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11/21/2012

Book Review: The Crisis of Crowding


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One of the most striking and important books on investing and risk management appears to be something it is not. Upon first glance of The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal (Bloomberg) (and not being acquainted with Prof. Ludwig Chincarini’s work), I wondered how a bunch of paper flowers on the wall was related to investing. After closer examination, I quickly learned that these were not paper flowers, but a pile of darts all stacked together on the dart board. At that point, I realized that Prof. Chincarini’s book would be essential reading for me. I wanted to learn how investors would pile into—and out of—the next big thing after the mortgage securities debacle of 2008. This informative narrative was an investigative and methodical look into major financial crises and the demise of Wall Street.

The book begins with the premise that the financial markets are dangerously overcrowded. The author explicitly analyzes and develops his hypothesis by examining specific and extreme incidents of overcrowding and copycat investors. Readers will rapidly become engrossed with his analysis of the Long Term Capital Management (LTCM) Crisis of 1998. At LTCM, John Meriwether and his experienced team contributed to its long-term investment success using a risk management system intended to enhance the power of its trade-constructing skills. Prof. Chincarini investigates specific examples of the team’s brilliance in constructing and executing investments, and how quickly the copycats duplicated LTCM’s successful strategies to accommodate their own investment pools. Among many other things, the swap spread trade decimated the values of LTCM’s holdings—with instruments as simple as on-the-run (OTR) and off-the-run (OFR) government bonds they thought they could hold until maturity. While significant leverage was utilized by LTCM, it was average when measured against competitors—and did not match the failure of liquidity resulting from volatility to materialize when needed the most. Had LTCM held its positions that it had in 1998 to maturity, it would have been solid financially and from an investment standpoint. Its risk created systemic risk, not because of its size, but owing to its interwoven system of financial positions. The Federal Reserve proved to be the lender of last resort to LTCM, injecting capital to deter additional systemic risks.

How familiar does this sound a decade later as we look to the financial crisis of 2008? It seemed as if the lessons learned after the fall of LTCM were ignored or misunderstood. The demise in March 2008 of Bear Stearns, one of the most highly levered Wall Street firms, was exacerbated by its large mortgage exposure—not to mention the cascading impact this had on its lenders and prime brokerage customers. As in the case of LTCM, the Federal Reserve stood by, providing support by purchasing almost $29 billion of Bear’s mortgage-related securities as part of its rescue and J.P. Morgan’s acquisition of it for a total value of $236 million. Still, thousands of workers and their families were impacted, with many losing their life savings.

Lehman, with its huge real estate exposure (35% at the end of 2007) was the next to fall—but without a rescue. A large part of the residential mortgage portfolio was illiquid—99% of the mortgage securities did not have a daily quote. Managers were concerned with the exposure along with the deterioration in Lehman’s capital ratio. It had to sell assets and raise equity, but could do neither to convince market players that it would survive. Market players distrusted its valuations and creditors cut off lines of credit. Its liquidity vaporized—and it shut its doors. Prof. Chincarini writes, “For those who wondered what would have happened had LTCM failed in 1998, Lehman Brothers was the answer. Its failure caused absolute chaos in both the short and long ends of the markets.” Still, excess leverage was pervasive, from our neighborhood streets to Wall Street. To date, the housing crash represents the most extreme case of overcrowding, from the banks making the mortgage loans to vulnerable homeowners, and also from the standpoints of both issuers of housing-related investment instruments and the investors in them.

Prof. Chincarini also analyzes Fannie Mae and Freddie Mac, the quant crisis of 2008, the AIG bailout, the Flash Crash of May 2010, and the origins of the Eurozone crisis head-on. The recurring theme is risk management, especially the management of systemic risk: the widespread failure of financial institutions and the freezing of capital markets. The recurring themes of leverage, capital strength, and liquidity raise eyebrows when related to immediate concerns associated with the Eurozone and possibly the US with its debt that remains fixed since 2011’s third quarter in excess of 100% of GDP. Who will buy US debt if a “crowd” swarms in to sell it?

The book reads very quickly, crisply, and colorfully despite its analytical approach. Prof. Chincarini provides fine graphics and an appendix providing further detail on the mechanics of the swap spread trade, the mechanics of the OTR and OFR trade, and correlation of LTCM strategies before and during the crisis, among many other topics readers may wish to probe further that are addressed through the main section of the book. His extensive bibliography and detailed footnotes leave nothing to be desired. He does leave us with more questions to ask than to have answered—providing much substance for thought as we approach the fiscal cliff.

–Janet Mangano

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