Perspective?

Here is some perspective on how much money the fed has lent to financial institutions recently.

The first chart is a graph of the amount of money the Federal reserve lent to banks per year. As you can see this lending peaks in the 80's at nearly 8 Billion per year.


This second chart is the same graph on a new scale to fit the most recent federal reserve activity. Notice how you can't even see the bumps when we include this years lending topping out at over 600 billion.

Hats off to East Coast Economics; they published these graphs. Original article can be found here. Thought this would be interesting to share to help put a little perspective on what we are going through. Remember the Federal reserve is suppose to be the "lender of last resort." Right now banks can get money from the fed for 0.00% interest and then deposit it back with the Fed and earn .25% interest.

I promise I will get back to making posts I had originally planned when I started the blog but keeping up with the most recent economic news has kept me pretty busy and it's just too important to completely ignore.

TRC

CMO, CDO, CDS and the Economic Crisis, what, what?

I have yet to make the kind of post I intended to make when I started the blog but as I was brain storming today and trying to think about pertinent concepts to blog about I thought of another subject that has been completely ignored by the mainstream media. The average American has now spent hours reading or listening to news about the financial crisis. The "news" on CNBC and other nightly news programs talk constantly about the current crisis but never actually explain in detail what any of the stuff they are talking about is. Now I consider myself pretty knowledgeable in the realm of finance but I must admit I spent several months reading about CDO, CMOs, CLOs and the CDS before I finally got frustrated and decided to go on a mission to understand what all of this junk was (turns out it actually was all junk). Journalist were content to just read what was on their prompter or quote other "financial guru's" but not actually understand what they were writing about. We were bombarded with these acronyms but no one has ever explained why they are a problem. Sounds a lot like what got us in this mess in the first place. I spent the better part of a month researching and reading about these different products to understand what it was exactly these financial instruments are and why they are so dangerous. So here goes my attempt to compile my findings in a format that can hopefully be understood by everyone. If you have no interest in understanding some of the more complex financial instruments behind sub-prime lending then you should probably skip this post completely.

Here is a quick and easy guide to what the acronyms stand for:

CMO = Collateralized Mortgage Obligation
CLO = Collateralized Loan Obligation
CDO= Collateralized Debt Obligation
CDS = Credit Default Swap

Great! Now we are getting somewhere. Much farther than most articles would ever take you. I don't know about you but I was always taught to write out the phrase the first time I used an acronym; apparently this lesson was lost on our media.

To really understand what all of these "new" financial instruments actually are, it's probably easiest to start with a high level look at how the financing arm of a bank may operate. Remember I'm keeping it as simple as possible here, there are many intricacies and nuances not covered in this article.

Suppose for a second that you are a bank that has 100 companies you lend to. All of these companies are paying 1 million in interest per year and have credit ratings of BBB. You estimate that 1 out of every 10 of these companies will default on their obligations but have no way of knowing which 10 it will be. You currently have a book of 100 loans, paying a an estimated 90 million a year in interest. This is how many banks operated for a very long time.

Now things start getting interesting. Instead of holding the 100 loans you decide to sell off the rights to the interest payments by creating a security that has rights to the stream of payments these loans generate but instead of selling this as one big chuck you divide it up into sections called tranches. Pay close attention here, this is important. The way you divide this is by creating several different packets (tranches). Remember we estimated that 1 in 10 of these companies will default, so at any given time we could reasonably expect at least 90 million in interest to be coming in. So the first section we create is the rights to the first 85 million in interest paid. What this means is, when the companies make interest payments no matter which companies are making payments, the first 85 million goes to the owners of this first tranche. Since we expect at least 90% of the companies to stay current on their loans when we issue this security it gets a AAA rating because there is virtually "no chance" that more than 1 in 10 of these companies will default on their loan, but wait I thought all the companies had a BBB rating (indicating they are slightly unstable and may not make good on their payments in bad economic conditions)? Ohh well just ignore that for now.

