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Bailout 1: Liquidity vs. solvency

Review of balance sheets. Difference between illiquidity and insolvency. Created by Sal Khan.

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Video transcript

In the next series of videos, I'm going to give my best attempt at trying to get a handle on the bailout and the financial crisis. So I'm going to try to explain different concepts in more than one way. Then I think hopefully it'll all sink in. But the big picture really is that there's a lot of fancy terminology being thrown around, but the underlying concepts really aren't that fancy. So I think a good place to start is just with the idea of the balance sheet. And you could watch some of the videos that I did before the whole financial mess on the balance sheet and that'll give you good primer, but it doesn't hurt to review it here. So a balance sheet is just a snapshot of what you have and what you owe and the difference between, and the difference between is kind of like your wealth. So if I just had a personal balance sheet, I could write my assets. They mean what you think they mean. These are things that will give you future benefit. So let's say I have $1,000 cash. Let's say I have a $100,000 house. Let's say I have a $10,000 car. And let's say everything else, I'll call it other, my furniture, my TV and everything else, is another $5,000. So those would be my assets. And so what are my total assets? It's $101,000, $111,000, $116,000. Well, it would be great if we lived in a world of only assets. But, unfortunately, let's say that I had liabilities as well. So liabilities. And a liability is what you think it means. It means something that you have to give future economic benefit for. You're kind of on the hook for something. And so let's say, my liabilities, I have a $20,000 student loan. And let's say on that house, unfortunately, I don't own it outright. Let's say that I have an $80,000 mortgage on that house, so essentially I borrowed $80,000 from the bank. And let's throw some credit card debt in there. Just to make this realistic relative to I think a lot of households out there, let's say that there's $5,000 of credit card debt, although for most households right now, this house is a lot more and this mortgage is a lot more. But anyway, I won't make social commentary. This is just to explain what a balance sheet is. So what is left over for me? What is my assets minus my liability? Let's calculate our total liabilities. So this is total assets. I'll use an A colon. So what are my total liabilities? 20 plus 80 plus 5, so it's $105,000. $105,000 total liabilities. So the difference between these two, my assets minus my liabilities, this is essentially my net worth. If I just liquidated everything tomorrow, if I sold all of this and paid off all this, this is what I would be left standing with. That's my net worth. Or you could view that as that is my equity. You often hear equity in the context of a house. In the context of a house, it's just the asset of the house minus the liability, but I'm talking about in the context of my personal balance sheet, not that these are the actual numbers. I don't want to give away too much about my life just yet. But anyway, so what is that number here? So my equity, and I'll do that in green since if it's positive it's a good number. My equity is $116,000 minus is $105,000. So what is that? That's $11,000. That's my equity. So there's a couple of things to think about here. You'll meet people with a $100,000 house or a $1 million house, and they say, oh, I am worth $1 million. And you're like, well, you're not really worth $1 million unless you own that house outright and you could actually sell that house for $1 million. It's not what you paid for it. It's what the market is willing to give for it. But your real net worth is your assets minus all of your liabilities. So in this case, your net worth is actually $11,000, not $116,000. And this is another important thing to think about. Assets are always equal to liabilities plus equity. That just comes out of the definition of what equity is. Equity was assets minus liabilities. If you take an MBA, they'll write it down, and it looks like an equation, but it's assets is equal to liabilities plus equity. But that's almost by definition that that's going to be true. So what can we do with this? How does this help us? Well, there's a couple of ways that we can think about this. First of all, what happens if my liabilities are larger than my assets? So if I owe the world more than the world owes me? Well, then this number is going to be negative. And if this number is negative, then there's no really good reason for me, maybe to preserve my credit score, but other than that, if we take that out of the equation, there's no good reason for me to continue living this existence. If my liabilities are greater than my assets, let's think about that situation. Let's say that my house is only worth $100,000, but for whatever reason, I owe $120,000 to the bank. Let's say maybe I originally bought the house with a no-money down payment for $120,000. And