Predicting the Next Financial Meltdown

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Consider the over-reliance of investors on the ratings of just a few ratings agencies in judging the risk of mortgage securities. Consider how all the "independent regulators" of Enron (the law firms, the accounting firm, the ratings agencies, the investment banks, the commercial banks, the Securities & Exchange Commission, etc.) reduced their own objectivity because everyone else had bought into a "standard" view that Enron was strong.

4) The rise of mathematical modeling as the dominant form of risk assessment.

Models are always based on detailed analysis of history—often limited history. They are thus unable to predict market behaviors under conditions that do not repeat history—a condition that seems to happen about once every five years lately. Models have their place in risk management, but not to the point that investors replace their hands-on understanding with model results. Just ask LTCM, Enron, and the mortgage modelers.

5) Near universal reliance on "risk shifting" as the primary tool for risk management, rather than true "risk minimization" or even risk bearing.

Hedges, swaps, markets for distressed assets, and credit insurance have their place. But each of these has a critical, unspoken limitation that has been long understood in the field of insurance, but not in financial markets. Insurance (and every one of the above named instruments is, in effect, insurance) works only if the portion of the players drawing upon it at one time is small. Said another way, a single player can protect itself by spreading the risk to other players—but only if all those other players are not hit by the same event at the same time.

Obviously, many factors converge to create a crisis. But there are patterns, and danger signs that mix with each other to compound the risk of a meltdown. The regulators and professionals don't understand them well enough—but they can if they expend the right effort.

Finally, if no one else takes the lead in understanding these risks, we the small investors in mutual funds should demand it of our own managers. It is time they learn to prevent their decades-long track record of win-a-little, win-a-little, win-a-little, lose-it-all. If you think that characterization is harsh, consider this: the Standard & Poor's 500-stock index is at the same level as it was in the summer of 1997—11¼ years ago. There is only one other time in the last 60 years when that dismal condition held—1974, after the oil price shock. With the exception of now and 1974, stocks have never in 60 years reverted to their levels of such a long-ago period. Given this, and the likelihood that another meltdown is less than five years away, surely anyone claiming the moniker "professional investor" must learn how to protect his clients from becoming victims again

Kevin P. Coyne is senior teaching professor at the Goizueta Business School of Emory University and a co-founder of The Coyne Partnership, a boutique consulting firm focused on top management and board issues. He was formerly a senior partner at McKinsey & Co. He writes The Strategist monthly for BusinessWeek.com/Managing.