What if you went to the doctor’s office with a sore wrist and she proposed bandaging your ankle?
That’s how I feel about the government’s proposal that venture capital be regulated along with other private capital pools including hedge and private equity funds. See this Mercury News story, Venture Capital Needs Transparency Not Regulation, for background.
I’m no financial expert, but far as I can tell, the root causes of our current financial crisis are:
- Leverage. Investment banks and hedge funds building 30:1 levered portfolios (and somehow managing to only get 8-10% returns on them). Kind of reminds you of buying on margin as a root cause for the crash of 1929.
- Financial system interlocking and the too-big-to-fail problem. Like it or not, as a citizen and taxpayer, it does seem to me that many of these firms/funds are indeed too big to fail and the government was correct to use my/our money to stop the collapse.
- Agency problems and excess compensation. Basically, you had very smart people who could make $10M+ per year by taking excess risk. When viewed from their perspective, put undiplomatically, who cares what happens to their employers? It doesn’t take many years (e.g., one) of $10M income to become permanently wealthy so senior managers had huge agency issues (where the interests of the owner and the agent diverge) which seemingly were left unchecked both by the companies’ own boards and by government regulators.
- The housing bubble and the conflicts of interests among loan-originating banks, assessors, developers, and mortgage brokers. Arguably, the root cause here is the securitization of mortgages combined with the next point.
- Conflicts of interest in the ratings system. I never knew this before, but the people who pay ratings agencies are the issuers of debt, not the buyers. This would be like Sony paying Consumer Reports to rate their new television sets. Perhaps this is how a portfolio of zero-down, floating-rate mortgages on overpriced houses in Stockton gets rated AAA.*
- The lets-insure-each-other problem associated with credit default swaps. In a tightly interlinked system where each player is too big to fail, this strikes me as a mathematical hallucination designed to make it look like each player is taking less risk. But, in reality, it seems like a bunch of people living on the same street in Florida insuring each other against hurricanes. The question isn’t when will the insurance system fail, but indeed will it ever work — i.e., will there ever be a hurricane that wipes out only a few of the houses in the pool?
- Lack of regulation to control / keep in check the amount of risk, leverage, ratings, and agency issues.
I’m sure I missed some and if you think I got anything wrong in this laundry list, feel free to comment. Because my primary point is that nowhere on this long list will you find anything related to venture capital.
In fact, as I’ve previously argued, venture capital looks quaint by comparison. VCs buy and hold the shares of start-up companies on 5-year, plus or minus, timeframes. No leverage. No ratings agencies. Investment professionals (e.g., foundation managers) are typically the only investors, so there’s no duping of John Q. Public.
Yes, venture returns are down over the past decade. Yes, there are probably too many VC firms and a shake-out is imminent. Yes, VCs make lots of bad investments. Yes, VC is increasingly a “hits business” where the biggest winners in the portfolio account for a disproportionate share of the returns.
Yes, VCs can make a lot of money. (And yes, I view carried interest as income and not capital gains.) And yes, there is probably an element of Fooled-by-Randomness / increasing returns inherent in the VC pecking order.
Sure, there are lots of flaws, but overall, I believe the VC system works. Much as you might say democracy is the least bad form of government, VC strikes me as the least bad way of driving innovation in the economy.
It wasn’t part of the problem, so let’s leave it out as part of the solution.
* I know the ratings problem is more subtle and involves mixing loans of various quality to stay just-within the bounds of a given creditworthiness level. Nevertheless, I’d argue a “good” rating system would differentiate between a basket of all-solid loans and a basket which mixes solid, semi-solid, and wobbly ones. As an aside and largely from a position of pure ignorance, I’m amazed that someone hasn’t raised some venture capital and tried to challenge the ratings industry with a new consumer-focused model.
Besides intuition, what is the rationale for too-big-to-fail? There are plenty of arguments against: moral hazard, hurting competitors, etc. We need to realize that companies going out of business are a sign of a healthy market, and govn’t subsidies are not.
