red style avatar for user limfxoo
    Why should a company take the market value of Bank A as a reference point to take over it? Are there any other ways to value Bank A?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      Because the market value gives you a good indication of the price you will have to pay. There is also a lot of evidence to suggest that the market value is usually a better indicator of the "correct" value (if there is such a thing) than values that are calculated by other means. This makes sense since the market participants all have those other means at their disposal to help them make decisions about how much the company is worth, and they also have their own information, which then gets incorporated into the market price as buyers buy and sellers sell.

      Valuation is a complex art more than it is a science. Financial theory tells us that the value today should be equal to the present value of all the future cash flows of the company. The problem of course is that we do not know what the future cash flows will be. We also don't know what the proper discount rate is to attach to those future cash flows. Investors do their best to make judgments about these things, and they also use shortcuts and rules of thumb as substitutes for actual long term financial forecasts.
      (3 votes)
  • blobby green style avatar for user LG.gigun
    When he mentions liquidating the CDOs because everybody agrees they're really shady at 7.00, how do you get rid of them and sell them, if no one's buying?
    (2 votes)
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    • male robot hal style avatar for user Damian Roy
      At a low enough price there will almost always be a willing buyer of these securities. In this example, Sal states that as part of the liquidation, the court is able to sell the CDO's for $1Bn. This is only 25% of what the bank stated they were worth. The bank was unwilling to do so before, because management had no incentive to do so (it would have meant the firm was bankrupt.) As such, it took the courts to intervene to force a sale.
      The alternative is that the lenders (owners of Loan C) can accept the CDO's at a lower price (say the $1BN) and the cash of the balance sheet as payment for their conversion to equity holders of the new bank. In this situation, as in the previous one, the old shareholders are totally wiped out.

      Hope this helps.
      (2 votes)
  • duskpin sapling style avatar for user Hayden
    Why did the Sovereign Wealth Fund willingly pay above the market price for the shares of this bank?
    (2 votes)
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    • leaf green style avatar for user macgregor.d
      The intricacies of the deal itself determine what will be payed per share. Often there are stipulations which the buyer demands as part of the purchase deal. The buyer can then benefit when (if) they are successful at returning their acquisition to profitability. Swaps of cash for debt or restricted class shares are two examples.
      (2 votes)
  • duskpin ultimate style avatar for user tuannb1997
    When members of Loan C (let's call them that way for the sake of simplicity) literally take over the company, thus creating a whole new entity, where does the $3B go ? I mean, $2B is only the liquid cash the company can squeeze out of all of their remaining assets, right ?
    (2 votes)
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    • male robot donald style avatar for user geegeeler
      There was only $2B of cash on the asset side & that wasn't enough for creditors of Loan C to make them whole ($3B), so they (Loan C) decide to restructure this corporation and settle for the 100% ownership of the post-bankruptcy shares in hopes that it bounces back in the future and make them money.
      (2 votes)
  • male robot hal style avatar for user Aditya Joshi
    What is a premium? Why would anyone want to pay more for a share? Isn't it better for the SWF to buy shares for less price per share?
    (2 votes)
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  • aqualine seed style avatar for user K B
    Would it not be injustice to original 500M shareholders by issuing 2.5B new shares? As their per share value would come down.
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      It depends on what price is received for the new shares. The bank was already on the verge of bankruptcy. That means the original shareholders were going to be wiped out. Instead they are only almost wiped out. A tiny percentage of something is worth more than 100% of nothing. Shareholders get hurt badly when companies get themselves into financial distress. If they don't want that to happen, they should be sure to elect a board of directors that chooses a good management team.

      Since, in practice, shareholders don't really get to choose their board of directors, what this really means is that before you buy a stock you better understand the risks involved. Few people really do, which is why individual investors should not screw around with individual stocks but should instead invest in highly diversified, low cost mutual funds or ETFs.
      (0 votes)

