Learn about Bailout 2: Book Value
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Khan Academy Presents: Hypothetical bank balance sheet. What book value means.

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In the last video, I discussed a personal balance sheet or what illiquidity or what insolvency means and if you understood that I think we're now ready what a balance sheet of some of these potentially troubled banks might look like. And I'm not going to, you know, go into the details but I'm going to give you the big picture, I think that’s, that’s essentially what matters. So essentially this banks they have a bunch of assets and I'm just going to talk about banks very generally right now both commercial and investment banks, in the future video I’ll tell you the difference between the two and what regulation means and what leverage means and all of that maybe I’ll touch on that in this video. But let's just kind of think about a generic balance sheet for bank, so its assets. So assets, so I don’t know I'm just going to make up some things, let's say that it has I don’t know one billion, one billion in government bonds, US government bonds I'm just throwing that in there just this kind of filler, just to show that there could be a lot of different types of assets in there. Let's say that they, it has another I don’t know 10 billion in Triple A corporate bonds. So, you know, this are loans to really solvent or really high credit where a very credit worthy company, so Triple A corporate bond, so companies that have really good cash flows. There is very little chance of them defaulting on their loans. And what is a bond? Well a bond is just a loan to another entity right? If you loan me money I could give you and IOU, right. Saying that “Sal owes you, whatever $10.00” and that IOU you could call that a Sal bond. So, you know, one billion dollars of govern bond that’s an assets that says the government owes me a billion dollars and then in the mean time it's going to pay interest. Similarly corporate bonds that saying that you know this corporation wherever this bonds are issued by, they owe me collective 10 billion dollar in the mean time they're going to pay me interest, so that’s all it is and all in asset is something that has some future economic value and that’s what this are, this bonds have some future economic value. They have the value of the interest payments plus eventually they're going to pay you the 10 billion dollars back or maybe to something less than that, so the 10 billion is the interest payments plus what they're going to pay you back which might be I don’t know 9.9 billion, I'm making up numbers. But that’s not the issue here, what the crocks of the issue are that there is this stinky asset here. Actually, let me draw a couple of more assets here just to show you that this is the stinkiest of them all. So let's say I have another, another group of assets I don’t know let's say I have a 10 billion dollars of commercial mortgages, commercial mortgages. So this is essentially, I lend the money to companies to you know buy land or develop land or buy buildings that they're going to go rent out to other people. So ones again it's just alone to someone else and alone to someone else that I've given is an assets because they owe me interest and eventually they're going to have to pay the money back to me. And then finally I'm going to throw and I'm not being comprehensive here I'm going to throw the crocks of the issue here. Let's say that I have two—but let me I have 21 right now, let me just make it an even number. Let's say that I have four billion dollars that I’ll add up to 25, I have four billion dollars in residential CDOs collateralized debt obligations, residential CDOs. And I've done a video on the CDOs but just to kind of have a review, CDOs are a derivative instrument and I know that sounds complicated but that just means they derived from another instrument, which probably, you know, that’s a sign of the stinkiest starting to emerge from this part of the balance sheet. What does it mean derivative? Well you take a bunch of mortgages, so I’ll just draw it down here. You take a bunch of mortgages, so you know this are house mortgages and maybe you take a million of them. You group them all together and you end up with a mortgage-backed security. Although mortgage-backed security is a loan to a ton of big group of people and you put them all together so that you can kind of you know be able to statistically give it properties because if you lend to anyone person that’s hard to trade but if you lent to a bunch of people you can—it starts to become something that you could trade with other people because they can understand it and you know, in aggregate you can say, “Oh, 8% of the people are going to fall and then all of that” but anyway that this isn’t the crocks of it either, I have a whole video on mortgage back securities. CDOs collateralized dead obligations are derived from mortgage-backed securities and that’s why they are called derivative instruments. What CDOs are and you take this mortgage back securities you know that there are loans to some people and some region of the country or maybe they’re at—they're diversified across regions and then you slice and dice them, so what you do is you slice them in to traunches