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Bailout 5: Paying off the debt

How the bank can liquidate assets to pay off debt that comes due. Created by Sal Khan.

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Video transcript

In the last several videos we talked about the difference between the book value and the market value of a company's equity. And in this example here, where I said this is some type of a financial institution. And these are its assets. And at least on its books, it had $1 billion of government bonds. $10 billion of very highly rated corporate bonds, so these are loans to corporations that are very likely to pay back. $10 billion of commercial mortgages, those would be loans for someone to buy an office building, or build an office building, or something like that. And then we focused in a little bit on this piece, this green piece here, residential CDOs. And I explained what those are. Those are essentially derivative securities that are derived from mortgage backed securities. Which are just a bunch of mortgages that are packaged together. And we focused on that because this is really the crux of everything that everyone's been focusing on since the credit crunch started. Although, I'll throw it out there, this is just the first wave. This is what's deteriorated so far. Housing prices have gone down, you had all of these people with these liar loans where you could make up your income and get a million-dollar loan with no money down. So this was just the first wave. But you can imagine, if the economy gets bad enough, then a lot of these commercial mortgages are going to to start looking not so great either. And actually, there was an article that I read this morning where they talked about because of all of the turmoil in the financial system, because of this piece, that the commercial vacancies actually going up. And a lot of the people who own commercial mortgages, they're actually getting a little bit worried right now because a lot office space is going free. But anyway that's not the focus of this. What we should focus on now is well, fine, this bank has a shady asset. And that makes it look a little uncertain as far as what its equity is worth. If we said this asset was worth $4 billion, we said we have $3 billion of equity here. Because everything would have added up to $26 billion. And we have $23 billion in liabilities. And so liabilities plus equity is equal to assets. Or assets minus liabilities is equal to equity. So 26 minus 23 is equal to 3. And I gave you the example of well what if the stock market is actually valuing this thing at an equity of $1.5 billion. And the way you get that is, they're saying $3 a share and there are half a billion shares. So what if the stock market is saying no, I think that this company's equity is only worth $1.5 billion. And a rationale for that could be that they just think that this asset right here is worth $1.5 billion less. Anyway, I just wanted to make that point because a lot of people often get confused between book and market value. But now, let's think about why this matters. Why is Hank Paulson, and Ben Bernanke and George Bush, and seemingly everyone else, so scared? The logic goes, well if this is just one bank and maybe these things are worth zero, what's the problem? If these things are worth zero, this one bank declares bankruptcy, and it just gets resolved in the bankruptcy process. And I'll do another video on how the bankruptcy process works. Or, there's another scenario where you say, oh well this one bank, maybe this isn't worth zero. Maybe this is worth $4 billion. And as long as people just continue to loan it money, it should be able to be fine and it'll weather out the storm. And that's the crux of the issue. Whether people will continue to loan them money. So, corporate loans, or loans to corporations or banks. Most of the loans we're familiar with in our personal lives, maybe a mortgage, where it's a fixed term, 30 years, at the end of it you've paid all of the interest and you've completely paid off the loan. Corporate loans tend to be for simplicity purposes, interest only loans. There might be a little bit of paying down the equity. But for the most part they're interest only loans. So for example, this Loan A over here. It'll have some interest rate, let me make something up, maybe it's a 7% loan. And maybe its term, they'll give you the money for some period of time, let's say it's for three months. So that says that whoever lent this money to you, they'll give you $10 billion. Every year you pay 7% but on I guess a monthly basis, you'll pay roughly 1/12. We know that that's not the exact math, but you'll pay it's actually 1.07 to the 1/12 power, but it's roughly 1/12 of this. And then at the end of three months, you pay that lender back the $10 billion. You might say, well that's a strange way of financing yourself. Because every three months you're going to have to go and get another loan. And that's absolutely true. But in a normal credit environment, most companies can say, OK I'll borrow this $10 billion for three months at an annual rate of 7%. And then when three months pass, I'll just got another loan, maybe from the same lender, maybe from another lender, that has maybe similar terms. Pay off the old loan, and get a new loan. You can kind of say they keep on renewing those loans. They're able to keep keep getting