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Chapter 7: Bankruptcy liquidation | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
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In the last set of videos, we've
hopefully familiarized
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ourselves with the different
ways that a
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company can raise capital.
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It can do it through
debt or equity.
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And we learned that debt
securities are
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often called bonds.
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And equity securities you're
probably familiar with.
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Those are stocks.
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And then I left you with
a cliffhanger.
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Let draw it so I don't
get ahead of myself.
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So these are the assets of a
company and it was able to
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generate these assets.
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So there's a couple of ways
you can generate assets.
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You can get investors through
equity, and we've done several
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videos on that.
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You start with the angel
investors, or maybe your rich
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uncle, and then eventually get
venture capitalists, and you
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do an initial public offering.
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And then you can do follow-on
offerings.
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And so on and so forth.
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Now we see governments will buy
equity in you if you are a
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bank that's too big to fail.
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But we'll do a whole
playlist on that.
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So equity.
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That's one way that you can
get cash or get capital so
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that you can buy assets
to run your business.
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The other way is you can borrow
money from people.
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So the equity holders
are actually the
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owners of the company.
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So you might have been part of
the equity holder, and you
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have to sell some of the equity,
or sell some shares in
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your company for someone
else to give money.
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Then they become kind of
like your partner.
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And the other way is you
could borrow money.
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Let me draw that.
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That we'll just put generally
as liability.
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Debt isn't the only kind of
liability, but that's a pretty
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reasonable simplification
for now.
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There's other things.
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In general, liability means you
owe something to somebody
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in the future.
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So these are liabilities.
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And we'll assume right
now that your debt
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is your main liability.
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You might have other
liabilities.
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You might have some type of
legal liability, where someone
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is suing you or you had sprayed
asbestos on a bunch of
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playgrounds, thinking that it
was actually good for the
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playground equipment and now
there's all of this liability
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because, well, you
get the idea.
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But from now on we'll have the
simplification that debt is
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your liability.
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And we said there's different
kinds of debt.
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If you securitize it,
it's often a bond.
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Right?
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That would be a certificate
that's an IOU from a company.
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It'll pay you coupons or
interest and so forth.
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Or you can also just get regular
bank debt, where you
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owe the bank money.
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And I left you with a question
the last time around.
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I said, let's say this company
goes into bankruptcy.
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And let's say that these assets
aren't worth what we
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think they are, right?
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In this world, if we just
have to sell off
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these assets, fine.
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The debt guys would
get paid off.
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And the equity guys would get
left over with whatever else.
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So let's say if this
was on our books.
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Whenever you hear things like
book value, and I've done a
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couple of videos on book value
versus market value, but the
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book value is essentially
what you have on
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your accounting books.
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You say that this is
worth $10 million.
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Right?
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Let's say we've bought land
and factories and whatever
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else worth $10 million.
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Let's say your debt
is $6 million.
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Then your equity would
be worth $4 million.
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And let's say, for whatever
reason, the economy turns
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south or maybe this was some
type of business that's now
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not viable.
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So it's going to go
into bankruptcy.
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And I'll get a little bit more
specific on the different
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types of bankruptcy.
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But we're assuming
liquidation.
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Actually I'll just get
specific right now.
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So when we say bankruptcy,
bankruptcy is
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a very common word.
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I think most people have a
general sense what it means.
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They know it's bad and it means
to some degree that a
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company can't operate
as it was before.
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But there's a lot of confusion
over what it means.
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There's actually two types
of bankruptcy.
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There's liquidation.
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And that's essentially saying
that, you know what, this
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business doesn't
make any sense.
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It doesn't make sense
to have the
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employees and run the factories.
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You're never going to make any
money, so you might as well
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just sell everything you have.
You liquidate it all.
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That's one type.
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And that falls under the
category of Chapter 7.
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And we're just talking
about corporate
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bankruptcy right now.
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There's also personal
bankruptcy.
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And maybe we'll do a couple
of videos on that.
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It might be especially relevant
in this economy.
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Well, the other type is
reorganization or
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restructuring.
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And restructuring says,
you know what?
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This factory here,
it's actually
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making something useful.
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It's actually generating
money.
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And actually we can get more
value for what we have here if
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we keep it running.
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And we will just keep it
running, and we'll restructure
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the company.
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And usually that means changing
this side of it.
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So maybe we'll cancel some
debt and all of that.
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And I'll show you how that's
done in a reasonably fair way.
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But just to understand kind of
a simplified scenario, let's
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take liquidation into
consideration.
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So let's say that this was my
website selling shoes online,
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and that all of a sudden
people have
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stopped wearing shoes.
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It's just gone out of fashion,
so it makes no sense anymore
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to sell shoes online.
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So I'm just going to liquidate
my assets, my real estate that
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I might have, my warehouses,
et cetera, et cetera.
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My question that I left you with
in the last video was,
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who gets it?
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So let's say when we liquidate
it-- so we go into bankruptcy
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and essentially all of the
assets are taken into
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possession by the bankruptcy
court-- they're going to sell
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these assets.
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And let's say when they sell
them, they don't get $10
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million for these assets.
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They only get $5 million
for them.
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Right?
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I paid for them thinking that
they were useful in some way,
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but they end up not to
be, so my assets--
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You know what, I just realized
when I talked earlier about
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there's two ways to raise
capital, there's a third way
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to raise capial.
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Right?
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You can sell shares.
