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The Mechanics of Car Derivatives


This is another example of the dangers of deflation...


Derivatives are contingent liabilities: the value of that liability will change based on a change in price. Options are good examples of this as I have explained in detail.

One of the largest types of derivatives in the world are certain types of loans, loans whose value changes with price. Car companies provide a good example. I won't go through the math; I just want to get a point across.

Car companies do not want you to pay cash for a car; they can't make any money that way. They want you to lease a car. At least that way they can pretend to make money.

You go to a car dealer and try to pay cash and they will not discount the price of the car by much. But if you go there and lease a car they will give you a good deal ,or at least it will seem that way based on the payments you make. This is because the residual value of the lease, the price they say the car is worth when you turn it back in years later, is inflated.

When you lease a car, the financing company shows the interest earned on the lease as profits. But they are left with the car after the lease is up. In order for the car financing company to have actually earned what they say they earned over the life of the lease, the value of the car has to be equal to the future residual value they assigned to it years ago.

We talk to some very knowledgeable car people who are telling us that the residual value large car companies are assigning to their leases is getting more and more egregious. Just like pension plans that make unrealistic assumptions about what they can earn on their assets, car finance companies are doing the same. If a car financing company becomes more conservative in their estimates of residual values, they would have to write off a portion of the value of their loan portfolio.

This all in the middle of banks trying to buy GMAC. Much of the deflated expectations of that sale are due to the fact that the buyers are becoming nervous about those residual value assumptions.

This is another example of the dangers of deflation. Our economy is highly dependent on inflation continuing to avoid disaster.

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