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SVB Silicon Valley Bank publishes a quarterly synopsis of VC investment trends. The February 2008 edition is now available. As a weekly reader of Investment Strategy Outlook, SVB Asset Management invites you to download this valuable report. (PDF, 1.51 MB)
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SVB Asset Management has recently published an overview of the strengths and weaknesses in the auction-rate securities market. We encourage you to download this valuable report. (PDF, 123 KB)
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Is the Fed Pushing on a String?
Despite 225 basis points of cuts since the Federal Reserve began cutting rates in September 2007, the impact on the economy has been negligible. As the credit market meltdown has widened, it has impacted subprime borrowers, structured investment vehicles (SIV), collateralized debt obligations (CDO), and, more recently, auction-rate securities (ARS).
As a result, a few things have happened. First, as U.S. government security yields have fallen, spreads between them and corporate debt, bank debt, jumbo mortgages, auto finance, and high-yield debt, to name a few, have soared. As a result, the overall yields on many of these asset classes have either dropped negligibly (as in the case of jumbo mortgages) or risen sharply (as in the case of high-yield debt). Second, it is increasingly not the cost of credit, which is all the Fed can indirectly (and only partially) control, but the availability that is the issue — some parts of the credit market, such as auction-rate securities, have completely seized up, with lenders wanting out and borrowers looking to refinance into fixed rate debt. With banks writing down huge amounts, they face an acute shortage of equity, which has and will hamper their ability to lend — not that many have the desire to in this current climate. Finally, the flight to quality plus the demand for short-term investments (true short-term paper, not quasi short-term paper like auction-rate securities) and the increasing demand for long-term financing from municipalities and others has combined to sharply steepen the yield curve. Higher long-term rates create an additional burden on the housing market and institutional borrowers, while lower short-term rates hurt risk-averse investors, both corporations and individuals.
Does all this mean that what the Fed did was futile and that they are in fact "pushing on a string"? Not at all, in my opinion. Imagine where long-term mortgage rates would be without the 225 basis points of cuts, or where the stock market would be. With all the head winds the economy is facing with regards to housing, a slowing labor market, and, now, consumer spending, a route in the stock market (or a sharp rise in mortgage rates) would completely shut down consumer spending, which comprises over two-thirds of the economy. Almost as important, the Fed is signaling that they are aware of the issues and are willing to take action; that has bolstered optimism somewhat and is critical, as extreme pessimism would be a self-fulfilling prophecy.
The critics of the Fed, and there are many, say the Fed is creating a "moral hazard," is promoting a bubble, fueling inflation, and devaluing the dollar. A moral hazard would be created by bailing out those who default on mortgages, many of whom were never eligible for one anyway. Lowering rates is not bailing them out; it's countering some of the headwinds created by the housing situation. The bubble we had during Mr. Greenspan's era was only partially because of low rates — it had to do with an over-abundance of credit on easy or non-existence terms. Credit is clearly far from over-abundant and borrowing rates have not fallen for most categories, as I pointed out earlier.
Inflation is a function of too much money in the system or because the velocity of money is too high. Low interest rates only fuel inflation if real rates are negative for a sustained period of time. Real rates are currently just below zero, and they will almost certainly remain in negative territory for a couple of months. However, remember that Japan had zero interest rates for many years and had deflation at the same time, caused by a very similar set of circumstances: a housing bubble, a banking and credit problem, and a declining stock market. A case can be made that we will take some time to recover from this — not the 20 years it took Japan, but not the V-shaped recovery many are hoping for either. Finally, the type of inflation that is concerning is structural inflation caused by higher wage settlements and widespread increases in the prices of finished goods. Inflation is clearly higher, but most of the increases are exogenous to the system and beyond the Fed's control. That does not mean they should remain unconcerned about inflation; it does mean their primary concern in the near-term is (rightly) preventing a recession and not being overly focused on the recent rise in food and energy prices.
Finally, the dollar — yes, lowering rates has and will cause it to fall — why is that a bad thing, at a time when one of the few bright spots in the economy is our improving trade deficit, caused almost entirely by a falling dollar? The Treasury has talked up the dollar officially for years; no one has ever believed the rhetoric. The dollar is Treasury's concern, not the Fed's — clearly no one really cares as long as it is not in a dramatic free fall.
