Strategic Management
t for the
Capstone Business Simulation® and
Comp-XM®:
Analysis and Assessment
Michael L. Pettus, Ph.D.
ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced or
used in any form or by any means- graphic, electronic, or mechanical, including photocopying, recording,
taping, Web distribution, or information storage and retrieval systems without the written permission of the
author, Michael L. Pettus. mpettus@millikin.edu
Copyright 2012
® is a registered trademark of Management Simulations, Inc.
6th Edition
2
“I like this new 6th edition” Professor Renee English
Webster University
“This text is excellent as a strategic management text which uses the Capstone
simulation and cases to explain the linkages of strategic management concepts to
real world business problems.”
Joseph Mahoney, Ph.D.
Caterpillar Chair in Strategic Management
University of Illinois
Associate Editor, Strategic Management Journal
“If you use the Capstone simulation this strategic management text must be used.
No other strategic management text can drive the concepts of strategic management
into a real world based simulation.”
Peter Wright, Ph.D.
Free Enterprise Chair in Strategic Management
University of Memphis
3
Acknowledgments
I would like to thank many people for their hard work and dedication to the
construction of this book. First, I would like to thank Dan Smith, founder of the
Capstone Business Simulation, for giving me the opportunity to prepare the book.
Second, I would like to thank all the students who spent hundreds of hours
word processing this book: Karen Knight and Tim Wiggenbach deserve special
recognition. Amanda Walker was especially helpful in the construction of this
second edition. Denisa Smaldone was very helpful in the development of the third
edition. Victoria Dudleston was instrumental in the constructing of the fourth
edition. Kelsey Lee was very important, and made significant contributions, in the
construction of the 5 th
edition. Audra Davis was crucial in terms of assistance of the
updated 5 th
edition. Maddison Harner was outstanding in terms of assistance in
creating the 6th edition. Someday all of you will walk with industry giants.
Third, there are two people who were vital to the construction of this book:
May Zelner of Capstone Business Simulation and Hans Royal-Hedinger of Millikin
University. Without the hard work of these individuals, this book would never have
been accomplished. If I were to pick a number of individuals to start a business,
May and Hans would be among my ten top picks in the world! Someday both of
you will walk with captains of industry.
Fourth, I would like to thank Eddie Schwertz of Webster University for his
review of the 6th edition
4
Michael L. Pettus earned a PhD in strategic management from the University of
Illinois in 1997 and has more than 30 years of global experience in airline, airfreight
and trucking industries. He is published in the Academy of Management Journal, the
Strategic Management Journal, and many leading practitioner journals. He is the
author of Growth from Chaos (2003: Praeger) which explores corporate growth in
deregulated transportation industries. This book, Strategic Management for the
Capstone Business Simulation and Comp – XM, which is now in its 6th edition,
explains how the content of strategic management is integrated into business
simulations.
5
This book is dedicated to CAT.
6
Summary Table of Contents
Chapter 1 ……………………………………………………………………………………….. 15
Managing Environmental Turbulence …………………………………………….. 15
Chapter 2 ……………………………………………………………………………………….. 37
Industry Analysis and Industry Evolution for the 21 st Century ………… 37
Chapter 3 ……………………………………………………………………………………….. 59
Utilizing Internal Analysis to Build Competitive Advantage Over
Rivals ……………………………………………………………………………………………… 59
Chapter 4 ……………………………………………………………………………………….. 79
Business Level Strategy …………………………………………………………………… 79
Chapter 5 ……………………………………………………………………………………….. 97
Analysis of Markets and Positioning………………………………………………… 97
Chapter 6 ……………………………………………………………………………………… 121
Growth by Internal Development ………………………………………………….. 121
Chapter 7 ……………………………………………………………………………………… 141
Corporate Level Strategies and Restructuring ……………………………….. 141
Chapter 8 ……………………………………………………………………………………… 167
Growth Via Strategic Alliances ……………………………………………………… 167
Chapter 9 ……………………………………………………………………………………… 191
