Bailout 4: Mark-to-model vs. mark-to-market

So in the last couple of videos we've been looking at the balance sheet of what I called Bank A. And we said it has these assets. And the asset in particular we're going to focus on is this $4 billion in residential CDOs right here. But anyway, its total assets were $26 billion, at least it's telling us that its total assets are $26 billion according to its accounting on its balance sheet. Its liabilities are $23 billion. And so if you just subtract the $23 from the $26 billion, you get a book value of its equity. If you believe all of the numbers on the company's balance sheet, the company is worth $3 billion. That's what the shareholders own. They own this equity stake. And if there are 500 million shares, that's $6.00 for each of those shares. And in the last video we talked about if the market is actually trading at $12.00 a share, if people exchanging those shares between themselves. Remember, the secondary market, the stock market, most of that is between two people who are unrelated to the company, trading the shares of stock. It's not a transaction with the company. There are transactions every now and then with the company, and that's why the stock price is important. But for the most part what you see every day when you get a quote is just the transaction between two unaffiliated parties. It could be between me and you. I have my E-Trade account, you have your Charles Schwab account, we just traded the stock. For that second, we set the price for whatever, the value of bank A. So I said if the value the market is placing on a share is $12.00 per share, that's a $6 billion market cap. The market, at least for that moment, or at least the person who just transacted or just traded those shares, is saying that, no I don't think that this company only has $3 billion of equity, it actually has $6 billion of equity. And it might be because they have some kind of great brand, the equivalent of charisma and good looks, that can't be quantified on a balance sheet. Or maybe one of these assets are worth more. Maybe they've appreciated since the the last time to the bank wrote down their balance sheet. Or the last time that the bank kind of a evaluated the asset's worth. And then we had another situation. And this is very relevant to what's going on in the world today. Well what happens if the market price is below the book price? So, that was the case where the stock is trading at $3.00 per share. And $3.00 per share times half a billion shares, that's a $1.5 billion dollar market value of its equity. I think that's what I wanted a write here, market value of equity. And what is the market then saying? Or at least the person who's buying or selling the share right at that moment, what are they saying? Well they're saying that, OK Bank A, that's nice, you say that your assets minus your liabilities are worth $3 billion, but I don't think that's true. I think your assets minus your liabilities are $1.5 billion. And let's say, we can't read anyone's brain, we don't know why they think that. Maybe they think there are fewer assets. Maybe they think there are more liabilities. But let's say that we do read someone's brain. They're like you know where I think you're doing a little bit of shadiness? I think you're doing it on this line right here. I don't think that thing is worth $4 billion. I think that thing is worth $2.5 billion. And if this is worth $2.5 billion, then your total assets are what? There are a billion and a half left. And so your assets are $24.5 billion. I know this is a little bit messy. But if the market is saying that this is a $3.00 stock, $3.00 per share, then that says your market value is $1.5 billion. And we don't know why the market is saying that. They're saying that because they think that this thing is not worth $4 billion. They think it is worth $2.5 billion. So they think it's worth a billion and a half less. If this soon. is worth $2.5 billion, then all of this will add up to, if I did my math right, $24.5 billion, minus $23 billion. And then, that gets you to the market value the equity. So let's call that market equity. The market value equity of $1.5 billion. So this raises a very interesting question. How do people decide, or how do especially the banks themselves, decide what some of these assets are worth? And in particular, these CDOs. Well there's a couple of ways to do it. And there are all kinds of different schools of economic philosophy. You could put here what you paid for it. Maybe the bank originally paid $4 billion back when real estate could only go up, or so people thought. And all of these CDOs looked like these great high yielding instruments. Based on those assumptions, the bank says, I'll pay $4 billion for it. They put on the books for $4 billion and they never kind of reassessed it. So they just put the $4 billion at cost. And then people would have every right to question that number. And they'll be like, well that doesn't make sense. Since then, we know that housing prices can go down. We know that especially since this was the riskiest slice of the CDOs that these could be completely wiped out, even if we only have a small number of defaults on mortgages. And we know that you as the CFO or the CEO of your bank have every incentive to not write the real value here because you want to prop up the stock because you have a lot of options in the company. And you are evaluated on the stock price. But anyway, maybe I'll make another video on incentives. So that's one way. My phone is ringing. I'll answer it later. I'm too worked up to answer the phone right now. I need to channel this energy into this. But anyway, so that's one way of saying it, the cost basis. And now I'm going to introduce some words that you might have heard on the news. I was