09-093
Rev. March 16, 2012
The Global Financial Crisis of 2008: The Role of Greed,
Fear, and Oligarchs
Cate Reavis
Free enterprise is always the right answer. The problem with it is that it ignores the human element.
It does not take into account the complexities of human behavior.1
– Andrew W. Lo, Professor of Finance, MIT Sloan School of Management;
Director, MIT Laboratory of Financial Engineering
The problem in the financial sector today is not that a given firm might have enough market share to
influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down
the economy.2
– Simon Johnson, Professor of Entrepreneurship, MIT Sloan School of Management;
Former Chief Economist, International Monetary Fund
On October 9, 2007, the Dow Jones Industrial Average set a record by closing at 14,047. One year
later, the Dow was just above 8,000, after dropping 21% in the first nine days of October 2008.
Major stock markets in other countries had plunged alongside the Dow. Credit markets were nearing
paralysis. Companies began to lay off workers in droves and were forced to put off capital
investments. Individual consumers were being denied loans for mortgages and college tuition. After
the nine-day U.S. stock market plunge, the head of the International Monetary Fund (IMF) had some
sobering words: “Intensifying solvency concerns about a number of the largest U.S.-based and
European financial institutions have pushed the global financial system to the brink of systemic
meltdown.”3
1
Interview with the case writer, April 10, 2009.
2
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
3
“IMF in Global ‘Meltdown’ Warning,” BBC News, October 12, 2008.
This case was prepared by Cate Reavis under the supervision of Deputy Dean JoAnne Yates.
Copyright © 2009, Massachusetts Institute of Technology. This work is licensed under the Creative Commons AttributionNoncommercial-No Derivative Works 3.0 Unported License. To view a copy of this license visit
http://creativecommons.org/licenses/by-nc-nd/3.0/ or send a letter to Creative Commons, 171 Second Street, Suite 300, San
Francisco, California 94105, USA.
THE GLOBAL FINANCIAL CRISIS OF 2008: THE ROLE OF GREED, FEAR, AND OLIGARCHS
Cate Reavis
By early 2009, the markets had stabilized to the point where the U.S. stock market was no longer
down 700 points one day and up 500 the next. In May, the results of the stress tests conducted on the
19 largest banks in the United States to test their capacity to withstand a further economic downturn
were less negative than feared, with 10 out of the 19 subjected to the test ordered to raise $75 billion
in new capital. A number of the banks that were told to raise additional capital saw their stocks rise
sharply on the day the results were released, with Wells Fargo up 24% and Bank of America up
19%.4
Despite the seemingly improved situation, academics, practitioners, and politicians alike were
debating how we got to where we were, and what to do in both the short and long term to bring more
lasting order to the chaos and prevent the same level of turmoil the next time a financial crisis hit.
That there would be a next time was indisputable in the eyes of Andrew Lo, a professor of finance at
the MIT Sloan School of Management and the director of MIT’s Laboratory of Financial
Engineering. In fact, since 1974, 18 bank crises had occurred around the world, and each shared
something in common: a period of great financial liberalization and prosperity that preceded the
crisis. As Lo remarked in his November 2008 testimony before the House Oversight Committee
Hearing on Hedge Funds, “Financial crises may be an unavoidable aspect of modern capitalism, a
consequence of the interactions between hardwired human behavior and the unfettered ability to
innovate, compete, and evolve.”5
Simon Johnson, a professor of entrepreneurship at the MIT Sloan School of Management and former
chief economist at the IMF from 2007 to 2008, believed that the current crisis was caused by
powerful elites, what he called a banking “oligarchy” that overreached in good times and took too
many risks. As he wrote in an article for The Atlantic, “Elite business interests played a central role in
creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the
inevitable collapse.”6
Understanding what, how, and why the crisis happened was a critical part of the process to stabilize
the financial system in the short term and soften the blow of the next financial crisis. Johnson and Lo
were actively involved in finding those solutions. Whether they were advocating the right solutions—
and whether such solutions could or would be implemented—remained unknown. What also
remained unknown was whether their solutions aptly addressed what David Beim, a finance professor
at Columbia Business School, believed was at the heart of the problem:
4
Damian Paletta and Deborah Solomon, “More Banks Will Need Capital,” The Wall Street Journal, May 5, 2009.
5
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 1.
6
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
Rev. March 16, 2012
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THE GLOBAL FINANCIAL CRISIS OF 2008: THE ROLE OF GREED, FEAR, AND OLIGARCHS
Cate Reavis
The problem is not the banks, greedy though they may be, overpaid though they may be. The
problem is us. We have been living very high on the hog. Our standard of living has been rising
dramatically over the last 25 years, and we have been borrowing to make much of that prosperity
happen. We have over-borrowed, and we have done that over many, many decades. And now it’s
reached just an unbearable peak where people on average cannot repay the debts they’ve got.7
What Happened
From a macroeconomic perspective, the collapse of the U.S. housing market triggered the financial
crisis that began in 2008.8 As Johnson explained, the erosion of the housing market led to an erosion
of wealth:
What is on everyone’s minds is this big loss of wealth. We had stocks that are now worth 50%
less than what they were worth. We owned houses that have fallen substantially in value. The
point is that people were banking on these assets having a certain value. And that has implications
for how much they were willing to consume and if they were firms how much they were willing
to invest.9
Few ordinary investors believed that the U.S. housing market would ever crash. For many years, real
estate was considered one of the safest and most profitable investments. From the late 1990s into the
mid-2000s, housing prices around the country rose at a compound annual growth rate of 8%. By
2006, the average home cost nearly four times what the average family made. (Historically, it had
been between two to three times.10) Demand was outstripping supply. Even though household
incomes remained flat during this time (Figure 1), more and more people were able to afford houses
due to an easing of lending requirements that began in the Clinton administration and continued into
the Bush administration.
High-risk loans, including subprime mortgages given to people with troubled credit, fueled the
growth. In fact, the housing boom from the late 1990s into the mid-2000s drove much of the U.S.
economy, adding jobs in construction, remodeling, and real estate services. Consumers feasted on the
equity in their homes, taking out a total of $2 trillion via loans, refinancings, and sales.11 The ratio
that measures household debt to GDP doubled from 50% in the 1980s to 100% of GDP by the mid2000s. The last time the level of debt was 100% of GDP was 1929, the beginning of the Great
Depression.12
7
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
8
For a more in-depth explanation of the financial crisis, see the blog http://baselinescenario.com.
9
Terry Gross, “Simon Johnson On Bank Bailout Plan,” NPR: Fresh Air, March 3, 2009.
10
Ben Steverman and David Bogoslaw, “The Financial Crisis Blame Game,” BusinessWeek, October 18, 2008.
11
Shawn Tully, “Welcome to the Dead Zone,” Fortune, May 5, 2006.
12
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
Rev. March 16, 2012
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THE GLOBAL FINANCIAL CRISIS OF 2008: THE ROLE OF GREED, FEAR, AND OLIGARCHS
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Figure 1
Growth of U.S. Housing Prices versus Household Income, 1991–2007
15
10
5
% Growth
Housing
Prices
Household
Income
0
-5
-10
-15
Housing Prices
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-2.2 -2.4 -0.7
Household Income 0.6
1.7
2
0.5
0
-0.8
2.7
5.7
5.5
6.2
5.8
8.1
8.7 10.9 10.7 -2.2 -12.5
3.3
5.6
4.2
6
3.4
4.7
3.2
0.6
0.4
2.1
2.3
4.5
4
4.2
Source: S&P/Case-Shiller National Home Price Indices; U.S. Census Bureau.
By 2006, it was evident that the housing bubble was starting to burst. People began defaulting on
their mortgages, sending a ripple effect throughout the financial system. As more people defaulted
and went into foreclosure, more houses came on the market and precipitously pushed down housing
prices (Figure 2).
Figure 2
U.S. Housing Prices, 1990–2008 (adjusted for inflation)
$300,000
$261,739
$250,000
$200,000
$171,421
$149,752
$180,100
$150,000
$100,000
$50,000
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
$0
Source: S&P/Case-Shiller National Home Price Indices.
As prices began to fall and the loan default rate began to rise, big Wall Street firms stopped gobbling
up the riskier mortgages, which at one time had been extremely lucrative. Smaller banks and
mortgage companies were left saddled with loans that they had borrowed money to buy in the first
place and now could not sell. Suddenly, banks started defaulting on their loans as well, triggering the
downward spiral that by late 2008 gripped the world economy. Many banks were facing insolvency:
Rev. March 16, 2012
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Cate Reavis
Their assets were too small to cover their liabilities, which meant that they owed more money than
they had. Credit markets started to freeze up, and individuals and businesses alike could not get
loans.13 This was more or less the simplistic macroeconomic explanation.
But Andrew Lo believed that the crisis was about more than economic forces. In his mind, a human
element was at play, most notably the emotions of greed and fear of the unknown. As Lo stated in his
House Oversight Committee testimony:
During extended periods of prosperity, market participants become complacent about the risk of
loss—either through a systematic underestimation of those risks because of recent history, or a
decline in their risk aversion due to increasing wealth, or both. In fact, there is mounting evidence
from cognitive neuroscientists that financial gain affects the same ‘pleasure centers’ of the brain
that are activated by certain narcotics. This suggests that prolonged periods of economic growth
and prosperity can induce a collective sense of euphoria and complacency among investors that is
not unlike the drug-induced stupor of a cocaine addict. The seeds of this crisis were created
during a lengthy period of prosperity. During this period we became much more risk tolerant.14
In other words, “we” became greedy. As Lo put it, this greed was spurred on by “the profit motive,
the intoxicating and anesthetic effects of success.”15 When everything began to collapse, our greed
then turned into fear. What we feared, Lo argued, was the unknown—in this case, who and what we
owed, what our assets were worth, and how bad things really were. As one journalist wrote, “Concern
about who is still holding dud paper has gummed up credit markets, with banks refusing to lend to
one another for fear that the borrowers may default or may have themselves lent to other banks that
could default.”16 Banks were not willing to mark-to-market. This meant that they did not want to enter
the actual market price of their assets on their books, for by doing so many would be declaring
bankruptcy. Instead, many banks chose to hold on to their assets, thinking either that they were worth
more than the market thought or that they would come back.17
Fear froze the markets, which in turn led to liquidity runs on financial institutions, even those that
were not facing insolvency. Johnson explained:
The fundamental problem is that all players in the financial system have realized that a bank that
is solvent can still be subject to a bank run. Once that happens, Bank A doesn’t want to lend
money to Bank B for two reasons: first, Bank A wants to hold on to its cash in case it becomes
13
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
14
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 12.
