This blog is about entrepreneurship, VC, startup ideas and more it is not about the economy. However, in this crazy times we are living in the economy affects every part of life including entrepreneurship. So I must take a sec and write about something that has been bugging me quite a bit.
There is probably 24 hours per day coverage on TV , radio about the economic crisis. Large part of that coverage is focused on “what caused the crisis”. I am shocked to see how little focus there is on the real cause ( in my opinion). Pundits blame the greed, overpaid executives, shady bankers, hedge funds, too much regulation, not enough regulation etc.
Greed may be an issue but it also causes many positives. Greed is the reason why your Starbucks coffee is fresh, why gas station is clean, why you can get a pizza in the middle of the night for 10 bucks. Try going to the DMV where there is no greed – you are lucky if your wait is under 1hr for a simple document check.
The biggest issue was (and perhaps still is ) principle – agency problems. This is a economic term but in plain English it means “you are playing with someone else’s money”. In our startup we faced this often. We had great honest employees but once in a while you get a sleazy sales guy who would find ways to beat the system and sell services below cost. He still gets commission even though the firm looses money on the sale. The problem was much bigger with the housing crisis. Lets look at the players
- The regular Joe mortgage owner – on the hook for the money – he is a principle
- The poor investor buying mortgage back securities MBS – it is his money he is on the hook – again principle
- The mortgage broker – he simply connects Joe mortgage owners with banks lending money – he is an agent
- The Lending Bank – they loan the money but then resell the mortgage to I banks – also agents
- The I bank – they buy mortgages quickly package then in MBS and resell them to the investors above – again agents
The Agents acted in their own interests
- Broker – gets commission for each loan. He doesn’t care about soundness of the loan simply chases the commission
- Bank – similar situation they know they will resell the loans so are not so concerned if they are sound
- I banker – I went to school with lots of those. There are many honest guys and gals here. But there are many who eat drink sleep their bonus. It is all about the bonus for them. That s all they care about. And guess how they get the bonus – based on how many MBS they package and sell to investors.
That is how the crisis happened. Of course there are some more complex nuances i.e there are the rating agencies and some banks did not sell all loans in MBS, but that is the gist of it.
Professor Sufi from The Chicago GSB ( booth) does great research on the principal – agency problems.
Of course solving the problem is much harder than pointing it out. VCs have done a moderately good job in solving these problems with entrepreneurs – perhaps after they found out several CEOs spending VC investments in strip bars in the dotcom boom. The VC contracts are so complicated and have several protections against bad agents. But the problem is much harder to solve in publicly held companies as shareholders ( principles) are so many, have different goals, and are hard to unite.
My guess is this crisis will bring us back to “small is good” . Investors will invest in smaller entities where it is easier to unite shareholders and where the agents are themselves shareholders. Companies with strong leader that has significant part of his/hers wealth invested in the company will be at a premium some examples Amazon, Morningstar , and maybe Microsoft if Bill comes back J , and of course the Buffet companies.
That maybe one of the few good things that comes out of the crisis.
The Idea Room 
Well, you have described it well, but what I see is you point out that the greed of the agents is to blame. Imagine they were not greedy? 🙂 Problem resolved!
And I dont think greed brought us all that good stuff – it was competitive enviroment that did.
So, yes – you have a point, but I think you need to reanalyze the main source of it.
Totally agree that some good stuff will come out of this whole mess at the end. Not very soon, but eventually it will happen. I am talking about all those entrepreneurial people who are getting new things started right now because they are out of jobs, are fed up with the current chaos or simply want to make the world a better place. I am certainly tempted to start something and I know a lot of people around me are too… Plus I feel that shortly a lot of people will just get used to the ‘crisis’ and will focus on better and bigger things instead of wasting all that valuable time reading about another company going down, perfecting and sending their resume a thousand times and thinking how to save a buck on a 6-pack when they can make 5 bucks if they didn’t think that much but took initiative instead.
Hi Theo,
nice theory and conclusion. Of course you can explain almost every single economic, and also not economic relationship with the principal-agency theory. It is one of the most important and for me very simple theories. I just want to give you support with some visualizations. Here is one link http://crisisofcredit.com/ to a site, which describes the problem or part of it very interesting.
The type of making money in the financial sector depends not only on the economy but also on the culture, where this financial market is working. In Europe i.e. Germany the savings (real, liquid money) are a huge amount of the balance sheets in the banking sector probably more then the credit site. That means the financial situation is more or should be more relaxed or stable as in the U.S. (of course not now, now everything is going down) where the financial market is overflowed with risky assets, which are not liquid any time. Also the credit lines of the citizens, the tri-ple AAA assets from not covered mortgages, the deregulation on the fi-nancial market and of hedge funds (keyword: Credit Default Swaps – CDS) and many other things are reflecting on the stability of the financial sector.
I am asking myself all the time, how can somebody rate CDS with AAA. Only state securities can be rated with AAA. That means no risk. No risk means the state. Every other type of financial instrument should be rated with less than AAA.
What is the effect now? As you can see, there is no bank that lends money to another bank and this is actually the most important function in this system. The small business can’t get also a credit from the lenders be-cause they are scared if he/she will pay it back. Many companies are bankruptcy now, because they usually use credits to produce in winter and to sell their products in the summer. One good example of this phe-nomenon is the caravan producer Knaus Ltd. http://www.knaus.de/en/topmenu/motorhomes.html who was saved by another investor.
The labor market is in extreme badly situation.
It will take some time to get back to the old “good” economy.