Few heed warnings of financial disaster

6/3/2008

We have a good early-warning system for financial disasters. Unfortunately, very few investors or consumers pay attention.

In the last two decades, we've seen more than our share of investment bubbles, stock-market crashes, a credit crunch, and a couple of recessions. In every case, the warning signs were there. Sometimes the signals were pretty loud - like sirens, or someone shouting at us to change direction.

Experts gave us amazingly accurate forecasts (mixed in with many misguided ones). At times, the facts were staring us in the face. And common sense told us when things were seriously out of whack. And yet, the financial calamities happened, and only the lucky, or very attentive, investors survived intact.

Surely another financial disaster is lurking out there somewhere. And surely we are already being warned about it, but are we paying attention?

The stock market crash of October, 1987, caught millions of investors unaware.

But we should have known the market was way oversold. The Dow Jones industrial average had set 55 record highs in the first eight months of 1987. By the time it peaked above 2,700 in late August, analysts were already warning about the consequences of a weakening dollar and a ballooning trade deficit.

Sure enough, stocks slid for two months and then crashed on Oct. 19, 1987, when the Dow fell 508 points, or nearly 23 percent of the Dow's value at the time.

For more than a decade after the '87 crash, stocks rose ever higher. By early 2000, nearly everyone owned some dot-com stocks, technology was seen as part of the "new economy," and the stock market was red hot.

In January, 2000, the Dow Jones hit an all-time high of over 11,700 before backing off, and on March 10, the Nasdaq set its record of 5,048.62. It had gained about 1,300 points in two months. But analysts were warning that too many investors were jumping into tech stocks, were not properly diversified, and were exposed to huge risks. To make matters worse, day-trading had attracted even small investors, and after-hours trading soared.

Naturally, the dot-com craze ended badly. By October, 2002, Nasdaq's value had fallen 78 percent - and even today is just half its all-time high.

The massive failures of Enron Corp., WorldCom Inc., and Global Crossing Ltd., cost investors dearly six years ago. Warning signs were there for years. But who was looking at the books when Enron's annual revenue soared from $9 billion to $139 billion in a seven-year period when the energy firm vaulted from 129th to fifth place on the Fortune 500 list?

Currently, the U.S. economy is reeling from the subprime-lending mess, housing bubble, credit crunch, and an energy crisis.

Investors and consumers got early warnings about all of those problems, years ago.

Housing lenders had been lowering standards for years and even had pressed for regulatory changes to make it easier to lend to customers with blemished credit. Advertising blatantly courted buyers with bad credit.

Home prices in some regions of the U.S. rose at double-digit rates annually, and in some areas the average home price topped half a million dollars. Many of us knew deep down this couldn't go on forever.

What will cause the next financial disaster?

Many experts are warning about the possibility of crude oil at $200 a barrel, or $6 a gallon, in coming years. Others worry a weak dollar will set off spiraling inflation. Insurers are ill-prepared for another natural disaster like Hurricane Katrina, and some analysts are concerned that the re-insurance industry could be in for colossal losses in the future.

Experts have warned for years of a possible pension crisis, especially with corporate and government plans underfunding future liabilities by hundreds of billions of dollars.

Perhaps the biggest risk of all is from the murky world of derivatives, those slippery financial instruments that hedge against interest rates, insurance losses, energy prices, and other things. The problem is, the total value of derivatives could be hundreds of trillions of dollars - mostly off the books and out of public view. But they impose massive risks to the economy.

The warnings are there. Maybe they're even screaming at us to be careful.

We probably won't listen anyway. And, of course, no warning system is perfect. Not even the most savvy experts could have predicted the terrorism of Sept. 11, 2001, and the disastrous effects on the U.S. economy.