The first post in this series was about Human Resilience and how we as a species have consistently managed to harness crises to spur growth and progress.
But how does this progress happen? And why do we need crises to help us improve? What evidence is there that previous crises had roles to play in creating our current reality? In this post I’ll try answering these questions using three of the most devastating crises in the last half-century: The Dot Com Crash, 9/11 and the Global Financial Crash of 2008.
Crisis 1: The Dot Com Crash & 9/11
The turn of the millennium brought with it all the ingredients for the perfect economic storm that had begun brewing since June 1993, when the internet transformed from being a clunky, highly technical technology that less than 4% of the world used, to a widespread, user-friendly repository of the world’s information just a couple of years later. The company that kickstarted this revolution? NCSA Mosaic, or simply Mosaic, founded by one the partners of now-legendary VC Firm a16z, Marc Andreessen along with Eric Bina of Silicon Graphics. Betting on its potential and dismayed with how hard-to-use the web was, the duo sought to make the internet available to everyone in the world— even the laymen.
Mosaic was the first graphical web browser that effectively combined the tech required to make the internet work (earlier internet protocols, FTP, Gopher, etc.) with usability and distribution strategies that made the web widely accessible and useful (interactive GUIs, integration with MS Windows/Macintosh and easy installation). Netscape Communications, Andreessen’s next venture along with Jim Clark (founder of Silicon Graphics), took this usability to the next level in 1995 by introducing, among other innovations, “on-the-fly” displaying of images and text as they downloaded in its Navigator browser. This innovation may not seem revolutionary now, but it was enough to destroy Mosaic’s market share.
With business loan interest rates being at their lowest point in over 2 decades, Netscape’s meteoric rise in popularity followed by it’s wildly successful IPO in 1995 (when it was only 2 years old and still loss-making) and the company’s sale to AOL in 1999 for $4.2Bn, the internet had been successfully rebranded as a tool for business rather than just for communication. At the same time, other now-major digital industries also found their roots with companies like Yahoo! (search engine), Amazon and eBay (online retail), SixDegrees and theGlobe.com (social media) and even Sex.com (online pornography) being born and hoping for similar success. Widespread entrepreneurship, massive investor risk appetites, sky-rocketing web usage and a complete lack of understanding of what makes a good web-based investment combined to form the catalyst for one of the fastest growing stock market bubbles of all time (to put this frenzy in perspective, some companies simply added .com to their names and saw 10X growth in stock value overnight!)
While many of the survivors of the crash are household names today, the Get-Big-Fast philosophy (“Grow-at-all-costs” in 2018–20 lingo) that investors and entrepreneurs followed at the time led to several good ideas (including VoIP, eCommerce, online delivery and big data) failing fast and hard — and the market as a whole losing $5Tn in value along with tens of thousands of jobs and as many livelihoods since its peak.
And then, 9/11 happened. The twin towers fell, and along with them, global market values, optimism and peace — all of which, as a silver lining, created opportunity for innovation and progress. While entrepreneurship, venture capital and the startup movement as a whole faced major setbacks as a result of these two events, deeper change did ensue. Within the US and globally, the focus shifted from the potential to the real, and from hope to paranoia.
6 Degrees of Failure
The power of a crisis comes from its ability to expose failure, negligence and inadequacy. It draws a clear line from demand to the lack of supply, and this is what highlights opportunity and spurs innovation. Together, the Dot Com crash and 9/11 highlighted 6 areas of failure and subsequent opportunity:
Failure of Intelligence
Timely detection of useful information combined with effective synthesis, analysis & prediction is crucial to be able to pre-empt crises and create mitigation/prevention strategies.
Failure here led to heavy investment in data mining of structured and unstructured data, the relaxation of privacy laws to allow data collection and the formation of sophisticated data science fields such as pattern recognition, predictive analytics and machine learning to aid in suspect detection & crime forecasting. This formed the basis for our current AI and data revolution and also laid the foundation for now-commonplace technologies such as ad-tech and marketing-tech through the development of sophisticated user tracking technologies, which then contributed largely to the growth of the Social Media revolution.
