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