The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal

"One of the lessons from the crisis, rarely discussed, are the problems caused by a crowded trading place. Chincarini takes the reader down a path not looked at by many analysts. An excellent read."

JIMMY CAYNE, former CEO and Chairman of the Board of Bear Stearns

"The Crisis of Crowding is an excellent account of the financial crisis of 2008. This book has everything: an analysis of the trades, interviews with key players, and, most importantly, a simple, entertaining explanation of how we got into this mess. It stretches from the LTCM crisis in 1998 to the Greek crisis of 2012. Anyone who wants to know how our financial system works and how we can improve it should read this book."

FRANK FABOZZI, Professor at EDHEC Business School and former Professor at the Yale School of Management

"Dr. Chincarini gives an engaging description of the various crises over the last decade and how they are connected. It′s as if Chincarini were in the trading room taking notes as the crisis unfolded."

KEN KRONER, Chief Investment Officer and head of the firm′s scientific active equity business, BlackRock

"Do we need yet another book on the financial crisis? Yes, we do. Some books are fun to read, but leave you confused about what the actors actually did. Others give you a great deal of technical information, but can be a hard slog. This book by Ludwig Chincarini fills the middle. It is fun to read, and it tells you exactly who did what and how. Read, enjoy, and learn."

OLIVIER BLANCHARD, Chief Economist at the IMF

"Chincarini′s book, which combines a narrative style with an overview of economic fundamentals, should be on the reading list of anyone interested in the roots of our financial meltdown."

AUSTAN GOOLSBEE, former Chairman of the Council of Economic Advisors to the President, Professor of Economics, University of Chicago

"Chincarini looks at the financial crises of the last fifteen years starting with a comprehensive analysis of the LTCM crisis in 1998 and ending with the Euro–debt crisis of 2012 and argues convincingly that the central risk in these crises was accentuated from within the financial system rather than from external economic forces (it includes the best analysis I have read on the LTCM crisis). This bold new theory has important implications for both industry practices as well as for new regulations. This book should be required reading for anyone who wants to understand and help prevent future financial crises."

