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Additional Praise for TheCrisisofCrowding

“What causes systemic risk in economic markets? What are the signals that there could be problems? How do you prevent systemic risk? And how should we change our risk management practices to take this risk into account? Chincarini looks at the financial crises of the past 15 years—starting with a comprehensive analysis of the -Term Capital Management crisis in 1998 and ending with the Euro- 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. It is essential that we learn the lessons from the past (or else we will repeat the same mistakes). Chincarini’s book should be required reading for anyone who wants to understand and help prevent financial crises.” —Eric Rosenfeld, Co-Founder of Long-Term Capital Management and JWM Partners

“Chincarini connects the dots between LTCM, mispriced risk, the 2008 financial crisis, the flash crash, and the Greek debt crisis. The instability created by crowded trades, interconnected financial institutions, and too much debt is the recurring theme. For those interested in understanding the quantitative approach to investment, the section of the book focused on LTCM is a very useful reference. It contains, for example, a comprehensive inventory of the types of trades LTCM had entered into and an inventory of lessons learned. This book is not only a useful history of recent financial crises, but a treasure trove of insightful quotations from interviews with many luminaries among modern financial practitioners and academics.” —Robert Litterman, Former Partner and Head of Risk Management at Goldman Sachs; co-inventor of the Black-Litterman Model

“Chincarini returns to the proverbial crime scene of a decade earlier to find the origins of the crisis of 2008. Based on new interviews with key players and his own analysis, the book argues that the LTCM collapse of 1998 should have been the early warning signal of fragility in the financial system rooted in the fact that holders of sophisticated financial products so often just end up copying each other’s behavior. It also provides a cautionary tale about the unintended consequences of financial regulations. 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 Advisers to the President; Professor of Economics at the University of Chicago

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THE CRISIS OF CROWDING

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Since 1996, Bloomberg Press has published books for financial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and businesspeople. Titles are written by well- known practitioners, BLOOMBERG NEWS R reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages. For a list of available titles, please visit our Web site at www.wiley.com/ go/bloombergpress.

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THE CRISIS OF CROWDING

Quant Copycats, Ugly Models, and the New Crash Normal

Ludwig B. Chincarini

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Copyright C 2012 by Ludwig B. Chincarini. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Chincarini, Ludwig B. The crisis of crowding : quant copycats, ugly models, and the new crash normal / Ludwig B. Chincarini. – 1 p. cm. – (Bloomberg) Includes bibliographical references and index. ISBN 978-1-118-25002-0 (hardback); ISBN 978-1-118-28271-7 (ebk); ISBN 978-1-118-28438-4 (ebk); ISBN 978-1-118-28480-3 (ebk) 1. Financial crises–United States–History–21st century. 2. Global , 2008–2009. 3. Long-term Capital Management (Firm) I. Title. HB37172007 .C46 2012 330.973 0931–dc23 2012003587

Printed in the United States of America

10987654321

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Dedicated to the late Angus Butler. We’re still undefeated.

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Contents

Foreword xv Preface xix Cast of Characters xxiii

CHAPTER 1 Introduction 1

PART I: THE 1998 LTCM CRISIS 5

CHAPTER 2 Meriwether’s Magic Money Tree 7 The Birth of Bond 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 U.S. Swap Trade 41 The European Cross-Country Swap Trade (Short UK and Long Europe) 44

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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 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’sSizeGottoDowithIt? 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 Dej´ aVu` 118 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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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 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 TheWallStreetClub 191 Why Was Lehman Next? 193 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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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 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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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 311 Background 312 Flash Crash Theories 313 Fat Finger Theory 314 High-Frequency Trader Theory 314 Jittery Markets 315 TheRealCauseoftheFlashCrash 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 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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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 Creative Mortgage Accounting 379 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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APPENDIX I The Business of an Investment Bank 381 381 Capital Markets 382 Equities 382 Equity Cash 382 Equity Derivatives 383 Equity Finance 384 Arbitrage () 384 Fixed Income 385 Government and Agency Obligations 385 Corporate Debt Securities and Loans 385 High-Yield Securities and Leveraged Bank Loans 386 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 JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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Foreword

