Last week's stunner by auto maker Ford that it lost $12.7 billion last year has a number of readers, including Joe in Mississippi, wondering: how can it keep losing all that money and stay in business? Carol in Oregon is trying to figure out when interest rates on CDs will head higher again.
Ford Motors lost $12.7 billion in 2006. They expect to lose $-billions more in 2007. How do they stay in business and where does all this money come from?
-- Joe, Oxford, Miss.
In a lot of ways, corporate finance is not all that different than your household budget. The numbers are just a lot bigger. So let’s imagine that Ford is a typical American — call him Otto Mayker — sitting at the kitchen table trying to figure out how to pay his bills.
Otto has a good job in an established business where everyone knows his work. But lately, he’s been losing assignments to younger, overseas competitors, so his bonus has suffered. He still makes a decent living. His income had been going up recently — from $165,000 in 2003 to $177,000 in 2005 (just add six zeros to get Ford’s numbers.) But he had a lousy year in 2006 and only made $160,000. Even though his income went down, his annual costs – taxes, mortgage, household expenses, etc. – didn’t fall as far. So he spent about $12,700 more than he made last year.
But the drop in his income didn’t come as a big surprise: it was easy to see his monthly numbers were off. So he began cutting expenses last year (as did Ford). He and his wife don’t going out to dinner as much. He’s postponing buying that big screen TV she’s been bugging him to buy for this year’s Super Bowl. And he told the landscaper not to come around any more; he’ll cut his own lawn.
Because he knows his business has its ups and downs, Otto has saved up a pile of cash over the years. Even after last year’s shortfall, he’s got $34,000 in cash, bonds and other investment (as does Ford) he can tap quickly to pay bills. Since knew his savings were going to take a hit, he recently took out a second mortgage on his house (in Ford’s case, some factories). If things get really bad he can always ask for a loan, but when the banker gets a closer look at his financial situation, he probably won’t get a very good interest rate (Ford’s borrowing costs also go up when it’s credit rating goes down.)
Because Otto has seen his bonus go up and down in the past, he’s hoping he’s just hit a bad patch. It’s happened before. Back in 1992, just after a recession, he came up short by nearly $8,000 for the year (as Ford did). The way things are going now, he figures he may need to shell another $17,000 in cash (so does Ford) before his income covers his costs again with enough left over to start putting money back into his savings.
Still, his neighbors are a little worried about him. The guys at the country club are going around saying he overspent by more than anyone in his company in the last 103 years. While that’s true, the $12,700 that Otto (and Ford) “lost” last year – adjusted for inflation – it would have been more than 20 times that amount in 1904. As a percentage of Otto’s annual income (or Ford’s total annual revenues), it’s not quite as scary.
Still, Ford’ losses for 2006 were huge, and they’re not sustainable. Companies can cover losses from the corporate piggy bank for a time, but if they lose money year after year, they end up in bankruptcy court along with a bunch of airlines. So Ford can buy some time, but it has to move quickly to fix its basic problem — it’s not taking in enough money selling cars to cover its costs. Cutting those costs, which Ford is doing, is half the solution. Now the company needs to build cars at competitive prices that people want to buy.
Sometimes you have to spend money to save money. If Otto shells out for new energy-efficient windows, doubles up on his attic insulation and buy a more efficient furnace, his monthly heating bills will go down. Since it’s a one-time cost, it shouldn’t really “count” as an expense in his monthly budget. True, when he’s paying for it, there’s still more money going out the door than coming in. But over the long-term, Otto’s finances have improved because his ongoing costs are lower.
In Ford’s case, this is where most of the last year’s losses came from. For all of 2006, nearly $10 billion of the $12.7 billion loss came from these so-called “special items” – most of which covered the cost of massive layoffs, plant closings and things like “pension curtailment charges.”
And this is where corporate bookkeeping differs from and yours and mine. Some of these one-time “costs” for Ford aren’t hard dollar costs like Otto’s electric bill.
For example, when Otto bought his new Ford Explorer three years ago, he paid $26,000 for it; today, it’s only worth $17,000. So, even if he paid cash to buy the car, that ongoing drop in the car’s resale value “costs” him $3,000 a year. Few individual consumers bother to depreciate household assets this way because there are no tax benefits.
But companies do get a tax deduction for depreciation, so they keep careful track of the falling value of their assets. Last year, Ford said this “impairment of fixed assets” added $3.8 billion to its pre-tax losses.
What is driving the drop in CD rates and do and/or when do you see them going back up?
-- Carol,Portland, Ore.
A bank certificate of deposit is really just a loan between you and the bank – only you’re the one lending the money. Like most other loans, it has a fixed maturity – the date they promise to give you your money back. While they're using it, they pay you interest, just like any other lender. And like many loans, CDs also usually carry a penalty if you decide you want the money back before the agreed upon maturity date.
The price of the loan – the interest rate – is set in the money markets, which function pretty much like any other market. Lots of sellers (in this case, people with money to lend or invest) get together with buyers (people who want to borrow) and bid with each other for the best deal. Hundreds of billions of dollars flow through global money markets, and rates change every day (in some cases every second) as these deals are struck. Banks have lots of places to get their hands on money, so they’re only going to pay you the market interest rate for a chunk of your cash.
Usually, the longer you lock up your money — in a CD, or a Treasury bond or other money instrument — the higher the rate. That’s because borrowers have to pay a little more to convince people like you to give up the prospect of getting a better rate in a few months.
The market level of interest rates is subject to a number of factors. Inflation is probably the biggest. If inflation rises, that makes today’s dollar worth less when you get them back at the maturity date. To make up for that shortfall, the market demands higher interest payments while the money’s locked up. That’s why The Federal Reserve is so focused on keeping inflation low: if it rises, it hurts everybody who lends or saves.
Other forces that move rates include the value of the dollar; if it falls against other currencies, investors in those countries demand higher rates on dollar-based CDs and bonds to make up for that shortfall when they bring their money back home and covert back into their currency.
Keep in mind that if rates go up on your CD, they'll almost certainly go up on your credit card too. Banks make their money borrowing your CD, paying you 4.5 percent interest, and then lending it to me and charging 15 percent — or more.
As for where rates are headed from here, we’re of the opinion that it’s impossible to forecast the future direction of interest rates. But you can certainly find plenty of people out there interested in trying.