Learn about Bailout 4: Mark-to-model vs. mark-to-market Video

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

So the last couple of videos, we’ve been looking at the balance sheet of this what I called bank A. And we say you know it has these assets. And the assets that I wanted—the asset in particular we’re going to focus on is this four billion dollars 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 the23 form 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 three billion dollars. That’s what the share holders own. They own this equity stake. And if there are five hundred million shares, that is six dollars for each of those shares. In the last video we talked about well, if the market is actually trading it at $12 a share, people are 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 and the 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 everyday when you get a quote is a transaction between two unaffiliated parties. It could be between me and you. You have my—account, you have your Throlsh, Rob account, and we just traded the stock. For that second, we set the price for whatever the value of bank A. So I say if the market is placing our shares $12.00 per share, that's a six billion dollar market cap. The market at least for that moment or at least the person who just transacted or jut traded those shares, it's saying that “no, I don’t think that this company has only three billion of equity”. It actually has six billion of equity and it might be because they have some kind of great brand with the equivalent of charisma and good looks that can't be quantified on the balance sheet or maybe one of these are worth more. Maybe they have appreciated since the last time that the bank wrote down their balance sheet or the last time that the bank kind of evaluated the assets worth. And then we have another situation and this is very relevant to what is going on to 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 it three dollars per share. And three dollars per share times half a billion share, that’s a $1.5 billion market value of its equity. And I think that’s what I wanted to write here, market value of equity. 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 okay, you know bank A that’s nice. You say that your assets minus your liabilities are worth three billion but I don’t think that’s true. I think your assets minus your liabilities are $1.5 billion. And let’s say that you know, 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 now what, well I think you're doing a little bit of shading this. I think you're doing it on this line right here. I don’t think that thing is worth four billions dollars. I think that thing is worth 21/2 billion dollars. And if this is worth 21/2 billion, they your total assets are what—there are a billion and ½ left. And so your assets are what—24.5 billion, right? 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's says your market value is 1.5 billions dollars. And let’s say we don’t why the market is saying, unless we can get through their head. They're saying that because they think that this thing is not worth four billions dollars. They think it is worth 2.5 billion. So they think it is worth a billion and ½ left. If this is worth 2.5 billion, then all of these will add up to if I did my math right 24.5 billion minus 23 billion so then that gets you to the market value of the equity. So let’s call that market equity. The market value of the equity of 1.5 billion. So this race is a very interesting question. How do people decide 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. They are all kind of different schools of economic philosophy. You could put here what you paid for it, right? Maybe the bank originally paid four billion dollars back when real estate could only go up or so people thought and all of these CDOs look like these great high yielding instruments. Based on those assumptions, the bank says “oh you know I’ll pay four billion for us”. They out it in their books for four billion and they never kind of reassessed it. So they just put the four billion dollars at cost. And then people would have every right to question that number. They’ll be like well you know 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 a CFO or the CEO of your bank have every incentive to not write the real value you because you want to prompt 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 a whole another video on incentives. So that’s one way of—of let’s see my phone is ringing. 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 of the cost basis. Another one and this is—and now I'm going to introduce some words that you might have heard on the news, mark to martle. 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 theses 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. You know these are rocket scientists and some of them actually are. They can you know put the man on the moon and I'm going to—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 of how many of these mortgages are in default. All of that and those numbers, spit out a number and you know maybe they say that they are worth three billions dollars, right? And if that happen in any period, the company would actually have to re-state this. They would actually have to say “oh this wasn’t four billion, we’re going to have to re-state 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 four billion dollar asset maybe that's what we paid for originally. We re-ran our model based on new assumptions over marking-to-model. Now we have three billion dollar assets according to our assumptions or our new assumptions on our model. So we are doing a one billion dollar write off, right? To go from four billion, what we originally had on the books, maybe that was our old assumptions on 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. You know sure these might be well—maybe they have well intention though 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 as far as what assumptions you did make. So it's very hard to believe but you know it's probably a better guess than the four billion, right? Especially when they are taking it down and you also have to. I’ll do a whole video on this later on. You also have to question why they keep taking write downs, right? You know why their models keep having to make more pessimistic scenarios? Maybe they are 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 right? Because if this was worth zero, they only have $22 billion of 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, right? They don’t want to be responsible for running the company to the ground. So they don’t want to admit all at once that these are worth zero. Maybe they’ll admit that’s worth you know 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 costume. 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. Mark-to-market, and this essentially says well, if this is an instrument that is traded in some market, right? Let’s say tat these CDOs and they at least they used to be. Let’s say that they are traded in some market that you actually assign the market price. So that’s you know, maybe I don’t know, I have a billion of these CDOs and the market price of those CDOs is a dollar 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 then make this into a billion and a half and you would have to do another write down. Now why doesn’t everyone do that? I actually think that is a very good question, I’ll tell you why the banks don’t want to do that, they are making the argument that people are—well first of all, some of these markets, since no one wants to buy these things, 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 you know they are distressed in some ways so that you know that they're “it's a fire sale”. So people are arguing that the market price is not reflective of the true value of these securities. They are arguing that the few people who’ve transacted did it out of desperation so that you know 1.5 billion value of these CDOs, the market value CDOs is not truly accurate. So these companies are saying “No, no, no. I cannot admit what the market what capitalism is telling me what the price even though these people are the same people who have been for the last 30 years saying “let the market determine everything, you know I make $20 million a year because I am a capitalist and because I have taken risk and that you know I deserve that money”. And these are the same people now that—they are very adamant that says “oh, don’t believe the market price because those people—the market is wrong now. Our PhDs are correct”. And you know if you think about that that is a very communist way of thinking because in the communist government, 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 markets at depressed. Anyway I'm not going to vent on that. This 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 that 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 new wants of everything that’s going on. See you soon.

