Your finances

Negative Project Interactions

admin — Fri, 02 Dec 2011 08:06:43 +0000

Negative interactions mean that the sum of the parts is worth less than the parts individually. In this case, projects have negative influences on one another, and thereby decrease one another’s value. Economists sometimes call negative externalities diseconomies of scale. Here are a few examples.
Pollution and Congestion If there is only one major road to two divisions, and the traffic of one division clogs up the traffic to the other division, it can cause a loss of cash flow in the other division. A division that wants to expand and thereby clog up more of the existing infrastructure will not want to pay for the congestion cost that its own expansion will impose on the other divisions. (Of course, it is the overall firm’s headquarters that should step in and allow the expansion only if the NPV is positive after taking into account the negative externalities imposed on other divisions.)
Cannibalization If a new Apple computer can produce $100,000 in NPV compared to the older Windows machine that only produced $70,000 in NPV, how should we credit the Apple machine? The answer is that the Apple would eliminate the positive cash flows produced by the existing Windows machine, so the cash flow of the project “replace Windows with Apple” is only the $100,000 minus the $70,000 that the now unused Windows machine had produced.
Bureaucratization and Internal Conflict If more projects are adopted, project management may find it increasingly difficult to make good decisions in a reasonable time frame. This may require more cumbersome bureaucracy and reduce cash flows for all other divisions.
Resource Exhaustion Perhaps the most common source of negative externalities—and often underestimated—is limited attention span. Management can only pay so much attention to so many different issues. An extra project distracts from the attention previously received by existing projects.
Although costs always include opportunity costs, in the case of negative project externalities, they are more obvious. If your project cannibalizes another project or requires more attention, it’s clearly an opportunity cost.

Diminishing marginal utility

admin — Sat, 26 Nov 2011 08:01:14 +0000

The law of diminishing marginal utility applies: as the rate of consumption increases, the marginal utility derived from consuming additional units of a good will decline. Utility is a term economists use to describe the subjective personal benefits that result from taking an action. The law of diminishing marginal utility states that the marginal (or additioanal) utility derived from consuming successive units of a product will eventually decline as the rate of consumption increases. For example, the law says that even though you might like ice cream, your marginal satisfaction from additional ice cream will eventually decline as you eat more and more of it. Ice cream at lunchtime might be great. An additional helping for dinner might also be good. However, after you have had it for lunch and dinner, another serving as a midnight snack will be less attractive. When the law of diminishing marginal utility sets in, the additional utility derived from still more units of ice cream declines.
The law of diminishing marginal utility explains why, even if you really like a certain product, you will not spend your entire budget on it. As you increase your consumption of any good, including those that you like a lot, the utility you derive from each additional unit will become smaller and smaller and eventually it will be less than the cost of the unit. At that point, you will not want to purchase any more units of the good.