Acquisition Strategies ……………………………………………………………………. 191
Chapter 10 ……………………………………………………………………………………. 215
International Strategies …………………………………………………………………. 215
Chapter 11 ……………………………………………………………………………………. 245
Strategic Leadership Decision Making …………………………………………… 245
Chapter 12 ……………………………………………………………………………………. 267
Wealth Creation ……………………………………………………………………………. 267
Chapter 13 ……………………………………………………………………………………. 283
Conducting Case Analysis: An Exercise in Wealth Creation …………… 283
Chapter 14 ……………………………………………………………………………………. 295
Comp-XM® ………………………………………………………………………………….. 295
Appendix ………………………………………………………………………………………. 313
Glossary ……………………………………………………………………………………….. 315
Index …………………………………………………………………………………………….. 321
7
Detailed Table of Contents
Chapter 1 ……………………………………………………………………………………….. 15
Managing Environmental Turbulence ……………………………………………… 15 Learning and Assessment Goals ………………………………………………………………………….16 U.S. Economic Collapse ………………………………………………………………………………………18 U.S. Government Stimulus Plan ………………………………………………………………………….20 U.S. Auto Industry ……………………………………………………………………………………………..20 International Recession ………………………………………………………………………………………21 The “Secret” Global Bailout ……………………………………………………………………………….23
Economic Status as of 3 rd
Quarter 2011 ………………………………………………………………25
Economic Conditions During 1 st Quarter 2012 …………………………………………………….26
Discussion Questions ………………………………………………………………………………………….31
References ………………………………………………………………………………………………………….32
Harvard Business Cases for Chapter 1 ………………………………………………………………..36 Professor Case for Chapter 1 ………………………………………………………………………………36
Chapter 2 ……………………………………………………………………………………….. 37
Industry Analysis and Industry Evolution for the 21 st Century ………… 37
Learning and Assessment Goals ………………………………………………………………………….38 The Competitive Environment in the 21
st Century ………………………………………………39
Industry Structure ……………………………………………………………………………………………..40
Industry Classification ……………………………………………………………………………………….40 Porter’s Five Forces ……………………………………………………………………………………………42
Potential Entrants (Threat of New Entrants) ……………………………………………………. 42 Bargaining Power of Suppliers ……………………………………………………………………… 43 Bargaining Power of Buyers …………………………………………………………………………. 43 Threat of Substitutes ……………………………………………………………………………………. 43 Degree of Rivalry ………………………………………………………………………………………… 44
Industry Analysis Using Porter’s Five Forces Model ……………………………………………45 Industry Evolution ……………………………………………………………………………………………..46
Introduction Stage ……………………………………………………………………………………….. 47 Growth Stage ……………………………………………………………………………………………… 47 Maturity Stage …………………………………………………………………………………………….. 47 Decline Stage ……………………………………………………………………………………………… 48 Industry Forces During Introduction Stage……………………………………………………… 50 Industry Forces During Growth Stage ……………………………………………………………. 50 Industry Forces During Maturity Stage ………………………………………………………….. 51 Industry Forces During Decline Stage ……………………………………………………………. 51 The Upside of Declining Industries ……………………………………………………………….. 52
Discussion Questions ………………………………………………………………………………………….53 References ………………………………………………………………………………………………………….54 Intel Mini Case …………………………………………………………………………………………………..55 Harvard Business Cases for Chapter 2 ………………………………………………………………..57
8
Professor Case for Chapter 2 ………………………………………………………………………………57
Chapter 3 ……………………………………………………………………………………….. 59
Utilizing Internal Analysis to Build Competitive
Advantage Over Rivals ……………………………………………………………………. 59 Learning and Assessment Goals ………………………………………………………………………….60 The Resource-Based View …………………………………………………………………………………..61
Criteria for Competitive Advantage ……………………………………………………………….. 61 Value Chain Analysis and Capstone Simulation ………………………………………………….68
Technology Development …………………………………………………………………………….. 68 Human Resource Management ……………………………………………………………………… 69 Firm Infrastructure ………………………………………………………………………………………. 69 Procurement ……………………………………………………………………………………………….. 69 Inbound and Outbound Logistics …………………………………………………………………… 70 Operations ………………………………………………………………………………………………….. 70 Marketing and Sales …………………………………………………………………………………….. 70 Service……………………………………………………………………………………………………….. 71
Global Outsourcing ……………………………………………………………………………………………71 Discussion Questions ………………………………………………………………………………………….74 References ………………………………………………………………………………………………………….75 Ryder Mini Case ………………………………………………………………………………………………..77 Harvard Business Cases for Chapter 3 ………………………………………………………………..78 Professor Case for Chapter 3 ………………………………………………………………………………78
