Ludwig B. Chincarini - The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal

Additional Praise for

The Crisis of Crowding

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 yearsstarting with a comprehensive analysis of the Long-Term Capital Management crisis in 1998 and ending with the Euro-debt crisis of 2012and 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). Chincarinis 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 others behavior. It also provides a cautionary tale about the unintended consequences of financial regulations. Chincarinis 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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Copyright 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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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 crisesUnited StatesHistory21st century. 2. Global Financial Crisis, 20082009. 3. Long-term Capital Management (Firm) I. Title.
HB37172007 .C46 2012
330.9730931dc23
2012003587

Dedicated to the late Angus Butler. Were still undefeated .

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 interesting 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. equitiesthe 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.