I sat on the risk committee of Goldman Sachs during 2006 and 2007 as the financial markets began to crack and the forces that led the economy into recession and the financial sector into bankruptcy emerged. It was an inter- esting perspective. I watched as the heads of our trading businesses struggled to deal with one crisis after another. Like generals in battle, our vision of future events was clouded by fog. Liquidity in many markets was significantly reduced. Prices stopped reflecting fundamentals. Opportunities that looked attractive one day suddenly turned into crowded trades and became quicksand for those trapped in them. And most scary of all, the problems in subprime mortgages suddenly popped up in seemingly unrelated venues such as credit and money markets, and then in July 2007 in a large number of unlikely linear combinations of U.S. equities—the so-called quant factors. In the latter case one needed sophisticated computer algorithms to see what was happening. The firm’s instruction to its traders was clear: Stay close to home. In other words, continue to make markets, but don’t build up sizable positions. Increase your spreads to reflect market realities, but avoid crowded trades like the plague. With respect to mortgages, in late 2006 and early 2007 there was, as has been documented elsewhere, a growing recognition that the risk of a significant meltdown in prices was rising and the firm needed to liquidate inventory and hedge its remaining positions. I was lucky. I had a large personal investment in a four-times-leveraged market-neutral quantitative equity called “Global Equity Oppor- tunities,” run by the business I headed, Quantitative Investment Strategies, a part of Goldman Sachs Asset Management. Although I had a ringside seat, like most investors watching the events unfold, I did not see what was com- ing. However, when the financial tsunami spilled into and nearly destroyed those invested in quantitative equity portfolios in the first week of August 2007, Goldman Sachs senior management had the financial strength, vision, and crisis management expertise to quickly inject sufficient liquidity into our hedge fund to turn the situation around. Not only our hedge fund, but the

