CDO and Nonpositive Equity Questions

Question

I have two questions about statements made in this video: https://www.khanacademy.org/economics-finance-domain/core-finance/money-and-banking/bank-bailout/v/bailout-2-book-value

At 6:25, the video shows a Collateralized Debt Obligation divided into an AAA-rated tranche, an AA-rated tranche, and an equity tranche, in order of increasing risk but also increasing return, and the claim is made that no one wants to buy the equity tranche. In my mind, the return on the equity tranche should self-adjust to make the market indifferent between the riskier and less risky tranches. Why would it have been so difficult to sell equity tranches that banks had to give up on the idea and hold them instead?

At 10:30, the video claims that a stock price goes to \$0 when a company has \$0 equity. Does this actually happen in the real world? The video seems to state that this doesn't imply you can pick up the stock for free, but that's what a \$0 stock price sounds like to me. Since the value of a stock is indeed its equity divided by the number of existing shares, how does this case play out in companies that have \$0 or negative equity?

Answer 1

1. The speaker is too imprecise. Nobody wants to buy the equity tranche at a price that corresponds to its model valuation. If the tranche cannot be sold at that price, the bank structuring the CDO would take a loss. So they kept the equity tranche for themselves. Ideally, they would sell the equity tranche at model valuation, and eliminate their exposure to the deal (and just pocket the structuring fees for no long-term exposure risks).
2. It would be extremely unusual for someone to sell an equity of non-bankrupt firm at \$0, as the only conceivable motivation is to crystallize a loss for tax purposes. However, the equity can be made worthless in a bankruptcy restructuring, as the shares can be a claim on nothing. As such, the speaker in the video is speaking loosely.

There is no necessary relationship between the book value of a share and its market value. It is entirely possible that a firm has a negative book value for equity, yet a positive market price for its shares.