Chapter 4 ……………………………………………………………………………………….. 79
Business Level Strategy …………………………………………………………………… 79 Learning and Assessment Goals ………………………………………………………………………….80 Key Success Factors ……………………………………………………………………………………………81
Determining Key Success Factors …………………………………………………………………. 81 Utilizing Key Success Factors over Time ……………………………………………………….. 82
Generic Business Level Strategies ……………………………………………………………………….82 Cost leadership ……………………………………………………………………………………………. 83 Focused low cost …………………………………………………………………………………………. 83 Differentiation …………………………………………………………………………………………….. 83 Focused differentiation ………………………………………………………………………………… 84
Walmart Expansion ……………………………………………………………………………………… 85
Competitive Dynamics ………………………………………………………………………………………..87 SWOT Analysis ………………………………………………………………………………………….. 87 Strengths ……………………………………………………………………………………………………. 87 Weaknesses ………………………………………………………………………………………………… 88 Opportunities………………………………………………………………………………………………. 88 Threats……………………………………………………………………………………………………….. 88
SWOT Analysis of American and Southwest Airlines ……………………………………… 89
Competitive dynamics over time …………………………………………………………………… 90
Discussion Questions ………………………………………………………………………………………….93 References ………………………………………………………………………………………………………….94 Dell Mini Case ……………………………………………………………………………………………………95 Harvard Business Cases for Chapter 4 ………………………………………………………………..96
9
Professor Case for Chapter 4 ………………………………………………………………………………96
Chapter 5 ……………………………………………………………………………………….. 97
Analysis of Markets and Positioning………………………………………………… 97 Learning and Assessment Goals ………………………………………………………………………….98 Market Segmentation …………………………………………………………………………………………99
Market Segmentation of the Airline Industry…………………….………………99
Product Positioning…………………………………………………………………101
Sales Forecasting ………………………………………………………………………………………………103 Sales Forecasting Methods …………………………………………………………………………. 103
Sales Forecasting and Capstone Simulation ……………………………………………………….104 Marketing Mix Variables ………………………………………………………………………………….110
Product Variable ……………………………………………………………………………………….. 110 Price Variable……………………………………………………………………………………………. 111 Promotion Variable ……………………………………………………………………………………. 111 Distribution Variable …………………………………………………………………………………. 113
Discussion Questions ………………………………………………………………………………………..115 References ………………………………………………………………………………………………………..116 Proctor and Gamble (P&G) Mini Case ……………………………………………………………..117 Harvard Business Cases for Chapter 5 ………………………………………………………………119 Professor Case for Chapter 5 …………………………………………………………………………….119
Chapter 6 ……………………………………………………………………………………… 121
Growth by Internal Development ………………………………………………….. 121 Learning and Assessment Goals ………………………………………………………………………..122 Internal Development Strategies ……………………………………………………………………….123
Market Penetration …………………………………………………………………………………….. 123 Market Development …………………………………………………………………………………. 125 Product Development…………………………………………………………………………………. 127 Diversification…………………………………………………………………………………………… 129
Competition ……………………………………………………………………………………………………..129 Internal Development and Capstone Simulation ………………………………………………..130
Growth by Market Penetration…………………………………………………………………….. 130 Growth by Market Development …………………………………………………………………. 131 Growth by Product Development ………………………………………………………………… 133 Growth by Diversification ………………………………………………………………………….. 135
Discussion Questions ………………………………………………………………………………………..136 References ………………………………………………………………………………………………………..137 Starbucks Mini Case …………………………………………………………………………………………139 Harvard Business Cases for Chapter 6 ………………………………………………………………140 Professor Case for Chapter 6 …………………………………………………………………………….140
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Chapter 7 ……………………………………………………………………………………… 141
Corporate Level Strategies and Restructuring ……………………………….. 141 Learning and Assessment Goals ………………………………………………………………………..142 Diversification ………………………………………………………………………………………………….143
Diversification and Performance …………………………………………………………………. 143 Diversification and Value Chain Analysis …………………………………………………….. 145
Same Industry Diversification …………………………………………………………………………..146 Related Industry Diversification ……………………………………………………………………….147 Unrelated Industry Diversification ……………………………………………………………………148