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You can issue debt.
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You can borrow money.
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Obviously the third way is
actually just make money.
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Right?
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Once you start a company,
hopefully you generate
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earnings, and that'll also
generate cash or capital that
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you can reinvest in
the business.
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And we'll talk about that.
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But I just wanted to make it
clear that that's obviously
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the best way to generate capital
for your business is
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when the business itself
generates capital.
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So let's say that these assets,
when you actually sell
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them off, aren't worth
$10 million anymore.
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Let me make the pointer
smaller.
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They're worth $5 million.
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So my question in the
last video is, who
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gets this $5 million?
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Do you somehow split it evenly
between all of these people?
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Or does one of them get more
of it, or one of them gets
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less of it?
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And I think you'll get a sense
based on where I took the $5
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million out of, who
gets the money.
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It's the debt holders.
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And the way I drew it right
here, you can kind of view it
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as you go up in this
direction, you're
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getting more senior.
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Or if you're going down
in this way, you're
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getting more junior.
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And seniority, when you talk
about a company's capital
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structure, is just, you know
what, if there's anything
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left, who gets their
money first?
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And even within the
debt, you'll have
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different layers of debt.
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There might be different debt
holders who have different
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levels of seniority.
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So this one might be called
senior secured debt.
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Senior means they're high
up on the stack.
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They are one of the first people
to get their money.
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And secured means there's
actually some collateral on
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the asset side that they get
if the company can't pay.
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So maybe this is like
a piece of land.
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Right?
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So just in kind of our everyday
personal finance
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world, your mortgage is
actually secured debt.
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It's secured by the collateral
of your home.
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If you can't pay the debt,
the bank comes
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and takes your home.
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It forecloses on the property.
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So that's what secured means.
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It means that there's some
collateral, and in the event
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of a bankruptcy this guy can
immediately go and get the
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collateral that his debt
is secured by.
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So this is considered a very,
very senior form of debt.
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Senior secured.
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Then you might have here, you
might have senior unsecured.
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And there's a lot of words
around, senior, junior,
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subordinate, and all of that.
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But just to get a sense that
there's just a hierarchy here.
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Some people are the first people
to get the money, and
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then whatever money is left goes
to this person, then if
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there's any money left, it goes
to this person, and then
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if there's anything left
it goes to this person.
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And once you're in bankruptcy
court it does tend to be a
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negotiation between the
different, you can almost view
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it as buckets, of debt.
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And we'll do a more complicated
example in the
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future on that.
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We'll actually delve into the
details of bankruptcy.
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But this is the general
notion.
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That the senior guys get made
whole first, then the more
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junior guys get whatever's left,
and so on and so forth.
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And if there's no money for the
equity, there's no money
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for the equity.
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And that makes sense, right?
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Because the debt holders, all
they were getting-- their
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upside was just interest,
right?
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So they also should get limited
downside in the event
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things should turn bad.
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Equity holders, they kind
of took a gamble.
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If things were great, they would
get all of the upside.
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And now that things turn
bad, they take
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a lot of the downside.
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And they're actually lucky that
they don't owe money.
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That's actually the-- I guess
you could call it-- the beauty
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of a corporate structure, that
you have limited liability.
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In some times in history, these
people would actually
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owe the difference.
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They would actually owe
this extra $1 million.
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They would all go to debtor's
prison and all that.
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But we'll talk more about
it in the future.
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So anyway, just going back on
the different tranches of
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debt, or buckets of debt.
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So we could call this
senior unsecured.
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And that means that they're
still senior.
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They're still fairly high
up the seniority ladder.
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But they're unsecured.
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There's no particular assets
that they can go run.
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But as long as there's enough
for them, they'll get it.
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So let me put some
numbers here.
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So let's say there was, I don't
know, $1 million of
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senior secured.
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Let's say there's $2 million
of senior unsecured.
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And let's say that this is $2
million of subordinated--
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subordinated just means they're
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not senior-- unsecured.
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So in this reality, what would
happen is the bankruptcy court
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would liquidate all this stuff
and then they'll hand it out
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in order of seniority.
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These guys get their
$1 million back.
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So they're made whole.
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And they probably charged a
lower interest rate, because
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they didn't perceive their risk
that high to begin with.
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These guys, right here, the
senior unsecured, they'll get
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the next $2 million.
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And then there's $1
million left.
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Right?
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And that $1 million will go
to the subordinated debt.
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So they'll get 50% of
their money back.
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So they took a little bit of a
hit, but that's OK because
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when things were good, they
probably got higher interest
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to compensate them
for their risk.
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Usually as you get more and more
junior and you take on
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more risk, you get more upside,
or more interest. And
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in this case the equity
holders get nothing.
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They get wiped out.
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So it just goes to 0.
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So that's the answer
to the question.
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I said, who gets the money?
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Well, it's the debt holders
get first dibs.
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And if there was actually $7
million here instead of $5
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million, then you would have
paid the six off completely,
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and then the equity holders
would've gotten $1 million.
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And so they would have gotten
something if there was enough
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money to hand it to them.
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Anyway, in the next video I'll
cover-- this was liquidation,
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where we just say this
isn't worth running.
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Let's just give it all away, or
let's sell it, and give it
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back to our creditors.
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In the next video I'll talk
about reorganization, where we
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say, hey, you know what?
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This business is a
good business.
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It just has too many
liabilities.
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See you in the next video.
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