15
Ibid., p. 14.
16
Peter Gumbel, “The Meltdown Goes Global,” Time, October 20, 2008.
17
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
Rev. March 16, 2012
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THE GLOBAL FINANCIAL CRISIS OF 2008: THE ROLE OF GREED, FEAR, AND OLIGARCHS
Cate Reavis
the target of a bank run; and, second, Bank A is afraid that Bank B could be the target of a bank
run, and hence is afraid that if it lends to Bank B it won’t get its money back. Like all such
panics, this becomes self-fulfilling: because banks don’t want to lend, banks can’t get short-term
credit, which makes them vulnerable.18
To help arrest and fend off future bank runs, starting in the fall of 2008 the U.S. government stepped
in with financial assistance.
How Did We Get Here?
There were several reasons why the U.S. financial industry got to the point where the government
was propping up some of the country’s largest banks with hundreds of billions of dollars in financial
assistance. Among the most talked about were banking deregulation, increasingly close relations
between Washington and Wall Street, and an influx of “new money” looking for investment.
Deregulation and Derivatives
As Andrew Lo emphasized in his 2008 testimony, there was a direct correlation between the
loosening of regulations on banks during the late 1990s and early 2000s and the most recent financial
crisis:
The overall impact of relaxed constraints [created] an over-extended financial system—part of
which was invisible to regulators and outside their direct control—that could not be sustained
indefinitely. The financial system became so ‘crowded’ in terms of the extraordinary amounts of
capital deployed in every corner of every investable market that the overall liquidity of those
markets declined significantly. The implication of this crowdedness is simple: the first sign of
trouble in one part of the financial system will cause nervous investors to rush for the exits, but it
is impossible for everyone to get out at once, and this panic can quickly spread to other parts of
the financial system.19
Many considered the repeal of the Glass-Steagall Act in 1999 to be one of the more critical regulatory
changes that played a role in the financial crisis. Passed in 1933, the act (also known as the Banking
Act) helped control abuse and the level of risk to investors by prohibiting any one institution from
acting as both an investment bank and a commercial bank, or as both a bank and an insurer. Its repeal
opened up competition among banks, securities companies, and insurance companies. Commercial
lenders like Citigroup, which in 1999 was the largest U.S. bank by assets, were now allowed to
underwrite and trade instruments such as mortgage-backed securities.
18
James Kwak, “Financial Crisis for Beginners,” http://baselinescenario.com/financial-crisis-for-beginners/, accessed May 19, 2009.
19
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 9.
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THE GLOBAL FINANCIAL CRISIS OF 2008: THE ROLE OF GREED, FEAR, AND OLIGARCHS
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Another act of deregulation that many believed hastened the financial crisis was the Commodity
Futures Modernization Act. Signed into law in 2000, the act left much of the multi-trillion-dollar
derivatives market unregulated. Derivatives were contracts whose value depended on the underlying
value of something specific such as a stock, bond, currency, or commodity. (The value of the
instrument “derives” from some underlying item.) Derivatives allowed money to flow more freely
from those who had it to those who needed it. In addition to offering protection against the risk of
financial loss, they offered “fair” returns to high-dollar investors willing to take calculated risks.20 For
banks that loaned out tens of billions of dollars, derivatives, theoretically, helped mitigate risk by
protecting them in case loans defaulted.
Mortgage-backed securities and credit default swaps (CDSs) were two types of derivatives that
became quite popular during the housing boom. A mortgage-backed security was essentially a pool of
mortgages that were bundled together and sold as tranches up the investment chain: from mortgage
broker to private mortgage bank and then to a Wall Street investment house. Mortgage-backed
securities became a popular investment tool because they were initially considered to be low risk—
since housing prices kept going up—with high returns: an average mortgage would typically provide
returns of 5% to 9% in interest per year.
CDSs were insurance-like contracts typically used for municipal bonds, corporate debt, and mortgage
securities that promised to cover losses on certain securities in the event of a default. The buyer of the
credit default insurance would pay a premium over a period of time in return for being covered if
losses occurred. CDSs were sold by banks, insurance agencies, hedge funds, pension funds, and other
investment outlets as a way for banks to get credit risk off their books.21
With the growth of mortgage-backed securities in the early 2000s, CDSs exploded in popularity as a
way to protect against potential default. As an industry insider noted, speculative investors, hedge
funds, and others bought and sold CDS instruments without having any direct relationship with the
underlying investment: “They’re betting on whether the investments will succeed or fail.”22 Because
the CDS market was not regulated, contracts could be traded from investor to investor without any
oversight to determine their value and ensure that the buyer had the resources to cover losses in case
of default. As Johnson explained, “CDSs are one of the things that create uncertainty in the banking
sector; a bank may look healthy, but it may be counting on CDS payouts from banks that you can’t
see; you can’t be sure it’s healthy, so you won’t lend to it.”23
20
Steve Jordan, “Chancy Derivatives Also Have Good Side,” Omaha World-Herald, October 26, 2008.
21
Janet Morrissey, “Credit Default Swaps: The Next Crisis?” Time, March 17, 2008.
22
Ibid.
23
James Kwak, “Financial Crisis for Beginners,” http://baselinescenario.com/financial-crisis-for-beginners/, accessed May 19, 2009.
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In light of this more loosely regulated environment, banks which, according to Johnson, had became
“proprietary trading rooms,” buying and selling securities for profit,24 became “too big to fail.” AIG
and Bear Stearns both nearly imploded due to the investments they had made in CDSs. As one
journalist wrote, “Banks have become so big and so leveraged that their balance sheets can exceed the
gross domestic product of the country in which they are based.”25 Iceland was a case in point. Several
domestic banks had combined “toxic” assets that were larger than the country’s entire economy.26
Deregulation and the “exotic” investment products that flourished brought the industry enormous
wealth. According to Johnson, between 1973 and 1985, the financial sector never earned more than
16% of domestic corporate profits. By the 2000s, this figure reached 41%. Compensation shot up
from 99% to 108% of the average for domestic private industries between 1948 and 1982, and to
181% in 2007.27
And with this wealth came political influence.
Close Ties
Another ingredient that helped create the mix that nearly brought the U.S. financial industry to its
knees was the cozy relationship that had built up over the years between Wall Street and Washington.
As Johnson noted, “Oversize institutions disproportionately influence public policy; the major banks
we have today draw much of their power from being too big to fail. [Wall Street] benefited from the
fact that Washington insiders already believed that large financial institutions and free-flowing capital
markets were crucial to America’s position in the world.”28 By the time of the crisis, 90% of all the
money deposited in the United States was in 20 banks.29
It was no secret that Wall Street firms were big political contributors. The securities and investment
industry—which included Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman, and Bear
Stearns—gave $97.7 million to federal political candidates during the 2004 election and $70.5 million
for the 2006 congressional election.30 In addition to their financial contributions, there was a fair
amount of “interweaving of career tracks”31 between the two sectors. Goldman Sachs had been given
the moniker “Government Sachs” for the disproportionate number of executives who were taking
public-sector jobs, including Henry Paulson, who had been CEO of Goldman from 1998 to 2006 and
who was named Treasury secretary under President George W. Bush; Robert Rubin, who was cochairman when he was tapped to serve as Treasury secretary under President Bill Clinton; and Jon
24
Ibid.
25
Peter Gumbel, “The Meltdown Goes Global,” Time, October 20, 2008.
26
Ibid.
27
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
28
Ibid.
29
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
30
Ben Steverman and David Bogoslaw, “The Financial Crisis Blame Game,” BusinessWeek, October 20, 2008.
31
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
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Corzine, governor of New Jersey, who served as CEO during the majority of the 1990s. As one
industry observer remarked, “It is a widely held view within the bank that no matter how much
money you pile up, you are not a true Goldman star until you make your mark in the political
sphere.”32 A spokesman for Goldman noted, “We’re proud of our alumni, but frankly, when they
work in the public sector, their presence is more of a negative than a positive for us in terms of
winning business. There is no mileage for them in giving Goldman Sachs the corporate equivalent of
most-favored-nation status.”33
New Money Looking for Investment
At the same time that U.S. banking regulations were easing, the middle class in emerging markets
such as China and India was growing at a phenomenal rate. As a result of this economic growth, the
“global pool of money” doubled from $36 trillion in 2000 to $70 trillion in 2008. One economist
observed, “The world was not ready for all this money. There’s twice as much money looking for
investments, but there are not twice as many good investments.”34 What was once considered a safe
and profitable investment, U.S. Treasury bonds, was no longer appealing as the federal funds rate that
was 6.5% for much of 2000 dropped below 2% in 2003.35 Enter mortgage-backed securities.
As one executive director at Morgan Stanley recalled, it didn’t take long for mortgage-backed
securities, which offered returns ranging from 5% to 9%, to become the financial industry’s new
favorite investment tool:
It was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors
happy. More people wanted bonds than we could actually produce. They would call and ask, ‘Do
you have any more fixed rate? What have you got? What’s coming?’ From our standpoint, it’s
like, there’s a guy out there with a lot of money. We gotta find a way to be his sole provider of
bonds to fill his appetite. And his appetite’s massive.36
By 2003, the demand for mortgage-backed securities began outstripping supply, and the mortgage
industry needed to ramp up production. It was at this point that the guidelines for getting a mortgage
loosened considerably. Mortgages for $400,000 were being given to people who did not have to
provide proof of income or assets. One person in the industry quipped, “You [didn’t] have to state
anything. [You] just [had] to have a credit score and a pulse.”37 Equity lines of credit also were being
sold at an alarming rate, allowing people to take out another loan from the bank against the value of
their house, which for many was worth more than what they had paid for it. The banks did not care
32
Julie Creswell and Ben White, “The Guys From ‘Government Sachs’,” The New York Times, October 17, 2008.
