This is Your Bubble Now
Posted on March 11, 2008
Filed Under Dramanomics |
As the United States economy tanks, I’ve noticed quite a bit of arrogance amongst Silicon Valley types who are “This isn’t our bubble.” Many have expressed a sentiment that the serious problems in the greater market would not spill over into the Valley economy. VCs raised nearly $35 billion last year in a show of confidence.
But anybody with common sense knew that such confidence was foolish. Silicon Valley’s economy is part of an “open” platform called the United States economy - it’s not a “walled garden.”
Startups and the VCs who are backing them are apparently starting to learn this the hard way. Michael Arrington at TechCrunch is reporting that “up to 20% of venture backed startups may have been convinced by their financial advisors to put much of their spare cash into something called Auction Rate Securities, on the promise of money market-like liquidity with better returns.”
Last month, auction rate securities became the latest victim in the credit market clusterfuck. 258 auctions in the $330 billion ARS market failed on February 13 alone. In comparison, only 44 auctions failed between 1984 and the end of 2007.
ARS’s are typically sold to “sophisticated” investors and corporations. Some are being hit hard. Business airline JetBlue reportedly has 72% of its cash and investment securities tied up in ARS’s and pharmaceutical major Bristol-Myers Squibb on failed auctions.
Apparently a non-negligible number of VC-backed startups were convinced that ARS’s were an attractive alternative to money-market funds because of the higher interest rates despite the fact that some advisors, such as SVB Asset Management, had been warning clients about the risks posed by ARS’s :
Our principle concern is the liquidity in the auction process. A lack of interest in this security type increases the risk of a failed auction, which could result in the accounting reclassification of the bonds as long-term rather the “cash-equivalent” status used by many investors today. At that point, investors would be left with a 20 to 30 year bond position with an unattractive coupon. We recommend that risk-averse investors avoid these securities at this time.
One of Arrington’s VC contacts “believes 5-10% of total invested cash is frozen.” Some VCs apparently did not know that their portfolio companies were using ARS’s while others have admitted “We just had no idea this was even a risk at all.” In both cases, the notion that VCs effectively serve as knowledgeable, trusted advisors and partners is dented.
The situation is apparently pretty bleak for a number of startups who are experiencing cash flow problems and are running around trying to find access to money. Some of the VCs behind these companies are reportedly leaving them to fend for themselves, highlighting not only the fact that VCs are never your friends when things turn sour but also the fact that VCs are probably (wisely) recognizing that they funded startups that aren’t worth saving anyway.
Of course, the big take-aways from this mess are:
- The biggest financial crisis in decades will impact Silicon Valley. When the word “stagflation” starts getting bandied about, everybody is affected.
- While all companies, including startups, typically park some money in money-market funds, etc., the fact that quite a few seemed compelled to put money into ARS’s demonstrates a disturbing dynamic. Given that VCs fund startups so that they can build successful businesses, startups should be more concerned about putting the capital raised to good use than they should be in squeezing out the best returns from where they stash that capital. As VC Fred Wilson noted in a discussion of his firm’s experience with ARS’s, “we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year.” Startups committed to building a business and paying their bills should have taken a similar approach.
- If startups are running into cashflow problems that are exacerbated by failed ARS auctions, it still means they would likely have had cashflow problems anyway and sooner rather than later. If we assume that the average startup with exposure to the ARS market didn’t put an ungodly percentage of their capital into the market, any cashflow problem signifies that the company was in trouble to begin with. As noted by one TechCrunch commenter, “A startup without a steady flow of cash, is like a car without oil…it can’t run.” And as noted by another, “A far more interesting question is why are these startups trying to get at their ’spare cash’. It sounds like this may be the least of their worries.”
It will be interesting (and possibly amusing) to watch this play out. Whether this mess speeds up the inevitable busting of the Web 2.0 bubble remains to be seen, but at least some of the smugness in the Silicon Valley community will deflate as entrepreneurs and investors scramble to find cash.
Perhaps I should expand my loan shark operation to Palo Alto. Sand Hill Shark has a nice ring to it now that I think about it.
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Drama 2.0 spikes the Web 2.0 kool aid by providing critical analyses of Web 2.0, its people, its startups and its impact on the world of media. Other topics are explored when Drama 2.0 has been drinking too much 1975 Dom Perignon. Read more about the Internet's version of Keyser Söze here.
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You know I enjoy your writing, Drama, but you’re so incredibly wrong on this one it isn’t funny. Aside from the fact there is little to no empirical evidence that any of the current economic troubles are in any way affecting the Web 2.0 economy, your statement that this is the worst economic crisis in decades is utter hyperbole.
Do you not remember 9/11? Do you not remember the tech bust that preceded it? On the front page of the Dallas morning news in 2001, there was a man with a sign standing in the middle of the 635 expressway that read “Have CCIE, Will Work For Food.”
We are nowhere near that level of unemployment or economic hurt, either in the general economy or in the tech sector.
Mark: With all due respect, the general consensus amongst many top economists and high-profile advisors is that the market is in significant trouble.
The tech bubble and the 9/11 are entirely different financial beasts. What is occuring now is the unwinding of an insane debt market. We are not talking about simple downturns caused by overpriced equitities (as in the tech bubble) or panic selling instigated by an event that brought uncertainty to the markets (as in 9/11).