The economy is on fire and these companies are doing so well, no one is defaulting so we can sell off the second packet (tranche) which is the right to the next 5 million in interest payments which is also considered pretty solid since we only expect 1 in 10 to default. This packet gets a rating of A.

There is the leftover rights to the 10 million which based on our own model we would assume is worthless since we do not predict more than 90 of the companies to be current. Still since the economy is doing so well there is someone out there willing to bet only 8 instead of 10 we predict will default so we can sell this last package for pennies on the dollar to a speculator. We package the rights to any remaining payments and sell it as junk and allow very risk tolerant investors to speculate on the fact less than 10% of the companies default. This idea in and of itself is good for the economy. It allows banks and risk adverse investors to pass on the risk of owning these assets to someone who is willing to take the risk. The problem comes when the person who buys this "junk" values it much higher than it's really worth because in favorable economic conditions more companies are making good on their loans and the holders of these assets being to assume that this is the norm.

So now we have a bank with 100 million in interest coming in per year.
The first 85 Million goes to Tranche A (AAA) rating
The next 5 million goes to Tranche B (A) rating
The leftover 10 million Tranche C (C) is speculative but could potentially payoff big.

The bank now sells Tranche B and C to hedge funds, pension funds, and whoever else is stupid enough to buy it. Since banks are risk adverse they will even sell off a portion of the A tranche to limit their risk only to the first 60 million in payments. Now since the default rate was estimated at 1 in 10 and the banks have sold off and hedged themselves against roughly 40% of the payments. The first 60 million in payments is believed to be essentially riskless since there is no way 40% of the companies could stop payment at one time. Our genius has created what was known as a super senior tranche of income made up of BBB company debt. Who cares if the whole portfolio is made up of BBB rated companies, we essentially made an entire portfolio that is rated AAA instead of BBB. Remember the saying there is no such thing as a free lunch? Well apparently that doesn't apply to super smart bankers. Now they have their cake and can eat it too. There is no need to hedge the remaining 60 million because it is so super safe the banks can just collect interest and consider it a riskless position, they effectively isolated all their risk and sold it off....or so they thought.

Going through this kind of securitization is a huge plus for the banks since they don't have to worry about these assets they are holding ever going bad (or so they thought). They considered these riskless investments and did not insure themselves against them and were not required to hold much capital to compensate for any losses. This means they can make even more loans. Since everyone likes money and everyone wants more of it, especially those greedy shareholders, why stop with packaging up corporate debt. Banks observed similar tendencies in mortgages. Sure if we make $300,000 sub prime loans to unqualified people that can't even qualify for a car loan; some of them will default but only SOME of them will. Essentially follow the same process as above but with mortgages instead. We loan 1,000 people money to buy a house, and we know these are all sub-prime borrowers so the chances we get paid back may only be 70% but that's ok we sell off that 30% risk by bundling these loans and selling the 30% to someone willing to take on the risk. This was also a very profitable process because the banks made money every time they packaged these loans. They would make a markup on the difference between the intrinsic value of the individual mortgages and the eventual sale price of the combined tranches; plus whoever was managing the mortgages got an ongoing management fee.


Now it where it really gets tricky and this next idea is true genius. Suppose we do this process 10 times. So now we've taken 10 packages of 1,000 mortgages and split them up into tranches as we did with the corporate debt in the example above. Based on our models the first 70% seems fairly safe and secure so we don't really have much problem selling that portion off or keeping it on our books but that last 30% is harder to pass off individually. People can look at our models and estimate using their own models and come to the conclusion that the lower rated tranches are pretty worthless. Some may assume they can make a profit because their model only predicts 25% will default and we could possibly sell it for more than we would assume it's worth, but it's a hard sell. So instead of trying to sell this "leftover" tranche all alone we re-securitize the leftovers into one super mangled mess of junk called a CDO. Essentially we start the process all over again with that last 30%. Take all 10 of the leftover tranches put the rights to any remaining payments together and then split them up into A, B, C, D etc. tranches. So that if any of our MBS (Mortgage backed securities) have any leftover payments above our estimated 70% it will flow into the A tranche of the CDO. Once the A tranche is paid, any remaining leftovers will flow to the B tranche and so on. It looks something like this.