Diversification and Risk …………………………………………………………………………….. 148 Business Strengths and Industry Attractiveness ………………………………………………..149
Industry Attractiveness ………………………………………………………………………………. 150 Business Strength ………………………………………………………………………………………. 151
Restructuring …………………………………………………………………………………………………..152 Downsizing ………………………………………………………………………………………………. 152 Downscoping ……………………………………………………………………………………………. 153 Realignment ……………………………………………………………………………………………… 154
Restructuring and the Capstone Simulation ………………………………………………………154 Discussion Questions ………………………………………………………………………………………..160 References ………………………………………………………………………………………………………..161 General Electric (G.E.) Mini Case …………………………………………………………………….165 Harvard Business Cases for Chapter 7 ………………………………………………………………166 Professor Case for Chapter 7 …………………………………………………………………………….166
Chapter 8 ……………………………………………………………………………………… 167
Growth Via Strategic Alliances ……………………………………………………… 167 Learning and Assessment Goals ………………………………………………………………………..168 Trust ………………………………………………………………………………………………………………..170 Scale of Coverage ……………………………………………………………………………………………..171 Relationship-Specific Assets ……………………………………………………………………………..171 Complementary Capabilities …………………………………………………………………………….171 Interfirm Knowledge Sharing …………………………………………………………………………..171 Scale Alliances ………………………………………………………………………………………………….172 Link Alliances …………………………………………………………………………………………………..174 Joint Ventures ………………………………………………………………………………………………….176 The Downside of Strategic Alliances and Joint Ventures ……………………………………177
Strategic Alliances and the Recession ………………………………………………………………..177 The Future of Strategic Alliances ………………………………………………………………………178 Strategic Alliances and Capstone Simulation …………………………………………………….179 Discussion Questions ………………………………………………………………………………………..183 References ………………………………………………………………………………………………………..184 Oneworld Airline Strategic Alliance Mini Case …………………………………………………188 Harvard Business Cases for Chapter 8 ………………………………………………………………189
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Professor Case for Chapter 8 …………………………………………………………………………….189
Chapter 9 ……………………………………………………………………………………… 191
Acquisition Strategies ……………………………………………………………………. 191 Learning and Assessment Goals ………………………………………………………………………..192
Impact of the Global Recession on Mergers and Acquisitions ……………………………193
Attributes of Successful Acquisitions …………………………………………………………………197 Access to International Markets…………………………………………………………………… 197 Synergies Resulting from Economies of Scale ………………………………………………. 198 Synergies Resulting from Economies of Scope ……………………………………………… 198 Reduce Costs of New Product Development …………………………………………………. 198 Entry into More Attractive Industries …………………………………………………………… 199
Problems with Acquisitions ………………………………………………………………………………199 Paying Too Much ………………………………………………………………………………………. 199 Inability to Achieve Synergies …………………………………………………………………….. 199 Failure to Retain Key Personnel ………………………………………………………………….. 200 Too Much Debt …………………………………………………………………………………………. 200 Invest in Mature Industries …………………………………………………………………………. 201
Process for Achieving Successful Acquisitions ……………………………………………………202 Due Diligence …………………………………………………………………………………………… 202 Engage in Friendly Acquisitions ………………………………………………………………….. 202 Maximize Resource Utilization …………………………………………………………………… 202 Diversify Into Firms That Have Strong Brand Names ……………………………………. 203 Acquire High Growth Firms ……………………………………………………………………….. 204
Hostile Acquisitions ………………………………………………………………………………………….204 Are Acquisitions Beneficial? ……………………………………………………………………………..205 Acquisitions as a Source of Innovation ………………………………………………………………206 Discussion Questions ………………………………………………………………………………………..208 References ………………………………………………………………………………………………………..209 Pfizer Mini Case ……………………………………………………………………………………………….212 Harvard Business Cases for Chapter 9 ………………………………………………………………213 Professor Case for Chapter 9 …………………………………………………………………………….213
Chapter 10 ……………………………………………………………………………………. 215
International Strategies …………………………………………………………………. 215 Learning and Assessment Goals ………………………………………………………………………..216 Factors Encouraging International Expansion …………………………………………………..217 Innovation in Domestic Market …………………………………………………………………………220 Determining International Country Attractiveness ……………………………………………220 Role of Government ………………………………………………………………………………………….221 Determination of International Industry Attractiveness …………………………………….223 Determination of Firms’ Business Strengths ……………………………………………………..226 Adaptation Versus Standardization …………………………………………………………………..228 Determination of International Modes of Entry …………………………………………………228
