Consider the balance sheet of a typical investment bank. It looks like this
All numbers in billions(*) to get a realistic scale.
Total assets: $1000
Counter-party liabilities: $800
Debt: $150
Equity: $50
Total liabilities+Equity: $1000
The counter-party liabilities are promises that the bank has made to customers and other banks, etc. essentially money that the bank has guaranteed. Debt is money that the bank owes to bondholders. Equity is what the shareholders own.
As you can see, the shareholders don’t own much compared to the size of the operation. It is 20 times bigger! (1000/50=20) In other words, shareholders have put down $50 of their own money, borrowed another $200 from other people, and otherwise made three way deals with third parties for $1000 total.
(*) That means that total assets = $1,000,000,000,000, a staggering number. One trillion seconds corresponds to 31 millennia, almost as long as the totality of human existence. One trillion centimeters corresponds to going from the Earth to the Sun and back 3 times or around the Earth 250 times.)
Now you might have heard that people are not paying back their loans (click link to see a personal up and close example) like they used to do. Therefore some assets are going bad. The asset part of the balance sheet looks like this assuming that 5% has gone bad.
Good assets: $950
Bad assets: $50
Total assets: $1000
If the bad assets are written off (click link to see how that works), this turns into
Good assets: $950
Bad assets: $0
Total assets: $950
The liability and equity part now looks like this.
Counter-party liabilities: $800
Debt: $150
Equity: $0
Total liabilities+Equity: $950
Zero equity means that the shareholders have lost all their money. Due to a leverage-ratio of 20 it only took a drop of 5% in the asset value to wipe out 100% of the bank’s equity as it is now technically insolvent and unable to continue as a going concern (without bankruptcy protection). Further losses would allow the bondholders to foreclose or pull other legal tricks.
Hence, if you work in a bank it’s probably time to start polishing off your resume — but you probably did not need me to tell you that.
Now, there are still $950 worth of good assets, coupled to $800 worth of counter-party risk and $150 worth of liabilities. This is the “good part” of the bank and it could be sold off, so even while the bank(s) itself is in the dumps, or the stock(equity) market for that matter, it does not mean that the good assets are in the dumps as well. They are still there. Only the equity part is getting hammered.
Recent home owners will probably be able to relate to a similar situation. Imagine that you put 5% down, borrowed 95% and now your home declined 5% wiping out 100% of your equity. This does not mean that the house no longer exists or that the value of the house is zero. It means that your home-equity is zero and if shares of your home-equity traded on the market, they would be worth very little.
There are two solutions to this.
The first is to sell of the good assets. Suppose they sell for $945 along with the $800 counter-party liability. This leaves $125 for the bondholders which also take a $5 hit. The second is to take money from the tax payers and give it to the bank making it solvent again effectively bailing out the bondholders.
Consider the housing analogue. The first solution is to sell the house at market and hand the proceeds over to the lender who may take a loss. The second solution is to take money from the tax payers and give it to the home owner and indirectly to the lender.
Picking a solution is basically a question of politics in other words who should pay the price of a mistake: the one person who is irresponsible and will consequently take a lot of damage (conservative/free market approach) or the larger number of responsible people who will take less damage (socialistic approach). The form of this solution directly impacts the equity-owners which is why there is so much volatility in the market every time some politician speaks about the economy these days.
Originally posted 2008-09-24 00:53:55.