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entire quantitative equity space rebounded rapidly when news of the Goldman liquidity injection reached the market. The quantitative equity strategies, a narrow part of the much broader quantitative investment space, had become crowded when the financial crisis began. Although many details are unknowable, my best guess is that the un- winding of quantitative equity portfolios began in one or more multistrategy hedge funds that also had exposure to mortgages, credit, and other already directly impacted strategies. Of course with the benefit of hindsight I wish I had been able to make the connection earlier on between those risk com- mittee warnings about crowded trades and the quantitative business that I was heading. Unfortunately, at the time the admonitions to avoid crowded trades did not seem to apply to our investment strategy, which relied on com- plex computer algorithms that slowly and continuously adjusted thousands of relatively small individual equity positions in liquid markets around the world. As it turned out, the admonitions did apply; quantitative equity was a crowded space that was, in retrospect, just as dangerous as any crowded trade. This generalization of the concept of crowded trades is just one of the many lessons from the recent financial crisis that are highlighted in this book by Ludwig Chincarini, an economist I have known for many years. Both an academic and a financial market professional himself, Chincarini uses his economist’s perspective and quantitative expertise, as well as many in-depth interviews with academics turned practitioners, to bring insights to events that have stunned investors in recent years. Many of the lessons highlighted in this book, like the lesson about avoid- ing a crowded space, are hard to disagree with. In this case the only question is: how does one identify and deftly depart from a crowded space before oth- ers do? Other lessons learned, however, are less clear and will require careful consideration in the years ahead. The events covered start with a brief look at the market crash in 1987, and include an in-depth look at the Long-Term Capital Management (LTCM) crisis in 1998, multiple dimensions of the financial crisis of 2007 through 2009 (including the quant meltdown), and recent events such as the flash crash of May 2010 and the Greek debt crisis. Many of the events described started with a good idea. A crowded trade or space generally grows up around what seems to be a good idea. Portfolio was a dynamic trading strategy developed in the mid-1980s that seemed to be just such a good idea. The strategy used futures to replicate a that would protect a portfolio against a significant equity market decline. It was such a good idea that it was successfully marketed to large pen- sion funds by a number of investment advisors. Putting together a portfolio of convergence trades in fixed income, as was carefully crafted on the proprietary JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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trading desks of Salomon Brothers in the early 1980s and later by the hedge fund LTCM, was another good idea. Carefully identifying characteristics of equities that are likely to predict future returns and then using computer algorithms to incorporate those positions into equity portfolios, as was done inside my group at Goldman Sachs, was another seemingly good idea. And by far the biggest example of all, providing incentives to encourage home ownership, especially to those who might not otherwise be able to qualify for a mortgage, was the seemingly good idea embraced by the U.S. government. As we know from history, each of these good ideas ended in disaster. The path that leads from good idea to disaster is eerily similar in each case. A good idea leads to a successful business model. Others, whom Chincarini calls “copycats,” learn how to enter the space, and the business expands successfully. Capital flows into the strategy, leading to even more success for those already there, until at some point the pendulum swings and the music stops. And thus we have the crisis of crowding, copycats, and crashes. If you want to understand the rise and fall of LTCM, perhaps you might start with interviews of the Nobel laureates who were there. The business of LTCM, according to Robert Merton, quoted at length in this book, was as follows: “We were not faster, smarter, or had necessarily better models than others. We had good stuff, but that wasn’t the secret. It was institutional rigidi- ties. We provided a service. With all the rules, regulations, and complexities, it is inevitable that those rules will have unintended consequences which put intermediaries in a bind. If you can loosen the constraints of that rigidity you can get a premium for that. Just like you get paid for cutting someone’s lawn.” Similar insights are found throughout. There are, however, some unanswered questions raised by the concerns of Chincarini’s book. How, for example, can we identify ahead of time when copycats are turning an investment strategy into a crowded trade or a crowded space? This, of course, is a difficult question that does not have an obvious answer. Chincarini suggests that better risk models would help solve this problem. Risk models, he says, should take crowdedness into account as well as valuation. On this point I’m not sure how it could be done. You might criticize an investor for not recognizing the risk as others pile into his space, or for not pulling back having recognized the risk, but I don’t know how you can expect the investor’s risk model to identify a crowded trade before the investor does. Similarly, you might expect investors to try to identify cheap assets because they have more room to appreciate, but I don’t trust an investor whose risk metrics rely on measures of valuation. As Chincarini recognizes, fundamental valuation goes out the window when investors rush for liquidity. Chincarini raises some interesting arguments on crowding and risk models, JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

xviii Foreword

and practitioners and academics can debate these ideas since risk management is still evolving and the market events of 2008 showed that these models were not fully reliable. There are places where Chincarini applies the crowd idea differently. For example, the author puts “crowd behavior” at the center of the flash crash of May 6, 2010, which is the subject of Chapter 17. The flash crash was, no doubt, a very interesting event. Most accounts blame a large trade in the equity futures market, apparently implemented by a poorly designed algorithm that did not respond appropriately as market impact increased over time. According to this version of events, the trade created a shock that led to a whiplike impact in exchange-traded funds (ETFs) and then even more profound price moves in individual equities as liquidity, today largely provided by high-frequency trading algorithms, dried up. Chincarini suspects that the futures market trade may not have been so central to the event and summarizes the cause as follows: “Crowd behavior erased liquidity just when traders needed it the most, and just as the markets saw in the LTCM crisis, the quant crisis, and the subprime crisis.” We both agree that an initial order may have triggered confusion in the market space, but Chincarini believes it was the crowded behavior of liquidity providers that ultimately caused liquidity to vanish. It could have been simply that rational actors stepped aside in the midst of uncertainty. Either way, current risk models did not anticipate such flash crashes. Whether it is possible to set risk controls around the many examples of crowdedness may be debatable, but what is not arguable is that the market did and probably will continue to present surprises for which the crowd of investors is not prepared. This is an excellent exploration of many of the most interesting events in the financial markets of the past several decades, with insights from many of the former academics turned participants, as well as a very useful compilation of lessons learned.

