JWBT729-fm JWBT729-Chincarini Printer: Yet to Come June 19, 2012 22:16 Trim: 6in × 9in ib JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in 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 Long-Term Capital Management 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. 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 ia JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in ib JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in THE CRISIS OF CROWDING i JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in 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. ii JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in THE CRISIS OF CROWDING Quant Copycats, Ugly Models, and the New Crash Normal Ludwig B. Chincarini iii JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in Copyright C 2012 by Ludwig B. Chincarini. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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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 Financial Crisis, 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 iv JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in Dedicated to the late Angus Butler. We’re still undefeated. v JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in vi JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in 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 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 vii JWBT801-FM JWBT801 Printer: Yet to Come July 27, 2012 22:14 Trim: 6in × 9in viii Contents 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’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 Contents ix 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