The solution to the current credit situation will take time, full disclosure, more write-downs, more capital infusions, and the shutting down of structures like SIVs and ARSs that promote long-term investments funded by short-term borrowing. In my opinion, the Fed's actions, in hindsight, will help prevent a really sharp economic contraction — a long recession. Mr. Bernanke has shown that he is not an incrementalist, like his predecessor; there is every reason to believe rates will be raised more sharply as well when the time comes. By front-loading the easing, they demonstrate they are ahead of the curve, can complete their cycle by this summer, and get out of the way long before the elections, to avoid any impression of political maneuvering.
— Dave Bhagat, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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Slower Growth for U.S. Telecom
The U.S. telecommunications industry will grow at a slower rate than the global industry through 2011 at an annual rate of 7.2 percent to $1.3 trillion, compared with a rate of 10 percent for the rest of the world. The strongest global growth is expected in the Asia-Pacific region, followed by the Middle East, Africa, and Latin America. According to a study by the Telecommunications Industry Association, short-term U.S. growth will be fueled by spending on network upgrades and a government spectrum auction. (Reuters)
Push for Wireless Patent Reform
At the recent Mobile World Congress, Broadcom CEO Scott McGregor remarked that patent regulation in the U.S. is ripe for change due to the burgeoning number of patent lawsuits related to the wireless industry. "Patent enforcement has gone too far. It's time to see an adjustment in roll-forward royalties, where people have a business model predicated on charging royalties several times on the same component," said McGregor. To save the expense of paying royalties on existing U.S. technology, many believe Chinese companies will develop their own 3G technology and push it into the infrastructure at a low cost that Western companies won't be able to match. (NewsWireless.Net)
Powering Remote Mobile Stations
The rising price of oil is pushing mobile operators to use alternative energies to power remote cellular base stations. In locations like India and Africa, facilities usually get their power from diesel generators, but fuel can account for as much as two-thirds of station operating costs in addition to the expense of trucking diesel. As a result, equipment suppliers are preparing to roll out alternative energy technology in significant numbers. Two Asian network operators will shortly announce plans for more than 500 new base stations powered by a combination of sun and wind. (BusinessWeek)
Silicon Valley = Solar Valley
With its expertise in miniaturization and thirst for innovation, Silicon Valley entrepreneurs are determined to make solar power a ubiquitous source of energy for the masses. One novel approach is "solar thermal," which uses large mirrors to generate steam to run conventional turbines that generate electricity. Another exciting area is thin-film solar, in which cells are created in a similar way that memory is created on hard-disk drives — allowing the nascent industry to tap into the valley's expertise. (New York Times)
Election Year Biotech Push
Before election-year politics shift Washington away from biotech's interests, biotech companies are pushing for a law that lets generic drug companies sell cheaper copies of their medicines. The U.S. currently spends $40 billion per year on biotech drugs. With those costs expected to rise, generic biotech could prove an attractive cost saver for future administrations. Getting legislation to the president's desk won't happen until companies and Congress can hammer out disagreements on when and how generic copies of biotech drugs are approved. (AP)
VCs Adapt to Emerging Markets
Venture capitalists investing in emerging markets should adjust their strategy from focusing on tech investments to seeking out "emerging middle class" and "infrastructure catch-up" plays, such as Bessemer's investment in a construction and engineering services company. Although such fundings may not fit the standard investment in disruptive technology, they still meet VCs' risk-versus-reward criteria.
