D.F.A., or, Please Do, #2
D.F.A., or, Please Do, #2
Why we don't invest in blockchain-related mortgage products, 415 Records and what founders can do if they're hitting sales roadbumps
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Why We Don’t Invest In Most Crypto Use Cases:
I read the newsletters of many other VCs and Packy McCormick’s newsletter is one of my favorites. His August 8 issue contained a thorough review of his appearance on the podcast Cartoon Avatars where he discussed bringing mortgages on the blockchain. His key question was “Is it impossible to improve real-world financial markets by bringing real-world assets (RWA) on-chain?”
A lot of people ask me why I don’t invest heavily in crypto or blockchain. I have made a couple of bets in the space, like Hyperspace. I will look into crypto/blockchain/web3 investments, but only if they overlap with an area I’m very knowledgeable about, like telephony/telecom or hardware.
Also, I’ll do this when I feel the company creates value for employees, customers and shareholders on a relatively short time frame, like 5-6 years or less. Any company that does not do that, to me, is creating too high of an externality for me to get involved, as a steward of capital.
McCormick’s description of how securitization works is well done. The inefficiencies he describes are real. But, I’m skeptical whether the blockchain will contribute anything to reducing basis points (BPS) in this industry. The devil is in the details. Here’s why:
Every industry has reasons for why it exists the way it does, and funny enough, the American mortgage market evolved in parallel with what we know of modern investing. Just as Graham and Dodd’s Security Analysis was published in 1934, when the modern mortgage industry began in the early 1930s, only about 40% of families owned their homes. Today that number is at about 65.5%, 63% higher than nearly 90 years ago.
When you’re reviewing why industries evolve the way they do, you have to be super careful about removing steps that serve the interest of all stakeholders in the long run.
I know it’s not very punk rock but I f**king love french fries. Let’s start with an analogy to a far simpler business - distributing french fries.
Getting french fries into the mouths of consumers isn’t super-simple. The only reason I know about this stuff is because I have a buddy who’s a former hedge fund manager and a logistics manager. What the heck do I know, I was promoting punk shows until 1999, and selling computers until 2002. It probably seems "inefficient" to have french fries move through so many steps:
food manufacturer
public warehouse (as pallets)
distributor (as pallets)
grocery store warehouse (as cases)
grocery store walk-in freezer (as cases)
grocery store freezer aisle (as sorted individual units)
consumer shopping carts (as a collection of different individual units)
You might think, "Gee, let's skip some of these steps" and make a model that goes direct-to-consumer, Warby Parker style, sorta like this:
food manufacturer
local warehouse walk-in freezer(as pallets)
trucked direct to consumer homes (as a collection of different individual units)
So, back in ‘96, Webvan, along with HomeGrocer and a host of other online retailers launched. By 2001, nearly all were out of business. Webvan, which acquired HomeGrocer, blew over $800M in 3 years. Numerous Bay Area college students of smaller stature have spent many nights sleeping in defunct Webvan storage bins. Just ask around.
There was one really weird thing about Webvan. The big-name executives had zero food industry experience, and they moved to roll out nationally immediately. From everything I’ve seen in modular expansion (a la Uber, etc.), that’s unusual. This was bound to fail because the highest expense of a direct-to-consumer (DTC) food delivery business is, what they call the most difficult part of telecom or effective public transit: “the last mile”. It’s the door-to-door delivery expense.
The only way to make delivering french fries work is to have extremely dense routes (like delivering to, say, 25% of the people living on a single block). Since dozens of Webvan-type services started at the same time, density was super-low. It was impossible to charge high delivery fees to offset the low density.
It’s no big surprise that Webvan CEO George Shaheen’s next gig was running Siebel, overseeing the company’s sale to Oracle. There was one other thing that might have kept Shaheen off of Business Insider’s list of the 15 Worst CEOs in American History - had Webvan attempted to deliver the groceries from stores already right near customer’s homes, they’d have much of the infrastructure already in place to deal with food.
Then again…
If I’d have been a founder right out of college, in ‘99, I’d have gone after 3 things:
A market where nobody was competing
Really high density (i.e. assisted living facilities, Apartment complexes)
End consumers who are willing and able to pay a PREMIUM fee (think about Uber’s first 100k customers)
This would have made this type of venture possible in 1996-2009, and not only in 2009-2011, which was when many of these types of companies really began to take off. But there are so many tiny little details that aren’t spoke to, like:
How do we store the frozen french fries, so they don't go bad?
How do we process returns?
How to set up the french fry warehouse for efficient picking?
French fry distribution is way simpler than many other industries. It’s way simpler than mortgage securitization. If you don’t believe me, I know a guy who distributes french fries, and we can have him argue with your mortgage people.
If I was trying to disintermediate parts of the mortgage securitization business, I wouldn’t do it without learning the current industry structure super, super thoroughly. I’d want to understand all the minute details of what all these supposedly “extra” parties involved are doing. Because there may be reasons for them that are not super obvious at first glance.
