2012 Bay Area Economic Engine

It's that time of year again. Each November I publish my “Bay Area Economic Engine". In it I summarize the the business news and events that drive our local Bay Area economy, and I project the economic direction of our major Bay Area industries in the upcoming year.  You can download a copy of my economic engine by clicking here.


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The Bay Area recovery continues in 2012

The Bay Area added 83,800 jobs between September 2011 and September 2012.

This job growth was 30.4% of the State’s and 4.4% of the Nation’s. This compares to a population base that is 19.9% of the State’s and 2.4% of the Nation’s.

The boom in San Francisco and Silicon Valley is slowing - but beginning to spread to the North and East Bay; creating jobs for commuters and, to a lesser extent, local jobs.

Leasing brokers report that the super-hot markets in San Francisco and Silicon Valley are now “taking a breather”. Based on my review of trends, I expect more than just a breather in 2013.

Taking a breather or the fallout of disruption?

Much of the 2010–2012 surge in employment and demand for space was came from companies with disruptive technologies... tablets, smart phones, server virtualization, streaming video, software-as-a service, free games, cloud computing.... as these innovations won in their market they replaced something will loose market. In 2010-2012 the winning companies were launching and growing while the losing companies were still in place.
Now we are beginning to see the fallout from the disruptive technologies. Upcoming layoffs are being announced for chip manufacturers, network equipment manufacturers, PC’s, console video game companies and companies that produced products made redundant by the smartphone; including cameras, watches, tape recorders, navigation systems, MP3 players, newspapers, answering machines, game players, calculators.
Luckily for the Bay Area many of the losers are not local, consider for example recent losses for Nokia, RIM, Nintendo, Panasonic, Sharp and Sony.
But the Bay Area will see lay-offs in our older-school tech companies, such as HP, AMD, Cisco, Intel, and Yahoo. And there will be an impact from a recession in Europe, a slowdown in China and cuts in State and Federal discretionary spending.

What does next year hold?

The Bay Area is unlikely to see a downturn in 2013, but expect to see the force of mounting headwinds stalling the current boom

Fed announces QE3 and low rates through 2015... and rates go up? What??

Right now, my loan production team at Newmark has several loan applications under negotiation where the long-term interest rates are not yet locked. These borrowers are watching rates closely and were hoping for an announcement by the Fed at their September 13th meeting of more Quantitative Easing, the long anticipated QE3. They got their wish and more – a commitment by the Fed to keep rock-bottom rates through 2015 as well as to buy $40 billion in FNMA and Freddie Mac bonds each month with no end in sight. The stock market rallied. And, interest rates reacted: BY GOING UP!

I was caught by surprise on this one...

• I was predicting that the Fed would keep QE3 in their quiver as that last arrow to use if the financial markets melt down due to sovereign defaults and resulting bank-runs in Europe.
• If the Fed wants to help the economy to push the election in Obama’s favor, I felt it was too late. It takes a long time for the economy to feel the effects of lower interest rates. Plus rates are already so low, the effects of more easing would be minor.
• I expected QE3, with its commitment to buy bonds, would raise the price of bonds and lower interest rates.

 What I did not recognize was:

• The Fed knew QE3 would create a short-term run up in the stock market. And, when stock markets boom, incumbents get reelected.
• The anticipation of rates staying low for three more years, makes investors change their asset allocation plans. These tidal changes is vast pools of investor-funds effects interest rates far more than $40 billion in monthly bond purchases.

 Most pension funds are set up with long-term return projections of 7.0% to 8.0%. (Public employee pension plans are underfunded today based on these optimistic projections. If they used realistic return projections, of say 4%, these funds would be so far underwater that all tax receipts would need to go into these retirement accounts with no funds left over to run City and State governments.) Here in California, CalPers and CalSters use 7.5% as their average projected annual return. This compares to CalPers’ returns in 2011 of approximately 1.0%. Since only the riskiest of junk bonds return 7.5%, if pension investors want to pretend they can hit their 7.5% average annual return target with low bond rates projected for three more years, they need to shift more money from bonds into stocks. These are vast sums of money. 

Will this stock market rally last long-term?

Without fundamental changes to our weakened economy, the answer is NO.

"The problem is that the Fed doesn't have anything nutritious on its shelf right now," said Anthony Sanders, a finance professor at George Mason University and a senior scholar at the Mercatus Center. "They're just doing sugar highs. The stock market is getting a sugar rush. But the economy can't thrive on sugar rushes. It thrives on nutritious foods, which the Fed can't give out."

