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    The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
    The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
    The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal
    Ebook981 pages11 hours

    The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal

    By Ludwig B. Chincarini

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    About this ebook

    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    • Guides the reader through the real story of Long-Term Capital Management with accurate descriptions, previously unpublished data, and interviews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.

    LanguageEnglish
    PublisherWiley
    Release dateJul 30, 2012
    ISBN9781118282717
    The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal

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      Book preview

      The Crisis of Crowding - Ludwig B. Chincarini

      Contents

      Cover

      Additional Praise

      Series

      Title Page

      Copyright

      Dedication

      Foreword

      Preface

      Cast of Characters

      Chapter 1: Introduction Introduction

      Part I: The 1998 LTCM Crisis

      Chapter 2: Meriwether’s Magic Money Tree Meriwether’s Magic Money Tree

      The Birth of Bond Arbitrage

      The Dream Team

      Early Success

      Chapter 3: Risk Management Risk Management

      The General Idea

      Leverage

      Measuring Risk

      The ρ

      LTCM's Actual Risk Management Practices

      The Raw Evidence

      Chapter 4: The Trades The Trades

      The Short U.S. Swap Trade

      The European Cross-Country Swap Trade (Short UK and Long Europe)

      Long U.S. Mortgage Securities Hedged

      The Box Spread in Japan

      The Italian Swap Spread

      Fixed-Income Volatility Trades

      The On-the-Run and Off-the-Run Trade

      Short Longer-Term Equity Index Volatility

      Risk Arbitrage Trades

      Equity Relative-Value Trades

      Emerging Market Trades

      Other Trades

      The Portfolio of Trades

      Chapter 5: The Collapse The Collapse

      Early Summer 1998

      The Salomon Shutdown

      The Russian Default

      The Phone Calls

      The Meriwether Letter

      Buffett’s Hostile Alaskan Offer

      The Consortium Bailout

      Too Big To Fail

      Why Did It Happen?

      Appendix 5.1 The John Meriwether Letter

      Appendix 5.2 The Warren Buffett Letter

      Chapter 6: The Fate of LTCM Investors The Fate of LTCM Investors

      Chapter 7: General Lessons from the Collapse

      Interconnected Crowds

      VaR

      Leverage

      Clearinghouses

      Compensation

      What’s Size Got to Do with It?

      Contingency Capital

      The Fed Is a Coordinator of Last Resort

      Counterparty Due Diligence

      Spread the Love

      Quantitative Theory Did Not Cause the LTCM Collapse

      Déjà Vu

      Part II: The Financial Crisis of 2008

      Chapter 8: The Quant Crisis

      The Subprime Mortgage Market Collapse

      What Was the Quant Crisis?

      The Erratic Behavior of Quant Factors

      Causes of the Quant Crisis

      The Shed Show

      Chapter 9: The Bear Stearns Collapse

      A Brief History of the Bear

      Shadow Banking

      Window Dressing

      Repo Power

      The Unexpected Hibernation

      The Polar Spring

      Chapter 10: Money for Nothing and Fannie and Freddie for Free

      The Basic Business

      Where’s the Risk?

      CDO and CDO²

      The Gigantic Hedge Fund

      Big-Time Profits

      The U.S. Housing Bubble

      The Circle of Greed

      Freddie and Fannie’s Foreclosure

      Why Save Freddie and Fannie?

      Did Anyone Know?

      Chapter 11: The Lehman Bankruptcy

      The Wall Street Club

      Why Was Lehman Next?

      Business Exposure

      A Chronology of the Gorilla’s Death

      A Classic Run on the Bank

      Why Let Lehman Fail?

      Who Was at Fault?

      Who Would Have Been Next?

      The Spoils of Having Friends in High Places

      Chapter 12: The Absurdity of Imbalance

      The Long-Dated Swap Imbalance

      The Repo Imbalance

      The 228 Wasted Resources and the Global Run on Banks

      Chapter 13: Asleep in Basel

      Basel I

      Basel II

      Basel and the Financial Crisis

      Chapter 14: Chapter The LTCM Spinoffs

      JWM Partners LLC

      Platinum Grove Asset Management

      The Others

      The Copycat Funds

      Chapter 15: The End of LTCM’s Legacy

      The Bear and the Gorilla Attack

      November Rain

      What Went Wrong?

      Chapter 16: New and Old Lessons from the Financial Crisis

      Interconnectedness and Crowds

      Leverage

      Systemic Risk and Too Big to Fail

      Derivatives: The Good, the Bad, and the Ugly

      Conflicts of Interest

      Policy Lessons

      Risk Management

      Counterparty Interaction

      Hedge Funds

      The Importance of Arbitrage

      Part III: The Aftermath

      Chapter 17: The Flash Crash

      Background

      Flash Crash Theories

      The Real Cause of the Flash Crash

      The Aftermath

      Chapter 18: Getting Greeked

      Members Only

      The Club’s Early Years

      Getting Greeked

      Greek Choices

      The EU’s Future

      Chapter 19: The Fairy-Tale Decade

      I Hate Wall Street

      The Real Costs of the Financial Crisis

      An Avatar’s Life Force

      Economic System Choices

      The Crisis of Crowds

      The Wine Arbitrage

      Appendices

      Appendix A: The Mathematics of LTCM's Risk-Management Framework

      A General Framework

      Measuring Risk

      Appendix B: The Mechanics of the Swap Spread Trade The Mechanics of the Swap Spread Trade

      The Long Swap Spread Trade

      The Short Swap Spread Trade

      Appendix C: Derivation of Approximate Swap Spread Returns Derivation of Approximate Swap Spread Returns

