Risk can be...well, risky!

For the last few weeks we've been hearing how much risk there is in the economy.

One of the key words being thrown around is "systemic" risk, and I thought it might be wise to analyze the two basic types of risk one faces when running or managing a business. For some readers this will be a refresher course on managing and measuring risk; for others, we're going to slap some formal terms onto things you probably already know. Consider it a free Finance course.

The first goal of ANY venture is to remove as much risk as possible from the equation. By doing so we increase our assuredness that our project or investment will be predictable. We like predictability since it helps us create reasonable, realistic figures that we can present to our banker, shareholders or business partners. The way to remove risk is by doing something called "diversifying." Many of you know that word from meeting with your financial professional and them telling you to diversify your portfolio. It's a fancy way of asking you to not own only one type of stock, but rather, many different types of stocks. This creates a layering effect, so that one investment goes down, another might go up. It's a way of offsetting one risk with another.

Any risk that can be removed through diversification is known as non-systemic risk.

Let's look at a pizza shop for example since it's Sunday and pizza goes with church and football.

A pizza shop owner wants to remove as much risk from his or her business as possible. What are some risks they face on a daily basis that can be tweaked or changed?

Costs are largely contained in ingredients, so if the cost of mozarella cheese goes up from one supplier, our owner can look to another, cheaper substitute. Similarly, if business is slow during the lunch hour, our pizza shop could expand into new products such as salads, sandwiches, finger foods, etc. If our pizza shop is in a large metroplitan area, they may decide to eliminate delivery altogether and save the cost of labor. Basically, anything that can be readily changed to keep costs down/revenue high is a non-systemic risk.

On the flip side of the coin, however, is "systemic" risk. This is risk that CANNOT be eliminated through diversification.

For example (and there are many) oil prices. There is absolutely nothing our pizza shop owner can do about the cost of oil, which ultimately results in higher produce costs. Similarly, minimum wage increases set by government bodies will have an impact on the bottom line and there is nothing our business operator can do about those either. Other examples include inflation, unemployment, acts of terror, war, election results, interest rates,etc.

So as business people, it is our job to eliminate or diversify ALL of our non-systemic risk while carefully planning for ALL systemic risk.

We are very good at the first part since we know our business forwards, backwards and inside out. But for some reason, we are not real good at the second part, whether it's a result of too little time to plan for this type of risk or we aren't really interested in figures like CPI, PPI, GDP, Prime Rate and unemployment figures (both locally and nationally.)

I'm here to tell you that if you are to be successful for the long-haul, you have no choice but to be concerned about systemic risk. Otherwise, you are living a lie even though you have every product that could appeal to any consumer in the world.

Make a plan that includes tracking interest rates, inflation figures and employment figures; whether daily, weekly or at the least monthly. This will help you begin to see where the economy is heading six, nine or twelve months from now. By doing so, you would have known that this crash was likely to occur and you could have applied for that business line of credit in May rather than scrambling now to shore up some extra cash. Maybe you held off on that new piece of equipment because you were too busy to stop by the bank and make a loan application. Now, the cost of the equipment has gone up due to production costs and you are having a tough time getting approval for the loan since lending is being restricted.

Plan for the long-run by analyzing systemic risk and run your business day to day by measuring non-systemic risk.

It's really nothing more than a study in Macroeconomics (systemic) versus Microeconomics (non-systemic.)

Next week we will uncover some figures that help us put a number to the amount of risk we're taking on.

$700 Billion bomb

I told you that a vacation would do me a world of good. The result is two blogs in three days. But all of the credit cannot be given to rest - let's thank Treasury Secretary Paulson and Fed Chairman Bernake too. After all, it's not everyday the two get together on CNBC and talk to members of congress asking for quick passage of $700 Billion.

And at the risk of being labeled conservative in my common-sense approach to this whole thing, I would ask each of you to consider the following before giving Paulson carte blanche authority to buy these mortgages at "a deep discount."

If the assets can be purchased at such a deep discount, why isn't anyone else rushing into the market to scoop these up? Additionally, consider the fact that Bernake and Paulson are suggesting that they will pay a fair market value for these assets. Huh? If they pay fair value for these assets, or in some instances, above fair value, isn't that the same as creating profits for Wall Street?

