No More Bubbles

Finally, they’re talking regulation on Wall Street. And with straight – well, as straight as you can get in an election year – faces. Amazing. And, if you’re a tech investor – or start-up CEO – pretty worrisome.

Secretary of the Treasury Hank Paulson was right when he noted on Monday that the reforms he or anyone else envisions will take years to enact. But, don’t worry, there will be legislation. Anyone who thinks that investment banks, hedge funds and their cousins, private equity firms are going to somehow escape federal government scrutiny is flat wrong. Their time has come. Again.

The preferred vehicle for savings in the U.S. moved from the nice little bank down the street to the brokerage outlet on the corner about 20 years ago. And for the past 10, it’s been pretty clear to anyone who looked closely that rules about how those stock-based outfits ran their business were long over-due. The problem is that no one noticed until things went really bad. Twice.

Here in California, we got a front row seat to all this with the Internet stock bubble. The press releases said it was a period of enormous innovation during which fabulously intelligent people took massive risks with new technology and were reward in keeping with the size of that risk. That’s one way to look at the five years that minted billionaires like, well, Countrywide used to write $1 million mortgages to folks with shaky credit: By the minute.

Here’s another view: The late 1990s were a time when the investment portfolios of large institutions – colleges and universities, for instance, pension funds and charities – expanded in value as so-called average Americans put their savings into stocks (mostly via 401-K and other IRA-like plans) and as a result of good old supply-and-demand, stock prices rose. Richer than they’d ever been, these institutions put lots of money into venture capital funds. The venture capital funds spent like drunken sailors on an extended shore leave. As long as the stock market stayed up, they could reap the rewards of their investments at ridiculous rates of return – 20 and 30 times initial outlays wasn’t uncommon.

Venture capitalist – like mortgage companies – relied on investment bankers who buy and sell stock for a living to help them reap those rewards. And like mortgage brokers, the VCs laid off some risk by selling their wares to someone else, in this case, IPO stock to the public, a price much higher than what they initially paid. As long as the market headed up, up, up – again, because folks were putting money in and buying – the i-bankers were able to aggressively selling stocks of all kinds to all kinds of buyers, some less informed than they should have been.

If all this reminds you, expect for the terms of art, of the U.S. mortgage crisis – a time where anyone could get a loan because it was assumed that the price of real estate would go up, up, up – you are not alone. Everyone understands a mortgage – loan for a house – but not so many people understand the intricate financial arrangement that make today’s equity markets function. A lot of folks on Wall Street don’t understand the mathematical models used to buy and sell credit (or loans) on the street just as a lot of brokers didn’t understand what – exactly did even as they were hawking its wares to middle-aged school teachers with IRAs hoping to retire to Hawaii.

In both cases, those who profited the most were pretty left to oversee the quaility of the products they sold and – at the same time – look out for their customers.

During the stock bubble, the Securities and Exchange Commission made no bones about its inability to keep up with the number of filings it had to process, review and approve. As long as the appropriate statements about risk were included in the paperwork, the stock got sold. Something similar happened at the mortgage banks. As long as everyone signed a piece of paper saying they knew risk was involved – your mortgage rate could increase at any time – the loans got written. If there’s a difference it’s that many of those on Wall Street and in financial institutions around the world, didn’t take a lot of tech companies seriously. Too bad they didn’t feel that way about the bad mortgages that got written.

The end result of all this is going to be something that no one – particularly not tech investors here in California – likes to think about. Can you imagine a Netscape public offering – the company’s main product was given away – sponsored by a financial institution supervised by the Federal Deposit Insurance Corp.? Me neither. So get ready for a more cautious and more prudent system of underwriting risk for sale in the public stock market. From now on, the growth curves for the creation, development and sale of companies – in all industries but particularly in the tech business – are going to get longer and more moderate.

So, if you’re a Silicon Valley VC, the time to think about retiring is right about now. Maybe you should consider a career in politics.