Predicting the Next Financial Meltdown

There are common factors to such crises as the current financial mess, the collapse of Enron, and the bursting of the Internet bubble. We should heed the warning signs next time

By Kevin P. Coyne

Although it may be the last thing professional investors, regulators, or congressional representatives want to think about in the midst of the current financial crisis, the idea of a next financial meltdown ought to be on all our minds.

I say this because it turns out that "unthinkable" meltdowns seem to occur quite frequently. The stock market crash of 1987 was so unexpected, it resulted in congressional investigations. In 1989, the real estate market crashed, crippling the banking system. In August 1998 the "impossible" happened when Russia defaulted on its bonds and all the Asian countries "not to mention U.S. subprime borrowers) were thrown into crisis. Long-Term Capital Management "impossibly" followed within months. In the spring of 2001 (six months before 9/11), the Internet bubble "shockingly" burst, sending stocks into a tailspin.

In the summer and fall of 2001, Enron crashed, becoming the largest bankruptcy in U.S. history, only a year after achieving its highest stock price. And only six or seven years (depending on when you date the start of the current meltdown) after Enron, yet another "event of the century" has occurred. (And bear in mind that this list I've compiled doesn't include most company-specific crashes.)

Finding Patterns

While a few of these events are directly linked (e.g. Russia's default, the resulting disruption of the bond market, and the failure of LTCM), most observers would consider the above as nothing more than a list of historical events. But are there common underlying patterns? Is there is a set of factors that, while they may not actually spark the flame, accelerate the burn and intensify the heat—resulting in full meltdowns rather than a little charring on the surface? And can those patterns be used to predict in advance where there is high likelihood of future crises?

I think the answer to all the above questions is yes, and these questions should be central to the near-term tasks of both lawmakers and investors. After all, the point of the regulations that will be created by the new Administration and Congress must surely be to prevent the next crisis, not just to affix blame for this last one. (Although sending a few individuals to jail for this one would be beneficial for the country too—so some blame fixing would also be a worthy pursuit in my eyes.)

So what are the patterns? While I have not (yet) examined this statistically, I have identified five key danger signs:

1) Markets where there is long lag between the commitment to take risk, and the manifestation of its consequences.

The danger is particularly strong when the "early" participants appear (at least temporarily) to have "won big." Under those conditions, too much money pours in looking for similar "easy" gains. For example, the early venture capitalists in the Internet bubble reaped huge paper gains in the valuations when subsequent rounds valued their protégé companies highly. But the risk was still there—most of the companies later failed. But before that happened, huge amounts of capital flowed into venture capital funds, only to be invested into even worse ideas. At a high level, the same phenomenon proved true for LTCM, mortgages, Enron, and other meltdowns.

2) Misalignment between the true interests of originators and structurers on the one hand, and the investors/risk bearers on the other.

Products in which the originators and structurers are paid for volume, rather than quality, lead those players to continually explore new ways to find additional volume by reducing quality in ways the investors cannot detect or do not think of. This factor played a major role in the 1989 crash, the Enron crash, and the current mortgage meltdown.

3) The false appearance of "a large market of diverse views."

Markets work best when many investors conduct many different analyses and reach many different conclusions. But in some cases, a "standard" point of view emerges, and the vast majority of investors subjugate any independence.