Saturday, December 27, 2008

Venture Capital Trends: By Stage, Round, & Industry

In March, I noted that venture capital is moving "up the ladder" - more money was flowing into latter stage investments, with only about 10% of VC deals going to start-up stage investment (as compared to 25% in 1995).

In August, I examined venture capital investments by financing round which revealed that Series E round financing is on the rise which augments this earlier observation. Extending the March data through the end of Q3 2008 shows no real change - venture capital continues to flow into later stage rounds.

(click on the chart to enlarge)

However, there is a case for the "stability" of the Early Stage round trends. In their Fall 2008 recent report - "The Entrepreneurs Report," Wilson, Sonsini, Goodrich, & Sonsati (WSGR) stated that "this stability is one of the key indicators of the continuing rate of innovation in the sector, and clearly a positive sign in the face of the ongoing economic turmoil impacting world markets." (More on this at the end of these trend charts.)

Extending this analysis with the latest data from PWCMoney Tree, I examined venture capital investments by industry since 1995 to see if there were any structural changes of the industries receiving funding. Here is a summary of the data. (Note: Percentages measured in terms of total dollars invested.)

1. Hardware/Telecommunications: This industry grouping shows a clear downward trend in hardware-related industries since 2001.

This isn't terribly surprising, as many of the operational functions are moving from heavy equipment to cloud computing solutions.

2. Biotech/Medical/Energy: This industry grouping shows a clear upward spike in Biotechnology early in the decade (though waning a bit lately), a lagged spike in Industrial/Energy (reflecting the demand influence of clean and renewable energy technology), and a consistent rise in Medical Devices (maybe because more people are getting older and we're generally less healthy?).

Again referring to the WSGR report - "Early-stage companies are particularly well positioned to successfully respond to the challenges posed by future climate legislation." Further, the National Venture Capital Association released the results of a recent survey conducted from November 24 - December 12, 2008 and includes the predictions of more than 400 venture capitalists from across the United States. In a summary of this survey prepared by VCExperts - "clean technology is viewed by the highest percentage of respondents as potentially growing in 2009 with 48 percent predicting increased investment and 20 percent predicting unchanged investment."

3. Software, Financial Services, and Media/Entertainment: I grouped these together because of the movement towards cloud computing and the ongoing convergence of media and software applications in places like Facebook. No major changes in this group which was a bit surprising. With the influx of angel capital in recent years and the lower start-up costs required for software-related companies, I expected venture capital investment dollars to have declined, which is indeed falling steadily in the Software industry.

Overall, the consensus for the 2009 venture capital industry isn't terribly positive. The aforementioned NVCA survey reveals that 92% of VCs expect a downturn in 2009. The Fall release of the University of San Francisco Venture Capital Confidence Index reflects these sentiments as well.

While a general economic slowdown is an easy scapegoat for the negative outlook, Michael Malone wrote an outstanding piece in the Wall Street Journal - "Washington is Killing Silicon Valley." Malone's opinion article clearly describes the elephant in the room when it comes to innovation and technology - heavy regulation places a long-term management cost when start-ups seek their IPOs. These projected costs outweigh the risk-adjusted benefits to new business ventures. Maybe there's a reason we're seeing the trends outlined above.


Monday, December 22, 2008

A Case for Higher Interest Rates & Lower Home Prices

(Author's Note: This article was also published on Seeking Alpha on December 25.)

With the continual prodding by many to initiate 4.5% mortgage rates to pacify the current housing market glut, it's important to distinguish the effects based on two categories of buyers:

1. Existing mortgage refinancing
2. Home Purchase Mortgages

Fundamentally, the problem with this policy is that it is likely to have a minimal effect on latter category. Saskia Scholtes wrote about this in "Mortgage activity surges at US banks" -
With average rates for a 30-year, fixed-rate mortgage now at about 5.2 per cent, growing numbers of borrowers have an incentive to refinance to bring down their mortgage costs.