new loans that can replace the old ones. What's happening now is you have these short term loans, let's say three months, and then when it comes to renew, the bank or whoever lent you this money says, I'm not so sure anymore. Because one, your stock price has been tanking. And if anything, we know that a lot of these hedge funds out there, they're doing more homework than me, the bank, or the lender is doing, or at least these ratings agencies are doing. So maybe they see something fishy. And I know that you have some type of assets, you have some of these residential mortgage backed securities, or you have some of these derivative assets there. And you don't really give a lot of transparency to me. In fact, seldom you'll actually even see this much transparency on a company's balance sheet. They'll often say just like a big bucket of, they'll call them level three assets. And those are assets that really the management of this bank can decide what they're worth. So if I'm the person who lent them the money, I'll be like, you know what, I saw Bear Stearns go down. And Bear Stearns looked a lot like you. I saw Lehman Brothers go down and Lehman Brothers looked a lot like you look now. You know what? I just want my money back. Just pay me the $10 billion loan. And then you go out, if you're this bank, you say, OK well let me look and find someone else. And no one's willing to lend you the money because everyone's gotten a little bit irked. And they go for another guy for loans. And they're like look, I'm not going to give you a loan, but here's some advice. If you really think these assets are worth enough, why don't you sell these assets, and maybe some other assets, and then you can be good for your money? You don't even need the loan. You don't need to hold these assets. So what you do when this comes due, since you can't get any other loans, let's say that you sell these. So you sell these AAA corporate bonds. Those are very valuable. So you get $10 billion for them. So now you have $10 billion in cash. And you're able to pay off this loan. And actually, what I've just described, this is called deleveraging. Actually, I'll probably save it until the next video on what leverage and deleverage is. But just think of it this way, leverage is the ratio of how much assets you have over how much equity you have. And so if you think about someone who has a lot of assets, but they're controlling it with very little equity, they have huge leverage. If you're controlling $10 of assets and you only have $1 of equity, you have 10:1 leverage. Now, I just reduced my assets, but I didn't change my equity. So I've deleveraged. I'll do that more in the next video. But that's fine, so I was able to cover that. I didn't have to declare bankruptcy or anything. But let's say when this loan comes due, I'm in the same situation. This person, everyone's a little scared after Bear Stearns and Lehman Brothers and they say, I'm not prepared to renew this loan to you. And you go out into the credit markets and no one else is willing to give you this loan, but you're like, OK fine, I have these commercial mortgages. And I can sell them. They're fairly liquid securities. Liquid securities means that there's a market in them and that you can find buyers who are willing to buy them. But let's say since you have to kind of do it in a fire sale type of situation, since you have to do it very quickly and everyone's a little scared, let's say you only get $9 billion for these. They're worth $10, or so you say. But then when you actually try to sell them in the market, you get $9 billion. And let's say you have to sell your government bonds as well. So you get another billion. So that gives you $10 billion. And then you could pay off this guy right there. So now it's getting interesting. Notice, the book value of my equity, well it might have changed a little bit. Because I had $10 billion of assets. and I had to essentially write them down to $9 billion, because that's what I got for them. So let's actually recalculate our new book value. So if I'm the company, remember this $4 billion was what the company said it was worth, the $2.5 billion was what the market said it was worth. So they have $4 billion plus $1 billion, so we have $5 billion now in assets. And what's our liabilities? We have $3 billion in loans. And now the book value of our equity is now going to be $2 billion. And just to think about it, why did our book value of equity go from $3 billion to $2 billion? Well, because I actually thought that these commercial mortgages were worth $10 billion, but when I had to sell them really fast, I only got $9 billion for them. So I essentially had to write down those assets and then sell them and turn them into cash. So that's why the book value of the equity is now $2 billion. And now notice something here, the book value of this residential mortgage backed security, at least what this bank management says the book value is, is $4 billion. I shouldn't have crossed it out, let me write it again. $4 billion, the $2.5 is what the market was saying. Which is larger than my total equity. So if this is worth zero, then I actually have negative equity. If this is worth $2 billion instead of $4 billion, then I have zero equity. So now I'm getting into a very interesting situation. And I wonder what's going to happen when Loan C comes due. And we'll explore that in the next video.