But all that is being discussed is investor and counterparty disclosure requirements – why is that a big deal? It’ll keep the Ponzi guys from moving over to ‘venture funds’ as their new vehicle.Not to mention that the venture industry had something to do with the dot-com bubble — and it is reasonable to say that bubble catalysts should be monitored.
I sense a little govn’t-can-regulate-as-long-is-it’s-not-affecting-me-directly attitude. Besides intuition, what is the rationale for too-big-to-fail subsidies? There are plenty of arguments against: moral hazard, hurting competitors (why doesn’t anyone care about them??), etc. Companies going out of business is a sign of a healthy market, and govn’t subsidies are not. If we give up on the principle and let the regulation in one area, let’s not be surprised if the rest follows.
On too-big-to-fail, I’m arguing largely from intuition and also from watching the havoc related to Lehman’s failure. In general, I buy the argument that businesses should fail and that such failure healthy, Darwinian, evolutionary, et cetera. For some reason that I can’t quickly explain I personally think that too-big-to-fail doesn’t actually apply to the non-competitive automakers, but somehow doesn’t apply to banks and financial institutions.Partly because they seem more interlocked and partly because, applying the golden rule, I don’t want to lose money in my bank so I guess nobody else should either. (Unless I’m chasing obviously abnormal returns with accounts above FDIC limits.)Not a great or scientific answer, just sharing my opinion.
On the dot-com bubble, perhaps interesting, I don’t view that as a market failure but rather a market phenomenon. No one forced me to buy Beyond.com. No one forced anyone to buy any Internet stock. Yes, financial analysts seemed dubious and the Chinese Wall in the investment banks seemed clearly broken. But, I’d argue, all the VCs did was fund the companies that bankers pushed and the public, largely on greed / greater-fool theory, seemed to want to buy.And when it blew, there was no interconnection that blasted the rest of the economy. The NASDAQ got killed. Many individual dot-coms went to 0. But the damage seemed largely contained.
On regulation, while I’ve not thought about it much theoretically, I guess my view is: if the government is going to (need to) bail you out when you explode, then you need to be regulated.So I’m fine with banks being regulated. I’m fine with securities trading of public companies being regulated, though I think SOX is overkill and denying the American public a chance to buy shares in mid-stage companies.But I don’t know why, if a partnership wants to get say 50 partners together to go invest in “doing something” (e.g., buying office buildings or buying shares in startups) that it needs government regulation.
On too-big-to-fail, wasn’t “havoc related to Lehman’s failure” a needed correction to widespread overleveraging? I’ll rephrase my question about competitors: what about the banks that were responsible? Why should they face unfair, subsidized competition and have lower returns to their investors as a consequence? Also, by bailing out and pumping all the money into the system, isn’t another bubble being created?I don’t buy the interlocked argument, since all the businesses are interlocked. If tomorrow Google goes out of business, the number of dependent companies going out would be staggering. But eventually things would go back to normal. As far as losing money, today’s society values security over risk, and as a consequence, the returns and growth are much lower compared to say 19th century US.