33
Ibid.
34
Ira Glass, Adam Davidson, and Alex Blumberg, “The Giant Pool of Money,” NPR: This American Life, May 9, 2008.
35
Ben Steverman and David Bogoslaw, “The Financial Crisis Blame Game,” BusinessWeek, October 20, 2008.
36
Ira Glass, Adam Davidson, and Alex Blumberg, “The Giant Pool of Money,” NPR: This American Life, May 9, 2008.
37
Ira Glass, Adam Davidson, and Alex Blumberg, “The Giant Pool of Money,” NPR: This American Life, May 9, 2008.
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how risky these loans were because they would own them for a few weeks, then sell them up the
chain to Wall Street, and Wall Street would in turn sell them on to the “global pool of money.” But up
until 2005, the risk was considered minimal because the value of homes in the United States kept
going up. If someone defaulted on their loan, the bank would then own the home that was worth more
than it was when the loan was first made. 38
But the housing bubble burst, prices took a downward turn, and with it the economy followed. As one
journalist put it, “With all the brainpower on Wall Street, few made the connection between the
trillions of dollars in real estate assets held by financial firms and what would happen if the value of
those assets suddenly dropped.”39
Who Is to Blame?
Finger pointing over who was to blame had run amok and by early 2009 had become a “national
pastime”40 of sorts. Commercial and investment banks, mortgage lenders, credit-rating agencies,
insurance companies, regulators, politicians, government-sponsored entities, investors, and
homeowners all played a role.
Many people believed that those in senior management positions in banks and investment firms were
largely to blame for not understanding the highly complex models devised by their quantitative
analysts or “quants,” and for their inability to properly manage how and the degree to which those
models became highly sought-after products in the market.41 Some blamed the quants for creating
financial instruments that were simply too complicated for those in senior management to understand.
Still others blamed the regulators. In 2004, the SEC had loosened leverage (debt) rules for investment
banks, and by 2008 many were plagued by leverage ratios that were 30 to 40 times, as opposed to 10
to 15 times, their core holdings.42 Others pointed to the lack of relevant expertise that existed within
the halls of the SEC. As Lo explained, the SEC was staffed with lawyers who “don’t have the kind of
training that’s necessary to be able to deal with some of these more complex kinds of strategies.”43
Many blamed politicians for repealing Glass-Steagall. As Lo testified, the repeal of Glass-Steagall
fueled growth in shadow banking44 institutions like hedge funds. Hedge funds, he explained, were
among the most secretive of financial institutions because:
38
Ibid.
39
Ben Steverman and David Bogoslaw, “The Financial Crisis Blame Game,” BusinessWeek, October 20, 2008.
40
Ibid.
41
Ira Flatow, “Does Wall Street Need More Physicists?” NPR: Talk of the Nation/Science Friday, March 13, 2009.
42
Ben Steverman and David Bogoslaw, “The Financial Crisis Blame Game,” BusinessWeek, October 20, 2008.
43
Ira Flatow, “Does Wall Street Need More Physicists?” NPR: Talk of the Nation/Science Friday, March 13, 2009.
44
Shadow banking system: consists of investment banks, hedge funds, mutual funds, insurance companies, pension funds, endowments and foundations, and
various broker/dealers that provide many of the same services as banks but are outside the banking system and therefore are not controlled by regulatory bodies.
The shadow banking system grew rapidly after the repeal of the Glass-Steagall Act of 1999.
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Their franchise value was almost entirely based on the performance of their investment strategies,
and this type of intellectual property was perhaps the most difficult to patent. Therefore, hedge
funds have an affirmative obligation to their investors to protect the confidentiality of their
investment products and processes. It is impossible, therefore, to determine their contribution to
systemic risk.45
While most analysts did not believe that hedge funds caused the current crisis—after all, hedge funds
did do good things including raising tens of billions of dollars since the mid-2000s for infrastructure
investments in India, Africa, and the Middle East—they were heavy investors in risky mortgagebacked securities.46
Government-sponsored enterprises Fannie Mae and Freddie Mac also shared the blame. These
institutions, which had a charter from Congress with a mission of supporting the housing market,
were responsible for purchasing and securitizing mortgages in order to ensure that funds were
consistently available to the institutions that lent money to home buyers. As private companies with
close ties to the government, Fannie and Freddie could borrow money at relatively low interest
rates.47 Pressured by Congress to increase lending to lower-income borrowers back in the mid-1990s,
Fannie and Freddie began lowering credit standards and purchased or guaranteed “dubious” home
loans.
What Now?
As the full force of the financial crisis hit in October 2008, one month before the U.S. presidential
election, there was heated debate in Congress over what to do. There was a call for doing nothing and
letting the markets “work themselves out.” After all, that was how capitalism was supposed to work,
and having the government step in and help was a form of socialism. Federal Reserve Chairman Ben
Bernanke believed that doing nothing would be catastrophic, and told Congress, “If we let the
banking system fail, no one will talk about the Great Depression anymore, because this will be so
much worse.”48
Toward the end of President George W. Bush’s second term in office and continuing with incoming
President Barack Obama, the U.S. government was doing several things to stop the bleeding and put
the country on a path to recovery. First, in October 2008 the government gave certain banks and other
financial institutions considerable amounts of money from its Troubled Asset Relief Program
(TARP). Citigroup, for example, received $45 billion; Bank of America, $25 billion; and AIG, $180
billion. These loans came with certain restrictions, in particular pertaining to executive compensation,
45
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 8.
46
Ellen Nakashima, “The Year Hedge Funds Got Hit,” The Washington Post, January 3, 2009.
47
James R. Hagerty, “The Financial Crisis: Bailout Politics,” The Wall Street Journal, October 16, 2008.
48
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
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which were expanded under the new Obama administration (Exhibit 1). The hope was that this
money would help stabilize balance sheets to the point where banks would start to lend money again
and the credit markets would begin to loosen up. Months after the money had been given, however,
many banks still were not scaling up their lending as originally anticipated. Instead, they were
holding on to the money they received in order to build up their capital and make their balance sheets
healthy again. As a number of economists pointed out, unhealthy banks should loan less, not more.
After all, excessive lending was how the U.S. banking industry got to where it was in the first place.49
Second, in early 2009, Treasury Secretary Timothy Geithner introduced the Public Private Investment
Program, which was established to purchase real estate-related loans from banks and the broader
market. Financing in the amount of $500 billion had been set aside to subsidize private investors
interested in buying pools of the “toxic” loans. The value of the loans and securities purchased under
the program was to be determined by the private-sector buyers.
Finally, around the same time that the Public Private Investment Program was introduced, Geithner
announced that 19 of the nation’s largest banks (those with $100 billion or more in assets) would be
subjected to a stress test, also known as a capital assessment. The purpose of the test was to determine
if the country’s largest banks had sufficient capital buffers to withstand a further economic downturn.
Each participating financial institution was asked to analyze potential firm-wide losses, including
those in its loan securities portfolios, as well as those from any off-balance-sheet commitments and
contingent liabilities and exposures, under two different economic scenarios—scenarios that many
felt were “overly rosy”50—during a two year period. (See Figure 3 for economic scenarios.)
Figure 3
Economic Scenarios for Bank Stress Tests
2009
2010
-2.0
-3.3
2.1
0.5
Civilian Unemployment Rate
Average Baseline
Alternative More Adverse
8.4
8.9
8.8
10.3
House Prices
Average Baseline
Alternative More Adverse
-14
-22
-4.0
-7.0
Real GDP
Average Baseline
Alternative More Adverse
Source: FAQs – Supervisory Capital Assessment Program, http://www.FDIC.gov/news/news/press/2009/pr09025a.pdf.
49
Ibid.
50
Deborah Solomon, David Enrich and Damian Paletta, “Banks Need at Least $65 Billion in Capital,” The Wall Street Journal, May 7, 2009.
Rev. March 16, 2012
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Participating financial institutions also were instructed to forecast the internal resources available to
absorb losses, including pre-provision net revenue and the allowance for loan losses. Supervisors (as
named by the U.S. Federal Reserve) would meet with senior management at each participating
institution to review and discuss loss and revenue forecasts.51
The initial reaction of many to the tests was one of great suspicion that nationalization of the banks
would be the next step. However, the results announced in May indicated that the banks were
healthier than anticipated. There was widespread belief that most if not all of the banks would be able
to boost their capital without needing additional government funds. They could achieve this by
raising money privately, selling shares to the public, selling parts of their business, or converting
preferred shares into common shares, a move that would increase tangible common equity without
providing banks any new cash. One bank analyst called such a measure “window dressing” in that it
would not add one extra dollar to a bank’s capital buffer against losses: “It’s just moving capital from
one place to another.”52 If such a measure were taken, the government (and therefore taxpayers)
would go from being lenders to part owners.
The government’s multi-prong approach had its share of critics, Simon Johnson among them. In his
mind, there was a seeming unwillingness to upset the financial sector:
The ‘stress’ scenario used by the government turns out to be a mild and short-lived downturn, so
the tests were effectively designed to allow everyone to pass. Actual official outcomes for each
bank are the result of complicated closed-door negotiations, and at the bank level all we have
learned is who has more or less political power.53
Consumers and businesses are still dependent on banks that lack the balance sheets and the
incentives to make the loans the economy needs, and the government has no real control over
who runs the banks, or over what they do.54 The government is dictating how GM needs to start
behaving, but it is not doing it with the banks. There is asymmetry in how the financial sector is
being treated and how manufacturing is being treated. The government is not afraid of
manufacturing going into bankruptcy, but they are afraid of finance going into bankruptcy.55
Johnson believed that the administration’s current deal-by-deal strategy, whereby what was done for
one bank was different than what was done for another, would not work: “You don’t know what the
rules are. It’s complete chaos and confusion.”56 Johnson proposed that “you do it once and for all.