Unlike in the U.S., companies in India are rarely focusing all of their attention on delivery of one product — one might invest in a solar panel company and later find out that they are also making LED bulbs. (VentureWire)
Valuation Correction
Valuations of start-up companies in 2007 dropped for the first time in several years, suggesting that a correction may be in the works amid an economic slowdown. The median pre-money valuation for start-ups was $16 million, down from $18 million in 2006, according to VentureSource. Several investors said that some sectors such as Web 2.0 and clean technology remain overheated, and the downturn in valuations is more of a natural correction than a sign of impending doom. (VentureWire)
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February 25, 2008
In Search of the Subprime Borrower
Years ago after trying to characterize the behavior of private airplane purchasers so that we could securitize a portfolio of airplane loans for Raytheon, we reached the conclusion that there was no such thing as an average airplane owner, except to say that they were more eccentric than the general population and took bigger risks. In terms of predicting when they would default or refinance their loans, there was no obvious pattern. Without that understanding, it was impossible to predict the cash flows from the loans at which point our securitization deal died. That analysis was pretty standard fare in the 1980s.
So it's more than a little surprising that there was no similar analysis for subprime securitizations. One source told us that research on one securitization structure determined that 60 percent were based on false applications. Of course, these loans were no-doc or low-doc, and there was typically no income verification. So, did people accept up to a 200 bps higher rate simply to avoid the hassle of filling out a bunch of forms or did they intend to be dishonest on the applications? Psychological studies imply that the propensity to lie is in proportion to the perceived benefit and inversely proportional to the probability that someone will be checking the facts. As we think about the demographics of subprime borrowers, they are most likely members of Generation X, aged 27 to 47. According to a speech given by the CEO of Inspirion Inc., Misti Burmeister, to the APPA 2007 annual meeting, (Association of Physical Plant Administrators), about intergenerational communications, Generation Xers exhibit these characteristics: "unintimidated by authority, impatient, inexperienced and cynical." That profile does not bode well for loan portfolio performance, but, then, with so little hard data, it’s difficult to draw any formal conclusions.
The Economist had a piece last week which reported on two studies looking at default experience as related to mortgage securitization. They found that neighborhoods that had most of their loans securitized showed "increased credit supply, faster house-price growth, and rising default rates" compared to areas where securitization was less frequent. So now we have statistical evidence of this unholy alliance between lenders (or securitizes) and borrowers. Borrowers were given the opportunity (even encouraged) to lie and cheat, and so they did. Now that they are in these homes, what do they do next?
In 2006, Ronel Elul, an economist at the Philadelphia Fed published a paper, "Residential Mortgage Default," in which he examined that propensity to default. His concept was that a mortgage borrower had essentially bought a put option from the lenders. 
Source: Philadephia FRB
As the market price of the home declines, the option increases in value. As depicted in the nearby chart, when loan-to-value is close to one, there is a propensity to exercise the put (i.e., put the house to the lender). The gain for the borrower is the difference between the house value and the loan (negative equity) when the loan is expunged. Caught in the wicked crossruff of dropping home prices and higher interest rates, Gen X homeowners should be defaulting in droves. According to a Web site that gives advice to people that want to exercise their put (www.youwalkaway.com), 2.9 million homes foreclosed in the last three years.
So, there are some interesting policy questions here. How much government support should be provided to borrowers who submitted false loan applications or over extended speculators? The bigger picture is the application of a classic case of moral hazard. That is, the incentive to take increased risks if there are no consequences or, in the world of finance, if the consequences can be delivered to someone else's doorstep. In this odd case, both borrower and lender are incited by that moral hazard. Today, it seems the homeowners are taking a page from Wall Street's play book. They are walking away.
Fed in a Box
The bond market jumped after reading the tale of woe contained in the minutes of the last FOMC meeting. The euphoria quickly faded, however, when the Consumer Price Index hit the screens rising a brisk 4.3 percent. We are now seeing a dangerous pattern. Each successive bubble is bringing inflation to a higher level. With the "commodities bubble" now being inflated, CPI could rise to the 5 to 6 percent range by the end of 2009 to 2010. Despite moving up nine bps to 2.49 percent, the April 30 Fed Funds still expects a 50 bps easing.
This points to the core dilemma for the Fed — the need to ease to help refinancing homeowners — then quickly get rates back to normal to dampen inflationary expectations. The mix in price movements is really odd; housing rents and prices are falling, as is almost anything manufactured, while food and energy continue to climb quickly. When will the Fed u-turn occur? Possibly by the end of 2008, which coincides with the completion of the bulk of the ARM refis. But can the Fed really move rates up quickly in the face of an emerging recovery? Can they tighten 125 bps in 10 days in the reverse of their actions last month? It seems unlikely, but we may learn more during Chairman Bernanke's Humphrey-Hawkins testimony to Congress later this week.