I’ll take one more swag on the too-big-to-fail thing and then return to my normal job. First, as noted, the intent of the post was to make a laundry list of what caused the crisis and then note that VC wasn’t on it. While I’m happy to get educated on all things related to the crisis, let’s remember we’re debating an aside.Second, I am happy to be wrong on the too big to fail thing and enjoy the banter. As grokita points out, I’m no fan of subsidized competition of anything (e.g., the French idea to have the government subscribe every adolescent to a newspaper to help save that industry!) and I’m not at all in love with bailing out GM — i.e., my basic viewpoint is evolve or die and that means some businesses need to die.The question is can you / should you let banks die? My answer is: no. John Q. Public (or John Q. Company) needs to know he can put his money in a bank and get it back out when he needs it. Ergo, banks need oversight and regulation. If properly regulated they won’t need to get bailed out because they won’t take enough risk to fail.Then, I suppose the argument says that banks will banks and eliminate / reduce proprietary trading desks, which I guess would move that activity to hedge funds. Then the question is should hedge funds be regulated — I’ve avoided this thus far.My answer is again circular — if the government thinks there any possibility they will bail out someone because they are too big / too interconnected / too leverage “to fail” then I suppose they need to be regulated.For example, back to my real argument, it is inconceivable to me that the government would ever, ever bail out a venture fund. Ergo, leave them alone.In my personal opinion, the real problem here was the proprietary trading operations of the banks
I got this comment via email and thought I’d share it on the blog:I think you got this one totally right, even down to your tone of righteous indignation (I especially like the “looks quaint” reprise). I could imagine regulating the VC industry iff they started doing things like creating financial instruments that were composed of a mix of fractions of their portfolio and selling them on the open market, said instruments then being purchased by other VCs as a putative way of hedging their own risks and further participating in the ever-expanding goodness of startup success. Then each VC firm would issue stock and claim each of the aforementioned startup-backed bundled securities as an ever-appreciating asset and command even greater valuation for themselves.Except that only, say, ten percent or less of startups ever show any material profit for their investors, right? Just like only about 10% of first-time subprime mortgagees have a reasonable chance of making all their payments on time?So when VCs start making and drinking the moral equivalent of subprime Kool-Aid, then it’ll be time to regulate (or skip that step and just prosecute) them. As you rightly argue, not now.
The debate whether the banks should be able to fail or not could probably go forever. I tend to believe there is more harm in regulation. (Even if banks can’t fail, with really high inflation, money still can be lost. Also, if it were not for FDIC and some regulations, I’m sure there would be banks that backed their deposits in gold so that people with less risk tolerance have what they want.) But my main point is that voluntary transactions should not be interfered by the govn’t. If I’m not harming anyone, why can the govn’t restrict my freedom of giving my money to any entity I choose? If we allow this principle to be violated, I’m sure some govn’t official will come up with a theory or calculations showing that VC regulation is beneficial. The step from regulating banks to regulating VCs may appear large for us, but not for bureaucrats whose job is to regulate.
Hedge funds over leveraging wouldn’t be a problem if existing regulations were enforced and if a firewall were put around the banking system. The firewall was removed in 1999 for Citigroup, and then during the next decade the SEC took a laissez faire stance on enforcement while concurrently important economic rules were stupidly altered. The bankruptcy bill in 2005 removed the last risk of consumers walking out legally on debt. Mark-to-market changed the game in equity/debt reporting. The uptick rule removal then setup a feedback scenario where short sellers amplified any pain. Add in the corruption of high government and here we are today. Basically, none of this boils down to, “We need to regulate VCs.” So I agree on that point. Any attempt to regulated hedge funds and VCs is a knee jerk response to government failure, and shouuld not be tolerated. This is capitalism baby, not Soviet political theater.
“The question is can you / should you let banks die? My answer is: no. John Q. Public (or John Q. Company) needs to know he can put his money in a bank and get it back out when he needs it. Ergo, banks need oversight and regulation. If properly regulated they won’t need to get bailed out because they won’t take enough risk to fail.”Banks must be allowed to fail. This is precisely the reason for having the FDIC. The bank fails, the shareholders and some creditors are wiped out, the assets and liabilities are eventually sold by the FDIC, and life goes on. Though as a taxpayer I am not a big fan of the FDIC, I have to admit that such prepackaged liquidations are a convenient method of maintaining liquidity. What’s the alternative? Keeping festering failed businesses afloat by placing personal liability on the taxpayers, creating an anti-competitive environment for responsible banks, and reinforcing the moral hazard that already existed in the market?Because of the FDIC, John Q. Public should already sleep soundly at night knowing that his deposits up to a certain limit are in reality already backed by the full faith and credit of the U.S. The FDIC is already a tremendous source of moral hazard. Even though theoretically it could itself go bankrupt, all depositors know that the government would not allow it to happen.Banks are already regulated by the Fed, the FDIC, and several other agencies. What’s needed, if anything, is to consolidate the governmental sprawl under one or two roofs. The Fed, should it remain in existence, should be stripped of the regulatory authority and itself placed under the consolidated regulator. It is a privately owned bank, after all.