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So the last couple of videos, we’ve been looking at the balance sheet of this what I called bank A. And we say you know it has these assets. And the assets that I wanted—the asset in particular we’re going to focus on is this four billion dollars 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 the23 form 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 three billion dollars. That’s what the share holders own. They own this equity stake. And if there are five hundred million shares, that is six dollars for each of those shares.

In the last video we talked about well, if the market is actually trading it at $12 a share, people are 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 and the 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 everyday when you get a quote is a transaction between two unaffiliated parties. It could be between me and you.

You have my—account, you have your Throlsh, Rob account, and we just traded the stock. For that second, we set the price for whatever the value of bank A. So I say if the market is placing our shares $12.00 per share, that's a six billion dollar market cap. The market at least for that moment or at least the person who just transacted or jut traded those shares, it's saying that “no, I don’t think that this company has only three billion of equity”. It actually has six billion of equity and it might be because they have some kind of great brand with the equivalent of charisma and good looks that can't be quantified on the balance sheet or maybe one of these are worth more. Maybe they have appreciated since the last time that the bank wrote down their balance sheet or the last time that the bank kind of evaluated the assets worth.

And then we have another situation and this is very relevant to what is going on to 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 it three dollars per share. And three dollars per share times half a billion share, that’s a $1.5 billion market value of its equity. And I think that’s what I wanted to write here, market value of equity.

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 okay, you know bank A that’s nice. You say that your assets minus your liabilities are worth three billion but I don’t think that’s true. I think your assets minus your liabilities are $1.5 billion. And let’s say that you know, 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 now what, well I think you're doing a little bit of shading this. I think you're doing it on this line right here. I don’t think that thing is worth four billions dollars. I think that thing is worth 21/2 billion dollars. And if this is worth 21/2 billion, they your total assets are what—there are a billion and ½ left.