51
http://www.FDIC.gov/news/news/press/2009/pr09025a.pdf.
52
Edmund L. Andrews, “Banks Told They Need $75 Billion in Extra Capital,” The New York Times, May 8, 2009.
53
“Grading the Banks’ Stress Test,” The New York Times, May 6, 2009.
54
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
55
Interview with the case writer, April 7, 2009.
56
Ibid.
Rev. March 16, 2012
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You do it systematically. You have very clear rules that are pre-announced.”57 Reflecting back to his
years as chief economist at the IMF, Johnson asked rhetorically:
What would the U.S. tell the IMF to do if this were any country other than the U.S.? If you
covered up the name of the country, and just showed me the numbers, just show me the problems,
talk to me a little about the politics in a generic way. With the financial system, you have a boom,
and then a crash.... I know what the advice would be, and that would be, taking over the banking
system. Clean it up; re-privatize it as soon as you can.58
Johnson feared that by not responding to the crisis in a more consistent, systematic way, the United
States could go in the direction of the Japanese banking system during the 1990s. The IMF’s advice
that the Japanese government take over the banks; break them up into healthy, functioning smaller
operations; and re-privatize them fell on deaf ears. What arose instead were “zombie banks,” or banks
that were allowed to keep operating even though they had massive debts.59 The 1990s were
considered Japan’s lost decade, when economic growth was stagnant.
Recognizing that the word “nationalization” was a red flag, Johnson was calling for a “governmentmanaged bankruptcy program” or “government-run receivership” in which the toxic assets of banks
were put into a separate entity and then the healthy parts were broken down and sold off in smaller
chunks to the private sector. Johnson repeatedly made the point that these were the exact actions the
IMF had taken many times with emerging markets—including Korea, Indonesia, Russia, and
Argentina after their respective financial meltdowns in the late 1990s and early 2000s. Breaking down
the banks into local or regional entities also would break up the banking “oligarchy” that Johnson
believed played a central role in creating the crisis: “By selling off the banks into smaller, more
concentrated ownership stakes, you will get more powerful owners who will hold management
accountable.”60
Keeping the banks under government control long term was not something that Johnson advocated:
How much do you enjoy going to get your driver’s license renewed, going to the DMV, or, even
worse, moving to a new state and having to get a new driver’s license? The government does [not
do] a very good job of managing things as simple as a driver’s license, and certainly something as
complicated as a bank would almost certainly not go well at all.61
57
Ibid.
58
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
59
Terry Gross, “Simon Johnson On Bank Bailout Plan,” NPR: Fresh Air, March 3, 2009.
60
Interview with the case writer, April 7, 2009.
61
Terry Gross, “Simon Johnson On Bank Bailout Plan,” NPR: Fresh Air, March 3, 2009.
Rev. March 16, 2012
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Of course some people will complain about the ‘efficiency costs’ of a more fragmented banking
system, and these costs are real. But so are the costs when a bank that is too big to fail—a
financial weapon of mass self-destruction—explodes. Anything that is too big to fail is too big to
exist.62
A loud contingent of economists, politicians, and business leaders believed that nationalizing banks
was a “crime against the capitalist system.” Johnson thought otherwise: “My view is [that] the offense
against American capitalism was committed by the big banks who brought us to this point: Their
mismanagement, their compensation schemes, their attitude towards the public.”63 The government’s
priority, he believed, should be to protect the payment system: “You want to protect deposits and
anything that is like a deposit. If you force people to take losses on the payments part of the system,
then all hell is going to break loose.”64
Several hurdles needed to be cleared if the government was to take the route advocated by Johnson.
First, there was a manpower issue. One expert predicted that it would take thousands of people for
each bank takeover. A second problem had to do with timing. As Columbia’s Beim noted:
Nationalizations are kind of like potato chips. It’s hard just to have one. You’d have to come out
with a plan for all of the banks, and you’d have to do the whole thing in one day, at one time.
Because if you just start taking over one bank, people with money at other banks will start
worrying that their bank will be nationalized next, and that will cause investors to panic and
they’ll pull all their money out of that bank.65
When it came time to re-privatize, the question was whether there was enough well-capitalized
demand for all the potential supply. As one economist pointed out, “Finding enough private equity to
buy one bank would not be a problem. Finding enough money to buy all the banks was another
story.”66
In addition to the logistical hurdles, Johnson noted, there would inevitably be a lot of political
resistance:
The politics are awkward. Cleaning up a banking system, in my view, technically, is not that
difficult. But when you clean up a banking system, and you do it properly, some powerful people
lose. They lose their bonuses, they lose their banks, they lose their access; so who is going to
62
Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.
63
Terry Gross, “Simon Johnson On Bank Bailout Plan,” NPR: Fresh Air, March 3, 2009.
64
Andrew Leonard, “Simon Johnson Says: Break Up the Banks,” Salon.com, April 28, 2009.
65
Ira Glass, Adam Davidson, and Alex Blumberg, “Bad Bank,” NPR: This American Life, February 27, 2009.
66
Ibid.
Rev. March 16, 2012
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lose? Who is going to decide who is in and who is out? I don’t think the people at the top are yet
ready to have that conversation.67
Long Term
In his November 2008 testimony to the House Oversight Committee Hearing on Hedge Funds,
Andrew Lo made a number of recommendations for regulatory reforms and other changes to prevent
and/or soften the landing the next time a bank crisis hits.
Effective Regulation
Unlike many economists, Lo believed that financial markets didn’t need more regulation, but rather
more effective regulation that provided greater transparency:
As a general principle, the more transparency is provided to the market, the more efficient are the
prices it produces, and the more effectively will the market allocate capital and other limited
resources. When the market is denied critical information, its participants will infer what they can
from existing information, in which case rumors, fears, and wishful thinking will play a much
bigger role in how the market determines prices and quantities.68
The current financial crisis is a mystery, and concepts like subprime mortgages, CDOs, CDSs,
and the ‘seizing up’ of credit markets only create more confusion and fear. A critical part of any
crisis management protocol is to establish clear and regular lines of communication with the
public, and a dedicated interagency team of public relations professionals should be formed for
this express purpose.69
Lo believed that more information was needed on the shadow banking system, particularly hedge
funds. As he explained in his testimony, “Without access to primary sources of data—data from
hedge funds, their brokers, and counterparties—it is simply not possible to derive truly actionable
measures of systemic risk.”70 Lo recommended that hedge funds with more than $1 billion in gross
notional exposures provide regulatory authorities with confidential information on a regular basis on
the following: assets under management, leverage, portfolio holdings, list of credit counterparties, and
list of investors. Lo believed that the confidentiality aspect of the information was critical: “If hedge
funds are forced to reveal their strategies, the most intellectually innovative one will simply cease to
exist…. This would be a major loss to U.S. capital markets and the U.S. economy, hence it is
imperative that regulators tread lightly with respect to this issue.”71
67
Ibid.
68
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 21.
69
Ibid., p. 2.
70
Ibid., p. 7.
71
Ibid., p. 8.
Rev. March 16, 2012
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One change Lo proposed was to provide the public with information on financial institutions that had
failed: “It is unrealistic to expect that market crashes, manias, panics, collapses, and fraud will ever be
completely eliminated from our capital markets, but we should avoid compounding our mistakes by
failing to learn from them.”72 In his testimony, Lo called for the creation of a Capital Markets Safety
Board (CMSB), an independent investigatory review board similar to that of the National
Transportation and Safety Board, an independent government agency that investigates accidents.
“The financial industry can take a lesson from other technology-based professions,” Lo argued. “In
the medical, chemical engineering, and semiconductor industries, for example, failures are routinely
documented, catalogued, analyzed, internalized, and used to develop new and improved processes
and controls. Each failure is viewed as a valuable lesson to be studied and reviewed until all the
wisdom has been gleaned from it….”73 Every completed investigation would produce a publicly
available report documenting the details of each failure and recommendations for avoiding similar
future outcomes.
In addition to investigating financial “blow-ups,” a CMSB would be responsible for obtaining and
maintaining information on the shadow banking system, including hedge funds and private
partnerships, and integrating this information with other regulatory agencies. The CMSB would act as
a single agency responsible for managing data relating to systemic risk.
New Accounting Methods
Lo also believed that accounting methods needed to take risk into account. Current accounting
methods (e.g., Generally Accepted Accounting Principles or GAAP) were backward looking, focused
on value resulting from revenue and costs that had already occurred, and not risk: “Accountants tell
us what has happened, leaving the future to corporate strategists and fortunetellers.”74 In Lo’s view,
accounting methods needed to be counterbalanced with something he referred to as a “risk balance
sheet”: the risk decomposition of a firm’s mark-to-market balance sheet where both assets and
liabilities were considered to be random variables. “Since assets must always equal liabilities,” he
explained, “the variance of assets must always equal the variance of liabilities, hence the risk balance
sheet is just the variance decomposition of both sides…. Risk accounting standards must address both
the proper methods for estimating the variances and covariances of assets and liabilities, and the
potential instabilities in these estimates across different economic environments.”75
Corporate Governance
According to Lo, the single most important implication of the financial crisis was corporate
governance:
72
Ibid., p. 21.
73
Ibid., p. 18.
74
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 24.
75
Ibid., p. 24.
Rev. March 16, 2012
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Many corporations did a terrible job in assessing and managing their risk exposures, with some of
the most sophisticated companies reporting tens of billions of dollars in losses in a single quarter.
