Financial markets are not immune to the human tendency to group
together. Investors follow popular trends or latch onto profitable new
strategies with herd-like single-mindedness. In The Crisis of
Crowding: Quant Copycats, Ugly Models, and the New Crash Normal (Wiley;
August 2012; $40.00; 978-1-118-25002-0; Hardcover; Ebook), finance
veteran and professor Ludwig Chincarini explores how this
dramatic overcrowding has yielded terrifying results and contributed to
recent financial crises.
“Modern risk-measurement models generally ignore the presence of
copycats and the resulting crowded spaces. As a result, a shock to the
system can lead to sudden, sometimes large asset price moves, which can
cause panic and failure among the institutions involved in that
investment space,” explains Chincarini. “In the past 20 years,
globalization, technology, and increased leverage have made the effects
of overcrowding more apparent and dramatic. In fact, market crashes are
happening more regularly than in the past.”
The Story of Crowding: The Stock Market Crash of 1987
The first crisis caused by modern-day crowding was likely the stock
market crash of 1987. The financial industry has popularized dynamic
portfolio insurance, which involved protecting investors from losing
money on their portfolios. This practice can work quite well if only a
small portion of the market pursues these strategies. In 1987, there
were too many copycats, too much crowding, and too many models that
didn’t adequately account for this crowding.
Failure of Long-Term Capital Management in 1998
The next big crisis came 11 years later. In 1994, Long-Term Capital
(LTCM) launched their "Dream Team" hedge fund. . They were the new
financial juggernauts, and everyone wanted a piece of their amazing
performance. Soon other institutions, including the proprietary trading
desks of Goldman Sachs, Morgan Stanley, Lehman Brothers, and multiple
new hedge funds, began to reverse engineer LTCM’s strategies, all of
which involved leverage. The lucrative relative-value bond arbitrage
investment area became saturated with quantitative copycats. Heavily
leveraged positions meant that small moves could destroy an entire firm
in a short period of time.
In July 1998, one of the large institutions, Salomon Brothers, began
closing its copycat positions. In August 1998, the Russian government
defaulted on its bonds. The shock occurred as the relative value funds
were scrambling to survive. LTCM was on the brink of bankruptcy; many
feared that this would shatter the financial system. The Federal Reserve
stepped in and coordinated a private solution to prevent chaos.
The Internet Bubble of 2000
In 2000, Internet stocks traded at ridiculous multiples. By April 2000,
the bubble began to crash. The NASDAQ dropped by 70%. Yet despite
investors’ dramatic losses, the after-effects were comparatively mild,
mostly because of the limited amount of leverage in Internet stocks.
This put some brakes on the stampede to crash.
The Financial Crisis of 2008
Much that should have been obvious after the fall of LTCM could have
prevented the crises that followed. Instead, the problems of
overcrowding went unchecked so that when the next economic disaster hit,
increased leverage, policy mishaps, and an even more crowded trading
space resulted in a far bigger collapse in 2008.
From 2000 to 2008, every aspect of the U.S. economy got more involved in
a massively leveraged trade: real estate investing. Instead of involving
just traders, as most crowding does, the sub-prime lending bubble
featured politicians, greedy home buyers, mortgage brokers, real estate
agents, banks and investment banks, and quasi-government organizations
Freddie Mac and Fannie Mae.
Investment banks took outright positions in real estate and also
created, sold, and traded derivatives based on housing values. Hedge
funds also took various bets on real estate market segments. Insurance
companies joined the space by offering insurance to the crowded
investors. Rating companies joined the greed train and issued triple-AAA
ratings as fast as they could write the three letters and cash the
checks. Some homeowners took leveraged investing to new heights by
putting zero money down and enjoying a leverage ratio of infinity.
Risk models were glaringly inadequate. They used historical data, which
didn’t include the enormous amount of crowding and overvaluation that
existed by 2008. It was only a matter of time before we saw the worse
crash since the stock market crash of 1929: the 2008 financial crisis.
The massive exposure to a collapsing bubble combined with leverage and
short-term borrowing to create an unprecedented shock to quantitative
hedge funds. Known as the Quant Crisis, this destroyed Goldman Sachs’s
star hedge fund.
The crisis gave us a spectacular show: the historic collapse and rescue
of Bear Stearns, a government rescue for Freddie Mac and Fannie Mae,
hundreds of bank failures, Lehman Brothers’ bankruptcy, a market-wide
lending freeze, the failure of a whole host of hedge funds
(including-John Meriwether’s new fund, JWMP), and unprecedented
marketplace interventions from the U.S. government and Federal Reserve.
The Flash Crash of 2010
Three years and a depression later, the markets had slightly recovered.
On May 6, 2010, between 2:42 pm and 2:47 pm, the Dow Jones dropped by
600 points, then rose 600 points by 3:07 pm, events known as the Flash
Crash.
The European Debt Crisis
From 2001 to 2008, banks around the world lent money to Greece,
assigning it a risk level very similar to that of countries with more
discipline and higher productivity, such as Germany. The crowded space
kept Greek interest rates at unrealistically low levels, and the Greeks
were happy to borrow to fund consumption–until the crowd realized that
Greece was a mess.
Crowded
Investment Space Kept Greek Interest Rates Unrealistically Low Until the
Crowd Realized It Was a Mess
Part narrative, part quantitative analysis, The Crisis of Crowding
is filled with first hand recollections from those on the front lines of
the crowding crisis, including several LTCM partners. Featuring insights
from key banking and hedge fund authorities, including Jimmy Cayne, Sir
Deryck Maughan, Sir Andrew Crockett, John Meriwether, and perspectives
from Nobel prize winners Robert Merton and Myron Scholes, it brings the
events that led to the current crisis vividly to life, showing how and
why the market has evolved in new and dangerous ways, and what can be
done about it.