and I go into a lot more detail on this in the other videos, right. And you say this group of the CDOs, look at the first payments or if any payments that go, immediately go to this very senior traunch, right. And then the next payments go to this one and then this top traunch you could cut the most junior traunch and sometimes called the equity traunch. This traunch they're going to get whatever is left over. So if everyone pays they get and made it whole, but if a lot of people default. All the defaults are going to hit this traunch right. And to kind of make up the fact that this is the riskiest traunch or essentially this people are taking on all of the risk and are essentially this traunches are giving all of the risk to this traunch. And a traunch is just a layer it's just a slice, okay. I don’t want to use too fancy words. But in return for taking on all of the risk this person is going to get a higher yield, so you know all of this person might be getting 6% this person might be getting 7% on their money, maybe this person gets 12% on their money. And this is another interesting thing because this person is the most secure the ratings agency which I’ll probably do a whole another series of videos on, they might give it in like I don’t know a Triple A rating and maybe they give this traunch, I don’t know, I'm making up things but maybe they give it a double a ratings. But this equity traunch they will get a junk year rating and because it's a junk year rating no one is going to want to buy it. So the person who constructed this whole collateralized debt obligation and who sold this traunches to the public markets and this process by the way is call securitization because you're creating securities out of this assets that you sell to everyone, maybe the Chinese or whoever served at well funds. But people only want to buy this traunches, so the banks have to figure out what to do with this traunch which is the stinky equity traunch. So most of them just kept it on their balance sheet they said, “Oh, it looks like housing never goes down, we get a really high yield on this so we are going to keep this traunch for our selves”. And that’s what these residential CDOs are that are the crocks of the issue. But anyway that was just in a side and so I wanted to show you this because this aren’t just any residential CDOs, this aren’t the Triple A’s this—they might be some of them but just for the sake of argument let's say that this are junky ones or smelly. So anyway that’s my example bank asset, the asset side of its balance sheet. Let's think about its liabilities. So liabilities, liabilities well lest just say it has a bunch of loans, right. So let's say it has loan a, loan a for I don’t know 10 billion dollars and let me to actually just store some cash in here. Let's say it has a billion dollars of cash, a bank always has to keep some cash just incase someone asks for its, their money immediately, that’s in the context of a commercial bank but anyway. And let's say it has some cash for just immediate liquidity it needs. So the liability side has loan a and it owes someone 10 billion dollars it has loan b, I don’t know, let's say it's another 10 billion dollars. And let's say it has loan c, loan c is just to make it interesting. Loan c is—let's say it's for three billion dollars. So in this example right now, if we assumed that all of this asset values are correct and all of this liability values are correct, what are this banks equity? And in this case if the publicly traded company, what is it share holders equity? And let's figure it out, it's equity well it's assets are one plus—let's see 21, 25, 26 billion in assets, right and it's liabilities are 23 billion. So 26 billion of assets minus 23 billion of liabilities, means that we have three billion of equity of share holder’s equity and just to make it clear, what does equity—let's say this is a publicly traded company. If you own a share of the company, you own a share of this equity. So let's actually let's just write it out, let's say that this company has, you know, it's called this, I don’t know, Wachovia Bank actually that’s too close, let's called this bank a, right. And let's say that bank a, bank has I don’t know let me make up something. Let's say that it has a, I don’t know, a billion—let's say it has 500 million shares. 500 million shares right, if you're going to Yahoo Finance you said “How many shares are outstanding?” it has 500 million shares. So each share price or the book value of each air price essentially should be this three billion dollars of equity based on the balanced sheet. And that’s what they all it book equity because the balance sheet is often called the companies books. So it's these three billion dollars of equity divided by the number of shares. So each share should be worth let's say three billion divided by 500 million, it should be $6.00 of book equity, book equity per share. And that’s something important to realize because a lot of people think that you know for stock price goes to zero that, you know, that means if you're getting the company for nothing, you know, that’s not true that just means that the equity is worth zero. And I just realized that I'm out of time. I'm going to continue this in the next video and we’ll explore this a little more, see you soon.