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

ISBN: 978-1-118-25002-0
512 pages
July 2012
The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal (1118250028) cover image


A rare analytical look at the financial crisis using simple analysis

The economic crisis that began in 2008 revealed the numerous problems in our financial system, from the way mortgage loans were produced to the way Wall Street banks leveraged themselves. Curiously enough, however, most of the reasons for the banking collapse are very similar to the reasons that Long-Term Capital Management (LTCM), the largest hedge fund to date, collapsed in 1998. The Crisis of Crowding looks at LTCM in greater detail, with new information, for a more accurate perspective, examining how the subsequent hedge funds started by Meriwether and former partners were destroyed again by the lapse of judgement in allowing Lehman Brothers to fail.

Covering the lessons that were ignored during LTCM's collapse but eventually connected to the financial crisis of 2008, the book presents a series of lessons for hedge funds and financial markets, including touching upon the circle of greed from homeowners to real estate agents to politicians to Wall Street.

  • Guides the reader through the real story of Long-Term Capital Management with accurate descriptions, previously unpublished data, and interviews
  • Describes the lessons that hedge funds, as well as the market, should have learned from LTCM's collapse
  • Explores how the financial crisis and LTCM are a global phenomena rooted in failures to account for risk in crowded spaces with leverage
  • Explains why quantitative finance is essential for every financial institution from risk management to valuation modeling to algorithmic trading
  • Is filled with simple quantitative analysis about the financial crisis, from the Quant Crisis of 2007 to the failure of Lehman Brothers to the Flash Crash of 2010

A unique blend of storytelling and sound quantitative analysis, The Crisis of Crowding is one of the first books to offer an analytical look at the financial crisis rather than just an account of what happened. Also included are a layman's guide to the Dodd-Frank rules and what it means for the future, as well as an evaluation of the Fed's reaction to the crisis, QE1, QE2, and QE3.

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Table of Contents

Foreword xv

Preface xix

Cast of Characters xxiii

CHAPTER 1 Introduction 1


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 ρ 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


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


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


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

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Author Information

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.

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Appendix K
Appendix K - The U.S. Economy Before, During, and After the Financial Crisis
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Appendix L
Appendix L - The Policy Reaction I: If You're Dodd, I'll be Frank
809.46 KB Click to Download
Appendix M
Appendix M - The Policy Reaction II: Basel's Back: Three Strikes and You're Out
342.19 KB Click to Download
Appendix N
Appendix N - The Policy Reaction III: The Federal Reserve
889.50 KB Click to Download
Appendix O
Appendix O - The Policy Reaction IV: Fiscal Stimulus and Housing
540.09 KB Click to Download
Appendix P
Appendix P - A Simple Model of Banks

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Press Release

August 08, 2012
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.


Crowded Investment Space Kept Greek Interest Rates Unrealistically Low Until the Crowd Realized It 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. 

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