How demand elasticity and price changes affect total expenditures

admin — Tue, 15 Nov 2011 07:57:40 +0000

By looking at demand elasticity, we can determine changes in total consumer spending on a product when its price changes. We can do this in three different ways: by looking at (1) changes in an individual’s total spending, using the demand elasticity from his or her demand curve for the product, (2) changes in the total combined spending of all consumers, using the elasticity from the total market demand curve, or (3) changes in total consumer spending on the product, using the demand curve facing that firm that produces it. In other words, this third method allows us to look at elasticity based not on what consumers spend, but on what the producer receives from selling the product.
Total expenditures (or revenues) simply amount to the price of the product times the number of units of it purchased (or sold).
Because total expenditures are equal to the price times the quantity, and because the price and the quantity move in opposite directions, the net effect of a price change on the total spending on a product depends upon whether the (percentage) price change or the (percentage) quantity change is greater.
When demand is inelastic, the price elasticity coefficient is less than 1. This means that the percentage change in price is greater than the percentage change in quantity. Therefore, when demand is inelastic, the change in the price will dominate and, as a result, the price and total expenditures will change in the same direction. In other words, when the price of an inelastic product (say, cigarettes) increases, spending on it will increase, too – and vice cress. On the other hand, when demand is elastic, the change in quantity will be greater than the change in the price. As a result, the impact of the change in quantity will dominate, and therefore the price and expenditures will move in opposite directions. In other words, when the price of an elastic product (say, a ballpoint pen) – increases, spending on it will decrease and vice versa. When demand elasticity is unitary, the change in quantity demanded will be equal in magnitude to the change in price. With regard to their impact on total expenditures, these two effects will exactly offset each other. Thus, when price elasticity of demand is equal to 1,total expenditures will remain unchanged as price changes.
The demand curves can also be used to show the link between elasticity and changes in total spending. In the case of cigarettes (part b), the price elasticity of demand for the price increase from $1.00 to $1.50 is 0.26, indicating that demand is inelastic. This increase in cigarette prices leads to an increase in spending on the product from $100 million ($1.00 X 100 million units) to $135 million ($1.50 X 90 million units). If the change had occurred in the opposite direction, with the price falling from $1.50 to $1.00, total expenditures would have declined.
The price elasticity of demand for a ballpoint pen when its price increases from $1.00 to $1.50 is 3.0, indicating that demand is elastic. This increase in the price of ballpoint pens lowers total consumer spending on the product from $100,000 ($1.00 X 100,000 pens) to $37,500 ($1.50 X 25,000 pens). If the change had occurred in the opposite direction, with the price falling from $1S O to $1.00, total expenditures would have risen.
You can see how important it is for business decision makers to understand the concept of elasticity.When a fm increases the price of its product, its revenues may rise, fall, or remain the same. If the demand for the firm’s product is inelastic, the higher price will expand the firm’s total revenue. However, if the demand for the firm’s product is elastic, a price increase will lead to substantially lower sales and a decline in total revenue. In the case of unitary elasticity, the price increase will leave total revenue unchanged.
Beyond the price elasticity of demand, two other elasticity relationships are important in any given market.

Prioritizing Debt

admin — Sat, 05 Feb 2011 11:08:54 +0000

When growing a family this can be the time when a lot of debt is amassed. There will be times when you use a credit card, take paycheck advances, borrow for a home or car, or suffer an accident and need money for medical expenses. If debts start to pile up, you will have to get a handle on them all by prioritizing payments to help you gain time to generate more income.

Essentials First

Shelter, food, utilities, and transportation are the modern day essentials. The mortgage or rent should be paid first to avoid a situation where you are forced to move, incurring larger charges. Keep your utilities on automatic payments and join as many easy pay plans to keep those up and running. Sell any new cars, buy used, and use the savings to pay off more debt.

Loans

Credit cards will allow you to pay a minimum payment, rather than the full amount. Short-term loans like paycheck advances should be paid on the next paycheck cycle to avoid increasing the debt. Only borrow for a house or a car if your job situation is steady. Otherwise, you can buy a car outright used for a fraction of the cost of a new car and avoid financing it all together.

Medical Debt

This is only a priority if non-payment is going to keep you from receiving treatment. Most places will demand full payment, however will be very open to negotiating a payment plan or in some cases upon financial review, offering partial loan forgiveness. If it’s a situation of paying an old medical bill or keeping the heat on in the winter, prioritize the utilities first and the bill last. Even keeping your credit in good standing on accounts that offer emergency cash is better than paying off part of a bill you can’t afford and having nothing left to live on. If medical bills are extravagant and in collections, it may be time to seek bankruptcy protection, in which case much of the debt may end up dismissed in court.

IMPACT ON REPORTED EARNINGS, BALANCE SHEETS AND RATIOS

admin — Thu, 02 Sep 2010 10:04:49 +0000

Interpreting reported NPL and NPL cover ratios is fraught with uncertainty and ambiguity. The use of common ratios to compare asset quality and NPL cover between banks in different countries is plagued with definitional issues related to problem loans, provision accounts and loans:

