Saturday, April 17, 2010

Was Sheila Bair reckless and irresponsible? I report – you decide

Here is an email exchange between government officials leading up to the confiscation of Washington Mutual – courtesy Deal Breaker.


“I cannot believe the continuing audacity of this woman.” – Email from OTS Executive Director John Reich to OTS senior official Scott Polakoff (referring to FDIC Chair Sheila Bair), 9/10108, Polakoff

—– Original Message —–
From: “”Bair, Sheila C.”" []
Sent: 08/06/200805:46 PM AST
To: Donald Kohn
Subject: Fw: W

This is pretty over the top

—–Original Message—–
From: Reich, John M
To: Bair, Sheila C.
Sent: Wed Aug 06 17:32:482008
Subject: Re: W

Dear Sheila, You really know how to stir up a colleague’s vacation.

I do not under any circumstances want to discuss this on Friday’s conference call, in which I mayor may not be able to participate, depending on cell phone service availability on the cruise ship location.

Instead, I want to have a one on one meeting with Ben Bernanke prior to any such discussion – as early next week as possible following my return to the office. Also, I may or may not choose to have a similar meeting with Secretary Paulson.

I should not have to remind you the FDIC has no role until the PFR (i.e. the OTS) rules on solvency and the PFR utilizes PCA.

You personally, and the FDIC as an agency, would likely create added instability if you pursue what I strongly believe would be a precipitous and unprecedented action. And ifit occurs without my consent, I will not sit quietly by and observe – there would be a public reaction. Put yourself in the PFR’s shoes in this situation. We have our responsibilities, including the right of primary supervisory determination of this institution’s condition, and until Congress changes the statutes under which we operate, our responsibilities as the PFR are not to be simply tendered to the FDIC in a down economic cycle.

It seems as though the FDIC is behaving as some sort of super-regulator – which you
and it are not. I also believe there could be a high potential for FDIC actions of the type you are contemplating to calIse irreparable harm to Wamu if, at any point in the near future, Wamu wishes to actualy seek a buyer. The potential harm could stem from the fact that any such potential buyer may have been allready been contacted by the FDIC.
If in fact any meetings or discussions have already taken place by the FDIC with either JPMC, Wells Fargo, or any other entity, in any capacity in which WaMu was even mentioned, I would like to see a copy of the signed confidentiality agreement signed by the bank – required in any resolution scenario before an institution is told the name of the failing bank.

This is an OTS regulated institution, not an FDIC regulated institution. We make any decision on solvency, not the FDIC, and I have staff equally as competent as staff at the FDIC, whom I know well.

The FDIC can do whatever internal contingency planning it wishes, but should in no way go outside the FDIC. This is a 3-rated institution. Are you also trying to find buyers for Citi, Wachovia, Nat City and others?

Finally, ifWamu were to learn ofthe FDIC’s actions, there may well be a question as to whether these actions may constitute a disclosable event. That, in and of itself, is a reason not to proceed with this approach for a publicly traded institution. The government should not be in the business of arranging mergers – particularly before they are necessary, and we are not at that point in WaMu’s situation.

I will attempt to be on the Friday conference call, and I am going to assume this notion is not going to be raised.


—– Original Message —–
From: Bair, Sheila C.
To: Reich, John M Cc: Murton, Arthur J. ; Polakoff, Scott M
Sent: Wed Aug
Subject: W

Dear John,

I’d like to further discuss contingency planning for W during the calion Friday. Art talked with Scott about making some discrete inquiries to determine whether there are institutions which would be willing to acquire it on a whole bank basis if we had to do an emergency closing, and on what terms. I understand you have strong objections to our doing so, so I’d like to talk this through. My interest is in assuring that IF we have to market it on an emergency basis, there is multiple bidder interest.
In any event, both the FDIC and the FRB agree that there needs to be a contingency plan in place, so let’s talk this through on Friday. I’d really like to develop a plan everyone is comfortable with.


Thursday, April 15, 2010

Kick-back on First Solar

One of the biggest benefits I get from writing this blog is that sometimes some very smart people disagree with me. In the investing business you will be wrong often. The earlier you realize that you are wrong the smaller (on average) your losses will be. I don’t think the blog can move markets through talking my book. (I disclosed a good argument for shorting First Solar and the stock went up!) But I do think that kick-back from smart people can help reduce my losses when I am wrong. Believe me that is often enough! If all that the blog delivers me is smart people who disagree with me then I will wind up being a well-paid blogger (and my clients will be grateful)!

I got a lot of kick-back on my First Solar piece – some of which makes me more nervous about the short – and some of the kick-back is from people who are very smart. I thought I ought to lay this kick-back out at least in part to get my own thoughts straight.

One of the solar industry trade publications asked my permission to republish the piece – which I have granted. They also warned that they might have a follow-up piece titled: “Why I am short Bronte Capital”. That ought to put us in our place! I have yet to see that piece – but honestly I look forward to it (even though reading it will be painful). It may convince me that I am wrong – in which case I will cover my short forthwith!

The basis for the kickback I have received

The core to my argument was that First Solar has disadvantages (notably lower conversion efficiency) offset by a couple of advantages – notably keeping higher generation in low light, less sensitivity to angle of light – and most importantly – lower cost.

My view was that lower cost would determine almost everything. Solar modules are fundamentally a commodity – and whilst the low-light advantages were real – they could easily be overwhelmed by cost.

I then made an assertion – which I did not back – that the cost structure of wafer-based cells will be competitive against CdTe (First Solar) cells when the polysilicon price gets low enough.

Most – but not all – of the kick-back I have received is based around this cost structure issue. This falls into two camps. Firstly they assert that I have the cost structures of the competitors wrong. Secondly they asset that First Solar will reduce costs enough to offset the advantage that wafer-module-manufacturers get from lower silicon prices.

The other kick-back I have received is on the sales-and-marketing department. First Solar has – according to customers – by far the best sales force. “They are a machine!” First Solar they think that this will allow First Solar to travel well for longer than I might anticipate. Moreover they thought First Solar’s average selling price would remain high because FSLR has presold a lot of modules to solvent utility scale operators – notably EDF in France.

In this post I examine these issues with the aim of getting my own thoughts straight (and hopefully invoking more kick-back from more people that are smarter than me).

A cost model for polysilicon producers

Polysilicon has several disadvantages vis CdTe technology. First the materials are more expensive (wafers are thicker than thin film) – but just as importantly the manufacturing process is much more complicated. At First Solar glass goes into the plant and comes out – about three hours later – as an almost complete module. Human involvement is minimal. Wafers however require more manufacturing – they are sawn – they have breakage rates – they are laced with wires to conduct the electricity away – and they are “assembled”. Manufacturing cost are higher.

That said we can construct a simple cost model for wafer manufacturing from comments made by competitors. YingLi – a Chinese module maker – made the following comment in their fourth quarter conference call:

In the fourth quarter, our non-polysilicon costs including depreciation further decreased to $0.76 per watt from $0.81 per watt in the third quarter and $0.86 per watt in the second quarter and $0.90 per watt in the first quarter of 2009. This decrease demonstrates our strong R&D capabilities, and execution capabilities to continuously improve the yield rate, field conversion efficiency rate and operational efficiency.