We are dealing with a situation in which sophisticated and risky financial instruments that were poorly understood and abused by i-banks and investors (credit derivatives like CDOs that Warren Buffet himself has called “financial weapons of mass destruction”), coupled with ungodly amounts of leverage, have led to a liquidity crisis that The Fed seems unable to successfully fix despite the fact that it’s now printing billions of dollars daily in an attempt to control the problem. Hyperinflation anyone? The problem, of course, is that we’re not only dealing with liquidity, but solvency. And the timing couldn’t be worse for consumers (oil hitting record highs, etc.).
Just to give an idea of the scope of the problem: Friedman, Billings, Ramsey estimates that $11 trillion in US mortgage debt is backed by only $590 billion in capital. And with the mortgage debt crisis spilling into other markets, such as the ARS market, it’s clear that there’s a lot of other vulnerable dominoes that have the potential to cause significant pain.
Finally, I find your mention of a Web 2.0 economy funny. I didn’t know Web 2.0 had an “economy.” After all, hardly anybody is making any real money.
[…] d�rfte, macht die Sache nicht besser, schon gar nicht, wenn die Vermutung von Techcrunch (und anderen) zutreffen sollte, dass einige VCs von den Investmentaktivit�ten ihrer Portfolio-Firmen nichts […]
What’s going on now, is Peak Oil. It’s $110/bbl today, 800% price growth since 1999.
Sutro: while some say that production from major fields such as Ghawar has peaked (or has already started to decline), there’s a lot of myth to the concept of “peak oil.”
The truth is that we’re swimming in oil. Much of it, however, is hard to reach and much of it is heavy, sour crude that is difficult to transport and refine. The Orinoco belt in Venezuela, for instance, has a significant amount of heavy crude (some estimate 300 billion barrels) but it’s not being fully exploited for a number of reasons, including the fact that we don’t have enough heavy crude refining capacity.
Throw in other potential sources of oil, such as oil shale, for which there are probably around 3 trillion barrels worth of deposits and it’s clear that we are not running out of oil - we simply lack the ability to get to all of it, transport it and refine it. At current prices, however, it becomes economically feasible to start tapping into some of the unconventional reserves that were previously not viable to exploit. But exploiting these reserves isn’t going to happen overnight. Significant investment, R&D, etc. is required but fortunately, unlike in some markets (such as consumer Internet), if there’s money on the table, you can be sure oil men are going to make things happen to get it.
Also note that speculators are also playing a role in driving up oil prices but it’s hard to determine what portion of the price increase is due to instrinsic supply/production limitations and what portion of the price increase is due to investor speculation.
The bubble was already heading for the sharp points before 9/11. The last company I worked for was already in restructure. Friends in Silicon Valley were start-up hopping as companies were crashing around them hoping to find one that wouldn’t long before 9/11. And putting blinders on about this one is going to screw a lot of folks.
Also pimping a link just this once. Drama, you missed the most crucial pieces of all. A lot of the money market accounts were backed up by the BANKS investing in auction rate notes. So even the money market accounts are getting screwed.
Nope, nothing to see here. Everything is FINE FINE FINE!
Cyndy: I’m assuming you’re referring to this article.
If this is true, it is a unique situation and not currently reflective of money market funds in general. Typically money market funds invest in instruments such as T-bills, CDs and commercial paper.
I’m not a securities expert by any means, but if Comerica was investing funds that had been put into its money market accounts into ARS’s (which VentureBeat seems to imply), I believe it may have been violating Rule 2a-7 of the Investment Company Act of 1940 which specifies what type of securities money market funds are permitted to hold (amongst other things).
Of course, the entire financial system is a house of cards anyway. If you have an FDIC-insured money market deposit account, for instance, it’s worth noting that the FDIC insures more than $3 trillion worth of deposits yet only has insurance funds of $44 billion according to the FDIC website. In other words, if the house of cards starts to crumble, everybody is fucked.
Drama:
Those future barrels and their feasibility are projections (e.g. it could well be that shale oil and majority or tar sands are net energy negative). Let’s look at the recent figures instead.
World’s oil “production” has been basically flat since ‘05, despite sharp increases in prices. For example, look at
http://gailtheactuary.files.wordpress.com/2007/06/world-oil.jpeg
They would love to sell more, because they are collecting incredible profits, and money *now* never hurts, but they cannot.
Sutro: there’s a difference between oil production and oil reserves.
Right now oil shale *is* net energy negative and the EROI on tar sands is pretty low. Forget about them even though new technologies to make extracting and processing them more efficient do have long-term potential.
When it comes to heavy, sour crude, we’re awash in an ocean of oil. The problem is that the refining capacity just isn’t there yet. Valero has built an incredible business on being able to refine heavy crude. How’d they do it? Back in the 1980s, they saw the future and invested in building up the capacity to refine this crude.
The cost of upgrading facilities to handle heavy, sour crude is incredible. A hydrocracker can cost as much as 8 or 9 figures depending on processing capacity, for instance. Because the spread between the cost of the heavy, sour crude and the refined product has increased and will continue to increase (thus offering much higher refining margins that boost the bottom line), you can expect to see more production capacity in this area but it isn’t going to happen overnight.
I’m pretty sure they are fine in terms of the law since the auction-rate notes would be covered under the provision of municipal issuers. The whole thing is a train wreck, like dominoes set up in a circle. Doesn’t matter where you start, they all come down.
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[…] one of the most serious economic crises in recent history. As they’ve slowly learned that it is their bubble, I have joked “Silicon Valley’s economy is part of an ‘open’ platform called […]