First Look

June 21, 2011

Municipal Default Fears Overblown

Over the last year, both Wall Street analyst Meredith Whitney and JPMorgan Chase Chief Executive Jamie Dimon have predicted that up to a hundred municipalities will default amounting to hundreds of billions of dollars. But a new working paper by professors Daniel Bergstresser and Randolph Cohen, "Why Fears about Municipal Credit Are Overblown," argues these predictions are likely exaggerated. "This doomsday scenario is very unlikely," they write. "States, counties, and cities face long-term budget stress, related in large part to employee retirement benefits. These problems, though large, are long-term problems and are unlikely to create across-the-board short-term liquidity crises that could lead to widespread municipal default."

Poultry In Motion

When compared with domestic transactions, the financing of international transactions is unique because longer transportation times often increase working capital requirements and introduce institutional variables. To learn more about how these deals are financed, Harvard's Pol Antras and C. Fritz Foley analyzed transaction-level data of a US-based poultry exporter. "Poultry in Motion: A Study of International Trade Finance Practices" shows that prepayment was more likely to occur when the importer was located in a country with weak contractual enforcement and in a country that is farther from the exporter, but that "as an importer develops a relationship with the exporter, transactions are less likely to occur on terms that require prepayment," according to the researchers.

Bp: The Case Study

In a new case, Stephen P. Kaufman and Laura Winig use public sources to explore the failures behind the BP Gulf of Mexico disaster in "Drilling Safety at BP: The Deepwater Horizon Accident." The case explores BP's safety record as well as the role of two principal subcontractors, Transocean and Halliburton Energy Services. The learning objective of the study is to demonstrate the difficulties faced by management and employees when implementing safety changes in dangerous environments.

— Sean Silverthorne


Civilization: The Six Ways the West Beat the Rest

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Accelerating Energy Innovation: Insights from Multiple Sectors

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The Learning Effects of Monitoring


This paper investigates the relationship between monitoring, decision making, and learning among lower-level employees. We exploit a field-research setting in which business units vary in the "tightness" with which they monitor employee decisions. We find that tighter monitoring gives rise to implicit incentives in the form of sharp increases in employee termination linked to "excessive" use of decision rights. Consistent with these implicit incentives, we find that employees in tightly monitored business units are less likely than their loosely monitored counterparts to 1) use decision rights and 2) adjust for local information, including historical performance data, in their decisions. These decision-making patterns are associated with large and systematic differences in learning rates across business units. Learning is concentrated in business units with "loose monitoring" and entirely absent in those with "tight monitoring." The results are consistent with an experimentation hypothesis in which tight monitoring of decisions leads to more control but less learning.

An Evolutionary Approach to Financial History


Financial history is not conventionally thought of in evolutionary terms, but it should be. Traditional ways of thinking about finance, dating back to Hilferding, emphasize the importance of concentration and economies of scale. But these approaches overlook the rich "biodiversity" that characterizes the financial world. They also overlook the role of natural selection. To be sure, natural selection in the financial world is not exactly analogous to the processes first described by Darwin and elaborated on by modern biologists. There is conscious adaptation as well as random mutation. Moreover, there is something resembling "intelligent design" in finance, whereby regulators and legislators act in a quasidivine capacity, putting dinosaurs on life support. The danger is that such interventions in the natural processes of the market may ultimately distort the evolutionary process by getting in the way of Schumpeter's "creative destruction."

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Too Big to Live: Why We Must Stamp Out State Monopoly Capitalism


The problems of excessive economic concentration, so lucidly and incisively analysed here, are not limited to the financial services industry. For the problem is now widespread: while five firms control 80% of the banking industry, a similar or greater concentration is found in industries ranging from energy and telecommunications to tobacco and soft drinks. The dangers of excessive market concentration are greater in finance, however, because of the systemic importance of credit to the economy and the now widely held belief that governments must intervene to prevent the failure of big banks. But what is to be done? If we are to break up the institutions that are "too big to fail," does that contradict the benefits of economies of scale, the driving force of globalization? Or, if these huge firms are to be left as they are, and we are to rely on tighter, better regulation to control them, will not human creativity and ingenuity always find a way around any new rules, as it did in this last crisis? And finally, how can—in practical terms—we get rid of the "too big to fails," without increasing state intervention further?