ERIC ROSENFELD, cofounder of Long–Term Capital Management and JWMP

Foreword xv

Preface xix

Cast of Characters xxiii

CHAPTER 1 Introduction 1

PART I: THE 1998 LTCM CRISIS 5

CHAPTER 2 Meriwether s MagicMoney Tree 7

The Birth of Bond Arbitrage 7

The Dream Team 11

Early Success 14

CHAPTER 3 Risk Management 21

The General Idea 21

Leverage 22

Measuring Risk 23

The 24

Economics 24

Copycats, Puppies, and Counterparties 25

LTCM s Actual Risk Management Practices 27

Diversification 27

Operations 28

The Raw Evidence 29

CHAPTER 4 The Trades 37

The Short U.S. Swap Trade 41

The European Cross–Country Swap Trade

(Short UK and Long Europe) 44

Long U.S. Mortgage Securities Hedged 46

The Box Spread in Japan 48

The Italian Swap Spread 50

Fixed–Income Volatility Trades 52

The On–the–Run and Off–the–Run Trade 54

Short Longer–Term Equity Index Volatility 57

Risk Arbitrage Trades 60

Equity Relative–Value Trades 63

Emerging Market Trades 65

Other Trades 67

The Portfolio of Trades 68

CHAPTER 5 The Collapse 71

Early Summer 1998 71

The Salomon Shutdown 73

The Russian Default 75

The Phone Calls 77

The Meriwether Letter 79

Buffett s Hostile Alaskan Offer 81

The Consortium Bailout 82

Too Big To Fail 84

Why Did It Happen? 85

Appendix 5.1 The John Meriwether Letter 89

Appendix 5.2 The Warren Buffett Letter 93

CHAPTER 6 The Fate of LTCM Investors 95

CHAPTER 7 General Lessons from the Collapse 101

Interconnected Crowds 101

VaR 102

Leverage 105

Clearinghouses 108

Compensation 110

What s Size Got to Do with It? 110

Contingency Capital 113

The Fed Is a Coordinator of Last Resort 114

Counterparty Due Diligence 115

Spread the Love 115

Quantitative Theory Did Not Cause the LTCM Collapse 116

D´ej`a Vu 118

PART II: THE FINANCIAL CRISIS OF 2008 121

CHAPTER 8 The Quant Crisis 123

The Subprime Mortgage Market Collapse 127

What Was the Quant Crisis? 129

The Erratic Behavior of Quant Factors 130

Standard Factors 130

Quantitative Portfolio Factors 133

Causes of the Quant Crisis 134

The Shed Show 137

CHAPTER 9 The Bear Stearns Collapse 141

A Brief History of the Bear 141

Shadow Banking 143

Window Dressing 144

Repo Power 145

The Unexpected Hibernation 148

The Polar Spring 150

CHAPTER 10 Money for Nothing and Fannie and Freddie for Free 155

The Basic Business 157

Where s the Risk? 158

CDO and CDO2 159

The Gigantic Hedge Fund 162

Big–Time Profits 165

The U.S. Housing Bubble 168

The Circle of Greed 170

Real Estate Agents and Mortgage Lender Tricks 173

Home Owners 177

Profits and Politicians 177

The Media and Regulators 180

Grade Inflation 182

Commercial Banks 185

Freddie and Fannie s Foreclosure 186

Why Save Freddie and Fannie? 187

Did Anyone Know? 188

CHAPTER 11 The Lehman Bankruptcy 191

The Wall Street Club 191

Why Was Lehman Next? 193

Business Exposure 196

A Chronology of the Gorilla s Death 202

Double Down in Real Estate 203

Mildly Seeking Capital 207

The Final Days 213

A Classic Run on the Bank 217

Why Let Lehman Fail? 219

Who Was at Fault? 222

Lehman Brothers 222

The Counterparties 224

The Government and Market Structure 225

The Legal Opinion on the Lehman Bankruptcy 225

Who Would Have Been Next? 226

The Spoils of Having Friends in High Places 227

CHAPTER 12 The Absurdity of Imbalance 233

The Long–Dated Swap Imbalance 236

The Repo Imbalance 241

The 228 Wasted Resources and the Global Run on Banks 243

CHAPTER 13 Asleep in Basel 245

Basel I 246

The Concept 246

The Problems 247

Basel II 248

The Concept 248

The Problems 249

Basel and the Financial Crisis 250

CHAPTER 14 The LTCM Spinoffs 253

JWM Partners LLC 253

Platinum Grove Asset Management 258

The Others 259

The Copycat Funds 262

CHAPTER 15 The End of LTCM s Legacy 265

The Bear and the Gorilla Attack 265

November Rain 271

What Went Wrong? 274

Market Insanity 275

Bigger Shocks 281

Market Imbalance 282

Deleveraging 285

Coup de Grace 286

CHAPTER 16 New and Old Lessons from the Financial Crisis 289

Interconnectedness and Crowds 289

Leverage 291

Systemic Risk and Too Big to Fail 293

Derivatives: The Good, the Bad, and the Ugly 294

Conflicts of Interest 297

Policy Lessons 298

Risk Management 301

Counterparty Interaction 302

Hedge Funds 304

The Importance of Arbitrage 306

PART III: THE AFTERMATH 309

CHAPTER 17 The Flash Crash 311

Background 312

Flash Crash Theories 313

Fat Finger Theory 314

High–Frequency Trader Theory 314

Jittery Markets 315

The Real Cause of the Flash Crash 315

The Waddell–Reed Trade 316

The Computer Glitch 317

Gone Fishing 319

The Aftermath 321

CHAPTER 18 Getting Greeked 323

Members Only 324

The Conditions 324

The Benefits of Membership 328

The Drawbacks of Membership 328

The Club s Early Years 330

Getting Greeked 332

Greek Choices 333

Remain a Club Member and Order Finances 333

Ditch the Club and Keep the Debt 334

Ditch the Club and Ditch the Debt 334

The IMF and Euro Packages 335

The EU s Future 335

CHAPTER 19 The Fairy–Tale Decade 339

I Hate Wall Street 340

The Real Costs of the Financial Crisis 344

An Avatar s Life Force 346

Economic System Choices 349

The Crisis of Crowds 350

The Wine Arbitrage 351

APPENDIXES: 353

APPENDIX A  The Mathematics of LTCM s Risk–Management Framework 355

A General Framework 355

A Numerical Example 357

Measuring Risk 357

APPENDIX B The Mechanics of the Swap Spread Trade 361

The Long Swap Spread Trade 361

The Short Swap Spread Trade 362

APPENDIX C Derivation of Approximate Swap Spread Returns 365

APPENDIX D Methodology to Compute Zero–Coupon Daily Returns 369

APPENDIX E Methodology to Compute Swap Spread Returns from Zero–Coupon Returns 373

APPENDIX F The Mechanics of the On–the–Run and Off–the–Run Trade 375

APPENDIX G The Correlations between LTCM Strategies Before and During the Crisis 377

APPENDIX H The Basics of CreativeMortgage Accounting 379

APPENDIX I The Business of an Investment Bank 381

Investment Banking 381

Capital Markets 382

Equities 382

Equity Cash 382

Equity Derivatives 383

Equity Finance 384

Arbitrage (Proprietary Trading) 384

Fixed Income 385

Government and Agency Obligations 385

Corporate Debt Securities and Loans 385

High–Yield Securities and Leveraged Bank Loans 386

Money Market Products 386

Mortgage– and Asset–Backed Securities 386

Municipal and Tax–Exempt Securities 387

Financing 387

Fixed–Income Derivatives 388

Lehman Brothers Bank 388

Foreign Exchange 388

Global Distribution (Global Sales) 389

Research 389

Client Services 389

Private Client Services (Private Wealth Management) 389

Private Equity 390

Technology 390

Corporate and Risk Management 390

Summary 391

APPENDIX J The Calculation of the BIS Capital Adequacy Ratio 393

The General Calculation 393

An Example 395

Notes 397

Glossary 443

Bibliography 451

About the Author 465

Index 467

Ludwig B. Chincarini, CFA, PhD, is an Associate Professor of Finance in the School of Management at the University of San Francisco and a member of the academic council of IndexIQ, with over fifteen years of experience in the financial industry specializing in portfolio management, quantitative equity management, and derivatives. He was Director of Research at Rydex Global Advisors, where he co–developed the S&P 500 equal–weight index and helped launch the Rydex ETF program. He helped build an internet brokerage firm, FOLIOfn, designing its innovative basket trading and portfolio management platform. He also worked at the Bank for International Settlements (BIS) and Schroders. He is the coauthor of Quantitative Equity Portfolio Management. He received a PhD from the Massachusetts Institute of Technology and a BA from the University of California at Berkeley.