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The Crisis of Crowding


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Table of Contents

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 Dej`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 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 PART III: THE AFTERMATH 309 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 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 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

About the Author

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, FOLIO fn , 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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