Failure of Technology
Because both crises were technological in nature, every other failure outlined (Intelligence, Security, Communication, etc.) had an element of technological failure as well. The gaps in the intelligence process, however, first revealed what technological advances were necessary, which is why this is the second degree of failure.
Heavy investment followed in the fields of crisis preparedness, proactive detection, security enforcement and timely resolution. This included sophisticated sensor technology for physical and virtual activity tracking, threat detection, mesh networks, facial and speech recognition, gesture detection, virtual assistants, identity management, battery technology, UAVs and drone-tech — technologies that have now made their way into homes around the world and across industries in various ways.
Cloud infrastructure, broadband and web-based security vulnerabilities also saw significant progress, leading to the SMAC (Social, Mobile, Analytics and Cloud) revolution that formed the basis for AWS, HTML5 and the global entrepreneurial boom since 2001. The physical world and field of material sciences also saw paradigm shifts with extensive use of parametric design concepts in building construction, for example.
Failure of Security
Security systems failed at several points leading up to 9/11 and shortly after. Airport security saw the most significant change, with very strict rules being formed and the creation of the Transportation Security Administration (TSA). Additionally, the Department of Homeland Security was formed 11 days after the attack and given a budget of $586Bn to invest in natural disaster protection and counter-terrorism tech.
Apart from virtual assistants, gesture technology, voice recognition and body scanners, this Failure’s legacy is most felt through the widespread video surveillance technology that came to light after, laying the groundwork for “Surveillance State” frameworks globally ever since.
Failure of Communication
One of the most fundamental yet simple needs in the wake of a crisis is effective communication channels, and this failed after 9/11. First responders had no way of reaching out to each other and coordinate rescue efforts because of poor telecommunications technology.
This catalysed the wireless revolution, quickly leading the world beyond simple GPRS and WAP to 2G, 3G, 4G and beyond. Further, core technologies like mesh networks, low latency wireless networks, communication protocols in the internet, VoIP, etc. sprung up as a result.
Failure of Capital Allocation
“We’re in an environment where the company doesn’t have to be successful for us to make money,” a venture capitalist at Benchmark Capital once admitted when mulling over a pre-IPO investment in Priceline, a company that epitomises the dot com era hype. With companies like Netscape making IPO returns of 100% in minutes — something that took others like General Dynamics 40+ years to do — investors took increasingly risky bets because they did not know how to evaluate businesses in this new industry that had erupted. Eventually, almost every dot com company went bust, and the NASDAQ lost 80% of its value by October 2002.
After this, investors began evaluating startup investments with much more rigour — with concepts such as burn rate analysis, profitability and unit economics becoming much more relevant. PayPal’s acquisition in 2002 along with Google’s IPO in 2004 spurred new investments in the early-stage that fuelled the private funding industry for the rest of the decade.
Failure of Entrepreneurship
An unfortunate reality of entrepreneurship is that funding follows successful ideas, and hype is frequently used as a measure of success. The glitz, glamour and financial incentives that accompany this sort of success then push entrepreneurs to also devote their talents to those ideas that are likely to bring them success faster.
This refocusing away from actual problem statements of the time — for example, security, communications tech and the robustness of the internet — gave way to online retail, social media and other “lower hanging fruits”, so to speak, and while these are now very large industries, their business case only became clear once ad-tech and internet/mobile penetration became what it did by around 2010.
Crisis 2: The Global Financial Crisis of 2008
In an unfortunate twist, just as the world was coming to terms with 9/11 and the US economy rebuilding itself, another crisis began laying down its roots, and this time, innovators and entrepreneurs were on both sides of the problem — some caused it, and others fixed it.
On June 26th, 2003, the Federal Reserve, chaired by Alan Greenspan at the time, cut short term interest rates to 1%, the lowest they had been since 1958. This was done to stimulate customer demand and encourage people to make bigger-ticket purchases that would require loans — hence also stimulating the financial and banking sectors. While this is what economic theory dictates will happen, the key decision makers here forgot to factor in how much of an impetus they were giving to one already growing sector — the housing market.
