The Crisis of Crowding

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. Guides the reader through the real story of Long-Term Capital Management with accurate descriptions, previously unpublished data, and interviews Describes the lessons that hedge funds, as well as the market, should have learned from LTCM's collapse Explores how the financial crisis and LTCM are a global phenomena rooted in failures to account for risk in crowded spaces with leverage Explains why quantitative finance is essential for every financial institution from risk management to valuation modeling to algorithmic trading Is filled with simple quantitative analysis about the financial crisis, from the Quant Crisis of 2007 to the failure of Lehman Brothers to the Flash Crash of 2010 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 Preface xix Cast of Characters xxiii CHAPTER 1 Introduction 1 PART I: THE 1998 LTCM CRISIS 5 CHAPTER 2 Meriwether's Magic Money Tree 7 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 PART II: THE FINANCIAL CRISIS OF 2008 121 CHAPTER 8 The Quant Crisis 123 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 PART III: THE AFTERMATH 309 CHAPTER 17 The Flash Crash 311 CHAPTER 18 Getting Greeked 323 CHAPTER 19 The Fairy-Tale Decade 339 APPENDIXES 353 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 Notes 397 Glossary 443 Bibliography 451 About the Author 465 Index 467