10 individual MBS each generating 100 Million in interest
A tranche first 50 million
B tranche next 20 million
C tranche next 10 million
D tranche (junk) last 30 million (if paid)

Now you do this 10 times and take all of the leftover D tranches with rights to any of the remaining 30 million and repackage them.

10 D tranches with rights to any of the remaining 300 million
A tranche has rights to the first 20% of remaining payments
B next 20%
C next 20%
D last 40%.

What is amazing is the A tranche of these CDOs were getting AAA ratings because people were making good on their mortgages and that stream of income was considered guaranteed. There was even some left over for the B, C, and D folks. Now lets see how this can blowup fast. Suppose we are in a world where currently 82% of these sub-prime mortgages are paying interest. That means everyone in tranche A,B, and C is getting paid from the original securitization and everyone in tranche A and B of the CDO are getting paid, nothing left for C, D except possibly some hope of recovery if the foreclosures sells for more than the notational value of the mortgage. That's ok though, no on expected them to pay anyway and they sold for mere pennies on the dollar. Well what happens if the default rate on sub prime mortgages drops just 3%. The income stream being generated by Tranche B is cut in half. If it drops another 3% tranche B is now worthless, if it drops to 70% (which is what we originally predicted) now the entire CDO is completely worthless because there are no leftover payments. So one day you hold an asset generating 120 million in interest per year, the next day it's generating nothing. For a graphical representation of this concept checkout this great illustration. Merrill Lynch was the first to try to sell one of these super senior CDOs (meaning the A tranche of a CDO). It's notational value was 30.4 billion and they sold it for 6.7 billion, 75% of that 6.7 billion was actually a loan to the purchaser...from none other than...Merrill Lynch. So they basically loaned Lone Star Funds (the purchaser) the money to buy an asset they had initially valued at 30.6 billion for only 6.7 billion. Talk about a great business move. Based on this logic one garbage bag may be worthless but if you take a whole bunch of garbage bags together (also known as a dumpster) somehow it is worth something.

Now we have just one more issue to address. Suppose you were a buyer of one of these CDOs that happens to be paying well right now but you are smart and you know that times could change and you want to protect yourself if it does default. This is known as a Credit Default Swap and it is an insurance contract you can take out against a bond defaulting. So now you have bought protection on your holdings and hopefully if you do it right the premium for the insurance is lower than the interest you receive by holding onto that bad debt. But what happens if the person who you bought insurance from is accepting premiums by insuring trillions of dollars of the same garbage debt and there is no way they could possibly ever of have the liquidity if their bets went against them? This is like buying insurance on a house on the coast of Florida after a hurricane has already been spotted on the Doppler radar. Not only that but you and everyone in else in your neighborhood bought insurance from the same company. Joe Schmoe insurance (read: AIG) figures they are smarter than the weather people who predict the hurricane will hit Florida and their weather man predicts it will spin harmlessly off into the mid-Atlantic. So Joe Schmoe takes the $500,000 collected from insurance premiums on your neighborhood and throws a huge party for him and his 10 best friends and declare himself the most profitable insurance company in the history of business. Yet you consider your house 100% safe even if the hurricane hits your insurance will payoff and you can get a new one. Opps the hurricane does hit and now Joe Smchoe owes 50 people $250,000 each and he already spent the origional $500,000 on a party and put the leftovers in a CDO that is now worthless!!! Lucky for you Uncle Sam (our taxpayer dollars) stepped in to guarantee a lot of this insurance that would have otherwise not been paid.

Up to this point all of our models have been based on known information and we would never expect more than 30% of these sub-prime mortgages to default at one time. What happens if the estimated 30% becomes 50% or those companies that were only defaulting on 1 in 10 loans start defaulting on 3 in 10. As the example above shows those lower tranches and even some of the less senior tranches of the original MBS become worthless. All this paper that we thought was super safe is now worth nothing and what's more no one will loan you the money you need to pay back the money you borrowed to buy CDOs! So now no one will loan anyone any money to pay any of their loans. See how this spirals out of control quickly? It is ok though you can rest peacefully at night knowing that more than 1 trillion of your children s tax dollars have already been spent and another 2 trillion has been pledge as a backstop against further losses for those lending to these financial giants and possibly another 800+billion is in the pipe to get this whole mess sorted out.

