The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
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Ludwig Chincarini Explores How Crowded Trading Has Led to Financial Crises, including LTCM, the 2008 crisis, the Flash Crash, and the Greek debt crises
Financial markets are not immune to the human tendency to group together. Investors follow popular trends or latch onto profitable new strategies with herd-like single-mindedness. In The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal (Wiley; August 2012; $40.00; 978-1-118-25002-0; Hardcover; Ebook), finance veteran and professor Ludwig Chincarini explores how this dramatic overcrowding has yielded terrifying results and contributed to recent financial crises.
“Modern risk-measurement models generally ignore the presence of copycats and the resulting crowded spaces. As a result, a shock to the system can lead to sudden, sometimes large asset price moves, which can cause panic and failure among the institutions involved in that investment space,” explains Chincarini. “In the past 20 years, globalization, technology, and increased leverage have made the effects of overcrowding more apparent and dramatic. In fact, market crashes are happening more regularly than in the past.”
The Story of Crowding: The Stock Market Crash of 1987
The first crisis caused by modern-day crowding was likely the stock market crash of 1987. The financial industry has popularized dynamic portfolio insurance, which involved protecting investors from losing money on their portfolios. This practice can work quite well if only a small portion of the market pursues these strategies. In 1987, there were too many copycats, too much crowding, and too many models that didn’t adequately account for this crowding.
Failure of Long-Term Capital Management in 1998
The next big crisis came 11 years later. In 1994, Long-Term Capital (LTCM) launched their "Dream Team" hedge fund. . They were the new financial juggernauts, and everyone wanted a piece of their amazing performance. Soon other institutions, including the proprietary trading desks of Goldman Sachs, Morgan Stanley, Lehman Brothers, and multiple new hedge funds, began to reverse engineer LTCM’s strategies, all of which involved leverage. The lucrative relative-value bond arbitrage investment area became saturated with quantitative copycats. Heavily leveraged positions meant that small moves could destroy an entire firm in a short period of time.
In July 1998, one of the large institutions, Salomon Brothers, began closing its copycat positions. In August 1998, the Russian government defaulted on its bonds. The shock occurred as the relative value funds were scrambling to survive. LTCM was on the brink of bankruptcy; many feared that this would shatter the financial system. The Federal Reserve stepped in and coordinated a private solution to prevent chaos.
The Internet Bubble of 2000
In 2000, Internet stocks traded at ridiculous multiples. By April 2000, the bubble began to crash. The NASDAQ dropped by 70%. Yet despite investors’ dramatic losses, the after-effects were comparatively mild, mostly because of the limited amount of leverage in Internet stocks. This put some brakes on the stampede to crash.
The Financial Crisis of 2008
Much that should have been obvious after the fall of LTCM could have prevented the crises that followed. Instead, the problems of overcrowding went unchecked so that when the next economic disaster hit, increased leverage, policy mishaps, and an even more crowded trading space resulted in a far bigger collapse in 2008.
From 2000 to 2008, every aspect of the U.S. economy got more involved in a massively leveraged trade: real estate investing. Instead of involving just traders, as most crowding does, the sub-prime lending bubble featured politicians, greedy home buyers, mortgage brokers, real estate agents, banks and investment banks, and quasi-government organizations Freddie Mac and Fannie Mae.
Investment banks took outright positions in real estate and also created, sold, and traded derivatives based on housing values. Hedge funds also took various bets on real estate market segments. Insurance companies joined the space by offering insurance to the crowded investors. Rating companies joined the greed train and issued triple-AAA ratings as fast as they could write the three letters and cash the checks. Some homeowners took leveraged investing to new heights by putting zero money down and enjoying a leverage ratio of infinity.
Risk models were glaringly inadequate. They used historical data, which didn’t include the enormous amount of crowding and overvaluation that existed by 2008. It was only a matter of time before we saw the worse crash since the stock market crash of 1929: the 2008 financial crisis. The massive exposure to a collapsing bubble combined with leverage and short-term borrowing to create an unprecedented shock to quantitative hedge funds. Known as the Quant Crisis, this destroyed Goldman Sachs’s star hedge fund.
The crisis gave us a spectacular show: the historic collapse and rescue of Bear Stearns, a government rescue for Freddie Mac and Fannie Mae, hundreds of bank failures, Lehman Brothers’ bankruptcy, a market-wide lending freeze, the failure of a whole host of hedge funds (including-John Meriwether’s new fund, JWMP), and unprecedented marketplace interventions from the U.S. government and Federal Reserve.
The Flash Crash of 2010
Three years and a depression later, the markets had slightly recovered. On May 6, 2010, between 2:42 pm and 2:47 pm, the Dow Jones dropped by 600 points, then rose 600 points by 3:07 pm, events known as the Flash Crash.
The European Debt Crisis
From 2001 to 2008, banks around the world lent money to Greece, assigning it a risk level very similar to that of countries with more discipline and higher productivity, such as Germany. The crowded space kept Greek interest rates at unrealistically low levels, and the Greeks were happy to borrow to fund consumption–until the crowd realized that Greece was a mess.
Part narrative, part quantitative analysis, The Crisis of Crowding is filled with first hand recollections from those on the front lines of the crowding crisis, including several LTCM partners. Featuring insights from key banking and hedge fund authorities, including Jimmy Cayne, Sir Deryck Maughan, Sir Andrew Crockett, John Meriwether, and perspectives from Nobel prize winners Robert Merton and Myron Scholes, it brings the events that led to the current crisis vividly to life, showing how and why the market has evolved in new and dangerous ways, and what can be done about it.