Robert Litterman Former Partner and Head of Risk Management, Goldman Sachs; co-inventor of the Black-Litterman Model JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

Preface

My initial motivation for writing this book was to clarify many of the misun- derstandings surrounding financial failures and crises. After a collapse, we are often given incorrect versions of what happened, and this leads us to make mistakes again in the future. Therefore, even if a lot of work is required, it is best to get the story straight. This particular story begins with the failure of Long-Term Capital Man- agement in 1998, continues to the financial crisis of 2008 as well as the Flash Crash of 2010, and ends with the ongoing . I hope to show that all these events are connected and might have been avoided. These events all involved crowded trading spaces, where risk models did not take into account either the presence of crowds through valuation or their actions. Prices in many of these instances were determined by the holders of the securities rather than fundamentals. When LTCM collapsed, many people tried to explain what had happened, but in an effort to make the story easier to grasp, it was distorted, and so were our own perceptions of the financial world. As a result, an opportunity to improve the financial system was lost and bigger crises occurred. Still, it is never too late to learn. Thus, in the first part of the book I retell the LTCM story with the help of many conversations with the partners of LTCM and access to a wealth of proprietary data. Also, I decided to tell the story from a financial point of view rather than a personal one, so as to understand the real lessons that we should have learned in the historic LTCM collapse. The second part of the book goes through the financial crisis of 2008 in detail. While other books on the crisis have focused on the personalities and the inside stories, this book focuses mainly on explaining what happened in a straightforward way. There is something for everyone. Some technical bits for more specialized readers and simpler bits for more general readers. This part of the book includes the Quant Crisis of 2007, the collapse of Bear Stearns, the implosion of Freddie and Fannie and Lehman Brothers as the housing bubble burst, and finally, the collapse of Liar’s Poker king, John Meriwether’s xix JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