Video transcript

So the example of the bank we've been studying, we're actually kind of doing it in real time. And I was doing this on the fly. We actually showed how this bank got quote-unquote bailed out. And it got bailed out by the sovereign wealth fund. Because when this last piece of debt came due, it couldn't sell its CDOs for enough money to pay off that debt. So they just kind of held fast and didn't sell their CDOs. They couldn't get any other loans to pay off this loan. But what they were able to do is to convince some foreigners who were enamored by the brand of this institution of American capitalism. So they were willing to buy some shares in this company and essentially bail it out. So in the example, we used to have 500 million shares. The company issued another 2 billion shares. Sold them at $1.50 per share. And they got $3 billion for it. And so then you had $3 billion in cash. We had $1 billion before, so now we had $4 billion. We could pay off the loan with $3 billion of the cash and then we're left with $1 billion. And now this company would have, if you have $1 billion in cash and $4 billion of CDOs, it would think that it has $5 billion of assets. If these are really worth $4 billion. It has no liabilities, so it has $5 billion of equity. Notice the equity doesn't change. When you take some of your assets and you get the value of the assets that you think they're worth and you pay off some liabilities, it doesn't change the value of your equity. But what's happened now? This is just to get comfortable with some of this terminology. This company now is completely delevered. Because it has no liabilities, it has no debt, and its assets are equal to its equity. And you'll find that lot of companies that are startups and technology companies, a lot of those have very little debt. And so they're completely delevered. Anyway, that was just an aside. But this was an example of how a company could get bailed out. And who lost here? Well the shareholders lost. Because before, there was only 500 million shares that split up the equity. And now there's 2.5 billion shares to split this equity. So the book value of the shares, if you eve believe that these are really worth $4 billion, they went from $4 to $2. And I think this is an important aside here. Because I've mentioned before that the market price when you buy or sell a share, it's just transacting between another person who used to be holding that share. So how does it affect the company? Well it affects the company when the company needs to raise more money. And that's what happened in this example. The company had to raise more money. It had to go to, maybe it was the government of Singapore's sovereign wealth fund. And they say, government of Singapore, please invest in us, buy some of our shares. And when the government of Singapore, or any investor, wants to buy new shares, they use the market value, what that stock is trading at, as a good reference point for what you might have to pay for those shares. Oftentimes if it's kind of a desperate situation and this person is kind of saving you, they'll pay below the market price. But sometimes, if they say, oh, this is a lucky opportunity to get such a large number of shares and essentially take control of the company, I might be a little premium over it. So I'll pay $2 per share, which is a little bit of premium over the market value at the time, which was $1. But anyway, that's why the market price of something in the secondary markets, where a share is just trading between people who aren't related to the company, why that's important. Because when the company needs to raise money, that is used as kind of the fair market value of a company's shares. But anyway, this was the situation where the company gets bailed out. But what happens in a situation where it doesn't get bailed out? Let's do that. Let's say that the sovereign wealth fund never happened. Let me clear this. So the assets, we had $1 billion in cash. And we have these $4 billion of CDOs. For a total of $5 billion. The liabilities, we had Loan C, it's coming due for $3 billion. And then you had the equity, which is essentially the total assets minus the liability. So that's $2 billion. And that's split amongst 500 million shares. And that tells you that the book value per share is $4. We're not going to worry right now what the market value of the shares are. So let's say they shop everything around. All of these sovereign wealth funds, they've got burned, because they invested in Citibank last year and the stock just continued to plummet. They invested in Merrill Lynch, all of these they invested in and it just continued to plummet. So they've been burned. They don't want to be the last guy holding the potato. So there's no-one who's willing to invest equity. So it just forces the issue. These people, Loan C, they say, we're not going to give you a new loan, you can't pay this loan, because even if you sold these CDOs, you're only getting a $1 for them. So we are going to force you into bankruptcy. And that's how bankruptcy happens. When you break one of the-- they call it the covenants-- with one of the people who lent you money. The covenants say, if you don't pay a loan within this amount of time or some other thing happens to your financials, you are then declared insolvent and you go into bankruptcy. And what happens in bankruptcy? Well, in bankruptcy, the bankruptcy courts takes receivership of all of your assets. They just say, OK this is what you own. And we're not going to go into the details now. Maybe I'll do a whole series of videos on the details of bankruptcy. You might get some type of loan that helps you just continue to do business. Because people have to figure out, are they just going to restructure your liabilities? Or are they just going to dissolve you? Because you're not a viable entity anymore. But anyway, the bankruptcy court will take hold of you. And let's assume that they're going to dissolve you. They will then split you amongst the stakeholders, the people who you owe money to. Actually, let's not say that they dissolve you. Let's say that everyone agrees that this brand is worth a lot. Whatever we call it, Goldman Lynch or Lehman Sachs. Whatever our brand is, it's worth a lot. No-one wants to see it disappear. So what happens when you go into bankruptcy? Well, the creditors get first dibs on everything. So one way to think of it is Loan C gets first dibs on the assets. And then anything that's left over goes to the equity holders. So let's say the Loan C guys, they say we want to keep this bank as an ongoing entity. But what we want to do is we just want to dump these CDOs. So the bankruptcy court, OK we'll liquidate these CDOs just because everyone agrees that they're really shady. So they sell them and they only get $1 billion for them. So now we have $2 billion of assets. It's essentially $2 billion in cash. That's all that there is. Plus there's probably some buildings in all that. Which we're not listing here. But there's the brand and all that. So this guy is owed $3 billion. So he says, OK fine, you know what I'm going to do? I'm going to keep this company running. I'm owed $2 billion. I'm going to keep that $2 billion in there. But what I get is essentially all of the new shares of the company. So what essentially the bankruptcy court is going to do, they're going to create a new corporate entity. They're going to put all of these assets into it. And then issue another 100 million shares. So they essentially create a new entity, where the new entity has $2 billion of assets, $2 billion of cash. And let's say it has no debt. Or actually maybe these people, they say we'll even give you some money-- no, I don't want to confuse things. So let's say that you have no debt. So you have $2 billion of equity. And let's say that there are 100 million shares. So the book value of the new shares is $20 per share. And you might say, wow that's great. Someone could have gotten these shares for whatever I said they were trading for before. They could've gotten them for $1 per share before, now they are worth $20 per share. But no, that's not the case. It's actually horrible. These shares, the shares of the old company are worth zero. Because when you liquidated the company, or at least when you tried to value the company, we didn't liquidate it. Because we're saying we still want the company to continue its operations. But we're saying that the value of the company is only $2 billion. This guy is owed $3 billion. So he says, you know what? I should get the whole company. And I'm still getting not everything that I deserve. But I'm going to get the whole company. So essentially, whoever lent Loan C, all of these shares are now their shares. And the equity holders get wiped out, the old equity holders. So those shares go to zero. So this is an interesting example, because I've seen people on CNBC say, oh what a great deal, I could buy shares of Lehman Brothers for $1. But that's not the case. They'll say Lehman Brothers has all of these assets and it's never going to completely disappear. That might be true to some degree. But Lehman Brothers' assets might be greater than its liabilities, which means that its equity is actually worth negative. So that $1 isn't a great deal. If you really thought that Lehman Brothers in the long term was going to come back, what you might want to do is somehow try to become one of its bondholders. And then when it goes through bankruptcy, on the other side of the bankruptcy you might end up in shares of the new bank, whatever it's called. Goldman Brothers or whatever. Anyway, I realize I'm out of time. In the next video I'm going to put it all together and show you, one, why our financial system is freezing. And, two, what the government's bailout is attempting to do. See you in the next video.