But tighter underwriting standards for prospective borrowers, combined with funding and staffing difficulties for mortgage originators, are likely to restrict the supply of new mortgages.
It's clear that rates falling to 4.5% would stimulate mortgage refinancing, but not new mortgage approvals. Everyone from my father-in-the-law to our data clients at Altos Research have consistently pointed out the merits of such action. If you're paying 6% or even 5.5%, if would naturally be in your personal financial interest in the long run to refinance to a lower rate.

However, Scholtes' article indicates exactly what I've been piny about - that lowering mortgage rates will not significantly stimulate housing demand. Here's an example of what I mean:

What if we kept mortgage rates at 5.5% to compensate lenders for lending risk, but awaited a continued aggregate home price decline?

Using, I ran the numbers based on a $300,000 home price and a $240,000 loan (though I'm not sure someone buying a $300,000 house will have $60,000 to put down to cover the 20% down payment requirement, but this is an experiment...).

At a 5.5% rate, the monthly payments are $1,712.69. At a 4.5% rate, the monthly payments fall by $146.65 to $1,566.04. The move from 5.5% to 4.5% is a drop of 18%.

Now what if home prices fell 18% from $300,000 to $246,000 (a decrease of $54,000) but mortgage rates stayed at 5.5%? Assuming the same 20% down payment, the loan amount would be $196,800 for a home priced at $246,000 and the monthly mortgage payment would be $1,404.41 - a drop in the monthly payments of $308.28. Which would stimulate demand more - lowering the monthly payments by $146 or $308? Lower mortgage rates will lead to lower housing prices as viewed by the buyer (in terms of monthly payments), but not by as much as lower home prices.

Yes, I realize that this is blasphemy because I'm advocating unchanged mortgage rates and a continued fall in home prices. However, the net gain is that lenders can to more borrowers at the higher rate. Why? Because the extra 1.0% offers a risk premium to lenders that will enable lenders to account for the riskiness of the buyers (we don't pay our bills here in America), thus increasing the number of buyers that would quality for approval. Additionally, a decrease in home prices would lower the income requirements for approval for buyers of this same risk profile. At a lower interest rate (say 4.5%), lenders will be forced to maintain stringent mortgage approval guidelines and the lower rates would have less effect on a buyer's monthly mortgage payments.

Remember - it was cheap money to unqualified buyers that bears considerable responsibility for the housing price mess in the first place.

The counter to this argument is simple - if home prices continual to fall, the number of "walkaways" will increase because more current home owners will be under water in their existing mortgages. This brings us back to why advocates of the 4.5% mortgage rates feel this is a viable proposal to solve the housing problem - these homeowners will be more likely to refinance than walk away. I'm not so sure about that. Using same figures above, will a homeowner that's avoiding the $1712 payment above suddenly begin making payments if at $1566? Probably not. Check out the latest data on loan modification application-to-approval rates with the number of interest-only loans creating first and second-lien situations.


Friday, December 19, 2008

More on 4.5% Mortgage Rates

Came across this article on - "Against Lower Mortgage Rates."  The author, Felix Salmon, presents some good analysis, digging into Hubbard & Mayer's oped piece in the Wall Street Journal this week and using some of their own research to build a case against the proposed 4.5% mortgage rate.


Thursday, December 18, 2008

4.5% Mortgage Rates & Housing Demand

Earlier this week, I suggested lower price levels would spur housing demand far more than lower mortgage rates.  Using John Taylor's position that the Federal Funds Target rate was below the levels recommended by the Taylor Rule, it would appear that cheaper money led to the current housing glut but my conjecture is that cheaper mortgages in today's environment will have only a marginal effect on overall housing absorption.

In today's Wall Street Journal, Glenn Hubbard disagrees (not necessarily with me of course) -  but siding with the recommendation of the newly proposed 4.5% standard mortgage rate for homebuyers.   (What's even more interesting is that this proposed plan hasn't really been proposed and is purely rumor according to Treasury Secretary Hank Paulson.)

Hubbard argues:

Moreover, a 4.5% mortgage rate will raise housing demand significantly. A simple forecast can be obtained by applying the 2003-2004 homeownership rates to 2007 households. We use the 2003-2004 home ownership rates because those were the years of the lowest previous mortgage rates (the average mortgage rate was 5.8%).