The blended cost of polysilicon continuously decreased by the mid-teens in the fourth quarter. I would like to emphasize again that Yingli has now provided long-term (inaudible) provisions to write-down inventory costs or polysilicon prepayments the challenging fourth quarter of 2008.

Now YingLi is a good (meaning low cost) Chinese producer. It has terrible blended costs – but that is because it purchased silicon at high prices and its blended silicon costs are too high. But these costs do not seem wrong relative to competitors. [Inventory problems are surprisingly common in the industry as people hoarded polysilicon to avoid excessively high spot prices and wound up with huge inventories as the price collapsed.] The thing that is most notable about this is how fast the non-silicon costs have been falling – the sequence by quarter is 90c, 86c, 81c, 76c. This is roughly 4c per watt per quarter. It is of course impossible to know how far this will continue to fall – diminishing returns to technology and manufacturing reports will eventually occur. But for the moment we can take 76c and falling fairly fast (roughly 4c per quarter) as the non-silicon costs for various manufacturers. [Contra: slide 8 in Suntech’s latest quarterly presentation gives a much lower non-silicon price. That slide is so “out-there” different I tend to dismiss it – though if anyone has a clear explanation I would like it.]

Solar wafers used to require 7 grams of silicon per watt. Some manufacturers run at about 6.2 grams of silicon per watt – with 180 micron silicon. Applied Materials talk about 80 micron thick silicon wafers – though silicon use for those wafers is not reduced by 80/140 because wire saw (kern) losses are similar regardless of wafer thickness. Also as wafers get thinner they have higher breakage rates (and the incentive to cut wafers thinner is lower as silicon prices fall).

Its probably fair enough to use 6.5 grams of silicon per watt as the right number for modeling a silicon wafer module producer. The 6.5 grams is falling and in five years it may be 5 grams (if AMAT manages to sell more of their kit). Ok – but at 6.5g (or 0.0065 kg) per watt then the cost structure is easy to model…

YingLi cost per watt (in cents) = 76 (less any efficiency they get from manufacturing improvements) plus silicon price (in cents per kg) * 0.0065.

Now I am going to take a wild stab at what the number will be by June 30. My guess is that spot silicon will be $40 per kg and the 76c will be reduced to say 71 cents (which is still falling but by less than the 4c per quarter which the cost has fallen). This gives a cost per watt by the middle of this year of 97 cents. Polysilicon costs go below the magic dollar per watt!

Obviously this is highly dependent on the silicon price – a $20 silicon price would make the cost 13c per watt cheaper – say 84 cents per watt. A $100 silicon price takes cost per watt to $1.41.

Cost is also dependent on YingLi (and presumably the other commodity panel makers) getting efficiencies in the production of modules although at a reasonable clip – though as noted, I model a rate below the historic rate of cost improvement.

[I should observe here that Trina Solar – another Chinese manufacturer – gives their non-silicon costs at 78c per watt – 2c more expensive than YingLi in the fourth quarter. Trina’s cost reductions are also about 4c per quarter… See page 8 of their quarterly presentation.]

This cost model is fraught. The accounting of many of the Chinese players is difficult to decipher. One person I have talked to suggests that most other players are way above 78c per watt in non-silicon costs (although competition will get them there or force them out of business replaced by people who are at that level). They thought YingLi would be at 70c by the end of 2010. Against this the same person thought my grams per watt was too high (suggesting 6 grams per watt based on 180 micron thick wafers) and they thought that YingLi would be at 5.5 grams per watt by the end of the year. This is more or less a wash – with wafer costs a little lower than my estimate but base costs winding up a bit higher. Again all of this stuff is fraught – and although these broad numbers are not controversial the end competitiveness of First Solar is surprisingly sensitive to fine differences in base cost and silicon costs of their competitors.

What is the cost structure of First Solar?

First Solar has laid out ambitious plans to increase the efficiency of their cells and to further reduce costs. I do not want to go through those in detail – but I think we can extract two key charts from the last presentation. First slide 13 – which has the cost per watt falling still – but at decreasing rates. The cost-per-watt has fallen by 1-2 cents per quarter for the last couple of quarters (versus 3-5 cents for the non-silicon costs at YingLi).


Then there is the less-specific presentation from their “roadmap” (see slide 14) which shows their 2014 target cost per watt.


I wish I understood how all of these gains were likely to be achieved – but they think they can get to 52-63 cents per watt by the end of 2014. However – for the moment I assume that they can meet their cost target and get to 58c per watt (a reasonable midpoint) by the end of 2014.

That cost per watt reduction is 26c over 16 quarters – or 1.625 cents per quarter – roughly the rate at which costs have been falling historically.

Figuring that the were at 84c per watt during the fourth quarter of 2009 – and they are reducing costs by 2c per watt per quarter (that is a little faster than historic and slightly faster than their roadmap) costs will be about 80c per watt per quarter by the June quarter of this year.

A raw cost comparison – with the price of silicon being the main variable

With the trusty spreadsheet I can produce a reasonable cost-per-watt comparison…


On this cost structure the YingLi panels have higher production costs unless the silicon price is very low. That sort of makes sense. YingLi panels have higher production costs (the process for making them is more complicated) offset by lower non-silicon materials costs (they are more efficient and hence use less glass, backing wire etc). The swing factor is silicon.

This table however leaves off the single most important swing factor – which is that the YingLi panels are smaller per watt of output. (Remember my whole argument is dependent on the higher conversion efficiency of the polysilicon wafer modules.) There are wildly different versions of how much the installation cost advantage is. The advantage comes about because you need less cells, less land, less brackets and less converters to generate the same amount of energy.

This paper from the National Renewable Energy Laboratory has been my guide. This paper suggests that First Solar modules need to be priced 25-30 cents below c-Si modules to generate equivalent project returns (see page 26). Some people think this far too high. For instance Stephen Simko (an analyst from Morningstar who disagrees with me) thinks a 10 percent penalty (roughly 7c per watt) will do the trick. I for the life of me do not understand why this is a percentage (there is limited evidence that installation costs are falling at the same rate as manufacturing costs). 7 cents per watt is very different from 25-30 cents.

I would really like people to detail what the cost difference is. (If informed people send me emails I will be grateful…) I suspect it depends on all sorts of things like labor costs, brackets, land availability and things you would not expect like wind levels (wind requiring better anchoring for the panels).

For the moment I use 15c per watt (a number my research indicates is too low – but which Stephen Simko thinks is too high). At this point my cost table needs to be adjusted…


Now at this point the First Solar cells are about cost-competitive at a $40 silicon price. If silicon prices go as low as $20 per kg then the Chinese polysilicon makers (represented by YingLi) have the goods by a long margin.

I should note that this cost structure does not match the cost structure as presented by several people bullish First Solar… Here is a cost structure as presented by Stephen Simko comparing First Solar to Trina Solar (yet another Chinese wafer-module maker). In it however he keeps the silicon price constant at $45.