Professor Sanders uses the sugar analogy. This reminded me of the cartoon I published in June this year, just updated with a new steroid formula!

The New Geography of Jobs - Enrico Moretti

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Three years into our economic “recovery”, we are seeing some areas booming, while others continue to falter.
Here in Northern California for example, the declaration of bankruptcy by the city of Stockton stands in stark contrast to the strong recovery of the Bay Area tech and bioscience nodes only 70 miles away.
The New Geography of Jobs, by Enrico Moretti of U.C. Berkeley, provides an excellent big-picture analysis of the increasingly divergent outlook for our nation’s cities and delves into the reasons why this disparity is likely to widen.

In his book, Enrico Moretti outlines the many forces behind the agglomeration of talent at innovation hubs; Entertainment in Los Angeles, Software in Seattle, Finance in New York, and Biotech in San Diego, Boston, and the Bay Area. Although human capital is the economic hope of our nation, our universities and colleges are not producing enough graduates with the skills demanded by today’s employers, and those with the right skills are increasingly congregating in innovation hubs with deep labor markets.
 
In explaining the phenomenon of Silicon Valley to my lenders in the 1980’s and 1990’s, I would get a copy of the Sunday San Jose Mercury News and show them five sections of employment ads. By the year 2000, the Sunday Mercury News help-wanted section was larger than today’s entire edition. I could show multiple job openings for the most arcane of technical specialties. Now that employment ads have moved from newspapers to the Web, the attractive power of a deep labor market is magnified. The Web spotlights the world’s innovation hubs and the multiple job opportunities in a location generate the excitement that attracts young talent graduating around the world.

Dr. Moretti points to several demographic trends that exacerbate the divergence of our cities:

1. As people become more educated they are becoming increasingly more mobile. People with advanced degrees are more likely to relocate than people with a four-year college education, who in turn are more mobile than people with only a high school diploma. People leave home to go to college and then often move again to attend grad school. This talent is not averse to moving once more to pursue a career.
2. More and more people are marrying within their educational strata. Social networking and computer dating offers greater choice to potential couples, matching those with similar life experiences and ambitions. Especially, people with advanced degrees tend to marry each other.
3. The more educated the women the more likely she is to continue to work after child birth.
4. Couples with dual careers tend to remain in those areas with the greatest opportunities for both the husband’s and wife’s careers.

In prior generations people followed jobs. IBM could tell graduates to move to White Plains. GE could tell engineers to move to Ohio. Now, companies are following the talent. Employers in search of innovative talent are compelled to move their operations to these innovation hubs, and then offer high wages and generous benefits to compete with other employers attracted to this same hub.

The benefits of these innovation jobs are wide spread: These high wages result in greater spending – raising wage levels for the unskilled and non-technical workers in the area. Dr. Morreti estimates high tech jobs have a 5-times multiplier effect which compares to a 1.6 multiple for a manufacturing job. This spending attracts the amenities that attract new talent: And so a virtuous cycle ensues at these innovation hubs. Meanwhile a brain-drain occurs in the rest of the country. Stamford, CT ends up with five times the number of college graduates per 1000 residents as Merced, CA.

Dr. Moretti also provides an analysis of former innovation hubs, such as Detroit and Rochester, which have lost the magic that had once made them great. To remain competitive, Moretti writes, cities, companies and labor need to embrace disruptive change; creative destruction is the source of economic vitality and innovation.

Highly recommended, a compelling read!

The Feds pledge: if at first you don’t succeed; keep making the same mistake.

Today the Fed Open Market Committee declared it would push the free market further out of balance.

Thanks to Fed actions and to problems in Europe, we are at historically low long-term interest rates; the yield on 10-year T-Bills is down to 1.64%. As if this is not enough, the FED pledged to extend the TWIST program using $267 billion over the next 6 months to exchange short term bonds for long-term bonds, to force long term interest rates still lower. The rationale? To stimulate the economy.


The Fed has used a horse-sized hypodermic full of monetary stimulus to get the economy up and moving, yet the US economy continues to lie still. So if that did not work, let’s give it another shot? Like the over-used quote from Einstein, “insanity is doing the same thing over and over again and expecting different results.”

Steroids hype short-term performance with bad long-term consequences. 