How do you lose $40 billion in a quarter and then argue that you’ve properly assessed your risk
exposure? I don’t think it’s credible to say it was just bad luck. If troubled companies want to
explain away 2008 as a ‘black swan,’ then someone should take responsibility for creating the oil
slick that seems to have tarred the entire flock. The current crisis is a major wake-up call that we
need to change corporate governance to be more risk sensitive.76
As a way to increase risk sensitivity, Lo believed quants were needed in management positions and at
the board of director level where they would be a part of the decision-making process. He explained
that the absence of quants from top management was due to the fact that their specialty did not exist
when those in top management began their careers. In other words, there was a generational gap that
needed to be filled. In his mind, the lack of quants in the decision-making process made no sense:
“Can you imagine a board of directors of a hospital not having a few doctors or a technology firm not
having a few technology experts? It doesn’t make sense, and it’s got to change.”77
Lo also believed that the role of risk officers and how they were compensated needed to change. He
argued that the direct reporting relationship between risk officers and CEOs created conflicts of
interest and that those heading up risk management efforts should report directly to the board of
directors. How risk managers were compensated also needed to change: “Why is a risk manager paid
the same way as a CEO? They should be compensated based on their ability to keep the company
stable, not on how much money the company makes.”78
In Lo’s mind, reforms at the corporate governance level included distancing Wall Street from
Washington. “Politicians rely on corporate America for their campaign contributions,” he noted. “No
one wants to deal with it, but it must be dealt with. Corporations should not be allowed to make
contributions to political campaigns. Period. We’ll never get past this conflict of interest unless we
make this across-the-board change.”79
Education
According to Lo, finance education clearly needed to be addressed, particularly the knowledge gap
that existed between quants and those in senior management positions:
We often take it for granted that large financial institutions capable of hiring dozens of ‘quants’
each year must have the technical expertise to advise senior management, and senior management
has the necessary business and markets expertise to guide the quantitative research process.
76
Andrew W. Lo, “Understanding Our Blind Spots,” The Wall Street Journal, March 23, 2009.
77
Interview with the case writer, April 10, 2009.
78
Ibid.
79
Ibid.
Rev. March 16, 2012
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However, in fast-growing businesses the realities of day-to-day market pressures make this
idealized relationship between senior management and research a fantasy. Senior management
typically has little time to review the research, much less guide it; and in recent years, many
quants have been hired from technically sophisticated disciplines such as mathematics, physics,
and computer science but without any formal training in finance or economics.80
Lo believed that Wall Street needed more scientists: “The problem is not that there are too many
physicists on Wall Street, but that there are not enough.”81 He recalled one investment banker telling
him that Wall Street was not looking for Ph.D.s, but rather P.S.D.s—poor, smart, and a deep desire to
get rich.82 In his testimony, Lo called for government funding to expand the number of Ph.D.
programs in financial technology.
Conclusion
By spring 2009, the collateral damage from the financial crisis was still unknown. It would take time
before anyone knew the real value of the “toxic assets” that were plaguing the banking system.
Furthermore, personal credit card debt had yet to hit. When it did, many economists believed the
downward spiral could re-ignite, sending unemployment into the double digits and the stock market
well below 6,000.
It was also unknown whether the government’s plan to rescue the financial system would work.
Simon Johnson and Andrew Lo were advocating measures that they believed would solve the current
crisis and make the next one less severe. Whether and how the government would implement their
recommendations was uncertain.
Besides the fact that financial crises—in the United States and elsewhere—would happen again, Lo
noted that the financial industry was in a state of flux. For young people studying finance, the
industry held a lot of promise:
I look at this as an incredible opportunity for those who want to get into finance. Periods of crisis
breed opportunity. There will be many opportunities in the next five to 10 years to create new
financial technologies to help us prevent this level of crisis. The industry will not be what it was.
Compensation will not be the same. There has to be a paradigm shift in how we think about
financial markets, both from a financial technology point of view and the human side.83
80
Andrew W. Lo, “Hedge Funds, Systemic Risk, and the Financial Crisis of 2007–2008: Written Testimony for the House Oversight Committee Hearing on
Hedge Funds,” November 13, 2008, p. 27.
81
Interview with the case writer, April 10, 2009.
82
Dennis Overbye, “They Tried to Outsmart Wall Street,” The New York Times, March 10, 2009.
83
Interview with the case writer, April 10, 2009.
Rev. March 16, 2012
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Exhibit 1
Highlights of Expanded Restrictions for TARP Recipients
Bonus Retention and Incentive Compensation. TARP recipients are prohibited from paying
bonuses, retention awards, and incentive compensation until the financial institutions satisfy their
TARP obligations. Executives subject to compensation restrictions depend upon the amount of TARP
assistance received:
Amount of TARP Assistance
Covered Executives
Less than $25 million
Most highly paid employee
$25 million to $250 million
Five most highly paid employees
More than $250 million to $500 Senior executive officers (SEOs)* and next 10 most highly
million
paid employees
More than $500 million
SEOs and next 20 most highly paid employees
*SEOs include the top five most highly paid officers.
Long-term Restricted Stock. TARP recipients may provide long-term restricted stock so long as:
• The covered executive does not fully vest in the restricted stock during the TARP period;
• The value of the restricted stock does not exceed one-third of the covered executive’s “total
amount of annual compensation”; and,
• The restricted stock complies with such other restrictions as the Treasury Department may
impose.
Pre-existing Employment Contracts. The restrictions on payment of bonuses and incentive
compensation do not apply to amounts paid pursuant to a written employment contract entered into
on or before February 11, 2009.
Incentive Compensation for Risk Taking and Earnings Manipulation. TARP recipients are
prohibited from paying incentive compensation for “unnecessary and excessive risks” and earnings
manipulation.
Golden Parachutes (benefits promised to an employee upon termination of employment). TARP
recipients are prohibited from paying golden parachute payments to the SEOs and any of the next five
most highly paid employees. There is no exception for pre-existing employment contracts.
Clawbacks. TARP recipients must take clawback bonus, retention, and incentive compensation for
the SEOs and the next 20 most highly paid employees if payments were made on inaccurate
performance criteria.
Rev. March 16, 2012
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Luxury Expenditures. The Board of Directors of each TARP recipient must establish a policy on
luxury or excessive expenditures, including entertainment or events, office and facility renovations,
company-owned aircraft and other transportation, and similar activities or events.
“Say on Pay.” TARP recipients must provide shareholders with a non-binding advisory “say on pay”
vote on executive pay.
IRC Section 162(m) Deduction Limit. TARP recipients are prohibited from deducting more than
$500,000 in annual compensation from the CEO, the CFO, and the three next most highly paid
officers under Internal Revenue Code Section 162(m).
Compensation Committee Governance. The Board of Directors of each TARP recipient must
establish a compensation committee to review compensation plans. The compensation committee
must consist entirely of independent directors. This restriction does not apply to private companies
that receive less than $25 million in TARP assistance.
CEO and CFO Certification. The CEO and CFO must certify compliance with the requirements
noted above. For public companies, certification must be made to the SEC. For private companies,
certification must be made to the Treasury Department.
Treasury Department Review of Bonus Payments. The Treasury Department is directed to review
bonuses to the SEOs and the next 20 most highly paid employees paid before February 18, 2009. If
the Treasury Department finds the bonuses were not justified, it will negotiate with the TARP
recipient and/or executive to obtain reimbursement of the bonus.
TARP Fund Repayment. TARP recipients may repay TARP funds without replacing the repaid
amount with other funds and without a waiting period. If the amounts are repaid, the restrictions on
executive compensation would cease to apply.
Source: Marjorie M. Glover, Rachel M. Kurth, “2009 American Recovery and Reinvestment Act,” Chadborne & Parke LLP,
February 20, 2009.
Rev. March 16, 2012
21
17-181
September 13, 2017
First Solar
Neil Thompson and Jennifer Ballen
Tymen deJong, First Solar’s senior vice president of module manufacturing,1 fixated yet again on the
company’s latest 10-K. DeJong had joined the company in January of 2010, at a time when First Solar’s
future appeared bright. Now, just two years later, First Solar’s cost advantage was eroding and deJong
was facing challenges that would require tough decisions.
In 2009, First Solar broke cost records by becoming the first photovoltaic (PV) manufacturer to produce
panels that generated a megawatt of power at a manufacturing cost of less than $1.00 per watt.2 The
company’s proprietary thin-film cadmium telluride technology had made it the largest and lowest-cost
producer for nearly a decade. However, the 2011 Form 10-K on deJong’s desk revealed a net operating
loss of $39 million, the company’s first year-end net operating loss in the past seven years. Although
revenues were $2.7 billion, revenue growth had slowed from 66% in FY 2009, to 24% in FY 2010, and
then to a meager 8% in FY 2011.3 Much of this slowed growth was attributable to broader trends
affecting the entire PV industry. Chinese manufacturers, subsidized by their government, were flooding
the market with low-price crystalline-silicon (c-Si) solar panels. Market demand for PV panels was also
weakening. The 2008–2009 global financial crisis had squeezed government budgets and weakened the
financial positions of many banks. As a result, the once-heavy European solar subsidies were shrinking
and the willingness of banks to finance solar projects had virtually disappeared. Silicon raw material
1
As of July 2015, Tymen deJong became the chief operating officer (COO) of First Solar.
2
Watt: a unit of power is defined as 1 joule per second; it measures the rate of energy flow.
3
First Solar Inc., Form 10 K, 2007.
This case was prepared by Jennifer Ballen, MBA 2017, and Professor Neil Thompson.
Copyright © 2017, Neil Thompson and Jennifer Ballen. This work is licensed under the Creative Commons AttributionNoncommercial-No Derivative Works 3.0 Unported License. To view a copy of this license visit
http://creativecommons.org/licenses/by-nc-nd/3.0/ or send a letter to Creative Commons, 171 Second Street, Suite 300, San
Francisco, California, 94105, USA.
FIRST SOLAR
Neil Thompson and Jennifer Ballen
prices were also falling. This helped First Solar’s competitors, which produced silicon-based panels,
but not First Solar, which produced cadmium telluride-based ones.