You can see the difference between Simko’s estimates and mine. I have Q2’10 costs for the wafer manufacturer a few pennies (say 3c) lower than Simko. Simko has the cost structure of First Solar falling about 3c per quarter (versus my 1.5 cents per quarter and adding up to a further 3c cost advantage) and he has an efficiency penalty of about 8c versus my 15c (or another 7c of cost advantage). He thus has First Solar maintaining a cost advantage of about 15-18c per watt over the next twelve months whereas the extra costs I suggest wipe most of that advantage.

At a $20 silicon price even with Simko’s cost estimates First Solar’s cost advantage disappears. This of course led Stephen Simko and me to a discussion of what drives polysilicon ingot prices. In that he changed my mind somewhat…

What drives the polysilicon price?

Polysilicon is a commodity. Sure there is better quality stuff (which makes more efficient wafers) but it is still a commodity. Usually with a commodity – when there is spare capacity in the system – the commodity is priced at the cash running costs of the highest price operational plant. When the world runs out of capacity the commodity disconnects from its “cost curve” and is priced at whatever the market can bear. At that point being a commodity maker is frightfully profitable. That profit attracts new entrants and new capacity. Eventually there is enough supply and the commodity price reconnects to the cost curve. (This pattern is familiar to anyone who has – for instance – studied metal prices generally. The pattern drives much of the Australian economy.)

As the solar industry ramped up polysilicon prices disconnected from their cost curves. Spot prices of $450 were not unknown. The NREL paper cited above mentions spot prices higher than that. The spot price however was rarely paid – because most wafer makers purchased large inventories and entered into forward contracts. Some solar-cell makers have got themselves knotted up financially because they have purchased thousands of tons of polysilicon inventory at prices that are well above current prices and which prohibit them from making profits.

The excessive profits made by the ingot makers introduced many new suppliers to the industry. One source suggested that we have gone from six suppliers (and a cozy oligopoly) to 26 suppliers (who will cut each other’s throats). This market is becoming very glutted very fast. That means that the poly price will go to marginal cash cost. So what is that cost?

Well I started with the big players – and they have cash costs in the low 20s. I thought the polysilicon price would thus go to the low 20s. That would settle the issue because – even on the Stephen Simko’s numbers – the Chinese-wafer-based modules will have lower costs than First Solar at a $20 polysilicon price.

So – without stating it so clearly – I thought that the poly price would wind up closer to $20 per kg than the $45-55 modeled by most First Solar bulls.

Stephen Simko disabused me of this notion – and this time I am fairly convinced by his explanation. During the boom the most insane polysilicon manufactures built plants and with very different cash costs to the established (and presumably knowledgeable) players. He thinks the cash cost outside the established players is considerably higher than the cash costs of the established players. He points to a presentation by REC Silicon. Slide 45 of the presentation gives what REC purports is an industry cash-cost curve and whilst the Y-axis is not labeled the bottom of the curve represents about $20 a kg – and the top of the curve represents – well – who knows what? Here is the slide:


If this curve is correct the polysilicon price is unlikely to get to $20 because the marginal players will have costs substantially higher than $20.

The issue comes down to how flat is the cost curve? It strikes me – intuitively – as being likely to be very flat as the equipment to make silicon is pretty well understood – but if anyone is genuinely expert in this then I would love them to contact me. [The cost curve REC/Simko showed me however is emphatically not flat…]

This REC graph however has given me pause – because the really brutal outcomes for First Solar were dependent on a very low silicon price. If the silicon price were really to go to $20 and my cost numbers (somewhat more brutal than Simko and other bulls) are right then First Solar will wind up with no reason to exist – and the stock will go below $10 (currently about $130). If the poly price does not go below $45 and Simko’s numbers are right then First Solar will keep a cost advantage – and that cost advantage is sustainable – at least until a better technology comes along or First Solar’s patents run out. First Solar earnings might be difficult – but the business has a reason to exist.

Funny – I have not mentioned profitability

So far – in neither of my notes – I have not made a profit estimate for First Solar or any of the competitors. I have modeled cost – but thus far have not modeled selling price. Once we have a reasonable estimate of selling price and a reasonable estimate of cost we should be able to model profits give or take some things. [The main things we would need to give-or-take are inventory losses for the silicon manufacturers – some of whom have thousands of tons of overpriced silicon inventory, and the project gains and losses for First Solar which is an investor in utility scale solar projects.]

Looking at the current price for modules is not going to help you much. Many companies have both purchased silicon at fixed rates and pre-sold panels at fixed rates. First Solar locked in lots of fixed rate contracts – some with good solvent parties (for example EDF) – some with parties that are more questionable. The current prices realized by the solar manufacturers depend more on the contracts that they entered into (both price and solvency of the counterparty) and less on spot price for panels than a first glance might look.

There are disclosures in First Solar’s 10K which illustrate the problem. These disclosures can be read as “red flags” though I prefer to keep more neutral about their content.

During the first quarter of 2009, we amended our Long-Term Supply Contracts with certain customers to further reduce the sales price per watt under these contracts in 2009 and 2010 in exchange for increases in the volume of solar modules to be delivered under the contracts. We also extended the payment terms for certain customers under these contracts from net 10 days to net 45 days to increase liquidity in our sales channel and to reflect longer module shipment times from our manufacturing plants in Malaysia. During the third quarter of 2009, we amended our Long-Term Supply Contracts with certain of our customers to implement a program which extends a price rebate to certain of these customers for solar modules purchased from us and installed in Germany. The intent of this program is to enable our customers to successfully compete in our core segments in Germany. The rebate program applies a specified rebate rate to solar modules sold for solar power projects in Germany at the beginning of each quarter for the upcoming quarter. The rebate program is subject to periodic review and we adjust the rebate rate quarterly upward or downward as appropriate. The rebate period commenced during the third quarter of 2009 and terminates at the end of the fourth quarter of 2010. Customers need to meet certain requirements in order to be eligible for and benefit from this program.

Essentially the customers or sales channel was liquidity constrained – so terms needed to be made more generous (45 days versus 10 days). Moreover we needed to offer a price rebate (presumably a rebate on our fixed price contract) to enable customers to compete. Those rebates were subject to certain tests (presumably solvency tests but we do not know the content of those tests). Some of these contract changes exchanged smaller fixed price contracts for higher volumes at lower fixed prices.

Whatever – the industry is rife with fixed price contracts. Spot prices are below the fixed price contracts. One day these fixed price contracts will roll off – and new fixed price contracts will struck at considerably lower prices. As we do not know the duration of the fixed price contracts – and even if we did that duration keeps getting extended in exchange for lower prices – we can’t really tell the path of the selling price.

But I have a method which should be familiar to any economist – and I think works for working out where the long term selling price will wind up. It is simple really. The Chinese competitors are numerous and very hard to pick apart from each other. Some are ultimately going to be pennies per watt better than others – but because they are numerous and in fierce competition they will drive the price. This should be bleatingly obvious – anyone who has competed with numerous Chinese manufacturers by now would know that the price is driven down to the price where the Chinese manufacturers make a mid single-digit ROE.

That price however is much lower than the current selling price and probably much lower than the selling price First Solar will realize in 2010.

