Loans and financial matters

How do economic and accounting profit differ?

admin — Fri, 11 Dec 2009 14:57:06 +0000

Economists include both explicit and implicit costs when they measure total cost. Economic profit is total revenues minus total costs, including both the explicit and implicit cost components. Economic profit will be positive only if the earnings of the business exceed the opportunity cost of all the resources used by the firm, including the opportunity cost of assets owned by the firm and any unpaid labor services supplied by the owner. In contrast, economic losses result when the earnings of the firm are insufficient to cover explicit and implicit costs. That is why the normal profit rate is zero economic profit, yielding just the competitive rate of return on the capital (and labor) of owners. A higher rate would draw more competitors and their investors into the market; a lower rate would cause competitors and their investors to exit the market.
Remember, zero economic profits do not imply that the firm is about to go out of business. On the contrary, they indicate that the owners are receiving exactly the normal profit rate, or the competitive market rate of return on the their investment. They are earning no more and no less than they could earn elsewhere on what they use in the firm.
Whenever accounting procedures omit implicit costs, like those associated with owner- provided labor services or capital, the firm’s opportunity costs of production will be understated. This understatement of cost leads to an overstatement of profits. Therefore, the accounting profits of a firm are generally greater than the firm’s economic profits (see the applications in Economics feature on accounting costs). For most large corporations, though, omitting the implicit costs of services provided by an owner isn’t an issue. In this case, the accounting profits approximate the returns to the firm’s equity capital. High accounting profits (measured as a rate of return on a firm’s assets), relative to those of other firms, suggest that a firm is earning an economic profit. Correspondingly, a low rate of accounting profit implies economic losses. Either positive or negative economic profits, of course, call for a change in output. Such a change, however, will take time.

A Mountain of Money Looking for a Home

admin — Sat, 05 Dec 2009 14:36:10 +0000

Let’s start with the big picture. By the middle of this decade, the world was awash in cash.The International Monetary Fund (IMF) estimates that over $70 trillion of global savings in fixed-income securities, more than double the amount in 2000, was held by sovereign wealth funds, endowments, pension funds, insurance companies, central banks, and the like. That’s a lot of money—roughly equal to the entire world’s gross domestic product (GDP)—and it needed a home.
Typically, the largest fraction of it would have been invested in U.S. Treasuries, but for three years beginning in late 2001, Treasury yields were particularly unattractive thanks to Federal Reserve Chairman Alan Greenspan cutting short-term interest rates to extremely low levels and keeping them there in an attempt to keep the economy out of a prolonged recession after the bursting of the Internet bubble and 9/11. The federal funds rate was a mere 1 percent by June 2003, the lowest level since the 1950s.
Greenspan knew that these actions would have an impact on home prices. In fact, in testimony before Congress on November 13, 2002,1 he said: “Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years.” Greenspan was counting on consumers using the equity in their homes to create demand and keep the economy out of recession. He had no way of knowing then how right he was—and how disastrous the consequences would be. It is widely accepted now that Greenspan cut interest rates too much and kept them too low for too long, because this provided the liquidity and motivation to fuel the worldwide debt bubble.

Real risk-free rate

admin — Wed, 02 Dec 2009 14:35:03 +0000

The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the RRFR on an investment. Earlier, we called this the pure time value of money, because the only sacrifice the investor made was deferring the use of the money for a period of time. This RRFR of interest is the price charged for the exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price. The subjective factor is the time preference of individuals for the consumption of income. When individuals give up $100 of consumption this year, how much consumption do they want a year from now to compensate for that sacrifice? The strength of the human desire for current consumption influences the rate of compensation required. Time preferences vary among individuals, and the market creates a composite rate that includes the preferences of all investors. This composite rate changes gradually over time because it is influenced by all the investors in the economy, whose changes in preferences may offset one another.
The objective factor that influences the RRFR is the set of investment opportunities available in the economy. The investment opportunities are determined in turn by the long-run real growth rate of the economy. A rapidly growing economy produces more and better opportunities to invest funds and experience positive rates of return. A change in the economy’s long-run real growth rate causes a change in all investment opportunities and a change in the required rates of return on all investments. Just as investors supplying capital should demand a higher rate of return when growth is higher, those looking for funds to invest should be willing and able to pay a higher rate of return to use the funds for investment because of the higher growth rate. Thus, a positive relationship exists between the real growth rate in the economy and the RRFR.

Education loans

admin — Sat, 28 Nov 2009 14:33:42 +0000

Students (or their parents) have to meet their own day-to-day expenses while studying at college or business school. They may also have to pay tuition fees and other charges imposed by the college. Bursaries and scholarships are available for some students but many can only finance their education by taking out student loans. These loans are long term and may be made at relatively low interest rates. Governments may subsidize the costs of loans from banks or give borrowers a favorable tax treatment on interest paid on such loans.