Shooting up the economic horse with low-rate steroids

The Fed policy of manipulating the free capital market with artificially low interest rates, may hype short term corporate borrowing, may save Banks from paying interest on deposits, deliver mortgages to those who can qualify, and even reduce the government deficit… in the long term it destroys the foundation of the investment sector; our pension funds, cities, retirees, insurance companies… it defeats the very motivation for long term investment.

The low-rate drug is not good for the economy; the side effects in the long-term are terrible; but the Fed keeps increasing the dose.

Besides the political pressure to “just do something!” what is the rationale behind this failed Fed policy?

The economic perspective of the Fed Board was shaped during the Carter-Reagan years, when interest rates were high, and lowering interest rates was an automatic, fast acting stimulus to the economy. Most of the stimulus came from two sectors; (1) the housing sector, and (2) corporate capital spending.

Now, despite years of low interest rates, the housing sector is still dead. So, let’s look at corporate capital spending.. In classic monetary policy; if you reduce the cost of corporate borrowing from say 10% to 8%, companies will start projects that return better than their 8% cost of capital, that were not justified at the10% rate. That’s the theory; but what also needs to be understood are the accompanying concepts of “payback-periods” and “corporate planning horizons”. A project that can return 10% per year has a 10-year payback period. If you are building a factory, a 10-year planning horizon makes sense.

But as the return decreases, the payback period increases.

Just like in the physical world, where physical properties change as temperatures approach absolute zero, so it is in the business world where as interest rates approach zero, normal business behavior changes. If corporate borrowing falls from a 3% cost of capital to 2%, the payback period for a project justified by these rates, increases from 33 to 50 years! This is beyond any corporate planning horizon. No company is going to make a 33-year bet let alone a 50-year bet.

The stimulus effect of the Fed’s manipulation of the capital markets peaked several hundred basis points ago. Shooting up the economic horse with more low-rate steroids, has gone beyond diminishing returns and is now only adding to the long-term negative side effects

Court decision threatens to turn non-recourse CMBS mortgages into recourse

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An appellate court decision threatens to turn many existing CMBS mortgages from non-recourse to recourse.  It may take legislative action at each State level to fix it.

The commercial mortgage lending industry is abuzz over the December 27th, 2011 decision by the Court of Appeals of Michigan that confirmed a lower court ruling that Wells Fargo Bank as Special Servicer could pursue the warm-body guarantor of the non-recourse carve-outs for losses on a foreclosed conduit loan. The grounds? The failure to keep the borrowing entity, a special purpose entity (SPE) “solvent”.

Wait a second! Isn’t every borrowing SPE where the owner gives up and hands the lender the keys by definition “insolvent”? YEP! And, there was no argument on that fact in this case, by borrower, special servicer or judge. The judges finding: Standard CMBS documents have this SPE solvency carve-out and even though it makes no sense, the clause is not ambiguous. Be letting the loan go into default this carve-out was violated and the guarantor can be pursued for losses after foreclosure – despite the fact that both borrower and original conduit lender at the time the loan was created meant to enter into a “non-recourse” loan.

The loan in question was originated by Archon Financial (Goldman Sachs) and used standardized conduit documents. After successfully foreclosing on the property Wells Fargo Bank as special servicer brought suit to recover the deficiency under the non-recourse carve-outs. Amicus briefs supporting the borrower’s position were filed by the Mortgage Bankers Association, MBA, and the Commercial Real Estate Finance Council, CREFC. Even though this ruling will increase the recoveries on defaulted CMBS loans, it is bad news for the CMBS industry.

Scott Rogers, a real estate attorney at Rutan & Tucker, LLP, commented on the ruling:
"Cherryland may not only be bad for CMBS lenders, but bad for non-CMBS real estate lenders as well. The Court's strict and strained interpretation of some portions of the loan documents and not others resulted in an outcome that appears to defy common sense and defeat the parties' initial intent. Both lenders and borrowers must now be concerned that the implied intent of commonly understood provisions of their loan documents many years later may be wholly ignored or oddly reinterpreted by a court in unanticipated ways. This may lead to increased negotiation of loan documents, defensive drafting and yet further delay and expense in the closing process."

At Newmark Realty Capital, we’re seeing experienced borrowers becoming increasingly conduit-phobic. Many borrowers will only consider a CMBS loan execution if we demonstrate that we cannot solve their financing need with a loan from a life insurance company, bank or other portfolio lender. The Wells Fargo Bank vs. Cherryland Mall LP ruling will make these borrowers even more afraid to take a loan from a CMBS conduit.

