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

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.

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

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