Startup Lessons We Should Have Learned From The Mortgage Crisis
Recently, a movie came out called “The Big Short” which delved into the US mortgage crisis in 2007. In summary, it portrays several extremely intelligent, enterprising bankers who scrutinized the numbers behind mortgage backed securities…and realized the entire industry around mortgages was a broken system waiting to implode. They were portrayed as this elite squad whose brilliant insights identified these economic blunders, and gave them a vantage point that no one else saw.
I’ll agree that these smart bankers knew how to capitalize on their insights…but, I’d contend that many people in the mortgage industry at that time, including myself and my colleagues, foresaw the collapse coming a mile away. At that time, I was a wholesale mortgage sales account executive for the largest bank in the world, Citibank…so I guess you can say I was on the front lines of the mortgage industry. And since I sold mortgages on the wholesale level (which basically means I sold a lot more volume compared to retail loan officers)…I had a pretty high vantage point from up the food chain.
So how did my peers and I anticipate a collapse would be pending? Well, it all boils down to simple economics, simple math, and common sense…cause frankly, we’re not that smart. At the time, the number 1 mortgage product we were selling was a SISA (stated income, stated asset) product, which basically means that a borrower only needed to state what monthly income they earned, and how much money they had in the bank. Normally, you’d need to prove your income and assets with documentation like pay stubs, bank statements, tax returns, etc…but not with this SISA product. The bank would just take the borrowers word for it, check their FICO credit rating, verified they had a job, and do a basic risk assessment based on what the borrower stated they earned and had in the bank.
Crazy right? As you can guess, loan officers started pushing unqualified borrowers and home buyers towards these SISA products. On a daily basis, we’d see loans for low wage laborers, like waiters, cashiers, gardeners, and such…stating they made $120k a year, and have $100k in the bank. These borrowers would fly through they mortgage system…and a month later, they’d be in their new overpriced home (real estate was at an all time high at that time) with no real way to actually pay for their new mortgage month-after-month.
The borrower’s actual monthly take home pay was probably more likely around $4000/month (not the $10k/month they claimed), and their new financial burden for home ownership was probably around $3000/month. It didn’t take a financial genius to see that these home loans were bound to fail…and that borrowers would eventually start defaulting on their monthly payments. Add to this equation neg-am loans, balloon payments, and adjustable rate mortgages…and you’ve got the perfect storm for a disaster.
Simple micro economics, simple math, and a bit of common sense. You see, the risk assessment system for home mortgages (aka underwriting) was not only supposed to protect the bank…it was supposed to protect the borrower as well. A strict underwriting system that makes borrowers prove their earnings and assets actually keeps borrowers from overextending themselves by borrowing too much. But the system failed to do this simple thing due to pure enterprise greed.
What I learned from the whole mortgage debacle is that when people are making money hand over fist…people have a high propensity to turn a blind eye to basic financial sensibility and fiscal responsibility. Even the movie pointed out the many people actually knew the fundamental faults of the system, but chose to ignore it. When you’re making insane amounts of money and responsibility can be deferred to someone later in the food chain…then from your vantage point, there’s no real reason to sound any alarms. You just figure the system will work itself out, even though you know to a high degree that borrowers will eventually face harsh financial consequences.
When the mortgage industry collapsed…our entire department at Citibank shut down overnight…we all lost our cushy account executive jobs…not one of us on the front lines seemed overly surprised.
I think my personal history with the mortgage meltdown is making me sensitive to the current financial phenomenon in the VC tech startup industry. I definitely see some parallels with how the industry persistently ignores simple business and economic fundamentals.
In my former blog post about VC math versus business fundamentals…I basically said that for me, I just can’t seem to buy into the tech industry’s intense focus on revenue vs profit. To me, just like the mortgage industry’s sin of lending money to unqualified borrowers, I think a lot of money is being poured into “unqualified” tech startups…startups who might have a lot of revenues, but are fundamentally unsound.
Theses startups are currently being qualified and valued on their revenues and growth potential…but eventually, they will invariably be judged by their profitability. A business that’s built on spending 2 dollars to earn 1 dollar just can’t exist forever. People can choose to ignore this simple fact for a while in the life of a tech company…VC’s can keep paying for the party to continue, ignoring all businesses fundamentals, greasing the wheels at every up-round…but eventually someone is going to be left holding the bag to pay for all the bills for a party that got out of hand.