CMBS loan closings will slow down

Legal bills to close a CMBS loan will get even more expensive. Borrowers should not try to save money on their own counsel. Borrowers must remember when negotiating a CMBS loan that they need aggressive legal counsel who routinely negotiate these somewhat standardized but evolving CMBS loan documents. Unlike loans from portfolio lenders, borrowers with CMBS loans live and die by the loan documents: As shown in the Wells Fargo Bank vs. Cherryland Mall LP case, once the loan is securitized, common sense, the party’s common intent or reality will not trump the language in the loan documents.

So if this ruling could be bad for CMBS lending why did Wells Fargo Bank, a major player in the CMBS, file the case?

Earlier this month, I attended the West Coast CREFC High Yield Debt Investment Conference (CREFC is highly geared toward the CMBS industry) and had the opportunity to ask the Special Servicing panel how frequently do they, as CMBS special servicers, take legal action against borrowers claiming non-recourse carve-out violations. Each panelist, representing LNR, CW Capital, PNC, KeyBank, Situs responded with “All the time!”
It seems a multitude of legal actions going at any point in time the norm for each of the firms. Specifically they all agreed that in the CMBS world it is the Special Servicer’s fiduciary duty to the trust’s investors, to find and enforce springing guarantees under the non-recourse carve-outs, as a means to maximize the recovery on a defaulted loan.

Newmark Realty Capital is involved in loan servicing for both life insurance companies and CMBS loan pools, and we see the CMBS world taking a very different approach to that taken for life insurance company mortgages, where lenders carve-out violations are used more as a threat versus a gotcha to get at springing recourse.

For more information...

The decision on this case is quite readable; you can find it here: Wells Fargo v. Cherryland Mall LP.
Here are some highlights:
“Defendants (borrowers) have argued, in the alternative, that even if section 9(f) (the requirement that the borrowing entity be kept solvent) was an SPE requirement, it was not breached. Defendants assert that the provision was intended to prevent owners from removing all of the money from Cherryland (The borrowing entity) , thereby leaving it without assets sufficient to pay its debts. And, because the owners did -not remove any assets in the three years predating the default, Cherryland's insolvency was not created by the owners and, therefore, was not a violation of section 9(f).
First, defendants do not contend that section 9(f) is ambiguous; thus, there is no reason to resort to extrinsic evidence to interpret it. Second, the parties agree that Cherryland became insolvent. Cherryland's only basis for its contention that section 9(f) was not violated is that the insolvency was not based on its own actions, but the downward spiral of the market. Section 9(f), however, does not require insolvency to occur in any specific manner. Rather, any failure to remain solvent, no matter what the cause, is a violation. . . . .
We recognize that our interpretation seems incongruent with the perceived nature of a nonrecourse debt and are cognizant of the amici's arguments and calculations that, if accurate, indicate economic disaster for the business community in Michigan if this Court upholds the trial court's interpretation. Nevertheless, the documents at issue appear to be fairly standardized nationwide, and defendants elected to take that risk—as did many other businesses in Michigan and nationwide. It is not the job of this Court to save litigants from their bad bargains or their failure to read and understand the terms of a contract. . . . . .
In summary, based on the rules of contract interpretation and the persuasive authority of decisions of other courts that have interpreted nearly identical loan documents; we agree with the trial court that the mortgage, as incorporated into the note, unambiguously required Cherryland to remain solvent in order to maintain its SPE status. Having admittedly become insolvent, Cherryland violated the SPE requirements, resulting in the loan becoming fully recourse. “

Time to wake-up the Great Sleeping Middle and end Too-Big-To-Fail

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Where the Tea Party meets the Occupy Wall Street Movement
The power of Wall Street and a few mega-banks in Washington incenses the Tea Party movement on the right, and the Occupy Wall Street movement on the left. Both extremes demand that the Too-Big-To-Fail (TBTF) financial giants be curtailed. The right is incensed by the corruption of capitalism created by the bailouts and the Federal Government’s on-going involvement in propping up the big banks. The left is incensed by the failure of government to regulate for the consumer’s interest.

As voters we all feel insignificant compared to the political power amassed by the top 5 banks that were allowed to grow and control over half of all banking assets; both parties feed off their political donations. Congressional staffers and regulators feel productive as they regurgitate the legislation and regulations written by these banks’ lobbyists. Wall Street’s movement to “Occupy K Street” has succeeded for years.