It is possible when times get better and if the government continues to redistribute our nation's wealth to those who irresponsibly borrowed more than they could afford, those who loaned more than they should, and those companies than spent years making billions writing insurance they couldn't honor these mortgages will stop defaulting and some of those less senior tranches will again be worth something. Only time will tell. Until then expect the numbers to get bigger than you could possibly imagine. We are already at the point where the numbers are so gigantic that no one can honestly picture how much money we have spent, loaned and borrowed to get out of this mess. So how much of our future tax dollars are we spending? 3 trillion could buy 104,748 tons of gold at at price of 900 an ounce. You ask how much is 104.748 thousand tons of gold? Twelve times as much gold as the U.S. has in their national reserves in Fort Knox and more than triple the worlds gold held in national reserves.

As I said in the beginning this is a VERY VERY Simplified version of what actually occurred but it can at least give you a taste of what was going on in these gigantic financial institutions. There are plenty of resources if you feel the desire to investigate this further. One of the blogs I link on the right Calculated Risk had an amazing series of articles written by a blogger known as Tanta who wrote about the sup-prime mortgage crisis well before things started looking bad for the rest of us.

Feel free to comment on the post or send me an email with further questions. I will do my best to find the answer.

TRC

Paradox of value

"Life is a sum of all your choices"
~Albert Camus.

My initial plan was to examine the cost of buying a car in my next post but I chose instead to address a different subject. I may still get to the car today but I wanted to explore an observation of human decision making that has puzzled economist for decades. To introduce this to our readers I will start by posing a question.

Suppose a complete stranger walks up to you and says: "How much would I have to pay you to live the rest of your life without legs?" (Forget the pain factor, just assume you had to go the rest of your life without legs).

How much would your legs be worth? One million? More? Twenty Million? Would there be a price you are even willing to accept? Truthfully most people could come up with some number that they'd be willing to accept to live the rest of their lives without legs. Take a moment to try to figure out this "magic" number for yourself.

Ok. Now that you have that number in your head lets ask the exact same question worded in a different way. Suppose you were taken by force, trapped in a room and someone said how much would you pay me to be able to keep your legs? Now what is your answer? How much of your savings are you willing to part with? How much money would you borrow? Would you sell your house, car and other belongings in order to keep your legs? At some price you would agree it is not worth it and decide to go the rest of your life without legs.

Logically both questions are asking the same thing: What value do you place on being able to live the rest of your life with legs? Interestingly enough, nearly EVERY person responds with a much higher number in scenario #1.

Obviously this is not a very realistic situation but we can use this irrational behavior to observe many irrational decisions people make on a daily basis. Lets examine a similar situation that most people would face. Think about your yard and approximate how much work it would take to mow and trim your yard. Since you are likely the one that does this work you probably know how much work it takes to get your yard in tip top shape. Now suppose for a second it was not actually your yard, how much would someone have to pay you to get up every Saturday, go across the street and mow this yard? This is a very common situation many home owners are in. They hate mowing grass and if offered $50 to mow their own grass they would never accept the offer. The trouble of buying a lawn mower, paying for gas, maintenance on their equipment and two and a half hours of work every Saturday for a measly $50 a week is simply not worth it. Yet these very same people get up every Saturday and happily mow their own grass and would never "over" pay a yard man $50 dollars to do the job. The very same job they would not accept themselves if it wasn't their yard. This does not make any sense. If there is a job you would not do for the price you can pay someone else to do for you, this creates an efficient exchange. The person who was paid to do the job feels it is a good deal to complete the job for $50 and the person who avoids having to do the work is happy to part with $50 in exchange for not having to do it himself. Both people are better off.