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The End of Chimerica


For the better part of the past decade, the world economy has been marked by an economic order that combined Chinese export-led development with U.S. over-consumption. The financial crisis of 2007-09 likely marks the beginning of the end of the Chimerican relationship. In this paper, we look at this era as economic historians, trying to set events in a longer-term perspective. In some ways, China's economic model in the decade 1998-2007 was similar to the one adopted by West Germany and Japan after World War II. Trade surpluses with the United States played a major role in propelling growth. But there were two key differences. First, the scale of Chinese currency intervention was without precedent, as were the resulting distortions of the world economy. Second, the Chinese have so far resisted the kind of currency appreciation to which West Germany and Japan consented. We conclude that Chimerica cannot persist for much longer in its present form. As in the 1970s, sizeable changes in exchange rates are needed to rebalance the world economy. The token adjustment proposed recently by Beijing is unlikely to suffice.

Product Positioning in a Two-Dimensional Vertical Differentiation Model: The Role of Quality Costs


We study a duopoly model where consumers are heterogeneous with respect to their willingness to pay for two product characteristics and marginal costs are increasing with the quality level chosen on each attribute. We show that while firms seek to manage competition through product positioning, their differentiation strategies critically depend on how costly it is to provide higher quality. When the cost of providing quality is not too high, firms use only one attribute to differentiate their products: they maximally differentiate on one dimension and minimally differentiate on the other dimension (a Max-Min equilibrium). Furthermore, they always differentiate along the dimension with the greater attribute range. As for the dimension with the smaller range and along which they agglomerate, both firms either choose the highest quality level or the lowest quality level possible, depending on whether the marginal costs of quality provision are low or intermediate, respectively. However, for larger quality provision costs, firms exploit both dimensions to differentiate their products. In particular, we characterize a maximal differentiation equilibrium in which one firm chooses the highest quality level on both attributes, while its rival offers the lowest quality level on both attributes (a Max-Max equilibrium). We discuss the managerial implications of our findings and explain how they enrich and qualify previous results reported in the literature on two-dimensional differentiation models.

Working Papers

Towards an Understanding of the Role of Standard Setters in Standard Setting


We investigate the idiosyncratic influence of standard setters in standard setting. In particular, we examine how FASB members' and SEC commissioners' length of tenure, past professional experience, and political affiliations vary with the degree to which exposure drafts issued during their terms are perceived as decreasing accounting "reliability" and increasing accounting "relevance." Among other results, we find that members' and commissioners' length of service on the board and a prior career in investment banking/investment management are associated with exposure drafts perceived as decreasing accounting "reliability"; and FASB members' affiliations with the Democratic Party are associated with proposing standards perceived as increasing accounting "reliability." The results contribute to a broader understanding of the implications of regulated standard setting beyond our current knowledge of the role of corporate lobbying in the process.

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Poultry in Motion: A Study of International Trade Finance Practices


This paper analyzes the financing terms that support international trade and sheds light on how and why these arrangements affect trade. Using detailed transaction-level data from a U.S.-based exporter of frozen and refrigerated food products, primarily poultry, it begins by describing broad patterns about the use of alternative financing terms. These patterns help discipline a model in which the trade finance mode is shaped by the risk that an importer defaults on an exporter and by the possibility that an exporter does not deliver goods as specified in the contract. The empirical results indicate that transactions are more likely to occur on cash in advance or letter of credit terms when the importer is located in a country with weak contractual enforcement and in a country that is farther from the exporter. Letters of credit, however, are rarely used by the exporter. As an importer develops a relationship with the exporter, transactions are less likely to occur on terms that require prepayment. During the recent crisis, the exporter was more likely to demand cash in advance terms when transacting with new customers, and customers that traded on cash in advance terms prior to the crisis disproportionately reduced their purchases. These results can be rationalized by the model whenever 1) misbehavior on the part of the exporter is of little concern to importers and 2) local banks in importing countries are typically more effective than the exporter in pursuing financial claims against importers.

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Why Fears about Municipal Credit Are Overblown


Highly publicized predictions of 50-100 municipal defaults have caused anxiety among municipal bond investors. While there is some chance that negative investor sentiment will lead to further spread widening, the probability of the kind of widespread default that would be required to justify current municipal bond yields is low. In this paper we document the reasons why the fears of widespread municipal default during the current recession are overblown.

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Fractionalization and the Municipal Bond Market


We study the impact of ethnic and religious fractionalization on the U.S. municipal debt market and find that issuers from more ethnically and religiously fractionalized counties pay higher yields on their municipal debt. A two standard deviation increase in religious fractionalization is associated with a six basis point increase in bond yields, and a two standard deviation increase in ethnic fractionalization is associated with a ten basis point increase. To provide a scale for these results, a four-notch rating change, from AAA to AA-, is associated with an eight basis point increase in yields. Additional analysis suggests that at least some of this effect is not driven by the risk of the bonds, but instead reflects inefficiency in the underwriting process.