Hubbard, Taylor, and Paulson know far more about economics, finance, and the housing market that I ever will.  However, applying some very basic financial and economic principles to this case:

1. Past performance is no guarantee of future results.
2. Mortgage rates (and all interest rates) should directly reflect the risk profile of the borrower.
3. If mortgage rates are set at 4.5%, this would implicate that all borrowers fall into a low-risk profile category, as rates at 4.5% are close to historical lows and represent less than a 1% real rate of return for lenders after accounting for inflation (estimated at 3.66% as of October).

There has not been a fundamental shift in the population of buyers in the market.  That is, in aggregate, today's buyer population is not constituted of a fundamentally lower risk profile set. We can probably assume that buyers today pretty much have the same characteristics of buyers in the period from 2003-2007.  As such, providing mortgages at a price lower than a large chunk of buyer risk profiles would dictate would seems to only elongate the current housing glut since offering mortgages at 4.5% would enable those not truly lendable to receive mortgage approvals.  
One might immediately argue that there are tougher lending requirements now, so the lower mortgage rates would not necessitate irresponsible lending practices as seen in the previous business cycle.  However, with the Federal Funds Rate near 0%, banks are in a position to take more risk and provide money supply to those seeking it, which is what the Federal Reserve wants to happen to prompt economic activity.  See the circular logic here?

One could argue that because price levels are lower (and perhaps exhibiting deflationary characteristics), houses are more affordable to today's population of buyers and thus is creating demand.   If that's the case, will dropping mortgage rates from 5.5% to 4.5% really have an impact, or is it the change in price levels that will spur housing activity?  As argued in my previous article, it seems that lower home price levels will have a bigger impact.


Sunday, December 14, 2008

The Taylor Rule & The US Housing Market

(Author's note: This article was published on Seeking Alpha on December 26.)

I received a link to this article on Twitter from Paul Kedrosky, author of Infectious Greed, on John Taylor’s criticism of the Federal Reserve’s recent monetary policy. I was drawn to the post because of the chatter that I hear from residential mortgage brokers applauding cheaper money (a.k.a. lower interest rates) -- their belief that sub-5% mortgage rates will spur housing demand. (Much more on this shortly...)

The article described Taylor’s criticism as published in his most recent paper. This is particularly poignant because this criticism comes from John Taylor of the Taylor Rule.

The Taylor Rule is a simple rule for determining the federal funds rate:

Nominal Rate = Inflation + 2.0 + 0.5(Inflation – 2.0) – 0.5(GDP gap)

Using the Taylor Rule, the current federal funds rate would be calculated at approximately 4.5% (assuming that a natural rate of GDP growth is 3.5%, with inflation calculated in October 2008 at 3.66% and current GDP growth at -0.5%).

With current rates well under 2% and looking at a historical graph of the Federal Funds Rate since 2000, we are still well below the level estimated by the Taylor Rule and have been for several years, thus the reason for Taylor's scorn.

Going back even further to the 1990's, we see that that Federal Funds Rate more closely followed the Taylor Rule recommendation:

(Source: Gregory Mankiw's "Macroeconomics" 4th edition)

It was the Federal Reserve's policy starting in 2001 that irked Taylor, to put it lightly. More so, The Federal Reserve has been dropping it's target Federal Funds rate lately in an effort to combat recessionary pressures. This has perceived implications in the real estate industry by many mortgage brokers out there, as mentioned above.

Here's the catch - the demand for money in the housing market is probably not the problem right now, because the aggregated buyer demand will not change unless lending requirements change at the current price levels. There are a fixed number of buyers in the market to which lenders will approve and make loans. Lenders are offering few indications that they will be loosening lending requirements in the near future, and so we can't expect new buyers to enter the market simply with cheaper money available.

However, there are buyers at lower home price levels that would qualify for a loan if the overall price of homes were lower. For example, assume that there is a fixed supply of homes on the market (say 1,000,000 homes) and assume that all of these homes were all priced at $250,000. There are a certain number of buyers that are willing and able to buy a home at this price (meaning that they are actually receiving loan approvals), but given the surplus of inventory on the market, it appears that the number of buyers is below our assumed supply of 1,000,000 homes.