With low interest rates, Banks–who were now allowed to act more like hedge funds and execute riskier strategies because of powerful deregulation policies implemented in 1999 (more on this later)–encouraged customers to take on larger mortgages for bigger houses, sometimes engaging in what is known as predatory lending. For potential homebuyers, loan payments suddenly became much more affordable and low risk(or so they thought), and even if they couldn’t pay back, they’d be able to sell the house for a profit because of rising prices. This worked well from the banks’ perspective because even in the off-chance that a default occurred, the now more pricey house could be repossessed and the bank would be safe. As Brian Wesbury explains in his fantastic TED talk, as far as the economy was concerned, “all lights were green” on this economic highway.
In fact, as month-on-month housing price data reveals, increases of around 10+% (in annualised terms) were common during the first half of the decade, so in a loan recipient’s mind, they’re paying 1% but increasing value at, 10% per year — a 9% net return. On an annualised basis, this was a return even higher than that of the stock market at the time, creating clear incentive for the average citizen to get involved in this frenzy.
The Crash can almost perfectly be broken down into three acts, where market participants progressively found and exploited increasingly obscure loopholes in the fabric of global financial systems until, eventually, the entire system unravelled.
Act 1 — Grab a Slice
Any booming market creates the potential for profit and brings other institutions —in this case, investment banks, pension funds, corporations, mutual funds and hedge funds — into the fray.
When investment banks noticed the massive, well-protected (or so they made the world believe) pools of loans on banks’ balance sheets, they created a cocktail of sophisticated financial instruments to turn these pools and — and any others they could find — into profit. The instruments? Mortgage-backed securities (MBSs), the more general Asset-Backed Securities (ABSs), Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs). Without getting too technical, Banks, through a process called securitization, sold the rights to the loan payments to investment banks, who in turn divided up the pool of loans (including mortgages, credit card loans, auto-loans, etc.) into individual shares or securities that they could then sell to other institutions and the global investing public.
Act 2 —Get Greedy
When financing is cheap and qualification standards for loans are relaxed, riskier loan applicants with worse credit profiles suddenly manage to secure loans. These loans come with higher interest rates to compensate for the risk, and some institutions — these could be pension funds, mutual funds or even other corporations — will want to increase their returns further by allocating money to loan towards this more risky set of investors .
The catch? These companies are usually prohibited from taking on too much risk because of how important their capital is (for example, a pension fund manages large parts of people’s retirement funds, which may be their sole source of income after they stop working). The 2008 bubble was such a powerful force of hype, however, that even these funds looked for loopholes to this rule— and found them. This is where credit rating agencies (CRAs) and insurance companies come in.
Insurance companies that have suitably high ratings can stand as guarantors for the risky amounts, thereby allowing the institutions to make the risky investments. As long as actual defaults stay below the insurance company’s value-at-risk calculation (a probabilistic calculation of how much value they will lose to defaults), they assume they have the money to compensate for losses. Enter Hedge Funds, the most devious of this lot in some sense, who bet on all this going wrong instead. Hedge funds tried to identify borrowers who were very likely to default on their loans so they could then buy insurance against this happening—essentially hoping the borrower will default, so that they get the insurance payout when this happens.
One of the funny things about the [stock] market is that every time one person buys, another sells, and both think they are right.
— William Feather
At this point, as long as borrowers are paying their loan payments as planned, hedge funds pay their premiums, insurers keep their ratings, institutions get away with higher risk investments and higher risk borrowers get their loans. The base payment stream from borrowers is the single point of failure in this machine, and that stream critically depends on the interest rates that borrowers have to pay.
Act 3 — Crash
The final act in this tale began when the Fed, in an attempt to control an overheating economy, raised rates gradually from early 2003 until 2005. Because of how popular MBSs and ABSs were, however, ever-riskier loans continued to be disbursed, securitized and resold to domestic and global investors. Housing prices slowed their rate of growth, but still saw an upward trend until 2007, when interest rates had reached unsustainable levels, prompting mass defaults and sell-offs, and catalysing the crash.