The two political extremes agree that the United States financial system is broken and holds no promise of being fixed if the primary focus of the Treasury and the Federal Reserve is directed toward the health of a few mega banks. People on all sides are angry. Tax payers are angry about the bailouts. Retirees and savers are angry about a manipulated yield-curve that taxes savers and investors to benefit a handful of giant mismanaged or unmanageable banks.

The financial collapse of the Great Depression saw people marching in the streets to demand financial reform. That crises was not wasted. Meaningful legislation broke up banks, insurance companies and investment banks and curtailed the size of banks through interstate banking restrictions.

The anger from the current financial crises is being wasted.
Most of the regulations mandated by the Dodd Frank Bill are not even written yet and these rules are being crafted by regulators who are camped out with Financial lobbyists. (If you want to hear about the sausage-making going on to write the rules for the CMBS industry, give me a call.) Dodd Frank does almost nothing about TBTF. The “living wills” required of TBTF Banks under Dodd Frank will only work if a single institution falters in isolation. These TBTF institutions are too interconnected. Another major financial crises will hit all the big banks at the same time. This Too-Many-To-Fail (TMTF) scenario will force the government into another round of bailouts.

A voice from the middle
I am excited by the annual report from the Federal Reserve Bank of Dallas, “Choosing the Road to Prosperity: Why We Must End Too-Big-to-Fail Now.” This is not a political document written by extremists. It is an easily readable, persuasive argument from a frontline regulator. The message: TBTF is “A Perversion of Capitalism” “Capitalism requires the freedom to succeed and the freedom to fail.” Bank of America and Citibank were mismanaged and went bankrupt. When faced with its potential legal liabilities inherited from it Countrywide and Merrill Lynch acquisitions, BofA is probably still bankrupt. The Fed’s ongoing effort to throw profits to the big banks to earn their way out of insolvency has hurt the economic recovery.

We still need meaningful reform. Meaningful reform will require or incentivize the break-up of TBTF institutions. Dodd Frank does not do it. It is time to wake up the Great Sleeping Middle!

This is not another Dot-Com bubble

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In 2011 Silicon Valley absorbed office and R&D space at a rate to rival all but the biggest boom years of the Dot-Com bubble.

"We’ve just had five-straight quarters of hefty reductions of available space and we’re not seeing any let-up in sight. In 2011, the Valley finally took off in terms of gross absorption, which translated into 27.9 million square feet for the year or a 28% increase over 2010. We had 30 new office/R&D deals above 100,000 square feet in Santa Clara County in 2011 and half of those were above 200,000 square feet. While the volume of large deals may not be repeatable, the Valley is poised to generate more net absorption in 2012, even with a little less gross absorption.”
Jeff Fredericks, Managing Partner in the Silicon Valley office of Colliers International, on Silicon Valley Trends 2012, Press Release 2/15/2012

Colliers’ forecast is for 27 million square feet of gross absorption for Silicon Valley in 2012, with six million square feet of positive net absorption. According to Colliers the vacancy rate in downtown Palo Alto for grade “A” office space is currently 0%. Office vacancy for Mountain View is in the low single digits. With the space being reserved by Apple taken out of the inventory, Sunnyvale’s office vacancy will also fall into the single digit range. Rents are up 30% to 50% in the strongest locations when measured to the depths seen after the credit crunch two years ago.

Are we in a repeat of the Dot-Com Boom? I put this question to several knowledgeable market participants; their responses are unanimous.

Kevin Catlett at Principal Real Estate Investors: “The current growth in absorption is amazing. We believe a key difference is that this time a lot of Silicon Valley’s growth is coming from companies with proven business models and real profits. Last time we had a boom largely based on VC funding; this time more of these companies are financing themselves from their own cash flow. ”

Geoff Hubbard, Research Director for the Silicon Valley office of Kidder Mathews: “The leasing data for the last 12 months shows that the largest transactions are by large, established, public companies such as Google or Apple. Google is pretty much taking everything they can in Mountain View while Apple is doing the same in Cupertino. With available space in Mountain View and Cupertino becoming scarce, they’re both expanding their footprint into Sunnyvale and surrounding areas.”
Google bought and leased 1.9 million square feet of space in 2011. To put this in perspective, this is three times the absorption of the entire San Francisco Office market in a good year. Apple is also grabbing space; if they complete the deals currently under negotiation they will have leased 1.1 million square feet in Sunnyvale in the last 12 months.