This does ignore the fact that some people actually like keeping their own yard and the satisfaction of a job well done. Also when you pay someone else to do the job for you it's likely they won't do it "the way they like it". If people more closely examined the work they do around the house they may find some of the services out there are much better deals than they initially seem. Next time you are thinking about purchasing a service, do this comparison for yourself. Think to yourself, "How much would someone have to pay me to do it?" If that number is more than you are paying, it is likely a good deal. Incidentally this also happens to be a very good sales tactic. Position your product or service in a manner than gets the person to realize how much someone would have to pay them to do it, then they are much more likely to realize that it is worth it to have you do it for them.

I leave you with one last anecdote that is often use to argue against free trade and illustrates some of the "evils" of free exchange of goods and services. Similar to the first situation suppose some rich guy, who is obsessed with punching people in the face, comes up to you and offers to pay you $10,000 to punch you as hard as he can in the face. You accept, he is glad to pay the $10,000 because he actually gets $15,000 worth of enjoyment out of punching people in the face and you are happy to be punched in the face because a few days of pain is well worth $10,000. Now here is the tricky part, according to economic theory if he punches you in the face but doesn't pay the world economy (consisting of you and him) is still better off. The simple fact that you are willing to be punched for $10,000 means that you price the pain of being punched in the face at less than or equal to $10,000. We know Mr. Rich who likes to punch people in the face is willing to pay $10,000 that he values the enjoyment received from punching people at or greater than $10,000.

To show this in equation form lets suppose that you would be neutral about getting punched in the face at a price of $3,000. Meaning you would be just as happy to get punched in the face and have $3,000 as you would not not be punched in the face and not have $3,000. Since you are getting paid $7,000 premium in this situation it is a great deal for you. The man who enjoys face punching gets $15,000 of enjoyment out of punching people. So he is neutral at a price of $15,000 between being able to punch someone or keeping his $15,000.

An equation of the exchange would be as follow.

(payment received) - (pain caused) + (enjoyment) - (Payment) = Economic Surplus

In a situation where the man pays there is economic surplus of $13,000.

10,000 - 3,000 + 15,000 - 10,000 = X
7,000+5,000 = X
13,000 = X

But if the man doesn't pay, there is still surplus because the pain caused is less than the enjoyment received!

0 - 3,000 + 15,000 - 0 = X
x= 12,000.

In this example proponents of fair trade would say that right now developed countries can be compared to the rich man who enjoys punching people in the face. They are running around punching people but not properly compensating them. If we were to adequately pay for there would still be plenty of surplus to go around it would just be more evenly distributed between the people in relative position of power and those unable to defend themselves. Would you be willing to pay an extra $2 when you purchased a t-shirt from Wal-Mart if you knew that extra two dollars could double the standard of living of a child in China or would you prefer to buy the shirt a the current price and use your the surplus to join an "adopt-a-child" program knowing that $.50 cents of every dollar donated goes towards administrative costs of running the charity.

I happen to support free-trade for various not discussed here but it is some food for thought....

TRC

Your work, your dollar

Every day I get up and look through the Forbes list of the richest people in America. If I'm not there, I go to work.
-Robert Orben

There is one last issue to settle before we move on to evaluating hypothetical purchases and their true cost. We must discover the true value of your dollar in terms of hours of work. We talked about this in our last post but we need to more fully explore this concept before continuing. A common mistake someone that makes $25 an hour may make when considering the "true" cost of a $200 iPod is thinking "What the heck, it's only eight hours of work, I'll make that on Monday." But is this really the case? We must more fully consider this scenario. Does someone who makes $25 an hour really make $200 on Monday? Well yes, and no. It is true that nominally they will make $200 but are they really netting $200 for eight hours of work? Lets explore a typical situation.