now I'm honest with myself. I'm like the value has gone down. It's only worth $100,000 now. So I'm in the situation where you could say I'm upside down in my mortgage. Well, one, you could say there's no incentive for me to continue paying this house. An even bigger picture, if I now look at my balance sheet, what are my liabilities now? My liabilities would be $145,000. And my equity would be my assets minus my liabilities. So $116,000 minus $45,000, what is that? Minus $29,000. I'll do that in red. That's a bad number for your equity. So in this situation, there's really no reason for me to continue living like the way I am, at least financially. As long as you're breathing, there's no reason not to continue breathing. But you wouldn't want to live like this financially anymore, so there's no reason not to go seek bankruptcy protection. And bankruptcy protection is admitting I am insolvent, which means that there's no way that I'm going to be able to unwind all of my liabilities. Courts protect me. My lenders can't come back after me. Everything is going to be erased. They're going to take all my assets, all my liabilities, and they're essentially going to take these and divide them up amongst the people that I owe stuff to. So that's bankruptcy. That's insolvency. And I want to highlight the word insolvency because that's a word that we're going touch on when we actually talk about the credit crisis. And that is opposed illiquidity. So what is illiquidity? So insolvency means there's no reason for you to continue with this type of a financial situation. You're bankrupt. You go get bankruptcy protection. That's insolvency. Illiquidity is a different situation. Illiquidity says no, I actually do have positive equity. So let me go back to the original circumstance. It really was I only owe $80,000 on the house, so my liabilities really are only $105,000. So I really do have a positive equity of $11,000. So this isn't insolvency anymore. So I'm going to describe what illiquidity means to you. Or to me, in this case, because this is my balance sheet. So let's say that my wife comes to me and says we need to pay our child's tuition. It is $5,000 for the upcoming year. I need to pay $5,000 in tuition. Actually, let me take a better situation because if I'm talking about tuition, it should have shown up on liabilities. Let's say that I have to make a $5,000 payment on my student loan. So I have some kind of weird student loan, where $5,000 comes due all of a sudden. So I have to make a $5,000 payment on the student loan. Let me do that in red. Make $5,000 payment. And it could be for anything, but let's say it's to satisfy part of one of these liabilities. So if you look at my equity, if you look at my assets minus my liabilities, I clearly have $11,000. I'm worth $11,000. And if I could liquidate all my assets and all my liabilities overnight, I would have $11,000 in cash, and then I could pay that $5,000. In fact, in the process of doing it, I would have paid that $5,000. But in this circumstance, if I just look at my situation, let's say that student loan payment is due tomorrow. I only have $1,000 of cash. I only have $1,000 maybe sitting in my checking account. So I can't make that $5,000 payment just with my cash. And then I look at everything else, and I'm like, boy, can unload any of these assets overnight? Well, a house, absolutely not. There's no way I'm going to be able to unload my house tomorrow. Maybe I could find someone who would buy it for $50,000 tomorrow, but that wouldn't help my situation. Then my equity would go negative again. So that won't help. I can't sell my car overnight. Maybe I could sell it at a super low price for $4,000, just to kind of make this payment, but I don't want to do that either. And same thing, your furniture, you'd have to go on Craigslist and take pictures of it. You couldn't do it. So this is a situation where you are having a liquidity crisis. You are illiquid, but you're not insolvent. You have a positive net worth, assuming that you're not lying about what's going on in your balance sheet. And that's another issue. So how do you get past a liquidity crisis like this? Well, someone has to give you-- we could call it a bridge loan because they're giving you a financial bridge from here to where you need to go. Or they're giving you a bridge that essentially buys you time. Let's say your dad says, OK, Sal, or my dad, I guess, I'll give you a $5,000 loan for the next two months. And over the next two months, I expect you to find some other source of cash. Maybe sell your car, buy a cheaper car, sell some of your furniture or something. So that is a loan to prevent a liquidity crisis. And that loan wouldn't be a bad idea because if this person isn't lying about their balance sheet, or I'm not lying about my balance sheet, then I actually am good for the money. On the other hand, that loan be a bad idea if I had insolvency because it would just be throwing good money after bad. I'm not able to pay my current loans, and you're just giving me another loan that I wouldn't be able to pay. Anyway, I'm out of time. I'll see you in the next video.