Category: bubble economics

Selling Dollars For 85 Cents

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Writing on Above the Crowd, Bill Gurley digs into the recent spate of ultra-high valuation startup investments. 

Over the last few years, the late-stage (pre-IPO) market has become the most competitive, the most crowded, and the frothiest of these financing stages. Investors from all walks of life have decided that “late stage private” is where they want to play. As a result, a “late-stage” financing is no longer reserved for high-revenue, pre-profitability companies getting ready for an IPO; it is simply any large round of financing done at a high price. An unprecedented 80 private companies have raised financings at valuations over $1B in the last few years. These large, high-priced private financings are the defining characteristic of this particular technology cycle.

Conventional wisdom in the post Web 1.0 era has been that a "normal" state of affairs would be for these relatively mature companies to have reached an IPO already by this point, but due to a variety of terrors — lawyers, regulation, Sarbanes-Oxley, and so on – these poor companies have no choice but to resort to private equity. Gurley points out that this conventional wisdom is both incorrect and dangerous. 

Actually, very few of these companies are at a point where they could or should consider being public. Lost in this conversation are the dramatic differences between a high priced private round and an IPO.

The first critical difference is that these late-stage private companies have not endured the immense scrutiny that is a part of every IPO process. IPOs are remarkably intense, and represent the most thorough inspection that a company will endure in its lifetime. This is why companies and their board of directors agonize over whether or not they are “ready” to go public. Auditors, bankers, three different sets of lawyers, and let us not forget the S.E.C., spend months and months making sure that every single number is correct, important risks are identified, the accounting is all buttoned up, and the proper controls are in place.

He goes on to highlight the many minefields present in these deals, things like shady tactics in reporting gross vs. net revenue, or the broader problem of investing in a business that has had its economics severely distorted by the infusion of enormous amounts of capital, and are "simply selling dollars for $0.85."

All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.

Story: Late-stage Private Rounds Are Very Different from an IPO

The Difference Between NYC and Silicon Valley

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In New York, you may be a famous TV personality, who isn't nearly as cool as the fashion designer and makes less than a Goldman analyst, who in turn has money but is far less famous than you. Even if you can get into the hippest club you probably can't break into the ninth generation native gang sitting at the end of the Brooklyn bar talking about the Yankees, or be given the time of day by an NYPD detective.

Each of many subgroups is superlative, the subject of global admiration and books and movies and mythology. You can be truly exceptional in a category or three in a place like this but you will always be surrounded by people that have you badly beat in some other category that matters.

It keeps you humble, and prevents typical delusions like the idea that being the eleventh most crucial person in the creation of a killer 12 month old photo sharing computer program actually makes you consequential.

My favorite story so far involving the financial crisis.

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This post and the underlying story comprise the most amusing anecdote I’ve read since this entire mess began. I don’t know what the ethics are of blockquoting an entire post but whatever, it’s too good:

How to lose on a sure-fire bet

There was a wonderful story in today’s WSJ about how some big banks managed to lose some of their hard-earned TARP money. 

Let me begin with a little background. A credit default swap is sometimes described as an insurance contract written against the possibility of default of a particular underlying asset. If I buy a CDS and the specified asset defaults, I get to collect money from whoever sold me the contract. If I also have a long position in the asset in question, I might consider buying a CDS written against that asset as an insurance or hedge against the possibility that the asset loses its value. 

But I don’t actually have to own the asset in question in order to buy a CDS from somebody else. I might want to buy a CDS as a partial hedge against some other asset I hold with which the specified security could be correlated. Or maybe I just feel like making a bet with somebody I think is dumber than I am. 

The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event– the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset– becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event). 

And so the WSJ recounts the tale of a security based on $29 million (par) worth of subprime loans in California, half of which were already delinquent or in default. Betting that the loans weren’t worth $29 million sounds like easy money, and the smart guys were willing to pay 80 to 90 cents for each dollar of CDS insurance. 

It appears from the WSJ account as if little Amherst Holdings of Austin, Texas was happy to sell the big guys like J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America something like $130 million notional CDS on a $27 million credit event, used the proceeds to buy off and make good the underlying subprime loans, and pocketed $70 million or so for their troubles. The big guys, on the other hand, paid perhaps a hundred million and got back zip. 

Is tightening mortgage credit the solution?

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Here's an interesting premise:

What if we slowed lending on purpose, what if we decided there wasn't any good reason to make it easier to buy homes? What if you had to have 30-50% down to buy a home? What if you had to show real income to get a mortgage again? What if you needed revenues for bank loans again? Would that be so wrong? Would it be a hardship?