The next point to consider is that Paulson used to work for Goldman Sachs. Before the White House tapped him to be Treasury Secretary, Paulson ran Goldman Sachs and made about $50 million per year. I can only speculate that he still has shares in GS today. By the way, Sachs is no longer an investment bank and will likely survive this implosion. The cynic in me is guessing that they will be the first in line when it comes time to dump these valuable mortgage assets, too.

Here is the point that drives it home, however. I know that we all hate history, but I'm going to ask you to go back to your eighth grade civics class and revisit the New Deal in 1933.

That year, the New Deal disallowed investment banks from also acting like commercial banks. Five years later, the New Deal created Fannie Mae to increase liquidity in the mortgage market. This allowed lower down payments and easier terms to obtain home loan financing. Freddie Maca was created in 1970.

Skip ahead to 1989 and the Savings & Loan debacle. The government stepped in when the S&L's were writing bad loans before it was en vogue and had a TON of bad loans on the books. This action changed everything - setting precedent to banks and other investment firms that if you make bad loans, the government had yoru back and would bail you out.

In 1995, Congress re-established the CRA (Community Reinvestment Act) that emphasized lending to low-moderate income borrowers in less affluent communities. If a bank was going to buy another bank or merge with another entity, it had better adhere to CRA standards in order to get its plan approved. Homeownership skyrockets to over 65% of all Americans that could be homeowners becoming homeowners.

Flash forward to 9/11. Rather than allowing the market to shoulder the burden for bad loans that occurred as a result of the business slowdown due to the terrorist acts of that day, the Feds decide to continually lower interest rates; from 6.5% to 1%. This allowed an artificial "inflation" in the market for loans and created a new demand.

Now, we find ourselves in the same predicament and we are following the same exact path! It has to stop.

Worse yet, we are allowing Paulson the ability to do whatever he wants, whenever he wants, with our money. No checks or balances here, sir.

There is an alternative and it's a simple thing to enact. Sadly for congress, it doesn't come with pomp and circumstance or a $700 Billion price tag. It's changing an accounting rule that currently requires banks to list loans as assets and value them at their current price. In case you haven't followed the mortgage market, you probably would have more luck selling sand in the desert right now than selling a mortgage on Wall Street. This is why the market liquidity crunch has hit. Not because of foreclosures, which are bad, and not because of subprime lending, which is also part of the problem.

Think about it this way. If you absolutely HAD to sell your house today. Not tomorrow, not next week, but today, would you get top dollar for it? NO WAY JOSE (my five year old daughter's favorite quote.) THAT'S what is going on in the mortgage/banking market right now.

These investment banks don't have to sell their mortgage loans today, but they have to value them on their books based upon today's demand... go figure.

The real culprit is a little accounting requirement. Sorry it's not sexier, but that's too hard to explain I guess.

Please, I am asking you as someone that really doesn't want his children to pay for this horrible plan to spend two minutes and contact Congressman Altmire and Senators Casey and Specter and ask them to please NOT sign this horrible piece of legislation.

Send me your comments and don't worry, there will be another post Monday.

Deja Vu... All Over Again

I'm sorry. I can't drop the whole buyout situation going on right now. And while I realize this is a business-oriented blog, I teach Macroeconomics to very impressionable 19-20 year-olds. It's my job to ensure that they understand the gravity of this current situation we're in.

Consider the following quote:

"Everything predicted by the enemies of banks, in the beginning, is now coming to pass. We are to be ruined now by the deluge of bank paper. It is cruel that such revolutions in private fortunes should be at the mercy of avaricious adventurers, who, instead of employing their capital, if any they have, in manufactures, commerce, and other useful pursuits, make it an instrument to burden all the interchanges of property with their swindling profits, profits which are the price of no useful industry of theirs."

Whoever said that seems to have their finger right on the pulse of our current dilemma, don't they?

Is it Fed Chairman Bernake? Maybe Hank Paulson, or former Chairman Greenspan?

Nope.

Try Thomas Jefferson. Yes, THE Thomas Jefferson, and he said this in 1814 when addressing Thomas Cooper.

It's good to see that nothing has changed in the past 200 or so years now, isn't it?