Provision accounts. There are also differences in the definitions and use of specific and general provision accounts. There are also differences in practices within the same accounting standards that may have a material impact on derived ratios. Loans. The definition of gross or total loans as reported on the balance sheet varies between countries. The most common differences relate to whether or not interest receivables, lease financing and commercial paper are included in the definition of loans. Other differences may arise depending on how banks treat exposures to other banks and financial institutions.
This proliferation of definitions and varying degrees of conservatism in defining loans as impaired makes meaningful comparisons of NPL levels and cover between banks in different countries, and even within the same country, difficult.
A further complication is created when banks report related ratios without giving either clear definitions of numerator or denominator or their absolute values. They always try to paint themselves in the best possible light. Banks may include interbank assets in the definition of loans they are using as the denominator. Analysts then have to make the necessary estimates to adjust the numbers accordingly.
The ratios that can be calculated are constrained by what information is available but the following ratios are the ones that are most commonly used and referred to. The NPL cover ratio is sometimes referred to, albeit inaccurately, as provision cover.
When NPL levels are low these ratios provide a reasonable measure of asset quality but are paid little attention. A qualification on provisioning ratios is required, however. As we have already noted few banks provide fully for expected losses on current loans but only act when loans are recognized as impaired or non-performing. As NPL levels start to rise these ratios become the focus of analyst and investor attention but become increasingly difficult to interpret and may not provide a realistic measure of asset quality.
Using them blindly can be very misleading particularly when the use of common accounting standards and NPL definitions would appear to make such ratios between banks directly com- parable. Investors and brokerage sales people do not like analysts to give answers that start with “it depends how you look at it”. A low NPL level may reflect any of, or a combination of, the following:

Better asset quality. The bank has been more conservative in its lending approach. Hard, but indirect, evidence for this could be loan growth well below that of the industry as a whole at a time when credit was expanding rapidly or a below average level of loans to sectors regarded as highest risk. Less conservative approach to NPL classification. We have already looked at how, even when definitions of impaired or non-performing loans appear to be completely objective, there is almost always an element of judgment. A more conservative approach to classification will lead to higher reported NPL numbers.

Speed of write-offs. The faster that a bank moves to write off NPLs the lower will be the reported level of NPLs. Provision levels as a percentage of loans will also fall. The impact on NPL cover is less predictable. If the provisioning level for the loans written off is greater than its average NPL provisioning level then its NPL cover will fall. This could occur if the bank acted to write off NPLs that were either unsecured or had the lowest level of collateral cover.
On the other hand, if the bank writes off those NPLs that were best secured reported NPL cover would be likely to increase.
Foreclosed assets. If a bank acts to foreclose on pledged security for NPLs but does not sell these assets immediately then while NPLs will fall the level of foreclosed assets will rise. Restructuring. The rules on restructured loans being reclassified as performing loans vary significantly between countries. Some regulators allow these to be immediately reclassified as current while others require that borrowers adhere to the terms of the restructuring agreement for a defined number of months. The greater the level of restructured loans and the faster these are allowed to be classified as current the lower will be the reported NPL
level.
Bank management comments are rarely of any help to analysts. I’ve never come across an example where management has admitted that low reported NPL levels and high levels of provisioning cover are due to window-dressing. It is therefore virtually impossible to determine whether or not they are lying. Even when an analyst believes that management are being “economic with the truth” the best he or she can do is to point to indirect evidence that reflects a culture of creative accounting and past sharp practices.
Other related ratios that may be disclosed usually concern collateral cover. They tend to be highlighted by banks where a high proportion of their loans are “fully” secured. The usual definitional problems apply and their usefulness is highly dependent on the appraised value of the pledged security and the ability of the bank to realize that appraised value. Other ratios using NPL aging profiles, when reported, may also be derived.

