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

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

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.

As found on YouTube

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