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Exporting………………………………………………………………………………………………….. 228 Licensing/Franchising ………………………………………………………………………………… 230 Strategic Alliances …………………………………………………………………………………….. 231 Acquisitions ……………………………………………………………………………………………… 231 Foreign Direct Investment ………………………………………………………………………….. 232
Competition within International Markets Intensifies ……………………………………….233 Relocate to Low Cost Markets …………………………………………………………………………..233 New Innovation in Home Markets …………………………………………………………………….233 Discussion Questions ………………………………………………………………………………………..235 References ………………………………………………………………………………………………………..236 IKEA Mini Case ……………………………………………………………………………………………….239 L’Oreal Mini Case ……………………………………………………………………………………………241 Harvard Business Cases for Chapter 10 …………………………………………………………….243 Professor Case for Chapter 10 …………………………………………………………………………..243
Chapter 11 ……………………………………………………………………………………. 245
Strategic Leadership Decision Making …………………………………………… 245 Learning and Assessment Goals ………………………………………………………………………..246 Strategic Leadership …………………………………………………………………………………………247 Customers ………………………………………………………………………………………………………..249 Employees ………………………………………………………………………………………………………..250 Collective Bargaining Organizations …………………………………………………………………251 Shareholders …………………………………………………………………………………………………….252 Board of Directors ……………………………………………………………………………………………252 Investment Community …………………………………………………………………………………….253 Senior Managers and Ethical Decision Making ………………………………………………….253
Strategic Leadership and Growth ……………………………………………………255
Scandals and Strategic Leadership ……………………………………………………………………257 Industry Evolution and Strategic Leadership …………………………………………………….258
Introduction ………………………………………………………………………………………………. 258 Growth …………………………………………………………………………………………………….. 259 Maturity……………………………………………………………………………………………………. 259 Decline …………………………………………………………………………………………………….. 260
Discussion Questions ………………………………………………………………………………………..261 References ………………………………………………………………………………………………………..262 Hershey Mini Case ……………………………………………………………………………………………264 Harvard Business Cases for Chapter 11 …………………………………………………………….265 Professor Case for Chapter 11 …………………………………………………………………………..265
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Chapter 12 ……………………………………………………………………………………. 267
Wealth Creation ……………………………………………………………………………. 267 Learning and Assessment Goals ………………………………………………………………………..268 Balanced Scorecard and Wealth Creation …………………………………………………………269 Customer Wealth ……………………………………………………………………………………………..271
Consumer Costs ………………………………………………………………………………………… 272 Firm Costs ………………………………………………………………………………………………… 272
Shareholder Wealth ………………………………………………………………………………………….273 Liquidity Ratios ………………………………………………………………………………………… 274 Asset Management Ratios…………………………………………………………………………… 274 Debt Management Ratios ……………………………………………………………………………. 275 Profitability Ratios …………………………………………………………………………………….. 275 Economic Value Added (EVA) and Market Value Added (MVA) …………………… 275
Employee Wealth ……………………………………………………………………………………………..276 Positioning for Future Wealth …………………………………………………………………………..277 Capstone Simulation Measures of Wealth Creation …………………………………………..280 Discussion Questions ………………………………………………………………………………………..281
References …………………………………………………………………………..282
Chapter 13 ……………………………………………………………………………………. 283
Conducting Case Analysis: An Exercise in Wealth Creation …………… 283 Industry Structure ……………………………………………………………………………………………286 Competitive Dynamics for the Capstone Simulation ………………………………………….289 Wealth Creation Measures ……………………………………………………………………………….290 Conclusion ……………………………………………………………………………………………………….291 Recommendations …………………………………………………………………………………………….293
Chapter 14 ……………………………………………………………………………………. 295
Comp-XM® ………………………………………………………………………………….. 296 Balanced Scorecard ………………………………………………………………………………………….301 Board Query Questions …………………………………………………………………………………….308
Appendix ………………………………………………………………………………………. 313 U.S. Domestic Data Sources ………………………………………………………………………………313 International Data Sources ……………………………………………………………………………….314