I would want answers to many different questions, some of which didn't arise until I sleuthed out my investigation. Just a few high-level questions for my would-be mortgage industry detectives:
How do we prevent mortgage fraud in the current model and how will it be prevented in the new model?
How are individual mortgages selected for the appropriate tranche in both current and new models?
Is the way in which mortgage loans are originated going to be different between the new and existing models?
If so, how?
In what ways will loan quality be impacted?
What is the regulatory scrutiny like in the existing model, and what will it be like in the new model?
What is the role of ratings agencies in the existing vs the new model?
And here’s the whopper, and the main reason I’m not taking meetings with founders in blockchain mortgage banking:
“What exactly does the blockchain have to do with any of this?”
What does it offer that allows for disintermediation that can’t be done within the existing financial system?
The blockchain offers a central ledger. We can see how that can reduce the number of parties involved - clear enough.
But why can’t the existing financial system have a central ledger? Doesn’t it already exist, in the form of a central ledger for consumer credit (i.e.the big 3 consumer credit bureaus). I’m not saying that they’re awesome, or that they don’t have massive consumer data breaches roughly every 36 months, but they do seem to exist.
Why couldn't somebody create a central ledger relevant to mortgage securitization such as individual home tracking?
I recently heard that the Blockchain is a technology in search of use case. Most of the existing ways it’s being used are trying to do the same things as parts of the existing financial system, but worse. Bruce Schneier, a lecturer at Harvard’s Kennedy School, has written extensively about this.
So has Nicholas Weaver. (This is a really interesting talk, very straightforward.)
Avoiding regulation was supposed be one of the great things about cryptocurrency. But was it? In the past half year, all sorts of fraud issues within the cryptocurrency system have come to light, and there are likely more coming, making crypto far more volatile than government regulated currency. Regulation serves a useful function and avoiding it is just a recipe for attracting bad actors. (For perspective - there were $680M in reported crypto fraud losses per FTC in 2021, and $329M in Q1 ‘22 alone).
Blockchains, simply put, are a form of databases. Databases are stored centrally, it’s possible to have decentralized databases - computer professionals called them "distributed databases." Blockchain is a way to implement a distributed database.
No matter how many articles I read about the benefits of the blockchain, I’m puzzled as to why distributed databases are awesome. Maybe they overcome a limitation or two of centralized databases, but they create many other problems. The biggest one is the greater difficulty of controlling fraud. It’s possible this means it’s creating more problems than it’s solving.
There’s one of two things going on here, and you may need to pick which camp you’re in:
In technology, when something complicated comes along, because most people don't understand it very well, they simply listen to those spinning a story around the complicated technology and if the story sounds good, they're in. They do this, even if, upon closer scrutiny, the story makes no sense.
It could be I'm simply not intelligent enough to understand the benefits of the Blockchain and I'm totally wrong about it. Or maybe I don't understand the benefits because the story makes no sense.
Wrap-Up:
I get the basics of the securitization market and McCormick accurately described in the article, along with all the different parties involved.
Maybe there’s a way to make it more efficient. But it’s not obvious to me that the blockchain needs to be involved, or that most of the value chain needs to be excised.
If you use the frozen french fry distribution analogy above, Costco chopped out some of the steps in the chain and turned out to be successful without having to resort to exotic technology, software or even the web. That said, they didn’t mess around with the $1.50 hot dog/soda combo for 37 years, and people will sell their souls for that.
Not seeing a compelling case here for why Blockchain is fundamental to efficiency improvements to the mortgage securitization business. I’m sure there are relevant use cases for the blockchain, but I’m not seeing one here, in the mortgage market.
Bad Reads 📖 & Bad Tunes 🎸:
I moved to a new house this last month in Berkeley/Albany (California) and hoping to have a lot of founder/investor barbecues at the new place. Haven’t had a lot of time to read, but here’s what I’ve been reading:
Disturbing The Peace (Bill Kopp, 2022) - 415 Records was THE San Francisco record label of the early 1980s, and practically the soundtrack to the origin of Burning Man, because the original burners were hanging out in SF when all of these tunes were recorded and the bands were gigging in the SF clubs. 415 records was the premier record label that bridged the gap between punk rock and alternative rock. If you’ve ever heard classic tracks like “Never Say Never” by Romeo Void or “Everywhere That I’m Not” by Translator, you’ve heard stuff from 415 Records. I made a playlist that’s essentially a soundtrack to the book, here. I was turned on to this one by musician/author Paul Myers, the brother of actor Mike Myers, and author of Kids In The Hall: One Dumb Guy and Todd Rundgren biography, my personal fave. Section 415 of California Penal Code is the section that covers “disturbing the peace” or creating loud or unreasonable noise - so, the name of the record label isn’t a tribute to the Bay Area per se. The playlist is great for your next shindig or just any wild car ride on a Friday night. Definitely hot-night end-of-summer vibes.
Regards,
Adam
P.S. If you know any founders that are facing challenges with sales, feel free to send them to our founder community (APPLY HERE) focused only on sales and fundraising. We have about 70 hours of training, and a lively Discord. It’s 120 founders, growing at about 10 per week. There’s no fee and no dilution.