Margin loans

admin — Tue, 24 Nov 2009 14:32:43 +0000

A margin loan is a loan made by both brokerages (securities companies) and banks to enable investors to buy stocks using borrowed money, or at margin. A simple example shows how this is usually structured. An investor wishes to buy $100000 worth of stock. The lender agrees to lend the $100 000 but also requires the investor to make a $20 000 deposit with the bank. Interest is usually charged on the whole $100 000 but not earned on the deposit. If the value of the stock lent by the margin borrower falls to $90 000 the lender will make a “margin call”, and require the investor to make an additional $10 000 deposit. If the investor is unable to do so, or for some reason cannot be contacted, the
lender has the right to sell stock to the value of $10 000 in the market. When stock markets fall sharply many investors are likely to receive margin calls and forced selling by margin lenders adds further downward pressure on markets.
Borrowing at margin provides investors with gearing and in a rising market will enhance returns. It is a relatively-low risk business for the lenders unless markets fall sharply and liquidity dries up. The actual margin level required is frequently imposed by bank or securities’ regulators.

Overdrafts and installment loans

admin — Fri, 20 Nov 2009 14:31:32 +0000

Many banks and finance companies offer overdrafts and personal installment loans that are unsecured and are not granted for a specific purpose or purchase. An overdraft is a form of revolving credit akin to that provided by a credit card. Most of these loans and facilities have lower interest rates than those charged on credit card rollover balances and many borrowers take such loans to consolidate and repay outstanding balances on their credit cards.

Consumer finance

admin — Tue, 17 Nov 2009 14:30:44 +0000

Consumer finance loans are made for a range of consumer products such as autos and white electrical products such as refrigerators. In addition to the basic checks made on applications for credit cards lenders look to get security for larger-ticket items. For auto loans, for example, the bank will seek to get physical custody of the car ownership documents. This may be more of a symbolic act than an effective control.
The bank’s possession of these documents means that the only way the borrower can sell the asset is by reporting the loss of the documents to the relevant authorities and obtaining replacement documentation. In the event of default the borrower would be liable not just to a civil action but also risk facing criminal charges for fraud. A high proportion of other consumer finance loans is unsecured.

Risks for Bonds

admin — Sat, 14 Nov 2009 14:29:59 +0000

There are systematic risks that affect bond returns in addition to those described above. They include interest rate risk, call/prepayment risk, and reinvestment risk.

MANAGING REVOLVING CREDIT

admin — Fri, 13 Nov 2009 14:28:43 +0000

Managing retail revolving credit exposures calls for different approaches than used for term or installment loans. The conditions under which a term loan is classified as non-performing can be defined quite clearly in terms of failure to meet the conditions specified in the loan agreement. The main reason why credit card bills have some form of minimum monthly payment is to provide a default type of trigger. If the outstanding balance rises above the approved limit (due largely to the effect of capitalizing unpaid interest) and the cardholder fails to make the payments necessary to take the balance back below that limit within a defined period of time this provides a second default trigger.
Credit card receivables are usually managed on a “pooled” basis from a default loss perspective. An issuer may have one or more pools based on issued card characteristics (e.g. mass-market and premium cards). Due to their large number and small individual exposures default losses can be relatively well modeled using statistical techniques. This is also true of repayment patterns and seasonality.
Many legal systems disallow personal bankruptcy proceedings on outstanding debts below a certain minimum level, well above that of most credit card holders’ individual limits. Few banks actively pursue delinquent credit card accounts to the full extent allowed by the law in any case. They usually pass over delinquent accounts to specialist debt recovery agencies and write off the outstanding balance at that time. The delinquent account details would be submitted in the usual way to a credit bureau. Any subsequent recoveries would be netted against future write-offs and, again, at a pooled level, can be reasonably well anticipated.

Fraud Detection

admin — Wed, 11 Nov 2009 14:28:32 +0000

Having done what they can to prevent fraud from happening in the first place, banks face the problem of detecting fraud either when it is attempted or after the event to prevent repetitions. In order to do this banks have implemented sophisticated computer systems to identify potentially suspect transactions. These rely on a combination of two factors:
Statistical sampling and analysis.These systems search for unusual transaction behavior, for example a sudden increase in activity on a card that is only used infrequently, or a transaction well above usual levels. Improbable events. These systems look at multiple transactions and attempt to identify whether they are mutually incompatible. It is completely feasible that I could pay a hotel bill in London on Friday and buy an expensive camera in New York the following day. It is infeasible that someone could pay a hotel bill in Hong Kong and simultaneously buy a mobile phone in Italy. (This actually happened to me and the issuing bank caught the infeasible transactions.)
The gap between the large sophisticated issuers and those of small, inexperienced banks new to this business is illustrated with this example. I once visited a bank in Taiwan that was too small to be of interest to institutional investors but was a possible target for a bid. They had fairly recently entered the credit card business as an issuer and were very pleased with the growth in number of cards issued that they had been able to achieve. Their approach to fraud detection was breathtakingly simple. Once an hour they would print out a record of all the transactions over a certain minimum dollar value that had been automatically approved by their systems in the last hour. A handful of individuals then went through these printouts looking for any suspicious transactions. If they found one they then called the cardholder concerned to check whether the transaction was legitimate.