Chris Keith, Commercial Developer, at the Mozart Development Company lists nine reasons why this time it is different:

1. Corporate diversification and products within Silicon Valley markets is dynamic and broad with worldwide audience of product buyers.
2. Profitability is paramount and thriving (although I feel overall corporate growth and profitability will stabilize to a rational level, long term – stabilizing rents).
3. VC money is not available for unrealistic, unprofitable models. Venture money is being distributed wisely this time around.
4. Corporate profits and capital accounts are healthy.
5. For those companies that are marginal, costs have been cut, space shed, liabilities minimized, efficiencies realized - growth will occur slowly; if economic circumstances change most of these companies will not get caught with their pants down again.
6. For most firms we talk to current expansion is conservatively based (on current – 1 year growth) with fiscally solvent companies.
7. Shadow space and subleasing, today is almost non-existent.
8. Silicon Valley and surrounding area(s) will continue to attract the highest level of intellectual talent and corporate executives, managers, engineers in the world – the infrastructure has taken decades to build, billions spent by companies, cannot be easily replicated. To save costs support talent, manufacturing and assembly will be sent to secondary locations.
9. Silicon Valley specializes in the cutting edge technologies: The lowest price-point argument does not support intellectual property at inception.

Is this just a space-grab by the big profitable players?

There is definitely some of this going on. The leasing data is top heavy. But commercial property investors need to understand the changes in the typical business plan in the CEO’s desk of the average Silicon Valley start-up. It used to be: Get VC funding - Establish our value proposition - Go public with an Initial Public Offering. Now the typical business plan is to eschew VC funding as much as possible: Use funding from cash flow, customer partners, friends, family and angel investors. The exit strategy is not an IPO but to sell the company or product to Oracle, Google, Apple or Cisco.

These large companies have replaced the IPO option as the investor's exit strategy for much of the Tech world. Last time the growth in IT was reflected in lots of relatively small independent companies being housed by the commercial real estate community. This time these tech leaders are folding into the giants. Google bought 48 companies or packages of intellectual property in 2010 for $1.8 billion. In 2011 Google bought 79 firms or their inventions; I do not have Google total 2011 costs, but the the top three added up to $941 million. And already in 2012, Google's acquisition of Motorola Mobility at $12.5 billion was just approved by the EU and US Fair Trade Commissions. The appetites of Oracle, Apple, Cisco and the other mega players are equally impressive.

Will this pace of growth continue?

Phil Arnautou, Managing Partner at Colliers, worries that Silicon Valley’s current growth will be slowed down by the availability of technical talent. “The real problem is there aren't enough qualified people out there to fill the jobs to fill the buildings.”

Phil’s point drives home the other current theme of the Silicon Valley leasing world - it is all about the talent. Picking office space is no longer a tradeoff between rent and the distance to where the manager lives. Location decisions are both driven by, and constrained by how to attract new technical talent.
The next two years may see a slowing the Silicon Valley growth rate, but all indications are this is not a bubble, and this time it will not burst.

Why Silicon Valley?

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What drives our local economy? What are the area’s competitive advantages?

In the early 1980’s I lead a bus tour of the area’s “Golden Triangle” for a group of British pension investors. The introduction of the PC was transforming information technology and Silicon Valley was booming My audience were board members who looked at the larger picture. I was thrown this question: “History shows that after the introduction of a technology the winners are usually the low cost providers. Why won’t this entire industry move to a cheaper location, like Austin or Asia?” Sure, I found words to come out of my mouth, but frankly, I was stumped.

Since that day, I've been an avid student of Silicon Valley. Yes, manufacturing largely moved out, but the headquarters and design functions stayed. Why? Local companies seem to thrive while many of the pioneers in other parts of the United States (Wang, DEC, Compaq, NCR) were acquired or disappeared. Why? The new-new-thing always seems to either start in Silicon Valley or move here in order to blossom. Why?

The Start-Up Story is Well Known: Silicon Valley has an infrastructure for innovation second to none.

In reality and in the movie, “Social Network” Sean Parker tells Mark Zuckerberg "take your company to Silicon Valley if you want it to get it off the ground".

A startup in the Bay Area can contract out all aspects of its development, including product design. Every category of engineer and scientist is here; willing to be lured by the chance to be part of an IPO. Most important the money is here: Bay Area’s share of Venture Capital continues to grow and is now approaching 40%.

The minnows need to be here but why do the whales swim in a Silicon Valley Pod? Not widely recognized is the transformation of Information Technology (IT).