Now, if the price of these 1,000,000 homes for sale dropped to $200,000, then basic economics tell us that more buyers become willing and able to buy homes. That is, some buyers that would not be approved to purchase a $250,000 home would be approved to buy a $200,000 home, simply because income requirements are lower for the buyer at the lower home price. The profile of the buyer doesn't change for the lender under their stricter lending requirements - strong credit scores and meeting income level requirements - there's just more buyers when home prices drop overall.

The cheaper money will decrease the final price of homes to the eventual buyers, even if the actual sold price of homes does not change. This is because the lower interest rates will result in a lower long term mortgage payment. As many Realtors have told their buyer clients - the final price of the home matters far less to you monthly than does the monthly payments that you will be making for the next 30 years. That said, lowering interest rates to make money less expensive won’t spur housing demand in a drastic way.

This would indicate that the fundamental issue in the housing market is total quantity of homes demanded from qualified buyers as determined by the money suppliers – banks and lenders. Only buyers that will be approved are part of the buyer pool, the rest are just lookers. With more stringent (and responsible) lending requirements, the question is whether the true number of buyers in the market is numerous enough to purchase the existing supply. Given that suppliers (home sellers) are continuing to drop their prices, it would appear that the real number of qualified buyers are less that required for the housing market to find equilibrium.

Here's an illustration of this example, courtesy of my AltosXplorer application from Altos Research (shameless plug):

This graph illustrates the point of fixed supply and declining prices. Using a 90-day rolling average value for both Median Price and Inventory, we can see that Inventory has mostly leveled off since the end of 2007, but prices are still falling at a constant rate. There's just no buyers for the homes on the market at the price levels. As such, the suppliers (home sellers) are adjusting their price until they will reach a clearing price where willing, able, and funding-approved buyers will enter the market and begin purchasing homes.

To bring this back to John Taylor and his target for the Federal Funds rate - the problem with the housing market will likely not be improved with a decrease of interest rates, and cheap money bears considerable responsible for the housing price mess. Instead, long-term relief has better prospects with lower price levels that will clear the market.

Just one man's perspective.


Thursday, December 11, 2008

Update: Project Einstein now "His Catalog"

Back in the Spring, I met the guys at Project Einstein at the University of San Francisco Business Plan Competition. They are on the move!

They are now His Catalog. Check 'em out for the holidays! Great to see new companies with solid concepts continue to grow. I like their blog as well - lots of interesting articles and tips.

If you want to follow these guys in the social media world:

Twitter: @hiscatalog
Facebook: His Catalog by Project Einstein

Happy shopping!


Wednesday, December 10, 2008

Revisting Twitterer vs Googler User Valuations

Last week, I wrote did some quick math comparing the value of Twitterers relative to the value of Googlers. My initial thoughts were that Googlers were far more valuable - that the relative value of Twitterers based on the $500 mln offer from Facebook was an extreme valuation. Now I'm not completely sure.

After posting the article, I was playing on my Twitter feed and found a particularly good patch of tweets and posts by Twitterers I'm following. I'm fairly persnickity about who I follow - if I don't find the tweets useful from a business or personal interest standpoint, I'm quick to cut the cord and "unfollow" someone on Twitter.

During this run of interesting Twitter posts, I got to thinking how I was using Twitter as a personal scouting network for information I find useful and interesting - others are sifting through the morass of information throughout the web to pull out relevant content that they find interesting and useful, and in turn, are posting so that other like-minded people can benefit. I do the same for those following me on Twitter. Felt awfully efficient.

Then, I saw a tweet from @Jim Duncan

"Wondering if Twitter could be more useful than Google"

And this morning, I read Nick Bilton's article on O'Reilly Media - "The Twitter Gold Mine & Beating Google to the Semantic Web."

I'm not vain enough to think that I was the first to consider that Twitter could be valued on par or above that of Google, but there was a certain comfort in seeing others were thinking the same way. I'm still not sure what the structure of my thoughts are on this issue and how Twitter would supercede Google from a user valuation standpoint. Even Twitter hasn't publicly announced a revenue model for itselt, but there's something here...