REGULATORY PROVISIONING REQUIREMENTS

admin — Fri, 05 Mar 2010 10:03:39 +0000

Provisions for credit losses are inextricably tied up with regulatory capital requirements and this is acknowledged, to an extent, by the Basel Accord which allows certain provisions to be counted towards regulatory capital. In practice regulators fall into one of two camps, those that put the prime responsibility onto bank management for provisioning and where bank’s behavior is determined by a combination of market forces and moral suasion and those that impose a formulaic-based framework:

Laissez faire. Most regulators in developed markets leave provisioning policies up to individual banks’ management to act within the constraints of local accounting standards and influenced by tax considerations. This does not imply that regulators are disinterested in bank provisioning levels but that they believe that the disadvantages of a formal framework out- weigh any benefits. Where many banks have an exposure to a single counterparty (whether a company, public sector organization or sovereign) provision levels are effectively set by market forces. It would be very difficult for one bank to justify having a significantly lower level of provisioning than others in such cases. Regulators are also likely to act by having a quiet word with management at banks where they are concerned that a particular bank is underprovided. Formulaic. Formulaic provisioning requirements are common in developing markets. Most of these are based in one way or another on the following:

Local problem loan and NPL classifications, e.g. substandard, doubtful, loss.
Age, since problem loans or NPLs were classified as impaired or past-due, e.g. 90 days
past-due, 180 days past-due, one-year past-due.
Level of collateral cover.
General provisions that are not allocated to any particular group of exposures.
General provisions for specific pooled exposures.

Delaying making charges

admin — Tue, 05 Jan 2010 10:02:47 +0000

Under many regulatory regimes and accounting standards banks are not required to make any provisions for losses until the loans have been formally classified as non-performing. The level of provisioning required is also often defined in terms of collateral shortfall and NPL age. We have already considered some of the differences in definitions of problem loans that exist between countries. Within these definitions there is usually still room for management to delay classification. NPL definitions usually allow considerable latitude to bank management. Impairment, for example, is usually a subjective measure. Specific examples where judgment may be used include the following: A company is in arrears on one loan it has taken from the bank and this has been classified as non-performing. It also has other loans from the bank which it is servicing and are current. A company has defaulted on loans from other banks but remains current on loans from this bank. A guarantor of a loan has defaulted on loans from banks but remains solvent and there has been no move to liquidate the company. The borrower is servicing its loan and the loan is fully secured. Collateral cover has fallen from that agreed at the time that the loan was extended and the borrower cannot “top up” the collateral but collateral cover remains well above 100%. The loan is otherwise current. A company is servicing its loan but has only been able to because it has drawn down against facilities granted by the bank or by other banks or has taken out new loans from other banks. None of these actions break any loan covenants. Even when definitions appear to have hard criteria, such as day past-due, banks can often find ways such as evergreening to avoid having loans classified as nonperforming.

MORTGAGE DEFAULT RATES

admin — Wed, 16 Dec 2009 08:03:15 +0000

The historic default rates on mortgages have been generally much lower than on other consumer and corporate loans. They have also generally remained low even when borrowers have significant levels of negative equity. There are a number of reasons why this should be the case:
People have to live somewhere. Negative equity represents an unrealized loss. There is no incentive to realize this loss provided the borrower can service the loan. The advantage of moving to cheaper rented accommodation has to be balanced against the disadvantages of defaulting. Bankruptcy avoidance. If a borrower defaults on a property with significant levels of negative equity they are likely to face bankruptcy proceedings. In addition to the stress and loss of assets that such proceedings bring they are also likely to make it impossible for the borrower to ever own their own property.
Long dated option. A mortgage can be viewed as a long dated option. Given long enough most property markets eventually recover, even though it may take years. Option holders do not simply throw away an option that is out-of-the-money for the simple reason that it also has a “time value”. Given the typical term of mortgages the time value is significant, particularly as the “premium” they have paid (the down payment) represents a significant portion of their accumulated savings.
The level of defaults in the UK rose sharply after the residential property market crashed in 1986. A close examination of the problem showed that many defaulters had not actually made any down payment on their mortgage. Instead the lending bank had sold indemnity policies to them issued by an insurance company. These policies protected the banks from the first 20% of losses. Having paid very little for the option and being well out-of-the-money borrowers had little incentive to stay current and simply dropped off the keys after moving out.
The actual losses experienced by banks were relatively modest and the insurance companies simply responded by increasing the premiums charged for these policies. Few banks went through formal bankruptcy proceedings and, in the absence of a central register of defaulters, borrowers were able to go to another bank and took out a new mortgage on a different property. It’s a wonderful world.