When the bubble burst, housing values collapsed, securitised shares became worthless and heavy-weight insurance companies like AIG went bust overnight. Because of excessive borrowing to fuel their investments, foreign companies also saw their asset values evaporate in hours, triggering mass layoffs and cutbacks. Mutual Funds’ and individual investors’ investments and savings were eliminated equally fast, decimating livelihoods globally. Overall, $20Tn of value vanished and global economic growth dropped by 4%.
While 9/11 and the Dot Com crash were both highly technological in nature, the Financial Crash of 2008 occurred primarily because of the exploitation of loopholes in the financial system from previous policy changes (here and here for more information on these), severe failures in regulation and widespread lapses in corporate governance.
Failure of Regulation, Accountability & Transparency
Loans are a crucial piece of any economic puzzle. A healthy economy needs banks to give out loans to customers with good, verifiable credit histories, because this spurs economic activity and consumption. What shouldn’t happen is for banks to be able to find sophisticated methods of providing loans to people who would not qualify through the regular route — the sub-prime customers. Worse still, it should not be possible to then slice and dice the bad loans and transfer their risk to other market participants, including everyday citizens, who probably won’t be able to discern what the original make-up of their investments were.
When this series of events happen, the loans will have created a systemic risk in the entire economy, and if some of those participants were outside the country, this risk can spread globally. Regulators exist to keep checks on these activities, and they failed. And when they can then point the blame at poorly framed policies and get away relatively unpunished and a lot richer, belief in the entire machine fails. Widespread and long-term distrust in the banking system ensued, and mass-layoffs of qualified financial professionals along with now easy access to technology led to the FinTech boom we’ve seen in the last decade.
Regulations tightened after the crisis and two new Acts — the Dodd Frank Act & Basel 3 — were enforced to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen the banks’ transparency. This necessarily meant some individuals wouldn’t qualify for loans, leading to the JOBS Act and the birth of the P2P Lending (Kabbage, Lending Club, TransferWise) & Crowdfunding industries (Indiegogo, Kickstarter). Distrust in individual investment advisors led individuals to adopt rule-based software and systems more, opening up the market for Robo-advisory (Wealthfront, Betterment, Stash).
Mortgage Lending and Insurance Tech specifically saw widespread use of the platform- and marketplace-models to transfer power back to borrowers and help them make more informed decisions (Better, Blend, Roostify). Probably most prominent among the FinTech transformations has been companies that streamline Payments & Billing (Stripe, PayPal, GooglePay, WhatsApp Pay), the creation of Digital Wallets to hold currency assets and Cryptocurrencies, to decentralize the supply and ownership of money itself with the help of Blockchain technology. Indeed entire banking value chains have now been unbundled, and Banks themselves have now been born digital and branchless (Monzo, Revolut, Starling). To help regulators and financial services companies with compliance, RegTech (ComplyAdvantage, RailsBank, OnFido) evolved as well.
Overall, because trust, transparency, regulation and accountability failed in the Financial Crisis, the entire industry is now trending towards increasingly global, digital frameworks that depend less and less on human interaction, thereby making them less susceptible to manipulation, while becoming more convenient, accessible and cost-efficient for all.
Together, these three crises represented some of the most alarming, hopeless years in recent memory. The point of this post was not to rebrand them as positive events, but rather to drive home the idea that crises — especially when they occur at the global scale that they do today — expose all those vulnerabilities in our lives that we perhaps did not even realise were there previously. They highlight the potholes on humanity’s road to progress, and focus entrepreneurial energy like no other force we come across. It is precisely because they are so devastating that they create such change, and that is a significant realization to have. As individuals, crises of this scale are too powerful to counter alone, but as society, we’ve proven time and time again that there are those among us that can’t not try to fix them. All we need to do is understand why the world is going through what it’s going through, understand where the points of failure are, and gain hope from the fact that we’re not in this alone.
The next post brings the focus back to today’s founders and tries to establish a framework for thinking about any business model’s resilience to crisis. For existing founders reading this, the hope is that this framework will allow you to explore ways to galvanize your businesses against the threat of a crisis, and for new founders, to think about how to go about building a business so that it’s as crisis-proof as possible.
Next: Business Resilience
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