Hourly Rate: $25
Weekly Gross: $1000
SS 6.2% of 1000: ($62)
Medicare 1.145% of $1000 : ($14.50)
Retirement Contribution 10% of $1000: ($100)
FIT 25% of $900: ($180)
NC SIT 6% $900: ($54)

NET PAY: $589.50
Net hourly Rate: $14.73

So the iPod really costs you 13.577 hours of work, right? but wait...now that we have our net pay we have to figure fixed expenses. Estimates here should be used based on your current situation. Obviously these figures are going to vary widely depending on the individual. Don't forget to include items that may not occur every month or week like insurance payments and savings for emergencies.

NET PAY:589.50
Housing ($800/mo): $185/wk
Transportation: $50
Utilities: $50
Food: $100
Misc: $50
Emergency Savings Fund: $20

NET after fixed expenses: $154.50
NET disposable income after expense/HR: $3.86

This situation ignores any debt payments to credit cards or cars. It also does not count any additional savings other than saving for an emergency fund and a pre-tax retirement account. EVERYONE should know their disposable income per week/month. Be honest with yourself! IF this number is negative then you are either the U.S. Government or headed for bankruptcy. In this hypothetical situation the true cost of that $200 iPod is not just eight hours of work but actually 51.8 hours of work or 1.5 weeks worth of disposable income. One way to make this calculation much easier for yourself is to make a flexible spending account where you save a certain amount every month (say $100 a week/$400 a month) that is used to build reserves for the next big purchase. That way when you look at your next purchase it is easy to translate into weeks/months. A $2,000 TV would be 20 weeks of savings or a $500 trip would be 5 weeks of savings. It should be stressed that this is not considered SAVINGS since your eventual goal is to spend the money not save it for the long term. DO NOT BUY ANYTHING until your savings has reached a level to where you can afford it. If you follow this disciplined approach several things will happen: the purchases you do make will be a lot more meaningful, you will probably make a lot less split second decisions you later regret and you will probably find your reserve account will build up a sizable balance giving you the freedom to buy whatever you want or go where ever you want, with the satisfaction of knowing that you earned it! It's like the reverse of a credit card, except you don't earn 19.96 APR on your savings account (unfortunately the bank takes the difference).


Once you perform this exercise on your own situation you may discover something else. Anything you can do to boost your income above your fixed expenses will result almost a dollar for dollar addition to your disposable income. For example, if in the hypothetical situation above the person worked an extra five hours of overtime that week they could pocket an extra $187.50 pre tax above fixed expenses. By the same token anything you can do to reduce your fixed costs is even better because it results in a dollar for dollar addition to your weekly disposable income. Reducing fixed expenses is better than "working" harder to make more money since any additional money you make will be taxed but a reduction in expenses is not taxed.

Another way to look at this is figure out how many hours a week it takes you to "get even" in other words how many hours of work a week it takes to cover your fixed costs. In the situation above it takes the person 33.82 hours to cover all the weekly costs. The last 6.18 hours are "profit." (6.18*25=$154.50).

Go through this exercise on your own to find your magic numbers. If it a depressing situation the good news is that it's your life and you can change it. Take control of yourself, eliminate those pesky reoccurring expenses, setup a flexible savings account and reap the benefits of living life in the black. Be the person earning interest not paying it.

**EDIT** One of our readers was quick to add some very important aspects to calculating your "hourly" wage.

To figure your true hourly wage, I feel one should also calculate the time spent getting to and from work, the cost of getting there and the time spent getting ready for and winding down from work. If one was not working this time, this time and money would not be spent. So if you add all the hours each day getting ready for work + getting to work + working + getting home+ training + research/studying while at home, you will have the true hours that you spend related to work. If you weren’t doing that job you wouldn’t spend the time. Let’s call this number RELATED WORK TIME. Now let’s take the cost of working such as transportation costs + parking + tolls + any special expenses such as clothes you would ordinarily wear, suits come to mind, + tools + certifications + professional organizations + licenses + taxes + SSI + Medicare etc. Let’s call this number WORK RELATED EXPENSE.

I propose the equation would look somewhat like this:

(GROSS INCOME – WORK RELATED EXPENSES) / RELATED WORK TIME

Figuring these expenses and additional time spent will help give you an even more accurate picture of just how much time you really spend "working" and give you a better approximation of the "value" of your time. Thanks for pointing this out.