In Europe folks need 50% down for homes. Perhaps too much, but 0-10% is clearly too little.


That's an interesting and often unexamined question. It's taken as gospel that we (meaning the government and public policy) should do everything possible to make it easier to buy a home. But isn't that what got us into the problems we're facing now? Doesn't that inevitably lead to a bubble?

I think the answer is no, or not necessarily. What if we just went back to the same system we had as recently as, say, 1995 or so? Historically it was typical to have about 20% down, maybe 10% sometimes, interest rates weren't kept artificially low by a Fed determined to flood the economy with cheap credit, and the people who wrote mortgages actually had their own money on the line if it turned out that someone couldn't make the payments, so they'd actually have incentives to make smart loans.

The concept of "disaster capitalism" may be applicable here. Perhaps not in the crash, but in the response to it. 

Market fundamentalists thrive by taking a system that has worked well and been stable for decades, with a solid private sector overseen by effective regulation, and then dynamite it. Then everyone stands around saying well the system failed, we have to do something new. So let's frame the debate with various pet theories and ideas, which we just happen to have studies and white papers for. 

For some reason people find it hard to just let's look back at what the system was before it went to hell, see how it changed, and do our best to change it back to the system that seemed to work for decades. Often the previous set of standards and regulations was hard-won, with small adjustments and tweaks over years each responding to one or another problem that had cropped up. 

From about 1945-1950 through the late 1990's the credit system both for mortgages and small business lending was for the most part relatively stable, with the notable exception being some shocks in the 1970's, and of course the S&L crisis, which eerily echoes the current one, with very similar underlying causes. Still though, despite occasional severe hardship it's fair to say most of our previous problems fell well within standard business cycle limits, and in fact the boom/bust cycle seemed even to be flattening out by the mid 90's.

And most notably, perhaps, is that the residential lending market has never — in the modern era at least — threatened to take down the entire commercial banking system. This in fact is unprecedented. 

But what's wrong with using a system that developed over time and with lots of tweaking, and worked pretty well? The reason to require 20% on a residential purchase is that to align the borrower and lender incentives, and it does that job fairly well. The borrower stands to lose real actual out of pocket money if they overpay or otherwise can't afford and end up in foreclosure. The bank is insulated from all but the worst swings in value and the primary risk stays with the borrower, who after all is actually the person buying the house and assuming the risk. 


If the bank wants to allow a lower down payment they can demand higher returns to compensate for the higher assumed risk. As long as they actually face that risk we can assume banks are competent enough to demand an appropriate risk premium. The bank faces risk of non-payment but it's mitigated by the equity component, or compensated for by higher rates. As far as bundling and selling the loans that's even fine too if there are provisions that keep underwriting risk actually with the underwriters, or are subject to strict and clear standards that amount to a defacto "re-underwriting" by the mortgage purchaser. This is the model — in theory — that justifies the existence of Fannie and Freddie. To allow banks to do what they do well, lend to their local communities, by repurchasing mortgages and freeing up the bank's capital to be able to lend again. 

  
But the "problem" that's endangered our financial system I think is still pretty mis-understood in the common discourse. There's much talk about mortgage backed securities as the root of the problem. I'd even say that when CNBC or the talking heads go on about "toxic paper" most people assume they mean these large bundles of residential mortgages. But bundling mortgages into securities was popular back in the 1980's too. I suspect many have read the book "Liar's Poker," where that innovation figures heavily. The concept is hardly new.


The "real" problem in my humble opinion was the swap market that rose up this time, in parallel with the CDO/MBS market. And the roots of this can actually be traced, possibly to a specific date, December 15th, 2000. Here's a quick backgrounder.  

These swaps, as practiced in the MBS market, were insurance. Period. They were an agreement to pay for a security if that security defaulted. There's no way these MBS instruments could have been sold so easily by the investment banks if they hadn't also been offering insurance. 

It was a great deal for the buyer — hey I'm buying a bundle of mortgages that may or may not work out, but I have insurance on it, so if it doesn't pay out I still come out OK. What can I lose? 

Well if the MBS buyer isn't assuming the risk who is? Of course, the investment banks. But an MBS buyer thinks well what are the chances that Lehman is going to go out of business right? Inconceivable. I'll come out fine, and I don't have to consider my MBS portfolio risky, it's insured.  

But unlike insurance the swaps weren't regulated like insurance, which was not an accident as outlined in the link above. But they were insurance, and  there were no adequate capital reserve requirements. So the exact thing happened that you'd expect. Imagine if State Farm took all the premiums they get for homeowners insurance and called it profit and paid it out in dividends and bonuses. Then a hurricane comes along and with a couple billion in policies to pay out and oops, sorry we don't have that money any more.