Moreover the price should be fairly easy to determine: I will just do it for one manufacturer. At year end Trina Solar had book value of $677 million. Some of that value was inflated because they were carrying some high-cost silicon inventory. They had output ability of about 550 megawatts per year (averaging 600 in panels and 500 in wafers). To earn 15 percent pre tax on that equity they need to make roughly 100 million per annum or they need a margin of 18c per watt sold. The first-cut estimate of the long term price of these things is thus – and I am being very simplistic here – whatever the Chinese manufacturers cost plus 18c per watt.

This first cut however is a sharp over-estimate. The equity I am including is too high because of overpriced inventory. The ROE I am demanding is too high too (Chinese competitive manufacturers make far less than that!) The industry is continuing to get efficiencies – and they will be competed away – so the margin per watt will come down for that reason too. You do not need to make any unreasonable assumptions for the right margin per watt over the cost for the Chinese manufacturers to be 10c.

From here an earnings model is easy… First Solar will produce (on their guidance) about 1.7 gigawatts this year and 2 gigawatts next year. The selling price will be whatever YingLi’s cost is plus 10c… You can work out the margins using either mine or a bull’s cost estimates (I use mine). Multiply margin by wattage and you get pre-tax profit – give or take a little bit. I do this below.


Now – using numbers I think are inherently likely – I get earnings falling sharply. If we take the silicon price to $20 then First Solar has no earnings. If we think the installation penalty is 25c rather than 15c as per the NREL paper earnings go away up to a silicon price of about $40.

Now Mr Simko reckons that the cost advantage of First Solar is about 13 cents per watt better than my number. [He has an 8c installation cost rather than my 15 etc…] 13c per watt equates to $20 per kg on the silicon price (remember we are assuming 6.5 grams of silicon per watt). In other words if you use Simko’s numbers then take my silicon price estimate and add $20 (say $60 instead of $40) to read the earnings numbers. Even on Mr Simko’s numbers First Solar’s earnings fall fairly sharply when the competition amongst Chinese manufacturers drives their ROE down to normal Chinese levels. That makes me more comfortable with my short. First Solar may not be a devastating failure but earnings will fall sharply and the stock starts with a teens PE ratio…

Innovation and the long-term future of First Solar

So far my argument has been predicated on the silicon price falling. At low silicon prices First Solar becomes uncompetitive. The only real question being how low is low?

But First Solar can become more or less competitive depending on how much they can reduce costs or increase efficiency versus their Chinese wafer-based competitors. First Solar has an ambitious target of reducing costs over the next four years. I want to repeat the slide on that cost reduction strategy.


Now I know you have seen this slide before… what you probably did not notice is that it is not drawn to scale. The company plans to get 18-25 percent cost-per-watt reduction via efficiency – and and only 15 or so percent cost-per-watt reduction through everything else (plant utilization, scale etc). That makes sense because First Solar plants are already highly automated. Glass goes in one end and almost-complete modules come out the other end with little human intervention. It is almost impossible to improve that manufacturing because it is already almost perfect!

So the only place they can get their cost-per-watt down is by getting more watts-per-glass-sheet – that is improving efficiency. Efficiency is the core to First Solar’s roadmap to lower costs.

I will be blunt. I do not think they can do it. Efficiency is already 11.1 percent. If they get 21 percent out of efficiency – something like a midpoint of their 18-25 – then they need to get efficiency to 13.4 percent – and they need to do it over 16 quarters. Efficiency must improve almost 15 bps per quarter. Efficiency for the last six quarters was 10.7, 10.8, 10.9, 10.9, 11.0, 11.1 percent – something less than 10bps improvement per quarter. This is something which should asymptotically approach a theoretical limit – and yet First Solar is modeling that the rate at which they improve efficiency will increase for the next four years. Maybe they can do it – but trees do not grow to the sky.

Against this – what is driving the Chinese manufacturers is manufacturing efficiency as well as conversion efficiency. The Chinese processes are difficult – involving sawing, lacing wires on wafers and assembly. There are many more and difficult steps than First Solar’s thin film process. That is bad for them now but provides opportunity. Chinese manufacturers are – if we know anything about them – relentless in taking out costs.

So my guess is cost-per-watt will fall faster in the Chinese silicon manufacturers than in First Solar precisely because there are more opportunities for manufacturing improvement.

Stephen Simko had the opposite view. He figured that thin film is a new technology whereas wafers have been around for a long time. That means that there are more opportunities for conversion efficiency improvement in thin film than wafers – and he thought that would drive costs over time. I have an answer to that – 10.7, 10.8, 10.9, 10.9, 11.0, 11.1. But really to get comfortable with that I want to talk with a particle physicist who knows a lot about semiconductors. My knowledge of (low energy) particle physics (and hence the mechanism by which a thin film semiconductor might work) is not much more than you can garner from Brian Cox’s excellent mass market book on Einstein and the Standard Model and a few other populist things (many from Mr Cox). On the interaction between atomic sized gates and the efficiency at which electrons can be forced across a thin-film semiconductor layer I am – as you might expect – totally out of my depth…

So there you have it – the whole First Solar thing modeled out. I think I am right – but sensible people take the opposite view – and one industry publication wants to write a piece about why they are short Bronte Capital. If anyone tells you this investing game is easy ignore them. This is tough – and the bets we take occasionally fill us with angst.


Wednesday, April 14, 2010

My bit part in the Krugman-Sorkin debate

There is – at the New York Times – a spat between Paul Krugman and Ross Sorkin over whether Krugman was ever in favor of wholesale bank nationalization. 

I had a bit part in this debate – so I think I can offer some perspective.  Krugman debated the issue with me in his blog:

Who to nationalize (somewhat wonkish)

John Hempton somewhat misunderstands my point, but that’s OK. I should have been clearer — and he and I actually seem to be mainly in agreement.

I was not saying “nationalize all the banks”; I was saying do what the Swedes did — in tandem with a guarantee on bank liabilities, take the banks with zero or negative capital into receivership. It’s really important that you do this: if you offer a blanket guarantee on the assets of a bank that’s already underwater, you (a) are very likely to take a large hit on taxpayers’ money, without any share in the upside (b) create a huge moral hazard/looting incentive.

Basically, you really don’t want to turn Citigroup into a $2 trillion version of Lincoln Savings and Loan. If you guarantee the liabilities of a stronger bank, by contrast, it’s probably OK even if you don’t take it into receivership.

Let me also say that I think a blanket guarantee without some kind of seizures will just fuel a vast — and justified — populist rage.

Anyway, I think Hempton and I are more or less saying the same thing: guarantee all bank liabilities except for [fill in the blank here], while taking over large banks that are essentially insolvent.

I remember this well.  I thought it perfectly reasonable to nationalize large banks – but only after due process.   I thought that the Government should issue a “guarantee” over all big financial institutions – especially if they could get away with an implicit guarantee (as per the statement “no more Lehmans”).  And then they should have a process for determining which banks they would confiscate.  The process should determine how much additional capital that the bank would be required to raise.  If they did not raise it then they should nationalize it.  The idea was to nationalize in a way that respected the property of private equity providers.  [Incidentally the stress tests and the compulsory capital raises worked out roughly this way…]

I thought that nationalization without due process would be a disaster.  I worried at the time that Paul Krugman was in favor of some things that did not look like due process.