Glossary ……………………………………………………………………………………….. 315
Index …………………………………………………………………………………………….. 321
14
15
Chapter 1
Managing Environmental Turbulence
16
Learning and Assessment Goals
1. Understand why we are in a recession within the U.S.
2. Understand why a global recession has occurred.
3. Understand the role the U.S. Government is playing to improve economic conditions with its economic stimulus plan.
4. Understand the economic state of affairs as of 2011.
5. Understand, at the firm level, what has to happen to be able to grow in turbulent economic environments.
6. Understand how firms can maintain competitive positions in times of economic turbulence.
17
We live in a chaotic, changing world. The economic ramifications of 2007-2010
have had a negative economic impact on most emerging and fully developed countries
throughout the world. The United States has been very significantly impacted by this
economic downturn. Some economists believe that the 2007-2010 time period
represented a depression rather than a recession.
Are the 1930’s depression conditions upon us during 2007-2010? The Great
Depression of the 1930’s may have a more modern version. However, the solutions to
this current economic crisis need 2011 solutions. This chapter will address ways of
dealing with current economic conditions. If firms are to be successful in current
economic times, a number of decisions will need to be made which address conditions
specific to modern times. The first question that needs to be raised is, “Are we in a
depression or a recession?” In the United States, the Business Cycle Dating Committee
of the National Bureau of Economic Research (NBER) is generally seen as the authority
for dating U.S. recessions. The NBER defines an economic recession as: “a significant
decline in [the] economic activity spread across the country, lasting more than a few
months, normally visible in a reduction in real GDP growth, real personal income,
employment (non-farm payrolls), industrial production, and wholesale-retail sales 1 .”
Academics, economists, policy makers, and businesses defer to the determination
measurement by the NBER for the precise dating of a recession’s onset and end 2 . A
depression is a severe economic downturn that results in a decline in real GDP exceeding
10% and is a recession lasting three or more years 3 . Table 1.1 identifies the conditions in
the Great Depression of the 1930’s and current (2007-2010) economic condition.
Table 1.1
Comparison of the Great Depression (1930s) to the Current
(2007-2010) Economic Conditions
Factor 2007-2010 1930’s
GDP Less than 5% Down 30%
Unemployment 5-10% 25-30%
Consumer prices Fairly stable Down 20-30%
During the 1930’s depression gross domestic product fell by over 30 % 4 . Since
2007 gross domestic product has fallen by less than 5 %. While in 2007-2010
unemployment hovered about 5-10 %, unemployment during the 1930’s depression was
approximately 25-30 %. In the 2007-2010 time period, consumer prices have held fairly
stable; however, during the Great Depression there was between a 20-30 % reduction in
consumer prices. Fortunately, this economic downturn does indeed appear to be a
recession as opposed to a depression. However, the U.S. economy is currently
experiencing its worst crisis since the Great Depression 5 . The U.S. Government has
played a very significant role (e.g. Chrysler and G.M.) throughout this period of
recession.
In essence, the government has been regulating economic conditions (e.g.
economic stimulus package). As the government reduces its regulatory role, firms will
18
need to learn how to adjust to the new economic environment. These new economic
conditions (2007-2010) have had a significant impact upon industries and firms. Let us
begin with what caused the current (2007-2009) economic crisis.
U.S. Economic Collapse What happened was caused by a combination of two factors. The first factor was
people losing their jobs causing them not to be able to pay their mortgages. In the U.S.,
significant job losses have been going on since December 2007 and have accelerated in
September 2008. In 2008, 2.6 million jobs were lost. From January through April of
2009, 2.6 million jobs were also lost.
The rise of advanced economies in Russia, Brazil, India, and China increased the
total global labor pool dramatically. Recent improvements in communication and
education in these countries has allowed workers to compete more effectively with
workers in traditionally strong economies, such as the United States. This surge in labor
supply has provided downward pressure on wages and contributed to unemployment.
The second factor that has contributed to the challenging economic conditions is
falling housing prices in the U.S. Historically, the U.S. housing market has been very
strong. From the mid-1990 to 2005, housing prices grew. During the same period of
time, the U.S. gross domestic product (GDP) per capita was rising.