Historic Mortgage Drawdown

admin — Fri, 11 Dec 2009 08:08:23 +0000

We need to estimate the level of new mortgages drawn down over time. If residential mortgages were rising very rapidly (and this is usually the case when real estate bubbles develop) a reasonable first approximation is to take the net increase in mortgage loans and assume that it is close to the gross increase. This may be done at the system level or for individual banks. Some countries actually publish gross drawdowns and these should be used when available.
Next we estimate how much of these loans have been repaid. Based on our example of a 20-year mortgage we know approximately how much capital is repaid in each year.
We are only interested in the loans made in 1995, 1996 and 1997. These are the only loans that are at risk of being “under water”. A mortgage taken out in 1995 is approximately six years old and hence approximately 17% of the original principal has been repaid. This could be done on a quarter by quarter basis but besides from adding complexity and increasing the risk of computational error it does little to increase the accuracy of the estimates.
We then calculate the estimated balance outstanding and subtract it from the current estimated value of the properties bought. This shows that the only properties at risk were those bought between 1Q96 and 4Q96.
Finally, we can make a reasonable first-cut estimate of the level of negative equity. Approximately 12% of mortgage loans, by value, have negative equity with the level of negative equity highest for people who bought in 3Q96 at approximately 30% of their outstanding balance.
Part of the reason for including this example is to illustrate how in an imperfect world, where the data to arrive at a definitive answer either does not exist or is not reported, it is still possible with many problems to make some reasonable quantified conclusions using the data that is available, some clear approximations and a bit of creativity.
This method of estimating the level of mortgages with negative equity will not work in markets with significant levels of mortgage securitization.

The residential property market trap

admin — Sun, 29 Nov 2009 08:09:53 +0000

Property markets are at their most dangerous after they have enjoyed a strong run for many years. First time buyers start to panic as the prices of houses and apartments threaten to move out of reach. They become desperate to get a foot on the ladder. They are egged on by friends who have already done so and are sitting on large unrealized gain. The high level of gearing that mortgages provide accentuates this. Suppose someone buys an apartment for $750 000 with an initial down payment of $150 000, equivalent to 20% of the purchase price. If the market value of the apartment rises by 10% their equity increases by 50% to $225 000. If the market value goes up by 20% then their equity doubles.
Suddenly all the talk at dinner parties centers on how much prices have gone up for particular types of properties and locations. The market develops a momentum of its own with property prices rising well above the level implied by historic affordability measures such as average transaction prices versus average salaries.
All parties have to come to an end, however. The trigger is usually a change in the economic environment. Higher property prices increase the level of mortgage payments for people trading up and for first time buyers. Asset inflation also feeds through in the form of higher rents as landlords try to maintain yields. Employees then seek wage increases to maintain the real value of their earnings. These put upward pressure on inflation.
The usual response of central banks to rising inflationary pressures is to raise interest rates to slow the economy and choke off inflation. Interest rates for mortgages with floating rate loans follow and monthly payments start to rise. In countries where fixed rate mortgages are the norm the cost of new mortgages rises. This makes it harder for first time buyers to buy and for people looking to trade up to afford the payments on the next mortgage.
First, the volume of property transactions falls. Potential sellers are reluctant to cut asking prices. With the higher mortgage payments potential buyers cannot afford to meet the monthly mortgage payments implied by asking prices. The immediate result is that there is no market clearing price, that is a price at which sellers are prepared to sell and buyers to buy. At that time “appraised value”, the value that realtors and surveyors assign to properties, becomes increasingly meaningless.
In time these appraised valuations adjust to reflect the new reality. Sellers are urged to cut asking prices to “realistic” levels. As these agents make their money from commissions based on actual transactions they have a strong incentive to ensure that a clearing level is reached. Their profitability is more dependent on the actual volume of transactions than the absolute prices being paid.
It is at this point that first time and highly geared borrowers begin to realize that they are in a serious predicament. The gearing that works so well when prices are rising now kicks in with a vengeance when prices are falling. The borrowers find themselves facing the “negative equity” trap. This means that the market value of their property is less than the principal outstanding on the mortgage.