Remember anyone can comment on a post by clicking the "comment" link at the bottom of the post.

TRC

Back in action

Sorry for the hiatus. Like a good little U.S. citizen I was out spending money to do my part for the US economy over the holiday season. My biggest purchase was probably a new blackberry storm which has been a very good phone with the exception of the "random reboot" feature which has yet to be solved. Here's to hoping the new OS release will fix it.

My motivation seems to be somewhat manic (but positively correlated with caffeine use) so this blog unfortunately will not be as regular as I would like but in an effort to continue to collect my ramblings I will be making an effort to publish as often as possible. Blame netflix watch instantly feature for my recent lack of motivation.

So on to where we left off last post. How do you value your dollar? This is a tough question for anyone. When a person is asked this question most people will take one of three approaches (or hopefully all three) to describe the value they place on money. To make this easier we should probably use $100 so we can talk about something that is a little easier to assign value to.

Approach one: Assign a value based on what the most enjoyable (maximize utility) item(s) they can purchase with $100; we talked about this in the last post. Someone who really likes Wendy's chicken nuggets might tell you $100 is worth 362.31 Wendy's chicken nuggets. Where as another person may tell you it is worth 92.30 yuengling beers enjoyed at home or 36.36 enjoyed on domestic beer night at their local bar. This approach is assigning the value of a dollar (or $100) in terms of the goods and services you can buy with it. When I was young I thought of money in terms of the toy(s) it could purchase. Wal-mart had a big grab pack of baseball cards they sold for $14.99 and I always thought of money in terms of the amount of baseball cards I could buy. At that point in my life baseball cards were the most enjoyable product I could get with my money. Since money is very scarce resource to a child they put a much greater value on a dollar than an adult that can easily obtain money. Hence the reason my parents could talk me into washing, vacuuming and detailing their entire car for a measly two dollars (or one pack of 1993 tops baseball cards). Now I would probably pay up to $20 for that service. Another popular pass time is using money to buy stock. If you wanted to take your $100 an buy a steak in one of America's largest corporations, $100 would get you a .0000000644% stake in GE as of closing Friday Jan. 9th. (Based on market cap of 9.69B and stock price $15.99). With that kind of power the Board of directors better watch out!

This leads us to approach two: Assigning a value based in terms of what you had to do to earn it. So for a working adult they may value a $100 in terms of time they had to give to an employer in return for getting paid that $100. A common answer you may get from many working people when you ask them how they value $100 will be in terms of the time it took them to earn the $100. Most basically a high school student may say that $100 is the same as 19.08 hours work standing next to a road waving at passing cars and renting inflatable inter tubes to tourists. Six years later that person may say it is worth ten hours of calling unsuspecting North Carolina residents during dinner and attempting to convince them to do surveys on back and neck pain or most recently that person may respond it is 5.88 hours talking to angry, verbally abusive, impoverished retirement plan participants that have over extended their credit cards and are underwater on $300,000 houses (now worth $200,000) with $25,000 salaries utilizing a 0% down option ARM. Valuing money in terms of time can be a tricky exercise which we will discuss in detail next time.

The final way to value money is by considering what your money can earn you in the future. For example a 65 year old retiree who resides in North Carolina could grantee himself $.72 a month until he died and another 10 years of payments to his wife should he expire first via an immediate income annuity with rights of survivorship purchased for $100. Perhaps that person would prefer to invest in the "ultra safe" treasuries and receive .08% interest on 3 months treasuries or the ever alluring 3.04% 30 year treasuries were earning on 1/10/08. In that case his money is worth $.02 of interest on 3-month t-bills or $3.04 a year on 30 year treasury bond.


These three methods of valuing your money will be used in the future as different ways to consider the costs of hypothetical purchases. Before making any major financial decisions it is important to consider your situation and preferences to determine how you value the money (or lack thereof) in your bank account.

Up next disposable income and a better way to approximate your dollar in terms of time.