Net Present Value

This morning, we were talking to Modern Domestic about how hard it is for people to make rational, informed decisions about money – on everything from grocery shopping to refinancing a mortgage.

She said when she shops for Wonk the Plank’s Cheerios and has to pick between the different box sizes, she learned (under Wonk the Plank’s tutelage) to make sure she was always paying the lowest cost for the cereal and to not be fooled by different specials or box sizes.

Mmmmmmmmm...

Before we were dating, she would just pick the lowest posted unit price (the little calculation most stores post along with the cost of the item) and keep on shopping. She had no idea that 2 for 1 specials and other promotions can throw those numbers off and require the buyer to do some mental math. Still, at least she was checking the unit prices, something some folks never bother to do.

24.3 cents per fluid ounce!

So if people botch small and uncomplicated choices all the time, imagine the capacity for expensive mistakes when we set Cheerios aside and consider something like a mortgage, full of fine print and bewildering different options.

Wonk the Plank decided to give Modern Domestic a little test. “Suppose,” we said, “Wonk the Plank offered to pay you $5 a year for the next ten years. That’s a total of fifty dollars. But we won’t do it for free. How much would you be willing to pay us today for that $50?”

Modern Domestic thought hard and told us she would offer $25. She was clever enough to realize that money in the future will be worth less than it is today, but still, she was mostly taking a guess. “Is that way too much to offer?” she wanted to know.

That is actually a pretty reasonable try, we told her, but the point is that there’s an exact answer (with certain assumptions about interest rates, to all you haters out there) about the net present value of Wonk the Plank’s $5 payments.

Yikes!

Nobody panic, it’s just a formula for figuring out the present value of a stream of future payments. In our example, we’re going to plug in $5 for C, 4% as our interest rate i and 10 as the number n of times we’ll pay Modern Domestic the money.

$38.60! So while Modern Domestic’s guess wasn’t too bad, it could still cost her thousands if she were guessing about refinancing a mortgage or paying off a car loan. Folks, do the math before you make a such a decision. If you’re not sure how to do it, enlist someone you trust (NOT anyone trying to sell you something) to help you figure it out. You can still shop for Cheerios on your own, but for decisions with more serious implications, you should get help.

Indigestion

Last week Wonk the Plank was reading through Merrill Lynch’s quarterly report, and man, was it ever boring. (They usually are.) Merrill, in case you don’t remember, is the failed investment bank that was sold in a shotgun wedding to megafinancial company Bank of America.

We were plodding through the tail end of of Thursday’s filing, our little lids growing heavier as the legalese grew tougher and tougher to take. But suddenly, we saw a paragraph that snapped us out of our stupor (we added the italics for emphasis.)

Other Events

On January 16, 2009, due to larger than expected fourth quarter losses at Merrill Lynch, the U.S. government and Bank of America entered into an agreement in principle in which the U.S. government would provide protection against the possibility of unusually large losses on a pool of Bank of America’s financial instruments. As of the time of filing this document, Bank of America has not entered into a binding agreement with the U.S. government.

What are they talking about? Why was Wonk the Plank so astonished? As the filing explains, Bank of America had a little case of indigestion when it tried to swallow Merrill Lynch whole. The smaller Merrill’s balance sheet had soured so badly that Bank of America was ready to call the whole thing off.

So, in a smoke-filled back room, the government promised to guarantee some losses on a $118 billion package of grotesque mortgage backed securities, the culprits behind the whole financial crisis.While Wonk the Plank knew about all this beforehand, we had no idea the deal was more understanding than deal.

While on Friday, Bank of America announced it plans to terminate the government’s guarantee, it seems to Wonk the Plank that someone ought to have draw up a binding agreement for a $100 billion plus deal. Does anybody wonder what would happen if the tables were reversed? If the big shots at Bank of America faced a billion-dollar bill based on an “agreement in principle” but no signed contract, we somehow doubt they would honor it. More likely, they would shirk any back-room promises, and they would do it with a smile.

The Magic Way

We enjoyed this deconstruction of the lastest Geithner plan for big banks like Citigroup and Bank of America from businessinsider.com founder Henry Blodget. Blodget’s post was an instructive and simple explanation of why Geithner’s plan is bunk.

The Geithner plan involves converting the government’s preferred shares, acquired in the first round of the bailout, into common shares. The manoeuvre  will boost an important yardstick of the banks’ financial health called Tangible Common Equity. The best part(and biggest selling point) of this plan is its cost, $0. Since the government already owns preferred shares, it can convert them for free.

Still, Wonk the Plank didn’t need to read Blodget’s excellent post to know something was very wrong with the secretary’s plan because we don’t believe in Magic Ways.

The streets here in DC are mostly a grid of letters and numbers, but once Wonk the Plank astonished Modern Domestic by showing her a shortcut down a diagonal street. She was so charmed by the discovery that she christened it “The Magic Way.”

So very magical!

So this is Geithner’s big plan, to tell us all there’s a Magic Way that we’ve all overlooked all these years to make Citigroup and the rest much stronger than they actually are. We feel like we have been repeating ourselves, but alas, to no avail. One more time: There is no Magic Way to help banks out that doesn’t involve decidedly unmagical pain for someone else. Changing mark-to-market accounting rules is not a Magic Way. Converting preferred shares into common is not a Magic Way. These are sideshows, not Magic Ways.

Wonk the Plank thinks it’s funny that most people, when it comes to personal finance, understand that there aren’t any Magic Ways. Those same people, though, who understand so clearly that they can’t pay $200 in bills if they only have $100 in the bank, don’t seem to realize that those same rules apply to big giant companies like General Motors and Bank of America, or even the U.S. government.

 Banks can’t be made more valuable just by pushing numbers around on a piece of paper. Anyone who tells you differently is vouching for the existence of a Magic Way.