Which is why insurance policies are regulated. Swaps weren't. They underpinned the sale of mortgage backed securities. Without those this would never have gotten so out of control, without that assurance the funds could not have flowed into the MBS market in such quantity.

And it all trickled down to main street as money just flooded the market.

But the solution isn't all that complicated. What we had before worked. 


The people taking out these risky mortgages were behaving rationally. There was free money being given away. Of course people took it. They had tremendous upside risk and little to no downside risk. And in many cases these are people who had no other obvious path to escaping their lot as medium level wage earners. This was the clearest and most direct path to wealth most people could see, and in fact an entire industry was built up to exploit this concept. Remember seeing a "make money in real estate with no money down" commercial when you're jetlagged and flipping through channels late at night? Of course you do. 

But the investment banks writing these swaps that were not being rational. That's why they were wiped out completely. There are no more standalone investment banks. Now a public policy type might say this statement falsely presupposes a "Rational Actor" which in this case is the bank itself. In reality the people actually making the decisions may well have been rational, they themselves lieke the borrowers above were also insulated from downside risk. Heads I make a ton of money, tails I lose my job, but still have a lot of money. But as institutions the investment banks behaved in a way that precipitated their failure, hardly something you'd consider rational. 

But borrowers and lenders are of course capable of being rational. Most of the time, for much of history, they have been. And it's not really that hard to go back, it just requires financial regulation that doesn't allow people to assume risk that they are not adequately capitalized to take on. 


Ensuring proper capitalization and reserves has been the entire freakin' point of financial regulation since the Great Depression. This just didn't happen, these results were predictable, and in fact were well predicted by some. But it's not like there's a need to throw out the entire basic system. Just recapitalize and do it right this time. Again. 

Bubbles, they always seem so novel…

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So the talk over the past weekend has been deafening and all on one subject, the Paulson proposal to inject $700 billion dollars directly into the financial sector with no oversight or accountability or review whatsoever. It's beyond what anyone might call a "nuclear option."

Here's a sample of the kinds of discussions I found circulating over the weekend:    

The real problem is that the underlying assets are sharply overvalued due to liberal bank credit schemes from the 2001-2007 real estate bubble. People with no savings, bad credit, and low income could buy $250K to $500K homes. If banks are unable to finance the crazy prices that people pay for homes, then home prices have to come down equally sharply.

Paulson may be able to save banks from some of their stupidity by loaning them $700 billion, but the reality is that this is a $7 to $10 trillion problem, if not greater. 

How is a 10% bailout going to help anything or anyone? Is it not slowing down the inevitable for a six month soft landing at the taxpayer's expense?

If banks can't continue to lend in the crazy format of years past, how can home prices not deteriorate exponentially? If housing prices continue to drop, banks will not be able to continue to lend due to rational reserve requirements. How will banks with no lending capability dump the foreclosed assets that they hold in mass, keeping in mind that houses deteriorate quickly without maintenance? If they sell these foreclosed homes to the government, won't the government dump them for pennies on the dollar and tank the housing market

 

Well in my opinion it's even worse than that description. Paulson's proposal is not to "loan" $700 billion dollars. It's basically to just hand it over. And it happens whatever terms he sees fit with no review or accountability whatsoever. It is quite literally insane. It's more than the entire defense budget, more than our entire social security payouts for the year. All to be given to one person with no real restrictions whatsoever on what he can do with it, with the express purpose of basically just handing it to Wall Street firms. 

It struck me as insane, so literally and unbelievably crazy that I found it odd over the weekend to think that he wasn't literally laughed out of the room when he proposed it. It's the kind of thing that you'd think would cause armies of torches and pitchforks to descend upon the Capitol en masse.

We've all closed on a real estate transaction or worked up financing for something right? Can you imagine a $700 billion dollar deal sheet with the terms on 4 single spaced sheets of paper saying essentially: here's all the money, have fun, and there's no recourse to courts or anything else if we don't like what happens. It sounds alarmist but that quite literally was the proposal.

Thankfully, and somewhat to my surprise, people actually seem to have figured this out and the plan is going to be dead, or amended. As a gambit though it was classic disaster capitalism. Create a crisis and then act like we have to do something right now that gives massive power and money to the people responsible. As they say, it's not a bug in the system, it's a feature. It's the point, it's how this philosophy works.