There was a time when single firms (IBM, DEC, HP) dominated IT and could provide total solutions – like tall Sequoias reaching from the ground to the sky. These tall trees could be planted anywhere. Not anymore. Today IT solutions evolve through specialization, fragmentation, competition and collaboration, and have created a multitude of interdependent players, fast on their feet but needing to run as a herd. Sudden shifts in technological direction push established firms together to avoid being left behind. The goal is to anticipate a change of direction: Then do whatever it takes to keep up: Establish networks for intelligence, collaborate, imitate, and steal talent to keep up with the herd.

As such Silicon Valley consolidates its hold on emerging technology. If you are not here, you might find yourself isolated from the herd and vulnerable. Consider AOL and RIM Blackberry. AOL came back to Palo Alto. RIM is moving engineering here (though perhaps too late). Even Microsoft is growing its Silicon Valley campus, home to Bing.  Dell plans to double its Silicon Valley work force to 1500 employees in 2012.
Your collaborator today could become your competitor tomorrow, look at Apple and Google. In IT the old adage “keep your friends close and your enemies closer" still rings true, and in Silicon Valley it is truer than ever.

The world of Information Technology only needs one center. 
Perhaps the most important answer to "Why Silicon Valley?" is so obvious that it is often overlooked.
Fresh vegetables may need a local market for every few thousand people. The market for money has regional centers for each currency, and is united at two world centers, London and New York to accommodate time zones, currencies, tax laws and regulations.
The world of IT needs only one center. There is a single world-wide currency in IT, electrons, with only two denominations, Zeros and Ones. The Internet bridges time zones, languages and to a large degree outpaces regulations. To move a market center requires that market participants have a motive. Such a move will not happen; there is simply no compelling reason for another world IT center, besides Silicon Valley.

The half life of an engineer's education is 10-years and falling.
Why would a talented engineer join a major company at a location far from the center.  The Bay Area survives on its ability to attract the 20-something new talent from around the world and retrain the 30-something engineer whose specialty is no longer in demand.  Talent drives innovation.  In tech, old talent gets stale quickly and needs to be replaced with cutting edge new talent. The estimated half-life for an engineer's training is 10-years.  The Bay Area has the colleges, universities and institutes to offer continuing education for the 35-year old engineer who needs to be retreaded, but also attracts the fresh talent that brings the companies that foster more innovation that is taught in Silicon Valley first – a virtuous cycle. 
 

Why Greece matters

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Google reported fourth-quarter revenue and profit that missed analysts’ estimates as an economic slowdown in Europe crimped international sales. Bloomberg News. January 20th, 2012.

Does it mean Google will take a little longer to occupy the 2,900,000 square feet of office space they leased or purchased in Sunnyvale and Mountain View in 2011?
And does it mean that after two years in the making, the effects of the European Debt Crises are being seen in Silicon Valley?

As an observer of the commercial real estate finance world and a commenter on the Northern California real estate markets, Greece and the whole Eurozone financial crises can seem very far away. Yet Newmark’s institutional investor clients and correspondent lenders tell me the consequences of this impending slow-motion train wreck in Europe is the biggest threat to the current relative stability in our financial world, and a force that could push a recession onto the entire developed world and seriously slow down the growth of the exporting nations of the developing world.

Some form of disintegration of the Eurozone is inevitable
Creating a united currency without a united government controlling fiscal policy may seem in hindsight to have been a really dumb idea. Countries hid their financial picture to be admitted to the Eurozone then almost immediately violated the guidelines; even on their own reported numbers that turned out in the case of Greece and likely other nations to be fraudulent. The solution being floated: We will now be serious about the guidelines that almost every country (including Germany) violated. We will centralize economic monitoring in Brussels and create penalties if countries violate the guidelines.

This solution is destined for failure, due to three reasons:
1. Unless there is a single European treasury, no one can trust the numbers. You have to listen to this investigation from NPR’s Planet Money. It details how a European Union (EU) accountant was sent from Brussels to Greece to calculate the true amount of the Greek deficit. The prior administration had claimed the deficit was 6% of GDP, the new administration claimed it was 12%. The EU accountant thinks this should be a one day task. He ends up being Mao-Maoed by the union leaders for the Greek Statistical Agency workers. He brings in reinforcements from Brussels and eventually estimates the deficit at 16% of GDP. His private email communications with his personal lawyer are illegally hacked. He faces strikes from the Statistical Workers Union and office occupations. He ends up being investigated by Greece’s Prosecutor for Economic Crimes for the charge of treason and faces a potential sentence of life imprisonment.
You can find the podcast here: http://www.npr.org/blogs/money/2011/12/16/143846133/the-friday-podcast-how-office-politics-could-take-down-europe.