And indeed he was.  He was explicitly in favor of nationalizing Citigroup and Bank of America.  I thought he had no process for arriving at those two and wished to call him on that.  I happened to agree with him on Citigroup – but I disagreed with him on Bank of America and was busy buying shares.  When we started taking money for clients (June 2009) Bank of America was our largest starting position.  [Incidentally I thought that Barclays would probably wind up as Government property – and I seem to have been wrong on that.  We all got things wrong.]

Krugman was wrong about BofA.  Nationalization of it without a process (as per the confiscation of WaMu) would have been a disaster – a death-blow for confidence in the system.  It would – in my view – have led to the nationalization of the whole system – something that Krugman never advocated.

Krugman did want to nationalize banks that were ex-post sovlent (BofA in particular).  I think he wanted a process for doing it (witness his comment about negative net worth) – but he never spelt out the process.  Moreover he was polemical on nationalization and weak on process more generally. 

Sorkin is flat wrong when he says that Krugman wanted to nationalize the banking system.  I call it that way as do most other commentators.  But Krugman’s position is hard to defend because he was in favor of some nationalization, some of the nationalization he was in favor of (particularly BofA) looks flat-out-dumb and he never spelt out a process to get it right.

Tuesday, April 6, 2010

Why I am short First Solar

(The following is an extract from Bronte Capital’s client letter. I thought it deserved wider circulation. It also provides grist to Felix Salmon who described shorting – and in the context by implication me – as socially useless. I think that was harsh – but not necessarily in this case. I will write an article in the future on socially useful short selling.)


Case study: our short on First Solar

Investing in technology stocks has lots of traps for neophytes – and by-and-large we are neophytes so we do not do very much of it. We however spend a lot of time thinking about it primarily because we are scared of what technology can do to other businesses. (The demise of many low-tech newspapers provides a good demonstration of why – as investors – we should think about technology.)

Technology offers value creation like few other industries. In Australia Cochlear has created enormous value and improved the world. It can literally plug a bionic ear into someone's brain-stem and get them to hear. And the stock has paid about 20X – which is better than anything in our portfolio. Many of the biggest fortunes were made in technology. But technology – and specifically technological obsolescence has thrown many a fine company to the wolves. Palm for instance is likely to go bankrupt even though the concepts it pioneered are in everyone's pocket.

We do however have a framework to hang around our (limited) technology investments. A technology, to be a really great investment, must do two things. It must change part of the world in a useful way – a big part of the world is better of course – but you can be surprisingly profitable in small niches. And it must keep the competition out.

In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone's returns are inadequate but not until everyone's returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[1] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.

In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.

If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value. Businesses that produced plenty now, produce nothing then.

Surprisingly, changing the world looks like the easy bit. Plenty of companies do it. The problems are in keeping the competition out. Only a few do that (Microsoft, Google are ones that seem to). Hard drive makers changed the world (they allowed all that data storage which made things like digital photography and internet multi-media possible). But they never made large profits – and they trade at small fractions of sales.

The limited technology investments we have are not driven by any real understanding of the technology. Sure we try – but if you ask us how to improve the laser etching on a solar panel then we will not be able to help. The driver of our investment theses in almost all cases is watching the competition.

A simple example is Garmin. We have a small short position in what is a very fine company. Garmin – once a small avionics company - led the mass-marketing of satellite navigation and allowed John – without stress – to find his son's Saturday sports game. Sat-nav it seems has saved many marriages and meant that school sports teams do not run short players because dad got lost.

Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.

The only problem is that they can't keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]

Garmin has a great product. They have improved my world. The only problem is that they can't sell their product at any price that competes with “free”. Garmin's business is going the same direction as Palm. Bankruptcy however is only a remote possibility – they have a billion dollars on the balance sheet and unless they do something really stupid on the way down they will remain a profitable avionics business.

Is it fair that Palm is facing bankruptcy? Or that Garmin is being displaced? We don't think so – but then capitalism is not necessarily moral or fair – but it does produce goods and services quite well. We don't invest on the basis of fair – we invest to make you good returns.

The solar industry – and the possible failure of the good

First Solar is a company that improved the world. It drove the cost of production of solar cells to quite low levels and made utility-scale solar farms viable with only modest subsidies. There are some places where solar is now viable without subsidies.[2]

Our biggest short position though is First Solar – a company we have little but admiration for. There is a distinct possibility that First Solar's business will fail in the same way as Palm or Garmin. It won't be fair – but fairness has nothing to do with it. Like Garmin it probably won't go bust because it has a billion dollars in liquid assets on the balance sheet – assets which represent past profits.

Moreover we suspect that First Solar's profits are about the same as the rest of the industry put together. The stock still trades with a high teens trailing price-earnings ratio – a fading growth stock. It hardly looks like a failure. It is a strange conclusion to come to. So we should explain how we got there. To do that we need to explain how a solar cell works.

How a solar cell works

To make a solar cell you need three things.

1). A substance which is excited (i.e. spits off electrons) when a photon hits it.

2). A layer which separates the electrons. This layer is usually a “semiconductor” which means that electrons go through one way and cannot go back.

3). Something at the back which conducts the electrons away.

Thin film versus wafer

Traditional solar cells were made with a semiconductor ingot cut to a thin sheet. On one side it was “doped” with a substance that kicks out electrons. The other side was laced with wires to conduct the electrons away. This was expensive.

There were generally two types of ingot – monocrystalline – where the wafer structure was perfect or near perfect and polycrystalline which had visible crystals in the wafer. Monocrystalline wafers are primarily used for computer chips (where atomic level imperfections are problematic) and are expensive.

Polycrystalline silicon is cheaper. For most large-scale uses polycrystalline wafers were sufficient. These have about a 17 percent conversion rate – which means that 17 percent of the photon energy that strikes them is turned into electricity.

The ingot itself was a substantial part of the cost of a photovoltaic cell. Polycrystalline ingot used to sell for $450 per kg.

First Solar (and others) developed a process for making solar cells with considerably less semiconductor material. They have a Cadmium Telluride process which vapor-deposits semiconductor at atomic level thickness and comes up with a cell that is now exceeding an 11 percent conversion ratio.

This company is a technological wonder. Glass goes in on one end of the manufacturing process and comes out as solar cells at the other with next to no human intervention. Labour is used only when it comes to putting frames around the glass and for similar tasks.

This was revolutionary – it made cheap solar panels and hence made possible commercial scale plants like this 1.4 megawatt roof installation in Germany. This is enough to supply a few hundred households – not earth shattering – but a complete revolution in the solar industry.


We can think of few companies which have pushed a technology so far and with such high environmental benefits. Companies like this will allow us to maintain a modern lifestyle whilst addressing greenhouse issues.

Still for all the benefits of First Solar’s cells, they are inferior in many important ways to a polycrystalline cell. Their efficiency is lower – which means you do not get as much solar energy off the constrained roof space. Secondly, whilst they save a lot on the semiconductor part of the manufacturing process they have to use more glass, more wires etc to generate the same amount of solar electricity. Each cell generates less electricity too so inverters, connectors, installation all cost more with thin film. Thin film also degrades over time. First Solar warrants their performance over their lifetime – but with the warranty being for lower levels of performance in the second decade of operation (google the Staebler-Wronski effect for a non-trivial explanation). Thin film does however have some advantages in low light - keeping a slightly greater proportion of their peak capacity.