End Note
Cuban strongman and the longest surviving despot of totalitarian communism, Fidel Castro, stepped down last week. Lawmakers elected his brother Raul as new head of state. We're not certain, but we think Raul ran unopposed. When Castro took over in a 1959 putsch, Cuba had the fourth highest per capita GDP in Latin America. After almost 50 years of hysterical, economic mismanagement, the place is essentially destitute. Drowning the capitalist and entrepreneurial flair of the population for three generations, and having lost their sugar Daddy in the Soviet Union in 1991, Cuba has resorted to renting out its teachers, doctors, and soldiers to other countries to earn the hard currency needed to keep the government afloat. The key question now is whether Raul will continue the failed policies of the past or will he allow some measure of economic freedom to wake Cuba from her long nightmare.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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Dallas Fed Chief Says Businesses See Inflation
Dallas Fed President Richard Fisher said the top business executives he regularly talks to are worried about inflation, and that rising prices are cutting into their profit margins. Fisher said the Fed was in the "horns of a dilemma": trying to keep the economy from falling into a recession while at the same time not "stirring the embers of inflation." Fisher made a splash at the first meeting late last month by voting against the Fed's half-point rate cut. Fisher said the inflation pressures appear to be outside the control of U.S. monetary policymakers. (MarketWatch)
News Flash: Existing Home Sales Fell
Sales of existing homes in the U.S. fell last month to the lowest level in at least nine years, signaling the housing slump is deepening. Mounting foreclosures are adding to a glut of unsold homes that is driving down property values. Would-be homebuyers may be waiting for even lower prices, keeping the housing market depressed for a third year and dragging the economy close to a recession. Elevated inventories are driving down prices and causing some potential buyers to stay on the sideline to see if prices will go down further. (Bloomberg)
Recession Odds Going Up
The proportion of economists who forecast a U.S. recession this year more than doubled in three months, to 45 percent, according to a survey by the National Association for Business Economics. Of those, a majority expect the downturn to be "relatively muted," according to the poll of 49 professional forecasters taken Jan. 25 to Feb. 13. Less than 20 percent predicted a downturn in the previous poll completed Nov. 6. (Bloomberg)
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FDIC Chief Sees More Subprime 'Pain' to Come
Asking for stronger rules to protect homeowners, Sheila Bair, the chairman of the Federal Deposit Insurance Corp., said last week she expects "continued pain" as the market grapples with subprime mortgages. The FDIC Chairman said there needs to be an enforceable standard requiring lenders to determine if a borrower has the ability to repay and an end to compensation schemes that give mortgage brokers incentives to steer borrowers into high-rate products. Almost 8.8 million homeowners (or 10.3 percent of the total) owe more on their homes than they are worth, the New York Times reported, the most since the Great Depression. (MarketWatch)
Auction-rate Securities Carrying 'Predatory' Yields
Municipalies across the country may face a third week of higher interest costs as failures in the auction-rate bond market continue to roll. An estimated $45 billion in auctions run by banks failed last week. Even some successful auctions resulted in rates that were twice what borrowers paid in January, as investors who submitted bids demanded higher yields. "The market right now is very predatory," said Marcia Maurer, CFO of the Sacramento Regional County Sanitation District. The agency's weekly expense on $250 million of debt more than doubled to $343,000 from last month. (Bloomberg)
Treasury 2-Year Notes: Nowhere to Run
Treasury 2-year notes are about to become the next casualty of Federal Reserve Chairman Ben S. Bernanke's interest-rate cutting campaign. The securities are the only U.S. government debt to make money for investors since the Fed lowered borrowing costs between policy meetings on Jan. 22. That's especially true after the Labor Dept. said inflation is accelerating at the fastest pace since March. 2-year Treasuries currently offer yields almost one percentage point less than the federal funds rate but have averaged yields a half-point higher since 1981. (Bloomberg)
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