How to predict the next meltdown

Between 1989 and 1991 I worked at Bank of Boston. During the 1980s, the Bank had made a significant amount of money lending to finance the rapidly growing leveraged buyout and commercial real estate industries. As in the Southwest, this lending fueled rapid price appreciation beyond the point where it made economic sense. These industries ran out of steam – with many LBOs collapsing and commercial real estate ventures going belly up.

The Bank's peer – Bank of New England – was closed down and Federal Bank regulators required the Bank of Boston to develop a strategic plan to get itself out of the mess that had damaged its financial prospects. Bank of Boston survived the near death experience but ultimately merged with Fleet Financial – itself acquired by Bank of America Corp. (NYSE: BAC).

This pattern of rapid growth in an asset class attracting too much lending has repeated itself in this decade. Extremely rapid growth in lending to leveraged buyouts, housing, and asset-backed securities pumped up prices beyond the point of affordability.

Now that the credit tides are receding, the rocks – in the form of poor lending and borrowing practices – are being exposed. Based on my experience, it would not be surprising to see widespread damage among the lenders and borrowers who are most exposed to these shoddy lending and borrowing practices.

For future reference, when you see prices appreciating in a particular asset class – watch which financial institutions are lending the most money to those classes. These lenders are likely to be most vulnerable when the cycle turns.

The big challenge for investors seeking to profit will be picking the time to sell these lenders short.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Bank of America securities.