xx Preface

new fund, JWMP.I also discuss the lessons we should learn from the financial crisis. The third part of the book speaks about some of the same elements of crowd behavior that snuck into the May 2010 Flash Crash—when Apple traded briefly for $100,000 per share—and on to the continuing debt saga in Europe, which started with the Greek crisis. Throughout the book, I sprinkle in excerpts from my interviews with many of the people who were on the front line of the crises, including five LTCM partners: Eric Rosenfeld, Chi-Fu Huang, Hans Hufschmid, and Nobel prize winners Robert Merton and Myron Scholes. I also spoke with numerous bank authorities, like Sir Deryck Maughan, former Vice Chairman of Citibank; Andrew Crockett, former head of the BIS; Jimmy Cayne, former CEO of Bear Stearns, and the founders and CEOs of many leading hedge funds, including Goldman Sachs fund. These are supplemented by numerous other sources—testimonies, court documents, newspaper articles, and previous books on the crises—that helped me understand and explain what had happened. For completeness, I also provide an online appendix (www.wiley .com/go/crisisofcrowds) that goes through all aspects of the U.S. economy before, during, and after the financial crisis of 2008. There are other online appendices on policy reactions to the crisis, including a detailed analysis of Dodd-Frank, a detailed analysis of unconventional policies offered by the , a brief analysis of government policies such as Cash for Clunkers, and an overview of the most recent global regulatory standard for bank capital, Basel III. I had originally planned to write a small research paper on the financial crisis, but two people inspired me to write a whole book: Eric Rosenfeld and Chi-Fu Huang. Eric has been a friend for many years. He has taken time to come to speak to my students several times about LTCM. Not only did many students learn from his guest lectures, but I, too, learned a lot more about finance. He was patient with me throughout the process of writing this book, sharing his time, his data, his contacts, and his wisdom. Chi-Fu Huang also supplied his time, thoughts, and data. He also provided key insights into parts of the book, especially Chapter 12, The Absurdity of Imbalance. I would also like to thank other people who supplied key insights into various events described in this book, including Cliff Asness, Steve Blas- nick, Mark Carhart, Jimmy Cayne, Pierre-Olivier Gourinchas, Mark Hooker, Hans Hufschmid, Eric Scott Hunsader, Ray Iwanowski, Ken Kroner, Deryck Maughan, Michael Mendelsohn, John Meriwether, Sandor Strauss, Anthony Valukas, Cliff Viner, Chris Ward, and those people who chose to remain anonymous. JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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A few people took the time to read my long manuscript and give me their feedback, which helped me improve the book. These people include David Bieri, Mark Schroeder, Daehwan Kim, and Peter Sasaki. I would also like to thank Andrew Crockett for his insights and detailed comments and for reminding me not to be such a hedgehog. I thank Anthony Gonzalez and Matt Walkup for giving their excellent research assistance. They never gave up no matter how difficult things got and thirsted for knowledge. Other research assistance was provided by John Wick, Jason Blauvelt, Andrew Oetting, Bridgette Adams, Jing Wen, James Lambert, Coady Smith, Evelyn Khalili, and Saw Jae Won. For data help, I thank Alexey Polishcuk, Wayne Passmore, Terry Lobes, David Blitzer, Michael Rappaport, Kristof Starzynski, Lisa Finstrom, Sabya Sinha, Salvatore Bruno, Robert Mc- Cauley, Sabya Sinha, and Andrew Dialynas. For useful discussions, I thank Jim Barth, Bob Litterman, Wayne Ferson, Carl Hopman, Viral Acharya, Bob Mc- Cauley, Mark Schroeder, Wolfgang Chincarini, Chris Kawasaki, James Angel, Chris Lalli, James Hamilton, John Taylor, Steve Ross, Robert Whitelaw, Ross Waldrop, Kevin Brown, Bryan Bashaw, Dennis To, Jacob Gyntelberg, Stefan Avdjiev, Silvio Contessi, Gregg Berman, Claudio Borio, Kostas Tsatsaronis, Mathias Drehmann, and Frank Fabozzi. Thank you, Morgan Ertel, for trying. I thank Pam Van Giessen for putting up with me over the years and taking a leap of faith with me on this book, Evan Burton for helping to make this book a reality, Judy Howarth and Melissa Lopez for editing, Michael Freeland for his cover design, and Simone Black and everyone else at Wiley for their support. I wrote this book all over the country, but the place that most inspired me was Berkeley, where I had studied as an undergraduate. I thank the Royal Ground Coffee of Albany, California, for letting me live in their cafe. At times they must have thought I was a homeless person. The Aroma Cafe in Studio City, California, the Coffee Bean in Claremont, California, and the P.F. Changs in Rancho Cucamonga, California, also allowed me to work for long periods of time and for that I am grateful. If you would like to send me suggestions or comments on the book, please send them to my e-mail address below with the subject line: Book Comments. If you were involved in any of the events I describe, please let me know as well, and perhaps I can include your story in the future. If you are an instructor that uses this book as a supplemental text in your class, please let me know and I will add you to the acknowledgements.

Ludwig Chincarini,CFA, PhD [email protected] JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