As deJong reflected on the company’s recent financial slump, he wondered if First Solar’s competitive
edge had eroded permanently. How should First Solar respond to the threat from the Chinese
manufacturers? What could the company do to maintain its cost advantage? Were First Solar’s recent
acquisitions of down-stream solar panel installers a strategic benefit or a distraction? DeJong knew that
to answer these questions, he first needed to better understand the sources of First Solar’s competitive
advantage and whether these sources were sustainable.
PV Solar Manufacturing and Distribution
Solar Industry History and Evolution
In 1839, nineteen-year old French scientist Edmond Becquerel discovered the photovoltaic effect: that
shining light on the junction of two dissimilar materials, such as a metal and a semiconductor, creates
electric current. This led to Bell Lab’s 1954 creation of the first functional solar cell. Early solar cells
were inefficient and costly to manufacture, so their use was limited to high-value applications, such as
space satellites.4 By the early 1980s, PV solar cell use had broadened to consumer applications, such
as calculators and watches, and by the mid-1990s utility companies had begun using PV solar plants,
although costs continued to be higher than nonrenewable energy sources.
At the turn of the 21st century, two major types of solar technologies had emerged: solar thermal and
photovoltaic. Solar thermal power plants used sunlight to generate heat that was used to boil water,
with the resulting steam driving a turbine to create electricity. But, the fastest growing solar market was
photovoltaics: the conversion of sunlight directly into electricity. First Solar produced exclusively
photovoltaic panels
Overview of Photovoltaics
By early 2012, there were two dominant technologies used to produce PV solar power: (i) thin-film and
(ii) crystalline silicon (c-Si) (Exhibit 1). The PV supply chains typically involved the following steps
(Figure 1).
4
“Solar Explained: Photovoltaics and Electricity,” U.S. Energy Information Administration, October 25, 2015.
September 13, 2017
2
FIRST SOLAR
Neil Thompson and Jennifer Ballen
Figure 1
Steps in the PV Supply Chains
Production Stage
Process for Crystalline Silicon
i) Raw material
preparation
Raw silica, often in the form of
sand, is purchased and purified.
ii) Solar wafer production
5
iii) Solar cell production
Silicon is formed into thin circular
wafers.
Solar wafers are layered to
generate electric current when hit
by sunlight.
Process For Thin Film
A substrate (e.g. glass) and
semiconductor (e.g. cadmium telluride,
rd
CdTe) are prepared by 3 parties.
N/A
A thin layer of semiconductor is layered
on top of the substrate, coated, and then
defined with a laser.
iv) Module array
production
Solar cells are electrically wired together into solar modules and
weatherproofed.
v) System integration and
development
System integrators install completed modules and arrays. For utility customers,
integrators also provide financing, engineering, construction, and ongoing
maintenance.
Source: Case writers.
Crystalline silicon was the dominant technology in the market, accounting for nearly 85% of
manufactured solar panels over the last decade. Crystalline silicon was used for semiconductors in both
electronics and solar cells. In 2001, 20% of total silicon use was allocated towards solar cell production,
and 80% towards electronics. By 2010, this had reversed: 80% of total silicon use was for the
manufacturing of solar cells. The rapid growth in demand from solar manufacturers increased silicon
prices from $50/kg in 2001 to a peak of $475/kg in 2008.6 In response, crystalline silicon manufacturers
raced to improve cell efficiency and reduce the thickness of the silicon wafer, which decreased silicon
use in solar cells from approximately 15 grams per watt in 2001 to 5 grams per watt by EOY 2011.7
From 2008–2011, supply of silicon ramped up, causing prices to plunge from $475/kg back to $65/kg
(Exhibit 2). Industry experts predicted that silicon prices would continue to decline further in the near
future, benefiting First Solar’s competitors.
An alternative to crystalline silicon was thin film technology, first commercialized in the early 2000s
by First Solar and a small number of other manufacturers. True to its name, thin film technology
involved the placement of thin layers of semiconductor material, such as cadmium telluride, on top of
inexpensive substrates, such as glass or aluminum. Panels using thin film were typically lower cost and
required 98% less semiconductor material than traditional c-Si panels. In 2011, cadmium telluride use
in thin film solar panels was approximately 0.1 grams per watt. The price of cadmium telluride varied
5
“The Difference Between Solar Cells and Solar Panels,” RGSEnergy.com.
6
“Mineral Commodity Summaries,” U.S. Geological Survey, January 2012.
7
Shyam Mehta, “The Shifting Relationship Between Solar and Silicon in Charts,” Greentech Media, 2011.
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over time, from $48/kg in 2006 to $192/kg in 2011 (Exhibit 2). Offsetting thin-film’s cost advantage
was its historically lower efficiency in converting sunlight into power for most applications (Exhibit
3).
The cost of nonrenewable fossil fuel power had historically been lower than that of renewable power.
By the end of 2010, ignoring subsidies, it cost utilities approximately $0.15-$0.35/kWh to produce
electricity from solar power, $0.08-$0.10/kWh to generate electricity from wind, and $0.06-$0.08/kWh
for natural gas.8 Coal cost only $0.04/kWh, but was the dirtiest form of power. Indeed, many coal plants
with remaining useful life were being decommissioned to avoid the environmental and health damage
they caused. Natural gas was becoming cost-competitive with coal due to the reduced cost of extracting
natural gas through hydraulic fracking,9 a technique that had increased in use substantially over the past
decade. However, natural gas, while cleaner than coal, still produced carbon emissions and posed
environmental risks. Historically, the cost of solar was much higher than other forms of power. In 1976,
the cost of solar was approximately $2.00/kWh, but this cost was falling substantially as producers
learned-by-doing and took advantage of economies of scale (Exhibit 4).
Global Market
Over the last decade, PV solar energy had become the fastest-growing power generation technology in
the world. Much of this growth was driven by regulatory policies, as solar was still more expensive
than traditional fossil fuels. Government incentives typically enhanced the returns for solar providers
in two ways: either providing higher prices for solar power suppliers or requiring utilities to purchase
a specific amount of solar power.10 For example, Feed-in Tariffs (FiTs) were widely used, particularly
in Europe, and offered solar producers long-term contracts at above-market, government-mandated
rates. Another incentive, termed renewable portfolio standards, mandated that certain percentages of
the energy produced by utilities be sourced from renewables, such as solar, wind, geothermal, or
hydroelectric power. Renewable portfolio standards were used by many states in the United States,
most significantly California that had been increasing renewable percentage requirements since 2002.
From 2002–2008, global PV demand increased at an average annual rate of 48%. However, in early
2009 the global financial crisis impacted the solar market, tightening the wallets of financial institutions
and decreasing government spending. Existing subsidies allowed demand to continue increasing, but
at a slower rate, after 2009. By early 2012, many governments had significantly reduced incentive
programs. This was particularly evident in Europe, whose share of overall demand fell, albeit from a
8
“Electricity Generation Estimates,” U.S. Energy Information Administration and Michigan State University, April 2011.
9
Hydraulic fracking is an extraction technique for oil and gas wells in which pressurized liquid is injected into the cracks in rock formations. Once the hydraulic
pressure is removed from the well, the remnants of the fracking fluid ease the extraction of oil and gas.
10
Government incentives came in many different forms including, but not exclusive to: feed-in-tariffs, renewable portfolio standards, quotas, tax credits,
tendering systems, net metering, rebates, loans, and production incentives.
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high level (Exhibit 5). Despite this, the total global PV installed base at EOY 2011 was 65 gigawatts
and experts predicted that this would grow by 400-600 gigawatts by 2020.11
The biggest change in solar production was the large-scale entry of Chinese producers. In 2001, China
comprised less than 1% of overall solar production, but by 2012 Chinese producers were manufacturing
nearly 60% of the entire world’s supply of PV panels12 (Exhibit 6).
Market Segments
There were three broad markets for solar power: residential homeowners, commercial businesses, and
utilities. The residential segment represented 29% of the total market and was predicted to grow to 35%
by 2020. Commercial businesses comprised 40% of the market; this segment was expected to shrink to
25% by 2020. The utility market was predicted to be the fastest growing segment, with an expected
increase in market share from 31% in 2011 to 40% by 2020. In all three markets there were numerous
systems integrators.
The Residential Market In the residential market, PV solar manufacturers sold panels to third-party
system integrators, installers, and distributors, who would physically position the panel on a
homeowner’s roof and connect the panel to the regional electric grid. Residential users were encouraged
to adopt solar through investment tax credits and net metering incentives (which encouraged solar
operators to sell unused electricity back to utilities).
Residential customers typically did not focus on the technology or maker of their solar panels, but
instead on the overall costs and benefits of the installed system. The key criteria for a residential
customer purchasing from a panel manufacturer were (in descending order): the levelized cost of
electricity (an average cost measure per kWh across the lifetime of the system),13 installation and
distribution costs (expenses that were paid by the homeowner), watts per unit area, and sometimes even
aesthetics, as some residential homeowners were concerned about the appearance of highly visible
rooftop panels.
The Commercial Market Commercial and industrial businesses seeking to lower their operating
expenses and carbon footprints also purchased solar power systems through third party system
integrators and distributors. As commercial projects were typically larger in scope and required greater
wattage per panel, the primary purchase consideration for commercial businesses was the levelized cost
of electricity. When purchasing panels, commercial customers also focused on watts per unit area,
installation and distribution costs, and reliability of the technology.
11
Krister Aanesen, Stefan Heck, and Dickon Pinner, “Solar Power: Darkest Before Dawn,” McKinsey & Company, May 2012.
12
Robert Castellano, “China’s EV Battery Industry Could Be A Repeat of Solar and Rare Earth Dominance,” Seeking Alpha, October 25, 2016.
13
See Glossary for more details.
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The commercial and utility markets both financed solar projects with solar leases and power purchase
agreements (PPAs), financial contracts between buyers and providers of electricity. With a PPA, the
developer was responsible for the design, financing, and installation of the solar system at little to no
cost for the customer. The developer also operated and maintained the system over the duration of the
contract, typically 10-25 years. In return, the customer purchased the generated energy at a fixed rate
from the developer. At contract termination, the customer would either extend the PPA, remove the
system, or purchase the system from the developer. PPAs provided an assurance of both volume (all
the kWh were sold) and price (as set by the PPA contract).
