Banker Bob's reaction is sure and swift: "I'm going to kick out the tenants and take the dollhouse."
So now Bob's bank owns
Caitlin's house and he needs to sell it, to get his money back. But it's a down market in dollhouses. And all the dollhouses out there just like
Caitlin's are only selling for 95 dollars, which is a problem for Banker Bob's
balance sheet. Because, now it looks
like this: Liabilities,
90 that he has but that he also owes Alex, and 10 of his own dollars, equals 100. Assets,
on the other side of the balance sheet:
one dollhouse, worth 95 bucks. Banker Bobby's balance sheet is out of
balance. And the only way to correct it is by acknowledging, and then recording the fact, that his 10 dollars in capital has been transformed into 5 dollars in capital.
Having lost 50% of his investment, Bobby now has only five dollars in capital, which is all that remains of Bobby's initial investment of 10 dollars. So both sides equal 95, they're back in balance, but Banker Bob has lost five dollars. The important point here is that there was no other way to make the balance sheet balance: Bobby had to take a hit. That 90 dollars of Alex's money isn't going to change because if he wants to withdraw it, Banker Bob has to be able to hand him the 90 bucks -- at a moment's notice. So the only thing that can change is Bob's capital, i.e. the 10 dollars of Bob's own money that he started out with. To reiterate, he's lost half his money. And this situation he's in with Caitlin, this is the situation a lot of our biggest banks are in right now. They've lost at least half their investment money because the value of housing has fallen precipitously.
And instead of one Caitlin, there are millions of them. They all bought "dollhouses' at the height of a doll house mania. And dollhouses have lost not 5% of their value, but 10, 20, sometimes 50% of their value, depending on where they are located. They've gone from being 'assets' ... to 'toxic assets.' But unlike Bobby, the big banks don't want to admit this. They want to keep it a secret how much they own in the way of toxic assets. Because if the full truth were widely known, they might very well be forced out of business.
Let's go back to Bobby's Bank and Caitlin's doll house for a minute. Let's say the doll house becomes a VERY toxic asset, because it's market value drops by as much as, say, 50%. If Bobby's bank takes over Caitlin's dollhouse, and he can sell it for only half of it's original value, then Bobby's balance sheet looks very bad indeed. Why? Because a 50-dollar loss on the left side of the balance sheet, has to be matched or balanced on the right side of the sheet. In other words, Bobby's original 10 dollar investment, his capital, is totally gone. But not just that: 40 dollars of Alex's 90-dollar deposit are also gone.
So, not only is Bobby's Bank wiped out, but also he can't even pay back his creditor. Depositor Alex loses half his savings and Bobby loses his bank. And it's all because of Caitlin and her stupid dollhouse?
But wait, there might be a way out.
Banker Bob says, "I don't want this disaster to happen, and so I came up with a plan: I'm not going to sell Caitlin's dollhouse.
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