And what a burden it is going to be, my friends. Early estimates put this little project at $700 billion, but we know that our estimates always come in short. If you have any doubt, ask any good home builder or remodeler and they'll tell you to throw an extra 10-20% on top. That puts this project at about a Trillion bucks. Now we're talking real money, not little 'chump change' in billions.

Why do we do it?

Economists (I don't consider myself one even though I teach it) say it's necessary to avoid financial calamity. For whom, though?

My house, while probably worth less today than a year ago, still has a solid roof over it and I'm not behind on my payment. Same goes with my cars, although I don't drive a Bentley.

I didn't speculate on an investment condo in Miami or Vegas, so I didn't get to participate in the great real estate land grab during the past five years. Oh well. My loss.

Again, review my previous post with mind boggling phrases such as "risk equals reward." My reward now is for not taking on huge financial risk. My reward is sleeping each night. My families reward is enjoying meals at home instead of a restaurant (Suzy Q's is exempted from this since they've got the best grilled cheese in America.) Our reward is (hopefully) a stable environment that is fairly consistent in its approach to living, working and worshipping.

Now, the speculator in me is taking hold, however. Everyone is running for the door, exclaiming financial armegeddon. Sell, sell sell! Head for the doors and don't let them hit you in the rear on the way out.

Hmmmm.... aren't these the same folks that told me to BUY BUY BUY four year ago?

I wonder if they're selling? Because to be honest, I'm in a buying mood right now.

Call it contrarian, unorthodox or crazy, but I think the time to buy is soon. Not right now, but very, very soon. So soon, in fact, that I'm storing up money for down payment and might go shopping for an itty-bitty condo in SC or FL sometime around Christmas. Don't worry. It's one I can afford without a renter and one that will likely double in value in about 15 years. That's only a 5% annual return if you're keeping score at home. I don't think my 401k will do that well anytime soon, quite frankly, and it will leave me with two homes I own free and clear 15 years from now. Just about the time I'm ready to retire...

Email me your thoughts on this, folks. I really do value your judgment and opinions, and if I get out of line with my economic preaching, smack me in the head and tell me to stick with writing about business.

Help me pay the rent, too, by checking out the advertisers and their links.

Bailing More than Water

Well it's been one of those weeks in the economy. And while I attempt to stress the importance of everything to my students, I can't help but wonder if any of them get it.

The reality of the situation is very simple: our federal government is bailing out private enterprises faster than Homer Simpson can dunk a donut. It concerns me beyond compare.

To date, the feds have stepped in and assisted Lehman Brothers buy out Bear Stearns, and they've also taken over Fannie Mae and Freddie Mac. As of this writing, there is speculation that they might assist an entity buy out Lehman Brothers. Yes, the same Lehman Brothers that just purchased Bear Stearns about six months ago. The automakers are also asking for $50 billion in government handouts (fortunately, they will probably only get $25 billion.)

Throw in an election year with two candidates that desperately want to win, and it's evident our federal reserve system is really just an ATM (except they don't get to keep the $2.00 fee each time.)

I'm not going to argue whether or not the economy is in dire straits. It is. I don't need Ben Bernake to tell me that and my students don't need me to remind them that their dollar is worth about $.85 compared to last year. That's called inflation.

What I am going to argue, however, is this: I don't think the government should step in and bail ANYONE out - ever.

Get your pencils out for this terribly complex economic/financial formula. Risk = reward. Whew. Got it? Good. Repeat after me. Risk = reward.


So I have to ask you this. Where is the risk to start and mismanage a business if you know the government is going to come in and save the day?

And make no mistake about it. Each of the companies seeking goverment assistance has been horribly mismanaged for years, not just the last few months. Fannie Mae and Freddie Mac epitomize mismanagement, providing deep pockets for Wall Street while simultaneously spending in excess of $150 million in lobbying during the past decade. There is a reason prices of housing escalated so quickly - both agencies allowed consumers to qualify for loans they couldn't afford, with debt ratios in excess of 50% of a homebuyers GROSS income. Think about that for a moment. You make $4000 per month before taxes, utilities, groceries, car insurance, etc. and Fannie Mae tells you to go ahead and take that $2000 per month payment. Where does the rest of the money go?

