The Crisis of Crowding

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.

Foreword xv Preface xix Cast of Characters xxiii CHAPTER 1 Introduction 1 PART I: THE 1998 LTCM CRISIS 5 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 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 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 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 Man