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Collaborating across Cultures: Cultural Metacognition & Affect-Based Trust in Creative Collaboration


We propose that managers' awareness of their own and others' cultural assumptions (cultural metacognition) enables them to develop affect-based trust with associates from different cultures, promoting creative collaboration. Study 1, a multi-rater assessment of managerial performance, found that managers higher in metacognitive cultural intelligence (CQ) were rated as more effective in intercultural creative collaboration by managers from other cultures. Study 2, a social network survey, found that managers lower in metacognitive CQ reported a deficit of new idea sharing in their intercultural but not intracultural ties. In Study 3, a laboratory experiment involving a collaborative task, higher metacognitive CQ engendered greater idea sharing and creative performance only when participants shared personal experiences prior to the task. The effects of metacognitive CQ in enhancing collaboration were mediated by affect-based trust. We discuss the theoretical and practical implications for understanding and promoting creativity and problem solving in multicultural global contexts.

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The Three Foundations of a Great Life, Great Leadership, and a Great Organization


I argue here that the three factors my co-authors and I identify as constituting the foundation for being a leader and the effective exercise of leadership can also be seen as the foundations not only for great leadership, but also for a high quality personal life and an extraordinary organization. One can see this as a "value free" approach to values because 1) integrity as we define it (being whole and complete) is a purely positive proposition, 2) authenticity is also a purely positive proposition (being and acting consistent with who you hold yourself out to be for others and who you hold yourself to be for yourself), and 3) being committed to something bigger than oneself is also a purely positive proposition (that says nothing about what that commitment should be other than it be bigger than oneself).

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Cases & Course Materials

Online Research Guide

Lynda M. Applegate, William R. Kerr, Ann Cullen, and Alexis Brownell
Harvard Business School Note 811-095

This note provides students with an approach to using online databases to analyze companies, industries, and markets, including country markets.

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Market Design in Online Businesses

Peter A. Coles
Harvard Business School Note 911-066

"Market Design in Online Businesses" characterizes the challenges entrepreneurs may face in creating a well-functioning ecosystem of users and helps equip entrepreneurs with tools to overcome these obstacles. Key principles include ensuring thickness, alleviating congestion stemming from overuse, addressing asymmetric information, ensuring that it is safe and straightforward for users to participate, and designing monetization strategies that do not disrupt, but instead contribute to the well-being of the ecosystem.

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Cipla 2011

Rohit Deshpandé, Sandra J. Sucher, and Laura Winig
Harvard Business School Case 511-050

Dr. Yusuf Hamied, head of the Indian pharma and generics manufacturing company Cipla, is weighing options for how to continue to support the global fight against HIV/AIDS while positioning his company for growth in a changing regulatory landscape.

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Competing through Business Models: Introductory Note for Students (Half-Course Version)

faculty names
Harvard Business School Course Overview 711-489

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Calit2: A UC San Diego, UC Irvine Partnership

Linda A. Hill and Alison Berkley Wagonfeld
Harvard Business School Case 411-105

Larry Smarr, the founding director of the California Institute for Telecommunications and Information Technology (Calit2), reflects on the Institute's past 10 years of successes and challenges. In 2010, more than 700 university scientists, artists, engineers, and social scientists and over 300 non-university partners are associated with the Institute. Innovative and multi-disciplinary research projects are being carried out in diverse fields such as environmental monitoring, human/robotic communication, digital archaeology, nanotechnology, life sciences, information technology, and telecommunications. Calit2 was one of four new research initiatives created in 2000 in a partnership between the State of California, the University of California, and California industry in order to foster and drive entrepreneurial business growth and expand the California economy into new industries and markets. Calit2 was the result of a partnership between both the University of California, San Diego and University of California, Irvine. As Calit2's first decade comes to a close, Smarr considers the future of the Institute and, in particular, its leadership and sustainability.

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Dharavi: Developing Asia's Largest Slum (B)

Lakshmi Iyer and John D. Macomber
Harvard Business School Supplement 711-107

In July 2009, as investors prepared to submit financial bids for the $3 billion Dharavi slum redevelopment project, considerable economic and political risks remained.

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Stock Reform of Shenzhen Development Bank

Li Jin, Li Liao, Aldo Sesia, and Jianyi Wu
Harvard Business School Case 211-080

Shenzhen Development Bank, China's first publicly traded company, was undergoing the non-tradable share reform. Its current controlling shareholder, private equity firm Newbridge Capital LLC, needs to negotiate with its diverse minority shareholders to find a compromise on the terms of the conversion of the non-tradable shares held by Newbridge into tradable shares. Further delay in implementing this reform will put Shenzhen Development Bank into jeopardy as the bank will not be allowed to raise the additional capital it very much needed, but the negotiation between Newbridge and other shareholders was breaking down. The case discussed the non-tradable share reform in China, its causes and its implications, and from the perspective of one private equity play, discussed the issues of corporate governance, conflicts of interest, and the fiduciary duty of corporate managers in an emerging market.