going to say mark-to-model and then my brain was going to say mark-to-market. Mark-to-model. So what this says is I'm going to mark these assets, I'm going to value these assets, based on a model that I have. I hired a bunch of PhDs from the best schools in the country. These are rocket scientists and some of them actually are. They can put the man on the moon. And they're going to make fancy computer models with some assumptions. And those are going to spit out what these things are worth. So they're going to model the behavior, how many of these mortgages are going to default, all of that. And those numbers spit out a number and maybe they say that they're worth $3 billion. And if that happened at any period, the company would actually have to restate this. They would actually have to say, oh this wasn't $4 billion, we're going to have to restate that. We're going to take a write down. And you've heard this a lot when banks report their earnings. We took a write down. We thought we had a $4 billion asset. Maybe that's what we paid for it originally. We re-ran our model based on new assumptions, so were marking to model, now we have a $3 billion asset according to our new assumptions in our model. So we are doing a $1 billion write off. To go from $4 billion, what we originally had on the books, maybe that was our old assumptions in our model, to our new model. And immediately, you should be suspicious of that. Because once again, you're being dependent on the banks to report on themselves. Sure, these might be well intentioned. But at the end of the day, this value is being set by a model where the assumptions into that model, and frankly I don't care how fancy your model is, and how many PhDs the people who made the model have. At the end of the day, you can always rig this number based on the assumptions you make. And frankly, the market has no transparency you as far as what assumptions you did make. So it's very hard to believe. But it's probably a better guess than the $4 billion. Especially, when they're taking it down. And I'll do a whole video on this later on, you also have to question why they keep taking write downs. Why their models keep having to make more pessimistic scenarios. Maybe they're just buying time. Maybe the first time they run their model, they actually say it's worth zero. In which case they have zero equity. Because if this is worth zero, they only have $22 billion in assets and $23 billion in liabilities, which means they have negative assets. Which means that they are insolvent. Which means that they should go bankrupt. But they don't want to do that. They don't want to be responsible for running the company into the ground. So they don't want to admit all at once that these are worth zero. Maybe they'll admit it's worth not four, it's worth three. But then they'll go to the market and they'll try to raise more money. And I'll explain that in a little bit. Because I know that can get very complicated. So this is mark-to-model. You've heard a lot about it. It's not a fancy concept. The models might be fancy. But it's just like, I'm going to make my own assumptions to figure out what they're worth. And as you can imagine, they aren't the most credible assumptions of the value of this. The other idea is mark-to-market. And this essentially says, well if this is an instrument that is traded in some market. Let's say that these CDOs, and at least they used to be, let's say that they are traded in some market. That you actually assigned the market price. So maybe I have a a billion of these CDOs. And the market price of those CDOs is a $1.50 per CDO. I'm just making up numbers. In which case, the market value of them would be a billion and a half. So if you did mark-to-market, you would have to make this into a billion and a half. Then you would have to do another write down. Now, why does doesn't everyone do that? I actually think that's a very good question. I'll tell you why the banks don't want to do that. Well first of all, some of these markets, since no one wants to buy these things, because maybe they think they're actually worth zero, the markets have disappeared. And the few people that are selling them, they're usually selling them when they are distressed in some way. So it's a quote unquote fire sale. So people are arguing that the market price is not reflective of the true value of these securities. They're arguing that the few people who transacted did it out of desperation. So that $1.5 billion value of these CDOs, the market value of these CDOs, is not truly accurate. So these companies are saying, no I cannot admit what the market, what capitalism, is telling me what the price is. Even though these people are the same people who've been for the last 30 years saying let the market determine everything. I make $20 million a year because I'm a capitalist and because I have taken risk. And that I deserve that money. And these are the same people now, they're very adamant, that says, oh don't believe the market price. Because the market is wrong now. Our PhDs are correct. And if you think about it, it's a very communist way of thinking. Because in communist governments, they didn't believe in markets, they believed in hiring the smartest people that they could find, i.e. the PhDs of their relative countries, to essentially engineer their markets to determine what things are worth. Without letting the market set the price. Anyway, I'm not going to vent on. That is supposed to instruct you. As opposed to make you angry. Although I think just by learning about this, you might get angry. But anyway, that's what mark-to-market means. And I just realized I'm out of time again because of my rant. So I will see you in the next video. And we'll continue to learn the nuance of everything that's going on. See