Housing prices stopped increasing in 2006, started to decrease in 2007, decreased
in 2008 and have fallen about 25% from the peak in 2005 6 . During 2007-2010, the
decline in prices meant that homeowners had more difficulty refinancing their mortgage
rates. This action caused delinquencies and defaults of mortgages to increase sharply,
especially among subprime borrowers. Sub-prime loans were made to customers who
had spotty credit histories. In 2006, it was estimated that over half of the loans were sub-
prime. Banks who had financed these mortgages tried to sell the loans to other banking
institutions. In order to sell the loans, these institutions had to lower the price. These
actions made the initial bank and the bank who acquired the loans worse off. In general,
this is what led to the demise of Bear Stearns and Lehman Brothers. Many other firms
were also dramatically affected. From Table 1.2, the top U.S. bankruptcy filings of all
times included six firms in 2008 and 2009.
19
Table 1.2
Top 10 U.S. Bankruptcy Filings of all Time
Company
Bankruptcy
Date Assets ($ billions)
1. Lehman Brothers 6/15/2009 691
2. Washington Mutual 9/26/2008 328
3. Worldcom Inc. 7/21/2002 104
4. General Motors 6/1/2009 91
5. Enron 12/2/2001 66
6. Conseco Inc. 12/17/2002 61
7. Chrysler 4/30/2009 39
8. Thornburg Mortgage 5/1/2009 36
9. Pacific Gas and Electric 4/6/2009 35
10. Texaco Inc. 4/12/1987 34
Although the economic crisis started in the home mortgage market, it spread to
commercial real estate, corporate junk bonds, and other forms of debt. Total losses to
U.S. banks reached as high as one-third of the total bank capital. The crisis has led to a
sharp reduction in bank lending, which in turn caused a severe recession in the U.S.
economy 7 . How mortgages were affected needs to be discussed.
Borrowers were given low mortgage rates from banks for the first two to three
years (these initial low rates were called “teaser rates”) 8
. The strategy was that by the
time the teaser rates expired and the rates were to be adjusted upward, the value of their
homes would have increased enough so that a new mortgage could be taken out and the
old mortgage paid off. However, this strategy worked only as long as housing prices
were increasing.
When housing prices stopped increasing in 2006, this strategy no longer worked 9 .
Old mortgages could no longer be refinanced, so the borrowers were stuck with higher
mortgage rates that they could not afford, and the default rates started to increase. From
the first quarter of 2006 to the third quarter of 2008, the percentage of mortgages in
foreclosure more than doubled from 4.5 % to 10 % 10
. This foreclosure rate was the
highest since the Great Depression. 11
According to data from Bankruptcy Data.com, a division of New Generation
Research, Inc., bankruptcy filings among publicly traded companies surged 74 % in
2008 12
. There were 136 bank bankruptcy filings in 2008, compared with 78 in 2007.
While the year-over-year growth in bankruptcies rose quickly, the value of the firms
seeking protection grew much faster. The 136 banks seeking bankruptcy protection in
2008 had about $1.16 trillion in assets, compared with just $70.5 billion in assets for
banks filing for bankruptcy protection in 2007 13
.
20
U.S. Government Stimulus Plan The U. S. government has tried to stabilize this economic crisis. President
Obama’s economic stimulus package, $787 billion, has been an attempt to get the
economy back on track. On February 10, 2009, the Senate voted 61-37 to approve
President Obama’s economic stimulus bill. The first piece of the plan would create one
or more banks that would rely on taxpayer and private money to purchase and hold the
banks’ bad assets 14
. In the credit markets, the administration and the Fed are proposing
to expand a lending program that would spend as much as $1 trillion to make up for the
$1.2 trillion decline created between 2006 and 2009 by issuing securities backed
primarily by consumer loans 15
.
The second major component of the plan would give banks capital with which to
lend. Banks that receive new government assistance will have to cut the salaries and
perks of their executives and sharply limit dividends and some corporate acquisitions 16
.
The third piece of the plan would use the last $350 billion that the Treasury has
allocated for the bailout to rely on the Federal Reserve’s ability to create money. The
Fed’s money will enable the government to become involved in the management of
markets and banks 17
.
By comparing the first six months of 2006 with the first six months of 2009,
results have not been promising. Retail sales have decreased from $360 billion in 2006 to
$340 billion in 2009 18
. Construction of new homes has declined from approximately 2
million in 2006 to less than 500,000 in 2009 19
. The purchasing managers’ index shows
the manufacturing sector activity has declined significantly since 2006 20
. Orders for
nondefense capital goods have decreased from over $60 billion in 2006 to less than $50
billion in 2009 21
. Jobless claims have increased from 300,000 to over 600,000 22
. In
2009, the number of people who are receiving jobless benefits rose to 670,000 million
individuals. This is the highest total since 1967 23
. The impact of the recession upon the
U.S. auto industry has been especially severe.