Indeed the main advantage of thin film is cost – and that cost advantage has been driven by the cost of the semiconductor component. After all ingot did cost $450 per kg.

That cost advantage made First Solar absurdly profitable – and they used that profit to grow into a behemoth. Revenue has grown from $48 million to over $2 billion. Gross profit (before selling and administrative costs) has grown to over $1 billion. We do not want to tell you how far the stock ran for fear of invoking insane jealousy. This stock would have made Berkshire Hathaway shareholders jealous.

But remember – all of that was predicated on a cost advantage (almost all other things being inferior). And that cost advantage is predicated on expensive semiconductor material.

Competition cometh

To make money in technology you need to do two things. Firstly you need to change the world (which First Solar clearly did) and secondly you need to keep the competition out. Alas very few businesses manage the second trick.

The competition came in a couple of forms. Firstly it came from Applied Materials. Applied Materials, or AMAT (as the company is known) is the most important company in the world you have never heard of. It is the dominant maker of capital equipment that goes into semiconductor factories and it is thus the company that – more than any other – provides the kit to keep Moore’s Law active.

AMAT has tried competing head-on with First Solar in the thin-film space. AMAT developed the vapor deposition equipment that made large-screen LCD televisions possible. This entails deposition in large sheets (5.6 square meters) which are then cut down into several large screen TVs. An imperfection in the vapor deposition shows on the TV as a bad pixel.

AMAT appropriated this technology for solar. The silicon semiconductor is not as efficient as First Solar’s Cadmium Telluride technology – and it is equally subject to the Staebler-Wronski effect, however they can do much larger panels than First Solar (with comparably lower wiring, inverter and balance of system costs). AMAT’s thin-film business could do some damage to First Solar – but it is unlikely to kill it. (Indeed AMAT appears to be de-emphasizing that business for the reason discussed below.)

Far more important have been developments in the wafer business. AMAT (often the protagonist) has developed wire saws for cutting wafers thinner and thinner. They are now 80 microns thick. These wafers are so thin that they flutter down in air and break if held on their side. AMAT will of course sell the whole kit for handling these wafers – including laser etching material and other steps in the manufacturing process. Much less semiconductor is needed in the wafer business.

But worse – the price of ingot has fallen – and spot prices are now $55 per kg – which is a lot less than $450. The cost of ingot is still falling. First Solar’s advantage is entirely dependent on the fact that they use much less semiconductor than wafers – an advantage that disappears entirely as wafer prices fall. At that point all of First Solar’s many disadvantages will shine through.

We are trying to work out the cost-structures of the polycrystalline manufacturers – but it looks to us that the extra glass and other balance of system costs that First Solar panels have are getting close now to completely removing the advantage of low semiconductor material usage.

If that happens though, First Solar is toast. It probably won’t file bankruptcy because it has so much in past profits to fall back on – but it will be every bit as obsolete as a Palm organizer is now or a Garmin car navigation system might be in five years.

We do not wish failure on First Solar – and if we are right it could not have happened to a nicer company (no irony intended). Capitalism is not fair – and technology investment is particularly unfair.

We don’t make money from fairness. We make money from getting the business analysis right and betting on (or against) the right business – and in this case we are betting against the most successful company in a massively important growth industry.

If we are right (and we think we are) then we will make money from the demise of a company that has much improved the world. We like to think our business is noble. And it is sometimes – but in this case we can see why people dislike short-sellers. Their opinion however is not our business.

[1] Unfortunately the hotel is usually mortgaged – and the value often reverts to the debt holder.

[2] One way amuses us greatly. Walmart started putting solar cells on the rooftops of many of their super-centers in the Southern United States. They did this originally because of implicit subsidies. However the test centers showed something quite interesting. Good solar panels turn quite a lot of the energy hitting the rooftop into electricity which is conducted away. That energy does not wind up as heat in the building – and the cooling load of the building went down. The rooftop solar installation may not have been justified by the electricity output alone – but combined with lower cooling bills it worked a treat. [Addendum. This footnote is anecdotal from good source rather than published... many people have asked us about it - and a few have said they have heard this sort of thing before but they would like hard data... I apologize as I am unable to provide...]

Thursday, March 25, 2010

A Jim-the-Realtor video

Jim the Realtor is a fabulous feed on the Southern Californian residential (and small-scale commercial) real estate market – its directions and its intricacies.

This video is one of his best ever.  It is 9 minutes long and in his usual monotone. 

I wish it were three minutes shorter because I recommend you watch it to the end.  The last two minutes are intriguing. 



Explanations sought.





Saturday, March 20, 2010

Repo 105’s antecedents: Ken Lewis

I agree with Felix Salmon that the former Lehman staffers who defend Repo 105 are psychopaths – certifiably insane.  They state (as if this justifies it) that …

The only people who would worry about using an old trick to reduce leverage from 13.9 to 12.1, are “yappers who don’t know anything.”

For those that don’t know Repo 105 was a sale and repurchase agreement by which Lehman parked about 50 billion in assets (presumably assets they did not want to discuss) overnight via a repo transaction so they would not appear on the balance sheet. 

By now anyone who does not realize that sort of accounting legerdemain is unacceptable is (a) entirely out of touch with reality and (b) self aggrandizing on a magnificent scale.  Both are signs of mental illness.

But unfortunately the Lehman executives do have one point.  Repo 105 type balance sheet faking was “an old trick” and well known to anyone who cared to read balance sheets (very) carefully.*

Let me take you back to 2006 and Bank of America.  Pages 94 and 95 of the 2006 Annual Report show (amongst other things) the average total assets by quarter from the fourth quarter of 2005 to the fourth quarter of 2006 inclusive.  Here are the numbers:

(US dollars - millions) Q4 2006 Q3 2006 Q2 2006 Q1 2006 Q4 2005
Average total assets 1,495,150 1,497,987 1,456,004 1,416,373 1,305,057

Now lets extend this table by including period end assets.  You can find the data here (see page 4 for both fourth quarters and third quarter, and page 4 here for the first and second quarters). 

(US dollars - millions) Q4 2006 Q3 2006 Q2 2006 Q1 2006 Q4 2005
Average total assets 1,495,150 1,497,987 1,456,004 1,416,373 1,305,057
End period total assets 1,459,737 1,449,211 1,445,193 1,375,080 1,291,803
end period less average assets -35,413 -48,776 -10,811 -41,293 -13,254


You will notice that the end period assets were always lower than the average assets.  Moreover it was not obvious unless you really looked because the quarterly earnings releases did not include average assets (but you could work it out because they stated return on average assets). 

It was not just 2006 either – this had been happening for a while.  Bank of America was parking its assets off balance sheet at the end of every quarter for some time and had been obscuring the fact


If Bank of America wanted to shove the assets off balance sheet someone (credit worthy) needed to be found to house the assets overnight.  There are not that many parties credit worthy for $50 billion or more of overnight repos. 