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Cast of Characters

Herbert Allison: President and COO of Merrill Lynch during the LTCM crisis. Appointed President and CEO of Fannie Mae in September 2008 and is currently the Assistant Secretary of the Treasury for Financial Stability of the United States. Madelyn Antoncic: Managing Director and Chief Risk Officer at Lehman Brothers during the financial crisis. Cliff Asness: Co-founder and CEO of the quantitative hedge fund AQR Capital Management. Previously was Managing Director of Quantitative Research at Goldman Sachs. : Chairman of the Federal Reserve during the crisis of 2008. Lloyd Blankfein: CEO and Chairman of Goldman Sachs. Steve Blasnik: President and CEO of Parkcentral Capital Management, a relative value hedge fund that managed Ross Perot and other investors’ private wealth. Warren Buffett: Billionaire investor and CEO of Berkshire Hathaway. Erin Callan: Managing Director and Head of Hedge Fund Investment Bank- ing; Chief Financial Officer, 2007–2008. Mark Carhart: Former co-head of Quantitative Strategies and Global Alpha hedge fund at Goldman Sachs. Jimmy Cayne: Chairman of the Board of Bear Stearns during the financial crisis. Former CEO of Bear Stearns. Ralph Cioffi: Managing Director of Bear Stearns Asset Management and head of two Bear Stearn hedge funds that collapsed in 2007. Jon Corzine: Former CEO of Goldman Sachs and Meriwether’s classmate at the University of Chicago. Also served as Governor of New Jersey from 2006 to 2010 and former CEO of MF Global. Christopher Cox: Chairman of the SEC during the financial crisis. Jim Cramer: Host of Mad Money television show, author, and founder of Street.com.

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xxiv Cast of Characters

Andrew Crockett: Former CEO of the Bank for International Settlements from 1994 to 2003. Currently President of J.P. Morgan International. Knighted by Queen Elizabeth in 2003. Jamie Dimon: Former President and co-CEO of Smith Barney Salomon. Currently CEO of J.P. Morgan. At Salomon when arbitrage group was shut down, which may have helped trigger LTCM crisis. Chris Dodd: United States Senator from Connecticut during financial crisis. Co-author of Dodd-Frank bill. Rudi Dornbusch: The late MIT professor of international economics. The mentor of almost every well-known international economist, including Paul Krugman, Ken Rogoff, Jeffrey Sachs, and many more. Stanley Druckenmiller: Former lead portfolio manager of the Quantum Group from 1988 to 2000, the George Soros hedge fund. David Einhorn: President of Greenlight Capital, a long-short value-oriented hedge fund. Antonio Fazio: Governor of the Bank of Italy at the time that the Bank of Italy invested with LTCM. Eric Felder: Managing Director and head of Global credit products at Lehman Brothers during the financial crisis. Barney Frank: Democratic member of the House of Representatives from Massachusetts. Co-author of the Dodd-Frank bill. Paul Friedman: Chief operating officer of Bear’s fixed-income division. Richard Fuld: CEO and Chairman of the Board of Lehman Brothers during the financial crisis. Timothy Geithner: President of the of New York during the financial crisis. Currently, Treasury Secretary of the USA. Michael Gelband: Managing Director and global head of fixed income who was asked to leave in 2007. Alberto Giovannini: Senior strategist at LTCM. Currently CEO and founder of Unifortune SGR. Ace Greenberg: Chairman of the Executive Committee of Bear Stearns dur- ing the financial crisis of 2008. CEO of Bear Stearns from 1978 to 1993. : Chairman of the Federal Reserve from 1987 to 2006. Joseph Gregory: President and Chief Operating Officer of Lehman Brothers up to the collapse. John Gutfreund: CEO of Salomon Brothers until 1991. Victor Haghani: Principal at LTCM and JWMP. Headed LTCM’s London office and also very influential trader. Gregory Hawkins: Principal at LTCM and JWMP. Nicknamed the Hawk. JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