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Drilling Safety at BP: The Deepwater Horizon Accident

Stephen P. Kaufman and Laura Winig
Harvard Business School Case 611-017

Following the 2010 Gulf of Mexico explosion and oil spill on the Deepwater Horizon, public attention focused on BP's safety record, practices, and management culture as the primary cause of the disaster. Drawing on public sources, this case traces the circumstances surrounding the accident, including not only the role of BP, but also of the two principle subcontractors hired to actually do the drilling and capping of the oil well (Transocean Ltd and Halliburton Energy Services). The case examines BP's safety record and prior accidents at a refinery in Houston in 2005 and along a pipeline in Alaska in 2006 and describes managerial changes imposed by the Board of Directors and safety programs instituted by Tony Hayward, the new CEO installed in 2007.

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Poweo: David and Goliath in the French Electricity Market

Noel Maurer and Elisa Farri
Harvard Business School Case 711-037

Charles Beigbeder, the president and founder of Poweo, an alternative electricity and gas operator in France, needs to decide on the company's strategy in light of electricity deregulation and the dominant position of Électricité de France (EDF) in the French market. Can Poweo successfully compete against EDF, with its giant installed nuclear base, and will competition bring benefits to French consumers?

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Government Policy and Clean-Energy Finance

Ramana Nanda, Sanjay Aggarwal, and Nilam Ganenthiran
Harvard Business School Note 811-026

What leads to market failures in finance of clean energy startups? How do different governments approach this issue?

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The Eleganzia Group

Elie Ofek, Elena Corsi, Bharat Sajnani, Sorina Casian-Botez, and Francesco Tronci
Harvard Business School Case 511-115

Eleganzia Group management faces tough decisions heading into the summer of 2010. With tourism on the decline due to the global economic recession, General Manager Giannuzzi must decide how to set prices at the Forte Village Resort, the Group's most well-known property. His management team is further divided on whether the pricing model at the resort should change to being all-inclusive (as opposed to one where guests are charged for each additional activity or dining option on a pay-as-you-go basis) and whether to convert a large number of the 4-star rooms into 5-star suites. Recently acquired properties, such as the Castel Monastero in Tuscany and the Maddalena Hotel & Yacht Club in north Sardinia, pose a branding challenge. Can all the properties, including the Forte Village, be successfully brought under one umbrella brand, namely, Eleganzia? Moreover, what should the character of each of these new properties be?

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Semiconductor Manufacturing International Company in 2011

Willy Shih and Jia Cheng
Harvard Business School Case 611-053

When David Wang took over as the CEO of Semiconductor Manufacturing International Company (SMIC), he knew that if he were to capitalize on the company's strategic location in the China market, he would have to transform the company mindset and its operating structure from its roots in the manufacturing of DRAMs to the service orientation that was necessary to support the customer promise of being a foundry. This meant transforming from a high volume continuous flow manufacturer of commodities chips to a job shop structure that focused on custom manufacturing services. This entailed more than rearranging the manufacturing lines; it meant a dramatic shift in the company culture. Wang also had to ensure the firm's ability to offer the most advanced process technologies. Having fallen behind in previous generations, his predecessor had chosen to license process technology from IBM. Now he faced the question of whether his rapidly changing and maturing organization had the ability to go it alone on future process technology development, or whether it still had to depend on IBM, at least for the time being.

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The Crisis at Tyco—A Director's Perspective

Suraj Srinivasan and Aldo Sesia
Harvard Business School Case 111-035

In 2002, Wendy Lane had been a member of the board of directors at Tyco International a little more than a year when the company's CEO, Dennis Kozlowski, and other top executives were accused of fraud, which ultimately led to resignations, imprisonments, lawsuits, and SEC filings. In a short period of time Tyco lost two-thirds of its market value. Many outside the company questioned the board's leadership and diligence. Lane, who had a successful career in investment banking before becoming a professional director, was caught in the firestorm. The case discusses the events that led to the crisis, her reflections on managing the crisis both personally and professionally, the reputational risk she encountered, and the lessons she learned as a director.

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Kumon India in 2007

Hirotaka Takeuchi and Yoshinori Fujikawa
Harvard Business School Case 711-459

Kumon is wondering how to expand its student base in India.

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