Learn about Bailout 1: Liquidity vs. Solvency

In the next series of videos, I am going to give my best attempt at trying to get a handle on the bailout and the financial crisis and so I'm going to try to explain the different concepts in more than one way and then I think hopefully it will all sync in. But the big picture really is that there’s a lot of fancy terminology being thrown around but the underlying concepts really aren’t that fancy. I think a good a place to start is just with the idea of the Balance Sheet. You could watch some other videos that I did before the whole financial mess on the Balance Sheet and that will give you good primer but it doesn’t hurt to review it here.

So balance sheet is just a snapshot of what you have and what you owe and the difference between and the difference between is kind of like your wealth. So if I just had a personal balance sheet, I could write my assets. They mean what you think, they mean these are things that will give you future benefits so let’s say my assets I have I don’t know. Let’s say I have a $1000 cash, let’s say I have I don’t know. Let’s say I have a $100,000.00 house. Let’s say I have a $10,000.00 car and I don’t know let’s say all everything else, you know or look like other with my furniture and I don’t know, my TV and everything else. I don’t know it’s another $5,000.00. So those would be my asset and so what are my total assets? So a thousand, a hundred ten thou—no it’s a hundred and one thousand, a hundred eleven thousand, a hundred and sixteen thousand dollars. Well, it would be great if you lived in the world of only assets but unfortunately let’s say that I had liabilities as well.

A liability is what you think it means, it means something that you have to give future economic benefits for. Or you’re kind of on the hook for something and so let’s say my liabilities, I don’t know. Let’s say I have a $20,000.00 student loan. Let’s say on that house unfortunately I don’t own a down rate. Let’s say that I have an $80,000 mortgage on that house so essentially I borrowed $80,000 from the bank and let’s throw in some credit card debit there. Let’s make this realistic. Relative to I think a lot of households out there. Let’s say that there’s $5,000 of credit card there. Although for most households right now, this house is a lot more and this mortgage is a lot more.

Anyway, I won’t make social commentary. This is just to explain what a Balance sheet is. So what is left over for me? What is my asset minus my liabilities? So let’s calculate our total liabilities. So this is total assets. I will use it with an A colon. So what are my total liabilities? 20 + 80 + 5, so it’s a $105,000. 105,000 total liabilities so the difference between these two, my assets minus my liabilities, this is essentially my net worth. If I just liquidated everything tomorrow, if I sold all of these and paid off all of these, this is what I would be let standing with. That’s my net worth or you could do that as my equity. You often hear equity in the context of a house. In the context of the house, it’s just the asset of the house minus the liability but I am talking about in the context of my personal balance sheet not of these are the actual numbers. I don’t want to give way too much about my life at this just yet.

Anyway, what is that number here? My equity and I'll do that in—I'll make it green since that’s positive, it’s a good number. My equity is a 116,000 minus a 105,000 so what is that? That’s $11,000, that’s my equity. So there are a couple of things to think about here. A lot of you, you’ll meet people with a $100,000 house or a $ 1 million house and they say oh I am worth a million dollars. And you’re like wow. You’re not really worth a million dollars unless you own that house out right and you could actually sell that house for a million dollars. It’s not what you paid for, it’s what you could—the market is going to give for it. But your real net worth is your assets minus all of your liabilities. So in this case, your net worth is actually 11,000 not a $116,000.

This is another important thing to think about. Assets are always equal to liabilities plus equity and that just come down to definition what equity is. Equity was assets minus liabilities but you know, if you take an MBA, they’ll write it down and it looks like an equation but it’s you know assets is equal to your liabilities plus equity but that’s almost a by definition but that’s going to be true.

So what can we do with this? How does this help us? Well, there’s a couple of ways that we can think about this. First of all, what happens if my liabilities are larger than my assets? So if I owe the world more than the worlds owes me, well then these numbers are going to be negative. And if this number is negative, then there’s no really good reason for me maybe to preserve my credit score but other than that if you put credit scores, if you take that out of the equation, there’s no good reason for me to continue living this existence.

If my liabilities are greater than my assets, so let’s say let’s think about that situation. Let’s say that my house is only worth a 100,000 but for whatever reason. I owe a $120,000 to the bank. Let’s say maybe I originally bought the house with a no money down payment for a $120,000 and now I’m honest with myself, I am like you know what the value is going down. It’s only with the $100,000 now. So I am in the situation where you could say I am upside down on my mortgage.

