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The Crisis of Crowding
Quant Copycats, Ugly Models, and the New Crash Normal
Ludwig B. Chincarini (Author)
9781118250020, Wiley
Hardback, published 21 August 2012
512 pages
23.4 x 16.3 x 4.8 cm, 0.748 kg
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 the 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 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 was 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. The 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 One of the lessons from the crisis, rarely discussed, are the problems caused by crowded trading places. 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
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. 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.
Foreword xv CHAPTER 1 Introduction 1 PART I: THE 1998 LTCM CRISIS 5 CHAPTER 2 Meriwether's Magic Money Tree 7 PART II: THE FINANCIAL CRISIS OF 2008 121 CHAPTER 8 The Quant Crisis 123 PART III: THE AFTERMATH 309 CHAPTER 17 The Flash Crash 311 APPENDIXES 353 Notes 397
Preface xix
Cast of Characters xxiii
CHAPTER 3 Risk Management 21
CHAPTER 4 The Trades 37
CHAPTER 5 The Collapse 71
CHAPTER 6 The Fate of LTCM Investors 95
CHAPTER 7 General Lessons from the Collapse 101
CHAPTER 9 The Bear Stearns Collapse 141
CHAPTER 10 Money for Nothing and Fannie and Freddie for Free 155
CHAPTER 11 The Lehman Bankruptcy 191
CHAPTER 12 The Absurdity of Imbalance 233
CHAPTER 13 Asleep in Basel 245
CHAPTER 14 The LTCM Spinoffs 253
CHAPTER 15 The End of LTCM's Legacy 265
CHAPTER 16 New and Old Lessons from the Financial Crisis 289
CHAPTER 18 Getting Greeked 323
CHAPTER 19 The Fairy-Tale Decade 339
APPENDIX A The Mathematics of LTCM's Risk-Management Framework 355
APPENDIX B The Mechanics of the Swap Spread Trade 361
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
APPENDIX I The Business of an Investment Bank 381
APPENDIX J The Calculation of the BIS Capital Adequacy Ratio 393
Glossary 443
Bibliography 451
About the Author 465
Index 467
Subject Areas: Finance & accounting [KF]