2. Democracy is a process that is almost impossible to reverse. To achieve a common fiscal policy throughout Europe, the EU needs to take away a great deal of sovereignty from the member nations. Without free powers to set spending, to create tax policies, to set pension and retirement policies, member countries will feel like occupied nations; especially, if they face truly punitive sanctions.

3. Una faccia, una razza, as the Italians say, or mia fatsa, mia ratsa in the Greek equivalent, meaning one face, one race. There is a great cultural divide between Northern Europe and the Mediterranean region. The Mediterranean is a culture rooted in out-smarting its occupiers. For thousands of years, Greek and Roman history tells of small city-states dominating their neighbors and sometimes occupying whole regions. Areas like Sicily spent much of its history under foreign control by Greece, Roman, Vandel, Byzentine, Moores, Normans, Catalonians and Bourbon occupiers. Italy was not “united” until Garibaldi accomplished this by force, defeating the final holdout, Rome, in the 1860’s. If you talk to “Spaniards” from Catalonia or the Basque region, Spain is not united today. The Mediterranean culture is set up to use whatever leverage or subterfuge is available to benefit family first, village second and cultural sub-region third. National identity is far down the list. The idea of sacrificing for the cause of “Greater-Europe” might ring true in the North but not in the Mediterranean.

So if the Eurozone breaks apart, what are the consequences?
The threat of a Eurozone meltdown is real if not inevitable, but what are the consequences? Here things get murky. We face three negative outcomes that could happen in various combinations:

1. European Recession: This slowdown has started and will intensify: due to the need for governments to rein in spending, cut benefits, and raise taxes. On top of the headwind from this fiscal austerity will be increased austerity in the private sector as we see a need to deleverage in the European household, corporate and financial sectors.

2. Banking Crises: Last year, prior to the falling value of their sovereign debt holdings, European banks were estimated to need to raise 25% to 50% more capital to be properly margined. Those banks that did stock offerings in 2011 faced major reductions in stock prices in the last six months, now making it hard for the laggards to tap the equity markets. So if a bank’s equity is fixed, the main tool to improve capital ratios is to shrink assets; a bank’s portfolio of loans and investments. To meet most minimal of current guidelines, European banks will need to trim their loan portfolios by $3 trillion. The easiest way to do this is to stop making new loans. This credit crunch will cripple the European economy. To ease the process, European Banks need bail-outs, mergers and accounting gimmicks. But far worse than any lending constipation that results from the lack of bank equity capital is the potential of a financial panic caused by bank runs, or the modern equivalent – banks being cut-off from credit by other banks. To stem this contagion, the lender of last resort, the European Central Bank, ECB, is helping troubled banks with a European version of TARP (aka cash-for-trash). And, the Fed is helping the ECB. Without any approval from the American people or Congress, the Federal Reserve is helping to finance this effort under the guise of “a temporary U.S. dollar liquidity swap arrangement”, announced in December. This program will further balloon the Fed’s balance sheet and create a further flood of dollars in the world economy: Some are referring to this program as QE3. Let’s hope it works. In spite of these efforts, huge amounts of capital are moving within and also fleeing Europe.

3. Countries leaving or being thrown out of the Eurozone: There are many versions of how this could or should happen. The developed world has seen three fairly recent downturns caused by deregulation of financial sectors that turned into credit bubbles that popped. Two in Scandinavia, Finland and Sweden in the early 1990’s and the third in South Korea in the late 1990’s. In these cases devaluations of the currency were major factors helping these economies recover. Sweden devalued its currency by 34% and South Korea by 50%. The weak Eurozone countries could use this stimulus today but can’t because they share a common currency. I have heard it said that if Germany really wants to help Europe, they should be the one to leave the Eurozone not Greece. If Germany went back to the Deutschmark the rest of Europe can benefit from a devaluation of the Euro: Imagine the inflow of money created by cheap prime beachfront property in Greece and cheap labor throughout the Mediterranean.

Preparing for the consequences of a Eurozone breakup?

Here things are even less clear. One of the best analyses I found is “What Next? Where Next?” by David Rhodes and Daniel Stelter of the Boston Consulting Group.  In a nutshell, these experts say the European outcome is so cloudy you need to prepare for both deflation and hyperinflation scenarios.