One, you could say that there’s no incentive for me to continue paying this house and an even bigger picture, if I now look at my balance sheet, what are my liabilities now? My liabilities would be 145,000 and my equity would be my assets minus my liabilities so 116 - 45 what is that? Minus $29,000 so I'll do that in red because that’s a bad number for your equity minus -29,000. So in this situation, there is really no reason for me to continue living like the way I am at least financially. There’s no, you should know as long as your breathing, there’s no reason not to continue breathing but you would want to live like this financial anymore so there’s no reason not to go seek bankruptcy protection.

And bankruptcy protection is essentially saying is admitting or I am insolvent which means that there is no way that I am going to be able to unwind all of my liabilities courts protects me, my lenders can't come back after me, everything is going to be erased. They are going to take all my assets, all my liabilities and they are essentially going to take these and divide them up amongst the people that I owe staff too. So that’s bankruptcy, that’s insolvency.

I wanted to highlight the word insolvency because that’s the word that we are going to touch on when we actually talk about the credit crisis and that is supposed to illiquidity so what is illiquidity? Insolvency means there’s no reason for you to continue with this type of a financial situation you’re bankrupt. You are going to get bankruptcy protection that’s insolvency.

Illiquidity is a different situation. Illiquidity says no I actually do have positive equity so let me go back to the original circumstance. Let me go back. Let me just go back to the original circumstance. It really was I only owe $80,000 on the house so my liability is really are only a 105,000. So I really do have a positive equity of $11,000 but let’s say, so this is into insolvency more or some are going describe what illiquidity means to you or to me in this case because it’s my balance sheet. So let’s say that I don’t know, my wife comes to me and says “oh you know, we need to pay our child’s tuition. It is $5,000 for the upcoming year. I need to pay $5,000 for tuition.” I need to pay $5,000.

Actually, let me take a better situation because if I am talking about tuition, it should have shown up on my liabilities. Let’s say that I have to make a $5,000 payment on my student loan so there is some kind of weird student loan where $5,000 comes do all of a sudden so I have to make a $5,000 payment on student loan. So let me do that in red. Make $5,000 payment, a 5k payment. And it could be for anything but let’s say it’s to satisfy part of one of these liabilities.

So if you look at my equity, if you look at my assets minus my liabilities, I clearly have $11,000. I am worth $11,000. And if I could liquidate all my assets and all my liabilities over night, I would have $11,000 in cash and then I could pay that $5,000. In fact, in the process of doing it, I would have paid that $5,000.

In this circumstance, if I just look at my situation, let’s say that student loan payment is due tomorrow. I only have a thousand dollars of cash right? I only have a $1,000 and maybe sitting in my checking account so I can't make that $5,000 payment just with my cash. And then I look at everything else and my boy, can I unload any unload any of these assets overnight? Well, a house is absolutely not. There is no way I'm going to be unloading my house tomorrow. Maybe if I did that, you know I could find someone who buy it for $50,000 tomorrow but that wouldn’t help my situation. Then I'm going—my equity is essentially will go to negative again.

So that won’t help. I can't sell of my car over night. Maybe I could sell it at the super low price for $4,000 just to kind to make this payment but I don’t want to do that either. And same thing, your furniture that’s something you know you don’t have to go on craiglist and take pictures of it. You couldn’t do it. So this is the situation where you are having a liquidity crisis. You are illiquid but you are not insolvent. You have positive, you’d have a positive net worth. If assuming that you are not lying about what’s going on your balance sheet and that’s another issue.

So how do you get passed a liquidity crisis like this? Well, someone has to give you, we could call it a bridge loan because they are giving you a financial bridge from here to where you need to get to go or they are giving you a bridge that essentially buys you time. Let’s say your dad says, “Okay Sal”, I’m—or my dad I guess will say “I'll give you a $5,000 loan for the next two months and over the next two months, I expect you to find some other source of cash or maybe sell you car by a cheaper car salesman and your furniture or something”.

So that is a loan to prevent a liquidity crisis and that loan wouldn’t be a bad idea because if this person isn't lying about the balance sheet, or I am not lying about my balance sheet, then I actually am good for the money. On the other hand, that loan would be a bad idea if I had insolvency because it would just be throwing good money after bad. I am not able to pay my current loans and you are still giving me another loan but I wouldn’t be able to pay.

Anyway, I am out of time. I'll se you in the next video.