The Utility Market
In contrast to the residential and commercial markets, the utility market
encompassed a smaller number of larger-scale projects. For example, in the United States, there were
approximately 60 new utility-scale solar projects in 2011, as compared to hundreds of thousands of
projects in residential and commercial markets.14 Some utilities purchased panels directly from PV
manufacturers, while others purchased from system integrators and installers. System developers
provided a variety of services to utility customers, including:
i.
ii.
iii.
iv.
Project Development: obtaining land permits, negotiating purchase agreements,
transmission interconnection, major engineering, and construction.
Operations and Maintenance: subsequent to development, signing long-term contracts
to provide on-site operations and maintenance, such as performance analysis, forecasting,
contractual and regulatory advice, performance reporting, and inventory management.
Project Finance: negotiating and executing power plant sales, raising capital from debt
and equity markets, and structuring non-recourse project-level debt financing.
Engineering, Procurement and Construction: engineering and designing power plants,
developing grid integration, construction management, and procuring component parts
from third parties.
The primary purchase consideration for the utility market depended on the placement. In spaceconstrained areas, the most important factor was typically watts-per-square meter, so that as much
power as possible could be generated in small spaces. Utilities that were not space constrained were
willing to purchase less efficient panels if the panels had a lower cost per kilowatt-hour. Many utility
installations were not space constrained.
A vendor track record of successful and timely installation was typically the next purchase
consideration for utilities. PV manufacturers that wanted to sell products to utilities in a certain location
would often first establish a relationship with integrators that had a favorable track record in order to
better reach that market. Finally, utilities purchased panels based on proven technology and anticipated
14
“An Analysis of New Electric Generation Projects Constructed in 2011,” Electric Market Reform Initiative and American Public Power Association, March
2012.
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reliability of the system. Feed-in-tariffs were implemented by many governments to encourage demand
and required utilities to buy renewable energy at above-market rates. Utilities often passed this
incremental financial burden to their customers through a small extra fee on monthly electric bills.
First Solar
Brief Company History
First Solar originated as a glass company in 1984 under the name Glasstech Solar, founded by glass
entrepreneur Harold McMaster. In 1990, the company was renamed to Solar Cells, Inc., and then once
again in 1999 to First Solar, LLC, after True North Partners purchased a controlling interest in the
company and the firm was recapitalized. John Walton, the son of Walmart’s founder Sam Walton, and
Mike Ahearn (who later became co-founder, Chairman, and the first CEO of First Solar) founded True
North Partners. Walton and Ahearn both believed in the power of technology to accelerate
sustainability.
On November 17, 2006, First Solar became a publicly-traded company (FSLR), raising $450 million
at an initial offering price of $20 per share.15 First Solar’s business model focused solely on component
manufacturing at first: designing and producing PV solar cells and modules to sell to project developers,
system integrators, and operators of clean energy projects. Beginning in 2007 with a series of
acquisitions, First Solar vertically integrated, buying system integrators primarily in the United States.
Through its systems business, First Solar controlled the engineering, procurement, construction,
operations, maintenance, and development of solar power plants, and at times, project finance.
Manufacturing and Costs
First Solar manufactured PV solar cells and modules using an advanced thin-film cadmium telluride
(CdTe) technology, controlling all stages of production entirely in-house which, according to First
Solar’s 10-K, “…eliminated the multiple supply chain operators and expensive and time consuming
batch processing steps that are used to produce crystalline silicon solar modules.”
In 2005, First Solar produced its first commercial solar module. First Solar used a proprietary vapor
deposition technology to coat glass panels with two thin layers of semiconductor material: first
cadmium sulfide, then cadmium telluride. High speed lasers then divided the semiconductor into cells,
the fundamental units for absorbing light and converting it into electricity. Solar cells were combined
to form solar modules and solar modules were combined to form solar panels to scale up the amount of
electricity provided.
Tymen deJong commented on First Solar’s use of thin-film:
15
Nasdaq, First Solar Inc. IPO priced November 17, 2006.
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Most of the early work in photovoltaic generation was done on crystalline silicon, so that’s where
the R&D investments went. While there was an awareness of thin-film and cadmium telluride, there
simply was not that much money being invested in it. There are significant technical challenges in
applying cadmium telluride. We figured it out early and, to this day, we have a tremendous amount
of IP around how to do that. The barriers to entry to figure this all out are years of R&D and
hundreds of millions of dollars in capital expenditures. And, to be fair, all of the early efficiency
records were based on c-Si…it looked like a better technology to new entrants. But, if you want to
look at thin-film, you have to do all that work yourself. Our company leaders had this vision around
CdTe and what we could do.
Historically, First Solar produced all of its modules at its manufacturing plant in Perrysburg, Ohio,
which later evolved to also become the company’s primary research and development (R&D) center.
In April of 2007, First Solar expanded production internationally and began to produce modules at its
Frankfurt/Oder Germany plant.
As of 2011, First Solar operated 36 production lines in Perrysburg, Ohio; Frankfurt, Germany; and,
Kulim, Malaysia. Of these, the Malaysian plants had the lowest production costs, but the other plants
had advantages in terms of R&D or serving particular markets. The company’s newest plant was built
in Frankfurt, Germany in November of 2011. This was First Solar’s second plant in Frankfurt, adding
a capacity of 250 megawatts per year to the region. The plant had taken First Solar one year to construct
and cost roughly 170 million euros (US $230 million).16 First Solar also had two plants under
construction in Mesa, Arizona and Ho Chi Minh City, Vietnam.17
Traditionally, First Solar had operated its plants very close to 100% capacity in order to maximize use
of the expensive fixed capital required to produce PV panels. By 2011, however, the increasing market
share of Chinese competitors led to First Solar producing only 1.7 gigawatts of panels (approximately
21 million solar modules) despite having the capacity to produce 2.5 gigawatts.
The manufacturing cost per watt for First Solar and its competitors is shown in Exhibit 7.
Customer and Market Strategy
The majority of First Solar’s early customers were system integrators, developers, and operators,
primarily located in subsidy-rich Europe. In 2008, approximately 74% of the company’s net sales
resulted from Germany alone.18 In order to diversify, First Solar expanded into direct sales in highsunshine, non-subsidy reliant markets, primarily selling systems to utilities in Africa, the Middle East,
and the Americas.
16
Jonathan Gifford, “First Solar Inaugurates Second German Plant,” PV Magazine, November 3, 2011.
17
First Solar Inc., Form 10-K, 2011.
18
First Solar Inc., Form 10-K, 2010.
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The company first ventured into the systems business in late 2007 with a $34.4 million acquisition of
system integrator, Turner Renewable Energy. Further acquisitions of Mission Edison’s project pipeline,
OptiSolar (a power plant contractor), NextLight Renewable Power (a solar panel developer), and Ray
Tracker (a component parts firm), expanded First Solar’s presence in the systems market.19 While First
Solar became closer to the customer, these acquisitions also brought with them higher SG&A expenses.
From 2009 to 2011, First Solar grew its utility-scale systems business from 5% to 25% of overall sales,
narrowing the gap between itself and systems leader, SunPower, which derived 53% of its business
from systems in 2010 and 46% in 2011. Chinese manufacturers were largely absent from the systems
business. Exhibit 8 provides additional details.
Financial Strategy
First Solar pursued a conservative financial strategy, borrowing less than its competitors. From 2007–
2011, First Solar had an average annual debt of $276 million, whereas SunPower had $687 million,
Suntech had $1.7 billion, and Yingli Solar had $1.1 billion. First Solar also consistently kept more cash
on hand than competitors, for use in financing promising solar projects. Capacity expansions were
typically funded with 50% cash and 50% equity. Bruce Sohn, former President and Board member
(2003–2011), commented on First Solar’s financial approach:
The reason we pursued a low leverage strategy was because we wanted a strong balance sheet. This
served to both lower borrowing costs [for First Solar customers] and provide confidence to buyers
that we would be able to sustain our business for the long-term. We did it by design for those
reasons. In contrast, our competitors during this time were levering up and borrowing to expand,
and thus had weak balance sheets. People didn’t trust those companies. First Solar took the opposite
approach.
Exhibit 9 shows both the income statements and balance sheets for First Solar and its main competitors.
Vertical Integration
All PV manufacturers produced solar modules, with several outsourcing various aspects of
semiconductor production. Few forward-integrated into systems, so First Solar was unusual in this
respect. The company divided its business into two interrelated segments: components and systems.
The components business manufactured cadmium telluride solar cells and modules, while the systems
business developed those components into complete solar systems. The components segment had
historically achieved higher profitability and generated more cash than systems, but the systems
business had less margin variability because the provision of ongoing maintenance, engineering, and
construction was less dependent on materials prices.
19
First Solar Inc., Form 10 K, 2007.
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Sohn commented on the vertical integration:
We realized that we could scale our production faster than our customers [the systems integrators]
were able to scale their business. Our customers were the constraint and we determined that if we
could vertically integrate, especially in places where our customers did not operate, then we could
grow significantly faster. This effectively doubled our shipment rate and enabled steep volume
growth even during a period of heightened competition.
Having our own utility scale solar business also provided us with the opportunity to optimize
overall system design…For several years, First Solar was able to deliver systems that yielded up to
5% better performance than competitors because of our intimate knowledge about the [First Solar]
panels.
Competition
United States
Although U.S. customers were initially slower to adopt PV solar power than their European and Asian
counterparts, by 2011 U.S. solar installations had grown enormously, doubling from 2009 to 2011. In
2011, the U.S. market share of total global PV installations increased from 5% to 7%. U.S. market share
was anticipated to outpace the growth of other nations over the next five years. Reported installed solar
capacity from 2010–2011 in the United States was a total of 1,855 megawatts, comprised of 16%
residential, 43% commercial, and 41% utility. The utility market had only recently grown in size, while
the commercial market had long accounted for over 50% of solar energy growth.20 As in the rest of the
world, the majority of modules produced in the United States used crystalline silicon technology.