And so your assets are what—24.5 billion, right? 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's says your market value is 1.5 billions dollars. And let’s say we don’t why the market is saying, unless we can get through their head. They're saying that because they think that this thing is not worth four billions dollars. They think it is worth 2.5 billion. So they think it is worth a billion and ½ left. If this is worth 2.5 billion, then all of these will add up to if I did my math right 24.5 billion minus 23 billion so then that gets you to the market value of the equity. So let’s call that market equity. The market value of the equity of 1.5 billion. So this race is a very interesting question. How do people decide 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. They are all kind of different schools of economic philosophy. You could put here what you paid for it, right? Maybe the bank originally paid four billion dollars back when real estate could only go up or so people thought and all of these CDOs look like these great high yielding instruments. Based on those assumptions, the bank says “oh you know I’ll pay four billion for us”. They out it in their books for four billion and they never kind of reassessed it.

So they just put the four billion dollars at cost. And then people would have every right to question that number. They’ll be like well you know 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 a CFO or the CEO of your bank have every incentive to not write the real value you because you want to prompt 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 a whole another video on incentives.

So that’s one way of—of let’s see my phone is ringing. 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 of the cost basis.

Another one and this is—and now I'm going to introduce some words that you might have heard on the news, mark to martle. 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 theses 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. You know these are rocket scientists and some of them actually are. They can you know put the man on the moon and I'm going to—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 of how many of these mortgages are in default. All of that and those numbers, spit out a number and you know maybe they say that they are worth three billions dollars, right?

And if that happen in any period, the company would actually have to re-state this. They would actually have to say “oh this wasn’t four billion, we’re going to have to re-state 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 four billion dollar asset maybe that's what we paid for originally. We re-ran our model based on new assumptions over marking-to-model. Now we have three billion dollar assets according to our assumptions or our new assumptions on our model. So we are doing a one billion dollar write off, right? To go from four billion, what we originally had on the books, maybe that was our old assumptions on 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. You know sure these might be well—maybe they have well intention though 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 as far as what assumptions you did make.

So it's very hard to believe but you know it's probably a better guess than the four billion, right? Especially when they are taking it down and you also have to. I’ll do a whole video on this later on. You also have to question why they keep taking write downs, right? You know why their models keep having to make more pessimistic scenarios? Maybe they are 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 right? Because if this was worth zero, they only have $22 billion of 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, right? They don’t want to be responsible for running the company to the ground.

So they don’t want to admit all at once that these are worth zero. Maybe they’ll admit that’s worth you know 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 costume. 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. Mark-to-market, and this essentially says well, if this is an instrument that is traded in some market, right? Let’s say tat these CDOs and they at least they used to be. Let’s say that they are traded in some market that you actually assign the market price. So that’s you know, maybe I don’t know, I have a billion of these CDOs and the market price of those CDOs is a dollar 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 then make this into a billion and a half and you would have to do another write down.

Now why doesn’t everyone do that? I actually think that is a very good question, I’ll tell you why the banks don’t want to do that, they are making the argument that people are—well first of all, some of these markets, since no one wants to buy these things, 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 you know they are distressed in some ways so that you know that they're “it's a fire sale”. So people are arguing that the market price is not reflective of the true value of these securities. They are arguing that the few people who’ve transacted did it out of desperation so that you know 1.5 billion value of these CDOs, the market value CDOs is not truly accurate.

So these companies are saying “No, no, no. I cannot admit what the market what capitalism is telling me what the price even though these people are the same people who have been for the last 30 years saying “let the market determine everything, you know I make $20 million a year because I am a capitalist and because I have taken risk and that you know I deserve that money”. And these are the same people now that—they are very adamant that says “oh, don’t believe the market price because those people—the market is wrong now. Our PhDs are correct”.

And you know if you think about that that is a very communist way of thinking because in the communist government, 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 markets at depressed. Anyway I'm not going to vent on that. This 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 that 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 new wants of everything that’s going on. See you soon.

Transcription by: Scribe4you Transcription Services