Cast of Characters xxv

Larry Hilibrand: Principal at LTCM and JWMP.One of the most influential traders at the firm. Chi-Fu Huang: Principal and head of Toyko office for LTCM. CEO and CIO of PGAM from 1999 to 2009. Head of Fixed Income Derivatives at Goldman Sachs with Fischer Black from 1993 to 1994. Hans Hufschmid: Principal at LTCM. Responsible for foreign exchange trading, among other things. Currently CEO of GlobalOp. Ray Iwanowski: Former co-head of Quantitative Strategies and Global Alpha hedge fund at Goldman Sachs. Bob Jones: Former head of the Quantitative Equity group and Global Equity Opportunities hedge fund at Goldman Sachs. Mitch Kapor: Founder of first commercially available spreadsheet program, Lotus 1-2-3 (the precursor to Excel). Business partner of Eric Rosenfeld. John Maynard Keynes: British economist who first mentioned ideas of quantitative easing. Alex Kirk: Managing Director and global head of high-yield and leveraged loans at Lehman Brothers during financial crisis. William Krasker: Principal at LTCM. Modeler at LTCM. Arjun Krishnamacher: Principal at LTCM and JWMP. Ken Kroner: Head of Blackrock’s global market strategies overseeing the quantitative hedge fund group. Jim Leach: Republican member of the U.S. House of Representatives for Iowa during LTCM crisis. Dick Leahy: Principal at LTCM and JWMP.Handled mortgage trading and co-managed with Meriwether the Macro fund at JWMP. Ken Lewis: CEO and Chairman of Bank of America during the financial crisis. John Mack: CEO and Chairman of Morgan Stanley during the financial crisis. Deryck Maughan: Chairman and CEO of Salomon Brothers from 1992 to 1997, Vice Chairman of Citigroup from 1998 to 2004, Vice Chairman of the NYSE from 1996 to 2000, and currently partner at KKR. William McDonough: President of the New York Federal Reserve during the LTCM crisis. James McEntee: Principal at LTCM and former Chairman of the Board and co-CEO of the government bond trading firm Carroll McEntee & McGinley. Meriwether and McEntee shared a love for horses. John Meriwether: CEO and founder of Long-Term Capital Management and JWMP. Vice-Chairman of Salomon Brothers from 1988 to 1991. JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in

xxvi Cast of Characters

Robert Merton: Principal at LTCM and Professor of Finance at MIT. Winner of the 1997 Nobel prize in economics. Euoo Sung Min: Chairman of the Board and Chief Executive Officer, Korea Development Bank. David Modest: Principal at LTCM. Managing Director at Morgan Stanley and J.P. Morgan and currently at the Soros Fund. Samuel Molinaro: CFO of Bear Stearns during Bear Stearns collapse. Paul Mozer: Salomon Brothers trader who made illegal bids in the Treasury auction causing Meriwether and Gutfreund to resign from Salomon. Peter Muller: Former head of Morgan Stanley’s Process Driven Trading group. David Mullins: Principal at LTCM and former Secretary of the Treasury. Principal role to raise capital and raise credibility of LTCM. Roger Nagioff: Managing Director and appointed Global head of fixed income in 2007. Hank Paulson: Treasury Secretary of the United States during 2008 and former CEO of Goldman Sachs. Chuck Prince: CEO and Chairman of Citigroup from 2003 to 2007. Re- signed in 2007 due to the poor performance of mortgage-related products. Franklin Raines: CEO of Fannie Mae from 1999 to 2004 and Vice Chair- man of Fannie Mae from 1991 to 1996. Julian Robertson: Founder of the very successful hedge fund Tiger Manage- ment. Eric Rosenfeld: Principal at LTCM and JWMP. Meriwether’s right-hand man. Myron Scholes: Principal at LTCM and PGAM. Winner of the 1997 Nobel prize in economics. Alan Schwartz: CEO and President of Bear Stearns during 2008. William Sharpe: Professor at Stanford University and co-inventor of the CAPM. Won the 1990 Nobel in economics for his work on asset pricing theory. Robert Shustak: CFO of LTCM. Currently CFO and COO of the hedge fund founded by Sanford Grossman, QFS. James Simons: Founder and CEO of Renaissance Technologies, one of the most successful quantitative hedge funds. This hedge fund also suffered during the Quant crisis. Simons was a mathematician prior to his entry into finance. George Soros: Founder of Soros Fund Management. Famous for his hedge fund bet that the British pound would devalue.