In 2011, First Solar controlled approximately 41% of the U.S. market. SunPower was the second largest
PV manufacturer, controlling 38.5%, while the remaining 20.5% of the market went to smaller players
including Solyndra, SunEdison, SunRun, Evergreen Solar, and Spectrawatt, Inc.21 SunPower
manufactured highly efficient (18.1%–20.1%) and more expensive, solar panels and modules. In 2011,
SunPower was suffering a similar fate to First Solar, also recording its first year-end net operating loss
since 2007. SunPower’s gross margin over the past five years had decreased from 19% in 2007 to 10%
at EOY 2011. In April 2011, SunPower sold a 60% controlling interest to the oil company Total for
$1.38 billion. Total offered SunPower up to $1 billion of credit over the ensuing five years.22
Solyndra, a California-based solar panel manufacturer, also competed in the thin-film market, using a
copper indium gallium (di)selenide (CIGS) technology to design and manufacture panels, primarily for
20
“U.S. Solar Market Insight Report 2011 Year-In-Review,” Solar Energy Industries Association, 2011.
21
First Solar, Inc., Form 10K, 2011; SunPower Corporation, Form 10K, 2011.
22
“Total to Begin Friendly Tender for Up to 60% of SunPower Shares,” Bloomberg, March 28, 2011.
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commercial customers. Although Solyndra had increased production from 30 MW in 2009 to 67 MW
in 2010,23 the company was ultimately forced to declare bankruptcy in September of 2011. Analysts
speculated the bankruptcy was due to an over-leveraged balance sheet and tightening credit conditions.
China
In 2009, the Chinese government declared leadership in PV solar production a national priority,
ratifying a multitude of solar subsidy programs that transformed China into the world’s largest producer
of solar panels in just a few short years. Crystalline silicon manufacturers from China began producing
quickly, cheaply, and in mass quantities, exporting over 90% of their panels abroad.24 Chinese
manufacturers also had much lower R&D expenditures, typically a third to a half as much as First Solar.
Major players in the Chinese market included Suntech, Yingli, and Trina Solar.
The Chinese government subsidized both the demand and supply of PV solar panels. Domestically, the
government subsidized demand through a series of initiatives. In March of 2009, China released its first
national solar subsidy initiative called “building-integrated photovoltaics,” a government subsidy
providing up to 20 RMB (US$3) per watt for such systems and 15 RMB per watt for rooftop systems.25
By July, the program had offered $1.2 billion in subsidies. That same year, China launched its second
national solar subsidy program: Golden Sun. This program sought to accelerate the development of
utility-scale solar projects, offering a 50% subsidy for building, transmission, and distribution costs.
The subsidy increased to 70% for PV projects in remote areas lacking connection to the grid. The
government’s stated intent was to install over 500 megawatts of solar power in two to three years.26 A
variety of similar subsidies were implemented in the following years. Collectively, the yearly
installation of PV panels in China grew more than 1000% from 2009 to 2011.27
Chinese subsidization of suppliers is harder to quantify. One 2011 U.S. Department of Energy and
Stanford University study attempted to quantify the scale of the advantages of producing in China,
including subsidies, low-cost equipment, cheaper labor, and regional supply chain advantages (Exhibit
10). This study found that the Chinese cost advantage due to subsidies for PV manufacturers was
approximately 18-20% of costs, when compared with a 60 MW crystalline silicon U.S. plant. In 2011,
the World Trade Organization (WTO) began an investigation of Chinese subsidies, ultimately
concluding that of the 18-20% cost advantage, 1/5 was due to subsidies, most of which manifested in
the form of lower depreciation. In other words, the Chinese government was primarily subsidizing the
building of new plants rather than ongoing operations.28
23
“2010 Solar Technologies Market Report,” U.S. Department of Energy, November 2011.
24
“Why Millions of Chinese-Made Solar Panels Sat Unused in Southern California Warehouses for Years,” Pacific Standard, June 30, 2015.
25
It is important to note that this number applies to the entire solar system, not just the panel, and therefore is not comparable to values in Exhibit 2.
26
Lin Jones, “China’s National Solar Subsidy Programs,” China Policy in Focus, 2012.
27
Greentech Media Research, PV Pulse, 2008-2011.
28
Mark Clayton, “China Subsidized Solar Panels, U.S. Finds…” Csmonitor.com, March 2012.
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Chinese manufacturers produced so many panels over this period that they had to store millions of
panels in warehouses in California. Many of these panels sat unused until they became obsolete for the
U.S. market.29 In October 2011, Solarworld, along with six anonymous PV manufacturers, filed an antidumping30 lawsuit with the Department of Commerce and the International Trade Commission,
contending that crystalline-silicon Chinese manufacturers were benefiting from illegal subsidies and
dumping their modules into the U.S. market. Industry experts had given credence to this anti-dumping
lawsuit by accusing Chinese suppliers of selling modules below their bill of materials and contending
that the Chinese government was giving free equipment, gifts of land, deferred taxes and other benefits
to its domestic manufacturers. The severity of this for First Solar was captured in the company’s 2011
10-K Filing:
In 2011, industry average module pricing declined significantly as competitors reduced prices to
sell-through inventories in Europe and elsewhere. If competitors reduce module pricing to levels
near or below their manufacturing costs, or are able to operate at minimal or negative operating
margins for sustained periods of time, our results of operations could be adversely affected. At
December 31, 2011, the global PV industry consisted of more than 150 manufacturers of solar
modules and cells. In the aggregate, these (global PV) manufacturers have installed production
capacity that significantly exceeded global demand in 2011. We believe this structural imbalance
between supply and demand (i.e., where production capacity significantly exceeds current global
demand) will continue for the foreseeable future, and we expect that it will continue to put pressure
on pricing, which could adversely affect our results of operations.
Bankruptcies
The combination of the flood of inexpensive panels from China and the drop in subsidies in Europe
drove down solar prices worldwide, forcing the closure of numerous manufacturing plants, particularly
in the United States. On August 15, 2011, U.S manufacturer Evergreen Solar, Inc. filed for bankruptcy,
closing at $0.18 on the NASDAQ, a dramatic end to a stock that in 2007 had a price of $113.10 and a
promising future. The price of solar wafers, Evergreen Solar’s main product, had dropped 35% in the
last 12 months.31 Just one week later, SpectraWatt Inc., backed by Intel Corp. and Goldman Sachs
Group, also filed for Chapter 11 bankruptcy.32 The U.S. solar industry was suffering, and higher-cost
producers were being hit the hardest.
29
“Why Millions of Chinese-Made Solar Panels Sat Unused in Southern California Warehouses for Years,” Pacific Standard, June 30, 2015.
30
Dumping: when a foreign producer sells goods or services in domestic country for a price lower than production costs and/or the domestic producer’s selling
price. The price difference is referred to as the dumping margin.
31
Nichola Groom, “Solar Company Evergreen Files for Bankruptcy,” Reuters, August 15, 2011.
32
Andrew Herndon and Michael Bathon, “Intel-Backed Solar Company Files for Bankruptcy as Prices Slide,” Bloomberg, August 24, 2011.
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In September of 2011, U.S. CIGS33 manufacturer Solyndra filed for bankruptcy after just six years of
operation, resulting in the loss of thousands of jobs. Solyndra’s insolvency was also politically charged
because just two years earlier the company had received a $535 million loan guarantee from the U.S.
Department of Energy, the first-ever loan recipient under the 2009 American Recovery and
Reinvestment Act. At the time, U.S. President Barack Obama had publicly praised Solyndra for setting
a positive example for the “future” of American energy businesses.34 Solyndra had also received over
$700 million in venture capital funding during its time of operation.35 Although Solyndra was not
considered a major player in the global solar market, its default on a federal loan guarantee carried
higher implications than other bankruptcies: Solyndra became a proof of concept for those seeking to
diminish loan-guarantees and other incentives for clean energy.
First Solar’s Response
Protagonist Prepares for Upcoming Meeting
DeJong was concerned. The quarterly Board meeting was just around the corner and he knew that the
company’s recent financial underperformance meant he would have to field intense questions from
employees and investors. The $413 million loss in 4Q 2011 amounted to a per-share loss of $4.78. Just
one year ago, during 4Q 2010, First Solar had earned a $155.9 million ($1.80 per share) quarterly profit.
Could First Solar still be profitable if silicon prices continued to fall? Was the systems business a
competitive advantage or a distraction? What changes did First Solar need to make to counter the threat
of Chinese entrants? If First Solar was forced to retrench, which market should the company focus on,
and would it be able to prevail in that market? Could the company maintain its competitive advantage
or would it follow other American solar manufacturers into bankruptcy in the face of these difficult
challenges?
33
CIGS: short for Copper-Indium-Gallium-Selenide, a technology used to manufacture thin-film solar cells and modules.
34
Joe Stephens and Carol D. Leonnig, “Solyndra Solar Company Fails after Getting Federal Loan Guarantees,” Washington Post, August 31, 2011.
35
Tom Hals, “U.S. Solar Frm Solyndra Files for Bankruptcy,” Reuters, September 6, 2011.
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Exhibit 1
Thin-Film and Crystalline Silicon Solar Cells
Thin film
Crystalline Silicon
Source: First Solar.
Exhibit 2
Raw Materials Prices
36
Raw Materials Prices
$500
$/kg
$400
$300
$200
$100
$0
2006
2007
2008
2009
2010
2011
Silicon Prices
$100
$280
$475
$140
$60
$65
Cadmium Telluride Prices
$49
$47
$115
$81
$118
$192
Sources: U.S. Geological Survey, Mineral Commodity Summaries, January 2012; PV Insights.
36
Cadmium telluride prices calculated based on the cost of the two input materials: cadmium and telluride.
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Exhibit 3
Module Size and Wattage
37
Company
Area of Solar Module
First Solar
8 ft
SunPower
Suntech
Yingli
2
Watts per Module
80
23.3 f...
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