But returning to the above it's not just a $7 to $10 trillion dollar problem. It's much bigger than that even, by far. It's not just mortgages, the total value of credit default swaps is well over $50 trillion dollars (yes, as much as five times the entire US GDP) and as far as I can tell — and I'm far from a complex securities expert — many of these were traded/exchanged with no regard to the counterparties ability to pay. So it appears there are companies "insuring" perhaps $100 billion in default risk, when they have nothing like that kind of money if there in fact is a default. It's madness, again it's hard to believe it really happened this way. But here we are.

But again, it's interesting to read the discussions of how this all relates to the real estate market as I still think it represents a classic fallacy, which loosely translates to the idea that 1) The problem is primarily based on home prices, and 2) The lack of liquidity and a newfound unwillingness to lend is a main culprit.

Indeed, prices of homes are always affected by access to capital, and bank willingness and ability to lend. But at the end of the day — always — the prices of any asset reflect underlying demand. Sure, housing prices rise and fall by interest rates. But the question is why? Because interest rates help determine monthly payments. And people buy houses based on a calculation of what payments they can afford, guesses as to their future income, and perceived value of being able to actually use and live in the property (ie rental equivalence). Of course as we know the housing bubble installed another variable — perceived appreciation. That's always been there but in this last market that became dominant. Which as we've seen is a problem.

I think it's actually pretty instructive to put this in the context of another bubble we can all understand and remember from the not too distant past, the dot com bubble. Stock prices and home prices have some similarities. Much like the price of Pets.com stock was based on the idea that someone else would be willing to pay more in the future for the stock, the same was true of a lot of marginal real estate. When capital dried up — and it did — I'm sure we all remember CEO's saying that the business was on track to be successful but recent developments in the market have made it impossible to continue. Remember all those homepages that had a note to that effect?

BubbleTech.com is sad to announce we are ceasing operations, even though we had a great product and lots of users the current climate has made it impossible to finance continued growth, so sorry to everyone.

Ummm… sure. But the reason Pets.com had problems at root was not that it lost access to capital. To channel my friend, the brilliantly blunt Phil Kaplan for a minute the reason was that nobody wanted to buy kitty litter over the internet via UPS delivery at a price that could make a profit. The underlying model was, in the parlance of the time, f*cked. Completely.

There was no relationship between the value provided by the company and the value people perceived from it and their willingness and/or ability to pay.

What does that have to do with houses? They're pretty similar actually. Sure, problems with lending are an issue. Just like in technology, where in late 2000 there were undoubtedly actual good — meaning potentially profitable — ideas that could not get funded. Right now there are no doubt people with willingness and ability to pay who are having trouble getting a mortgage.

But as a rule, housing values relate to income and perceived value (demand) and availability and quantity of housing (supply). Some things don't really ever change much. When housing prices got so out of kilter with income and rent equivalency then they were inevitably bound for a crash. That's just the way it is. Just like when dot coms spent $1 to get $0.50 back they were f*cked. Period.

But in housing, like all markets, at root there are market clearing prices. In fact probably quite a few of these mortgage backed securities have value. Because of the way they structured them (ie first loss provisions and tranches) many of them, literally, are valueless. But some will have value. Many of these foreclosed houses have some value.

So yes, there are market clearing prices for real estate, though a discrepancy between buyer and seller expectations can demolish liquidity, compounded by a credit contraction. Nonetheless things are falling fast — but they won't fall forever. Housing prices will probably fall to rental equivalency, overshoot, and then stabilize. Of course it's a moving target as incomes (demand) can drop too during a recession, but still, it's inevitable.

But the banking crisis involves a lot more than just residential real estate and mortgage backed securities. The debt insurance market dwarfs this problem. The reality is that the losses have already been made. People essentially spent on borrowed money, through HELOC abuse and equity withdrawals and the like. It propped up the economy for awhile, but that's over.

But to reference a phrase that was going around quite a bit this week – the fundamentals of our banking system are weak. I think there might be a chance that a good treasury plan will involve recapitalizing the banks (by giving the funds but taking equity in return, which is mandatory and insane that it was not part of the original plan). That kind of capital infusion could indeed work just fine. It could make the banks solvent, and return the economy and sector to some sense of rationality.

But housing prices got too high when they were decoupled from rent equivalence and incomes. Just like dot com stock got insane when it was decoupled with standard notions of profitability and return on investment and revenue. And to keep the metaphor going many people made money in technology during that time. And there will be much money to be made now in real estate for smart people. But the sector will contract and housing prices will continue to fall (in real terms — the idea of inflating our way out of this is another issue, and another 2000 word post). But that aside there's no other way for things to go.

That's a good thing. It just sucks for everyone holding the bag this month.