The reason we don’t hear about this much is similar to what happened in the mortgage industry. When a lot of people are making insane amount of money along the way, they tend to ignore the fundamentals and not talk much about it. VC’s, with their deep pockets from institutional investors, pension funds, endowments, insurance companies, etc (sound familiar?)…can pay for the party for quite a while, and defer eventual responsibility to the public market. It’s no coincidence going public is referred to as an “exit”…a clean way to cash out and end direct responsibility.
My theory is VCs and startup tech investors can kick the can down the road for quite a while, but eventually, public markets will be more critical of the need to turn profits. And when your company DNA is built on a lifetime of spending 2 dollars to earn 1 dollar…it won’t be very easy to just “switch on” profitability mode. Eventually, this reckoning will trickle back down to affect the entire startup machine…including many startup entrepreneurs left in a wake of an implosion.
Let’s take Uber for example, the unicorn of the industry, the pinnacle of success. The last valuation headline places Uber at a whopping valuation of $62.5 billion. According to my calculation, all in, they’ve raised a little over $10.5 billion total. Their gross bookings (revenue) in the first half of 2015 was $3.63 billion, which is on target to more than double the revenue of 2014. That all sounds great right? Healthy revenue, amazing growth…more than enough reason to keep the party going and infuse more cash right?
But when you look at their net losses, it was close to $1 billion for the first half of 2015…on target to have net losses of $2 billion a year! With that amount of cash bleeding, how many more rounds can they do before someone questions if this company can turn a profit…or at least show signs of reversing losses? How long does $10 billion of investor money last when you’re losing $2 billion a year and you’ve been losing since you’ve started? I can only imagine that every year, they’re forced to raise around $2 billion of financing in order to stay alive…and this can’t go on forever.
That’s the view from the high level…now let’s go down the the micro level where my simple mind works best. So let’s say Uber now wants to stop bleeding cash and start trending towards profit. Well, one way to do it is to cut staff…quite possiblly Uber’s biggest expense. Ok, well how would that play out in the headlines? “Uber cuts 15% of staff, more to come”. Well, that doesn’t bode well right? Investors lose confidence, valuation cools, the party doesn’t look as hot anymore.
But, that’s still not enough to make a huge dent in their yearly losses. Then what about also increasing revenues by increasing fares up to some sustainable ride rates? Up till now, Uber has basically bought the market by unsustainable fare promotions and price cuts. Well, how would those headlines play out? “Uber raises fares, riders flock to Lyft”. That doesn’t bode well either. Riders would do a lot more price comparing, Uber loses market share to their competitors, and revenue could potentially go down.
Eventually, analysts would take a deep look at Uber. They’d find that despite immense growth and a killer disruptive product…at the end of the day, it’s a 20% low gross margin product, and it would be difficult to eek much more performance out of those gross margins. They’ve hired at a rabid rate, and their spending is out of control…making their path to net profitability extremely challenging due to the already razor thin margins. What kind of rating would analysts give Uber?
People praise Uber for experimenting with last mile logistics and prognosticating self-driving cars into their business model. That’s not innovation…that’s desperation.
When you spend 2 dollars to earn 1 dollar…you can sell a lot of dollars fast. When you have stake in the company…it makes sense to draw a lot of attention to the number of dollars sold. If I were Lyft…try to stay alive for several more years, stay operationally lean, focus on profitability, see how the market nets out.
In the first dot com bubble, we basically sold the public the value of eyeballs. It was a naive premise that site visitors would one day magically turn into profits. Many people laughed their way to the bank, got out at the right time, and then the industry imploded. In this round 2 tech bubble, we’re selling something that appears a bit wiser than eyeballs…we’re selling the concept of revenue. A lot of rich investors are laughing their way to the bank based on this new premise. In my layman’s opinion, it’s still the wrong thing to sell and to focus on. If we’ve learned anything from that first tech bubble, or the mortgage crisis…have we not learned that the most simple, fundamental business and economic principles can’t be ignored forever?