Agile VC:
My idle thoughts on tech startups
The state of our financial system
September 26, 2008 · 5 min.
I’d be remiss if I let this week pass without noting the current state of our financial system and the furor this has caused among nearly everybody.
In my humble opinion, it is unfortunate that the remedy which has been proposed by the Treasury Department has become embroiled in politics from all points along the political spectrum. I personally have limited interest at the present time to try to apportion blame for the politization of this process.
Similarly I have limited interest in the present moment for attempting to discern who is “at fault” for our current crisis (Note #1). Objectively speaking some element of the blame can be laid at a wide swath of participants in our economic and political system including:
- Certain consumers – who took mortgages and other loans that in their heart of hearts, they knew they couldn’t really afford.
- Certain real estate agents – who told consumers that home prices almost never go down and encouraged them to buy more home than they could afford (if not outright speculate and buy lots of homes), yet knew in their heart of hearts that the fun couldn’t last forever.
- Certain mortgage brokers – who employed shoddy lending and underwriting procedures knowing in their heart of hearts they were simply gaming the securitization process.
- Certain investment banks – who created securities of such complexity that they knew in their heart of hearts could not properly be valued or understood by their buyers. Compounding this problem is that in some cases these banks ended up buying some of these securities either on their own balance sheet or through opaque off-balance sheet vehicles, exposing themselves to the complexity and risk of their own creations.
- Certain investment rating agencies and bond insurers – who improperly gave higher ratings of creditworthiness to various mortgage-backed securities, but in their heart of hearts were more interested in the fees they got from the investment banks than their fiduciary duty to objectivity.
- Certain institutional investors – like banks, pension funds, and others who in many cases bought investments they didn’t understand. They were motivated to get a little extra return versus safer alternatives, even though they knew in their heart of hearts they were taking on additional risk (risk they didn’t understand and underpriced) with these investments.
- Certain government sponsered enterprises (GSEs) – like Freddie Mac and Fannie Mae who were ostensibly “private” companies, but who knew in their heart of hearts they had an implicit guarantee from the Federal gov’t. The management of these GSEs took a plethora of risks and used the companies profits to heavily lobby lawmakers on both sides of the aisle to ensure this guarantee never went away and expand the purview of their risk-taking behavior.
- The accounting standards board (FASB) – who in the wake of the Enron collapse imposed “mark to market” accounting without fully appreciating its unintended consequences when markets freeze, but in their heart of hearts didn’t care so long as their SARBOX business kept growing and we didn’t have another Arthur Andersen type implosion.
- Federal & state regulators – who in many cases where outgunned from the start, but ultimately failed to grasp the gravity of the escalating credit crisis which began over a year ago.
- Politicians of all stripes – who in most cases take lobbying dollars from any variety of the parties above who will provide them. Who in most cases lack the perspective and depth of understanding of our current situation to be able to opine cogently on it. Who in their heart of hearts should know that the right thing to do now is figure out a solution, but instead spend most of their cycles blaming each other or some combination of the groups above.
- Anybody from one of the groups above who broke the law – and incontrovertibly there were folks in virtually every group above who have. But in reality there are not singular bad actors you can point to and the number of people in any of the groups above who actually violated laws is probably a small minority of the total. Virtually everybody in the food chain here benefited from inflating this bubble, which became self-sustaining as it drove real estate prices higher, so almostly nobody had incentive to try to stop it.
There’s plenty of blame to go around and plenty of time to spend apportioning it. However, this should not be the focus of our collective energies at present. The question at hand should not be “How did we get into this mess?” as some have suggested, rather it should be what are the steps we should take right now to prevent this mess in the financial industry from getting even worse thereby causing greater challenges in the broader economy.
Regardless of whether it is “fair” for the CEOs of investment banks or GSEs to receive severance compensation, whether they do so or not will not inherently fix our current plight. Whether the Treasury proposal smacks of socialism or not, no one with a true grasp of our financial markets has put forth a serious alternative with dramatically lower costs (note #2). Regardless of whether $700B is many multiples of the budget of [insert your favoriate govt program / department here] is irrelevant on two fronts. For one, spending more on any given project won’t address the financial crisis we face. For two, $700B is not the cost of this program… nobody on the planet knows how much this program will ultimately cost. The $700B figure is a ceiling on expenditure, and obviously a non-trivial one. But the ultimate cost of this effort is likely to be only a portion of that total, possibly a small portion and conceivably even a profitable outcome for the federal govt.
For those who doubt the gravity of the current situation, I urge you to study the history of the Great Depression. Many talking heads in the last two wks have compared our current plight as the worst crisis since then. The Depression was not caused by fundamental economic weakness which then precipitated a financial crisis in the form of the October 1929 stock market crash. Instead, a downward spiral in bank lending markets (itself precipitated by government tightening of interest rates, precisely when they should have been relaxed) essentially brought our credit system to a hault. This constricting (and utimately virtually complete seizure) of the credit markets is what led delfation, 25% unemployment, 50% foreclosure rates (in some areas), and a decade of misery for most Americans.
Let’s get to fixing first. If we do succed in fixing it, we will have ample time for scoring political points (on either side) and apportioning blame. Sadly if we fail to address the situation, we will all have far too much time on our hands t
o attend to these tasks.
o attend to these tasks.
Note #1: I want to publicly give credit to Peter Thiel who was right about this sooo long before the rest of us. He seems to have a habit of doing that, profitably.
Note #2: The only serious alternative I’ve heard propsed, put forth by Paul Krugman and others, is to inject equity capital into the financial institutions still standing. But the scale of an equity infusion that would be large enough to inspire confidence by banks themselves and among themselves as counterparties would surely be massive. The two remaining investment banks (and they were essentially converted to conventional banks earlier this wk), Goldman Sachs and Morgan Stanley, each have balance sheets in excess of $1 trillion on equity capital bases of < $50B each. Troubled banks/thrifts like Washington Mutual (insolvent and seized by the government yesterday) and Wachovia (looking rocky as of this afternoon) have balance sheets in excess of $300B and $700B respectively and each with equity capital <10%>