U.S. Auto Industry G.M. and Chrysler have received billions of dollars in government funds to try to
return to profitability. As of mid 2009, nothing positive has happened. Chrysler has
emerged from Chapter 11 bankruptcy (7 th
largest filing of all time: Table 1) and G.M. has
had to receive several billion dollars in additional government aid. G.M. is in a
particularly difficult position. On March 30, 2009, Rick Wagoner, the CEO of G.M. was
forced to resign. This was one of the first times that a U.S. government has forced out a
CEO of a publically held company 24
. This would appear to have been a necessary move.
G.M. has not turned a profit since 2004. Between 2004-2008, G.M. has lost 82
billion dollars 25
. G.M.’s stock was trading at $70/share in June 2000. On March 30,
2009 the stock was trading at $3.62. In May 2009, the stock was trading at $0.75 26
.
Because of these conditions, G.M. has had to borrow money from the
government. As part of President Obama’s bailout plan, G.M. borrowed $15.4 billion 27
.
In addition, G.M. was forced to borrow an additional $4 billion during the first quarter of
2009 to stay in business 28
. In addition, G.M. eliminated its Pontiac division and cut
21,000 employees 29
. On May 16, 2009, G.M. began to close 1100 of its dealerships 30
.
On June 1, 2009, GM went into Chapter 11 bankruptcy protection (4 th
largest filing of all
time: Table 1.2).
Several other businesses of G.M. were affected. The Saturn brand was
discontinued in 2009. In 2010, the Hummer brand was discontinued. G.M. has exited
21
Chapter 11 Bankruptcy Protection and has been increasing revenues, earnings and
earnings per share in 2010 and 2011.
Chrysler has taken a somewhat different approach. Chrysler has obtained $9
billion in bailout funds and exited Chapter 11 bankruptcy protection after 45 days on June
12, 2009. Chrysler has looked to Fiat for assistance. The U.S. Government has put in
place goals for Fiat if it desires to increase its ownership of Chrysler. Fiat will be
allowed to expand its ownership of Chrysler up to a majority stake if the Italian auto
maker meets certain goals 31
.
Fiat will get an initial 20% stake in Chrysler and can increase its holdings in
increments of five percentage points, up to 35%, if it achieves three milestones by
January 1, 2013. Fiat will get the first increase once it starts producing Fiat engines in
the U.S. To receive the second increase, Fiat must develop a vehicle in the U.S. that can
go 40 miles on a gallon of gasoline. 32
Fiat can get a third increase if Chrysler is able to generate more than $1.5 billion
in sales outside of North America, according to a “Master Transaction Agreement” that
was filed on May 9, 2009 in the U.S. Bankruptcy Court in Manhattan. 33
The agreement
also gives Fiat the option to purchase an additional 16% of Chrysler. If Fiat meets all
three goals and exercises its options, it could eventually end up with a 51% stake in
Chrysler. 34
Fiat won’t be able to take full control of Chrysler until it pays off the loans
Chrysler has received from the U.S. government. Prior to that point, Fiat’s ownership
will be capped at 49.9%. Until the loans are repaid, any Fiat stake above 35% will be
held in a trust controlled by the U.S. treasury. 35
As of May 2011, Chrysler has some success with repayment of its loans. Chrysler
used a $1.3 billion investment from Fiat to repay its loans. Fiat, which has had
management control over Chrysler since it emerged from bankruptcy protection in 2009,
paid that amount to increase its stake in Chrysler to 46 percent. The refinancing will
allow it to retire a $5.9 billion balance on the U.S. loans and $1.6 billion to the
governments of Canada and Ontario 36
. As of 2011, Fiat has an agreement to buy the U.S.
Treasury’s remaining 6% stake in Chrysler Group LLC, a move that would bring an end
to the U.S. government’s involvement in Chrysler 37
. The Canadian and U.S.
governments had taken stakes in Chrysler after providing the automaker $7.6 billion in
bankruptcy loans. Chrysler formally repaid those loans in 2011 38
. This agreement could
allow Fiat to skip a Chrysler IPO and move forward with its ambitions to combine
Chrysler