Well – being an obsessive reader of bank accounts I found the counterparty.  It was MUFJ.  If you wish to you can show – the same way that MUFJ had end period assets higher than average assets and that the differences and timing roughly match.  Someone had to assist BofA in its financial legerdemain and we know the counterparty.

Once – through an interpreter – I asked senior MUFJ executives about this.  Any nuance in the answer was lost in translation. 

So back to Repo 105

Repo 105 is fraud.  Its a lie to investors and rating and regulatory agencies.  It was also fraud when BofA did it.  But both Lehman and Ken Lewis compartmentalized it as OK.  And it was not the fraud that undid them – it was the overweening arrogance that thought this was alright.  The same overweening arrogance that made Ken Lewis think it was alright to pay a big premium to close for Merrill Lynch (and later force mass dilution of BofA common shareholders). 

But the chief executive (or other executive) who thought this was alright was probably certifiable.  Just as certifiable as the Lehman execs who Felix rightly chastises. 

Do we want to prosecute?

There is a big debate in the blogosphere as to whether anything in the Valukas Report rises to the level of prosecution.

I suspect in a vacuum it does.  But this was a collective insanity every bit as mad as the poisoning craze written about Charles Mackay.  Mass insanity does lower moral culpability and it takes an extraordinary person to stand up to it. 

Besides – if we are going to slap Erin Callan’s wrists in handcuffs then we are going to have to do the same to Ken Lewis and probably have to extradite the top-end of the Japanese establishment who were the counterparties. 

I do not want to go there – and I do not think it would be constructive.




Disclosure:  Long a lot of Bank of America – surprising given this post I guess. 

*It is my burden to read balance sheets like this and to remember details four years later. 

Friday, March 19, 2010

My tipper on Astarra

Tipping the authorities off about Astarra required – as I said – no special genius on my part.  I was tipped by a blog reader who noticed that the Astarra investment committee claimed Charles Provini as a member whilst Provini was the CEO of Paradigm Asset Management.  I have written extensively on Paradigm Asset Management (see here for a decent summary). 

Anyway my tipper has now revealed himself.  He is Dominic McCormick – the chief investment officer of Select Asset Management.  Dominic insists his team deserves any credit.

Dominic (and presumably his team) had many of the issues with Astarra nailed by the time he tipped me off.  I worked out a few more.   

I reported the story to the Sydney Morning Herald who did not think they had enough evidence to run the story.  [They printed nothing until much later.]

Later I worked a few more things out and using connections ensured that the whole story landed directly on the desk of Tony D’Aloisio (the head of our securities regulator). 

Dominic found about half a dozen red flags with Astarra.  He has since listed them in this article without revealing that he was my original tipper.  Dominic’s article shows clearly that there were plenty of reasons not to invest in Astarra – and these reasons are valid reasons to be wary even if you have no strong basis to allege fraud.

The problems are wider than either Dominic or I anticipated.  For instance we knew nothing of ARP Growth – and that may be the most seriously impaired fund of the lot.  It is also the only fund on which I am willing to determine – absolutely – involved fraud.  (I have two wildly different sets of accounts for ARP Growth - at least one of those accounts must be fraudulent.)

The rest of the issues with Astarra I will leave in the capable hands of our regulator and perhaps the class action lawyers.  I want to get back to making money for our clients.




Thursday, March 18, 2010

Barclays: do you employ these psychopaths?

Felix Salmon directs us to a blog post in which former Lehman executives (possibly safely employed by Barclays) talk about the Valukas report.

Felix rightly describes these people as psychopaths. 

I am not going to further roast these executives – I just want to know how much of this culture infected Barclays. 

It remains a source of amazement to me that Barclays came out of the crisis so well.  Sure they got a (real) bargain buying Lehman’s US Broker-Dealer.  But they were hardly Snow White and their leverage levels were way higher than Lehman.  Moreover the crash-or-crash-through attitude of Bob Diamond would not have been out of place at the most aggressive (failed) hedge fund.  [The first post on this blog that got more than 30 readers was on Barclays – and – unlike many of my early posts – it looked very good for a while – but less good in the long run.]

Barclays is here and prospering so my pre-crisis view of the investment banks (that Lehman and Barclays would be the troubled ones) did not turn out precisely right.



PS.  Sorry for the absence of posts – but I was busy walking from Mallacoota to Wonboyn and there were no people, phones, internet or stock quotes.

Thursday, March 4, 2010

A little follow up for people who want to reinterpret what Buffett said… oh – and a stock reason for looking at all of this…

There are a few comments on the blog that annoy me.  One for instance is repeated below:

A review of the transcript will show that Buffett believes that: a) the legislation must focus on cost, in order to achieve the goal of universal coverage. This has nothing to do with socialized medicine; b) he believes a broader political consensus is required. Everyone is entitled to the their opinion, but not to someone else's.

Buffett clearly said he was for universality of health care.  He would – if given no other choice – vote for the current bill.  Universality – unless someone else has worked out how it happens – involves a person who can’t pay (or possibly won’t pay) being covered by other people.  That can happen via the tax system or via some kind of forced levy on other people.  But it necessarily involves the (partial) socialization of medicine.

He implies however – though does not say so directly – that universality (necessarily involving some socialization of costs) – could be a disaster if costs are not controlled.  I will go further and say that it will be a disaster if costs are not controlled.  Australia has spent the last twenty years on measures that control costs (with considerable success).  In the UK – but to a much lesser extent in Australia – those measures include queue rationing of some services.  Queue rationing known here as “hospital waiting lists” was for a long time one of the dominant issues in State politics.  Queues are less of an issue now than (say) ten years ago – but if you run the expression “hospital waiting lists” through Google News you will still find that it is a political issue.  Anyone who tells you that you can have universal coverage without some queue rationing is lying.  A decent part of the system however is working out what procedures must take place quickly and what procedures can safely wait a while.  In Australia some people are in pain whilst on waiting lists. 

Buffett states clearly that controlling costs will not be done with a bill that pleases everybody.  There are $2.3 trillion of costs – and every bit of those costs has a constituency.  He wants a real analysis of medical spending effectiveness.  He wants experts – and he points favorably at Dr Gawande.  Dr Gawande focuses on things that involve medical incomes (including the use of the Doctor’s pen to order tests and specialist treatment). 

He notes that medical employees as a percent of population are low in the US compared to other jurisdictions and yet medical expenditures are high as a proportion of GDP.  Some of this must be expenditure that does not go to medical staff (he points directly at medical kit).  But some of it must be the incomes of the participants are high relative to the rest of the population.  [Simple math here – less employees – more cost – so more cost per employee.  And I know kit is part of that equation… but kit expenditures are simply not large enough to make up the difference.  And most of the rest of the cost of a doctor is the doctor’s income.]

Buffett does not prescribe how you would crush medical costs as he suggests – but he notes that other countries have done it with universal coverage, providing more doctors, more nurses and more consultations.  He thus thinks it is possible (though politically terribly difficult).  He specifically thinks that this cannot be done by consensus (despite the comment repeated above) because a bill that pleases everyone can’t deal with costs.  [I added – though Buffett did not say – that that implies that the bill cannot be bipartisan.  In the current context that means a filibuster process – though Buffett did not say that either.  Still if there is a way for a non-consensus medical bill which provides universal coverage and cuts costs to be bipartisan show me and I will stand corrected.]

