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Artifacts of Financial Engineering

Mises Daily: Thursday, June 29, 2006 by

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Suppose that company HN has been used to selling cars for cash at $10,000 apiece, but that business has been a little slow lately.

Faced with the imperative to re-energize the dealership, inspiration strikes some genius in the marketing department. Shortly afterward, he emerges smiling from a lunch with one of his buddies up in finance and makes straightaway to the CEO's office suite.

The gist of his idea is this: henceforth, HN will overcome sales resistance by offering a hot new deal. It will sell its cars for a sticker price of $9,500 — an ostensible 5% discount — and it will also allow the customer 5 years to pay back the money at a monthly rate of "only" $192.625.

This financing represents an interest rate of 8% monthly, or 8.30% compounded annually, and the "discount" will, in fact, cost the owner a total of60 x $192.625 = $11,557.54 by the time he has fully paid for the car.

The angle for the car company is that it knows that, with the help of its favorite partner in the Money Trust, it can now repackage the loan ("securitize" it) and sell it on to the bank at an internal rate of return of 5.85% (net of servicing fees accruable to HN), thus ensuring that it will receive its original $10,000 as an upfront payment which it can book directly as income.

Thus, the car company's profits will be unchanged, despite the lower selling price (in fact, some of these profits may subsequently be used to help fund the loan — whether directly extended to the buyer, or more indirectly by putting them on deposit with the securitizing bank).

Conversely, unless the customer can invest the $10,000 he would formerly have spent on the car in an annuity at the same rate of 5.85% (which, as a retail customer, he is highly unlikely to do), he is worse off under the financing deal than before, despite the illusion of an initial saving.

But — hey! — what does he care? By paying out less than $200 a month for his wheels, he is now free to decide whether he should play the stockmarket with the rest of his funds, or put it towards that second condo he wants to buy in the hope of flipping it for a quick turn. 

From HN's perspective, of course, the additional benefit is that the new program will allow lesser-quality, would-be customers who have not accumulated $10,000, or who could not previously borrow for so long or so cheaply, to buy the car for the first time.

Therefore, the deal could well result in even higher sales and hence profits for HN — and all this despite the fact that car selling prices have declined by 5% as far as those collecting data for official government indices are concerned.

Inflation (properly defined as the securitizing bank's monetary creation which supplemented the car company's circular diversion of profits towards this act of customer finance) has thus seemed to reduce the kind of "inflation" that is routinely misdefined as a rise in the consumer price level.

Lulled into false security by this seemingly benign outcome, the central bank will now be happy to keep interest rates lower for longer and so it will promote this very act of monetary expansion in the future.

As interest rates fall, the math means that lower dealer prices can be quoted, while generating the same or higher accounting profits, in turn encouraging the central bank to greater laxity, lower rates,and so on round again and again…

Here we should note that this is in no sense an academic exercise since, in Canada and the United States, the relatively low official CPI rates of recent years have accompanied rising corporate profits, yet these same higher earnings are, in good part, being used to finance increased consumer indebtedness and/or outright household dissaving (the same is true, to some extent, of New Zealand, Australia, and the United Kingdom).

But we must not stop there, for there is a deeper and more ironic inference to be drawn from all this.

As Bob Woodward never fails to mention in his gushing hagiography of our lately departed "Maestro," in the late 1990s, Alan Greenspan became so puffed up with his idea that productivity gains in the United States were being drastically understated that he ludicrously likened his bathtub insight to Einstein's theory of General Relativity.

However, Greenspan's sole support for this flimsy thesis came from the rather tautological identity that profits = selling prices - labor costs - non-labor costs.

The best money book ever: $17

Apart from the fallacy inherent in maintaining that, in a rapidly changing world, the last term could be regarded as a constant (when, as Roger Garrison has pointed out, the cost of capital is a key component that Greenspan himself could help lower by keeping policy too easy), this led the Chairman to argue that the higher profits that were seemingly being delivered against barely changed prices could only mean labor productivity was higher than estimated.

Eureka! No need to raise rates or slow the growth of credit!

With hindsight, we now know of course just how reliable the profits of WorldComs, Enrons, Nortels, and Fannie Maes really were as a measure of increasing prosperity, but as the above exercise in the arithmetic of securitization shows, the whole darn thing may have been little more than an artifact of financial engineering, even barring bad accounting or outright fraud.

In other words, in seeking to boost sales by exploiting the possibilities of modern finance (in a perfectly legal manner), GMAC and Ford Motor Credit, GE and John Deere (among countless others) may have misled our preening, erstwhile Maestro into financing the whole wasteful bubble of the late 1990s!

If so, we might point out to the irrationally exuberant Mr. Greenspan that his revelation was not so much Einsteinian, but rather had its parallels in the theories of cosmologist Alan Guth — a man whose popular treatment of his life's work bears the highly apposite title: "The Inflationary Universe."


Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management. Send him mail. See his articles. Comment on the blog.