Throw in the fact that you could purchase a home with $0 down payment (as in ZERO) and you have a recipe for disaster. Nevermind the fact that often the buyer had impaired credit and the seller was paying part, or all, of the closing costs associated with the transaction. Appraised values were inflated, inspections were skewed and sometimes even the real occupancy of the owner came into question. Oh, and everyone made gobs of money.

Even my first year business student recognizes the flaws in this business model. Mismanagement 101, my friend.

So I return to my basic question. Are you willing to kick in the $10-15 BILLION required to bailout Fannie Mae and Freddie Mac?

To be sure, GMAC isn't exactly the model of efficiency and Lehman has been called "greedy" from time to time. They, too, are asking for help.

For argument sake, recognize that we are spending about $10 billion per month on the war on terror in Iraq. Should we rob Peter to pay Paul? That's what we're doing.

How do you pay for these bailouts? There are two ways and neither one is a good option.

1. Alternative revenue sources (political speech for "raise taxes.")
2. Print more money since the value of Treasury Bonds will run more risk than current yields support. If this occurs, something called Hyperinflation will occur and yes, that's worse than it sounds.

There is an answer and it is a painful one.

Allow the markets to take care of themselves. Penalize Fannie, Freddie, GMAC, Lehman and any other company that fails due to mismanagement by letting them become extinct. Yes, it will hurt - bad. But investors will learn their lesson and adjust accordingly. If they don't, they will risk losing on their next investment.

The message being sent right now is "too big to fail." Tell that to Enron, MCI/Worldcom, Adelphia. On the flip side, is Microsoft too big to succeed? We try to break up successful models, calling them a monopoly. Where is the fairness? Is Wal Mart next to be broken up, or are they better of simply running themselves into the ground too?

Risk = reward. If you take big risks, you are entitled to big rewards - or big losses.

You cannot regulate risk any better than you can regulate deman; something communist countries discovered through the black market. And while I don't want to insinuate that we are heading toward communism, we are certainly further away from a free market economy today than we were a mere ten years ago.

Even it up

Wow. It's been a while since the last post; for that I apologize. However, for the long vacation and time away from the writing/business, I do not apologize. You don't realize you're in a rut until you have gone through it and look back. My rut was deeper than the lines on my face.

With that said, and a new perspective (I'm back in the classroom again - summer always makes me stale) I can tell you that my brain has a million article ideas running through it.

One thing that often comes up in initial conversations, however, is "breaking even." For whatever reason, we tend to not worry about profits but instead, we focus on breaking even. While I'm all for capitalism, I thought that I'd tackle the very basic, easy formula for breaking even, as many of us have not been property taught.

Take out your calculator or abacus for this one folks. The sample will be easy, though. I promise.

Let's assume that you own a Pizza Parlor (it's Sunday and that's what the Ola family ate during the Steeler game.) You know that it costs you $3 in ingredients per pizza, $1 for the delivery service you supply and you pay rent of $500 per month and charge $9 for a pizza. How many pizzas do you need to sell to break even?

(sound of crickets chirping here and an anxious 'gulp.')

We hate math, don't we?

Here's the easy way to calculate this.

Take your Sales price ($9) and subtract your total cost per pizza ($3 ingredients + $1 delivery.)

That equals $5.

Divide your fixed costs ($500 rent) by this amount, so that $500/$5 appears. Voila! You need to sell 100 pizzas at $9 per pizza to break even. The fancy formula for this is nothing more than BEP= F/(S-V) if you're ever at a cocktail party and want to win a bet.

Knowing this model, however, we can then begin to work figures and determine whether or not delivering pizzas is really worth it. Too many times we add a service just because we might make a few extra bucks and not realize it's counter-productive.

For instance, you might realize that only 10% of your orders come from delivery. Just for giggles, you send the delivery guy home and do takeout only.

Your new break even point becomes $500/(9-3), or 500/6, which is 83 pizzas. This number workable, as you estimated only a 10% reduction in orders and you needed 100 to break even with the delivery kid. Send the kid home in this instance and enjoy the extra profits with fewer headaches! After all, that's why you're in business, right?

If you like what you've read and you own a pizza joint, send me a coupon for a freebie and click on the advertisers here so that I can pay the rent. Plenty of comments keep me inspired too!

Thanks and I'm happy to be back!

Pat yourself on the back if you got it without my help. If you needed my help, keep reading