I doubt Buffett – as the world’s second richest man – would find queue rationing acceptable for himself – but that discussion never came up.  If you want to accuse him of hypocrisy go ahead.  When my wife damaged her knee in a skiing accident we queue jumped using supplementary private health insurance.   So accuse me of hypocrisy too.

Buffett obviously knows that a system that radically cuts costs but has the government meet some of those costs will necessarily involve rationing.  He is not a fool.  He just never said how the rationing should take place – preferring to leave that discussion to experts.  That way though he could sound reasonable and friendly whilst proposing reforms that will radically reduce some peoples’ incomes and somewhat limit access to medical care.  And that I guess is Warren Buffett to a tee.  He sounds all genial – but underneath is one of the most hard-headed men you will ever come across.

Why I am interested

This is actually a hard headed investment blog.  And Buffett is right.  Medical reform which does not control costs will be a disaster.  He is also right to finger medical kit.  The current bill does not address costs – so it is not the time to think about this – but some medical kit companies trade at nose-bleed valuations because they can sell growing amounts of high tech kit at high margins.  (Intuitive Surgical is a good example.) 

I am an irregular short-seller of stock in even the finest companies.  When America finally gets serious about controlling medical costs some of these stocks will be fantastic shorts – simply because controlling costs means reducing some people’s incomes and some corporate profits.

And – that is enough reason to take the partisan glasses off and look entirely rationally a the problem.  This bill does not give me a good reason to short Intuitive Surgical.  From the perspective of Warren Buffett however that is why it is not a good bill. 




Follow up: 

Namazu  - the provider of the comment that annoyed me - suggests we might be arguing over the meaning of socialized.

I think that is probably a fair comment... it is not a word Buffett used.

I consider the mixed market system of Australia partially socialized. By far the bulk of medical costs are picked up by government and are shared through the tax system - but it looks quite different to the UK.  [My UK friends also prefer the Australian system…]

Still – a system where by far the bulk of the costs are picked up by government and shared through the tax system meets my definition of socialized.  [Though people who say keep government hands off Medicare might have a different view…]

Still in many categories (for example pharmaceuticals) the Australian government is effectively the monopoly buyer - and it uses that power to reduce costs. That is a KEY part of the story as to how costs are reduced in almost all other countries.

And yes - it does crush incomes of doctors and corporate profits. 

Wednesday, March 3, 2010

Warren Buffett on Obama’s health reforms

Warren Buffett did one of his regular (extended) interviews with CNBC.  I think he appreciates the charm and attention from Becky Quick – even enough to get up at 5am and go to the steakhouse turned TV studio.  Most of these interviews are Buffett repeating his wholesome (and oft repeated) wisdom.  However he often comes up with a piercing analysis of something topical.  Today it was health care.

We (the US) have a little over 2.5 doctors per thousand.  Much of the world has over 3 doctors per thousand.  We have 11 nurses per thousand – much of the world has more.  We have three beds per thousand – much of the world has 6 or 7 beds per thousand. 

Having said this he points out that costs as a proportion of GDP are considerably higher than the rest of the world.  He then points out some statistics (for example infant mortality) where the US does worse than some other developed countries.  Importantly he points out that these costs are a passed onto other sectors of the economy.  He did not describe them as a “tax” on the rest of the economy – but that is what he meant.

He describes the situation as a “tape-worm” strangling American productivity and he is for health care reform but particularly health care reform that controls costs.  He would – in the absence of other choice – vote for the current bill.  That however is – in his case – very qualified support for the current bill.

The health-care part of the interview is worth watching.



In the interview he refers (favorably) to an article in the New Yorker by Atul Gawande which compares medical costs in high cost locations and low cost locations.  Dr Gawande describes health care driven by entrepreneurial doctors in an environment of over servicing.  I think the money quote in Gawande’s article is this:

Most Americans would be delighted to have the quality of care found in places like Rochester, Minnesota, or Seattle, Washington, or Durham, North Carolina—all of which have world-class hospitals and costs that fall below the national average. If we brought the cost curve in the expensive places down to their level, Medicare’s problems (indeed, almost all the federal government’s budget problems for the next fifty years) would be solved. The difficulty is how to go about it.

I have written about health care before (but I think Buffett says many things better).  Though in summary the costs of American health care is higher because:

  1. America pays its doctors more than other countries (indeed substantially more than other countries)
  2. There is less control on pharmaceutical expenditure and other medical kit (and Buffett notes that Americans spend a lot on medical kit), 
  3. There is more hospital and health care administration – especially insurance operating - expense than other countries (although anyone who follows the bureaucracy of the National Health might think otherwise), and
  4. There is more litigation and insurance expense than in other countries (though Buffett did not play up this aspect of cost comparisons).

I would love a decent breakdown of those things.  Unless however the costs are addressed health care reform will ultimately be an economic failure

And that is roughly how Buffett thinks about the Obama reforms.  The current health care bill provides universality of health care – but does not address the fundamental cost issues

That however is very difficult.  As Buffett puts it – the current health care bill is about $2.3 trillion annually.  And every one of those $2.3 trillion has a constituency.  Moreover that constituency is organized and are effective lobbyists.  Buffett thinks that there is simply no way to do an effective cost reduction health care bill by consensus.  That is hard to disagree with. 

As he puts it:

Everyone of those dollars is going to somebody and they are going to yell if that dollar becomes 80c or 90c. 

I thought he was being generous.  If American doctors were paid like Australian doctors my guess is those dollars would not become 85 cents.  More like 60 cents or less.  The squealing here was intense – but even after all that trimming doctors remain pretty well paid.  But you can’t get rich doing general practice and even specialist medicine is a ticket to the upper-middle class not to dynastic wealth. 

What allows Australia to pay so little for doctors is a monopoly buyer (the Government) actively suppressing their income.  It is little surprise that doctors do not in general support that bit of the reform agenda.

What ultimately Buffett was saying was that proper health care reform does not and cannot get broad agreement – and hence must be done with the expenditure of significant political capital.  He never says it – but I think he thinks that this would be a good time for the Democrats to outlast a filibuster.  Triangulating Democrats have their place – but not here.

Buffett thinks that if this is not done medical care will remain a growing parasite (“a tape worm”) for the rest of the American economy.  He supports an aggressive and interventionist solution.

Still – if you follow his numbers he thinks the savings are probably 4% of GDP.  The ambitious number in my original post was somewhat larger.  He is probably right on that too.





PS.  One of the more amusing things about this interview is Joe Kernan making an ass of himself.  Buffett is clearly saying that – correctly done – socialized medicine will improve the competitiveness of American industry (though the current bill is not a solution to costs).  This is anathema to Kernan’s oft-stated ideology – and Kernan repeatedly tries to restate Buffett’s position to suit his own ideological view rather than Buffett’s clearly enunciated position.  Becky Quick proves again that she is the heavyweight on that show and I can see why Buffett does appreciate her (intellectual) charms.

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