      Appendix D: Methodology to Compute Zero-Coupon Daily Returns Methodology to Compute Zero-Coupon Daily Returns

      Appendix E: Methodology to Compute Swap Spread Returns from Zero-Coupon Returns Appendices

      Appendix F: The Mechanics of the On-the-Run and Off-the-Run Trade

      Appendix G: The Correlations between LTCM Strategies Before and During the Crisis

      Appendix H: The Basics of Creative Mortgage Accounting

      Appendix I: The Business of an Investment Bank The Business of an Investment Bank

      Investment Banking

      Capital Markets

      Equities

      Fixed Income

      Foreign Exchange

      Global Distribution (Global Sales)

      Research

      Client Services

      Technology

      Corporate and Risk Management

      Summary

      Appendix J: The Calculation of the BIS Capital Adequacy Ratio The Calculation of the BIS Capital Adequacy Ratio

      The General Calculation

      An Example

      Appendix K: The U.S. Economy Before, During, and After the Financial Crisis Appendix K: The U.S. Economy Before, During, and After the Financial Crisis

      The Housing Market

      Unemployment

      The Level of Prosperity

      Inflation or Deflation?

      The Ballooning Debt

      The Banks

      Small Business Borrowing

      The Markets

      Appendix L: The Policy Reaction I: If You're Dodd, I'll be Frank

      Systemic Risk

      The Banking Industry

      Derivatives

      Hedge Funds and Private Equity

      Securitization

      Credit Rating Agencies

      Insurance Industry

      Consumer and Investment Protection

      Corporate Governance and Executive Compensation

      Last Thoughts

      Appendix M: The Policy Reaction II: Basel's Back: Three Strikes and You're Out

      Increased Capital Requirements for Banks

      New Liquidity Requirements

      Other Changes

      Some Thoughts on Basel III

      Appendix N: The Policy Reaction III: The Federal Reserve

      The Fed’s Business

      Unconventional Policies

      Quantitative Easing

      The Federal Hedge Fund

      Appendix O: The Policy Reaction IV: Fiscal Stimulus and Housing

      Capital Injections into the Banking System

      Supporting the Housing Market

      Stimulating the Economy

      Appendix P: A Simple Model of Banks

      A Simple Bank

      Credit Risk Management

      A Bank and Mark-to-Market Accounting

      Simple Answer to Puzzles

      Glossary

      Bibliography

      About the Author

      Index

      End User License Agreement

      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 years—starting with a comprehensive analysis of the Long-Term Capital Management crisis in 1998 and ending with the Euro-debt crisis of 2012—and 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). Chincarini’s 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 other’s behavior. It also provides a cautionary tale about the unintended consequences of financial regulations. Chincarini’s 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

      Since 1996, Bloomberg Press has published books for financial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and businesspeople. Titles are written by well-known practitioners, BLOOMBERG NEWS® reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages.

      For a list of available titles, please visit our Web site at www.wiley.com/go/bloombergpress.

      Title Page

      Copyright © 2012 by Ludwig B. Chincarini. All rights reserved.

      Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

      Published simultaneously in Canada.

      No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

      Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

      For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

      Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

      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 crises–United States–History–21st century. 2. Global Financial Crisis, 2008–2009. 3. Long-term Capital Management (Firm) I. Title.

      HB37172007 .C46 2012

      330.973′0931–dc23

      2012003587

      Dedicated to the late Angus Butler. We’re 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. equities—the 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.

      I was lucky. I had a large personal investment in a four-times-leveraged market-neutral quantitative equity hedge fund called Global Equity Opportunities, run by the business I headed, Quantitative Investment Strategies, a part of Goldman Sachs Asset Management. Although I had a ringside seat, like most investors watching the events unfold, I did not see what was coming. However, when the financial tsunami spilled into and nearly destroyed those invested in quantitative equity portfolios in the first week of August 2007, Goldman Sachs senior management had the financial strength, vision, and crisis management expertise to quickly inject sufficient liquidity into our hedge fund to turn the situation around. Not only our hedge fund, but the entire quantitative equity space rebounded rapidly when news of the Goldman liquidity injection reached the market.

      The quantitative equity strategies, a narrow part of the much broader quantitative investment space, had become crowded when the financial crisis began. Although many details are unknowable, my best guess is that the unwinding of quantitative equity portfolios began in one or more multistrategy hedge funds that also had exposure to mortgages, credit, and other already directly impacted strategies. Of course with the benefit of hindsight I wish I had been able to make the connection earlier on between those risk committee warnings about crowded trades and the quantitative business that I was heading. Unfortunately, at the time the admonitions to avoid crowded trades did not seem to apply to our investment strategy, which relied on complex computer algorithms that slowly and continuously adjusted thousands of relatively small individual equity positions in liquid markets around the world. As it turned out, the admonitions did apply; quantitative equity was a crowded space that was, in retrospect, just as dangerous as any crowded trade.

      This generalization of the concept of crowded trades is just one of the many lessons from the recent financial crisis that are highlighted in this book by Ludwig Chincarini, an economist I have known for many years. Both an academic and a financial market professional himself, Chincarini uses his economist's perspective and quantitative expertise, as well as many in-depth interviews with academics turned practitioners, to bring insights to events that have stunned investors in recent years.

      Many of the lessons highlighted in this book, like the lesson about avoiding a crowded space, are hard to disagree with. In this case the only question is: how does one identify and deftly depart from a crowded space before others do? Other lessons learned, however, are less clear and will require careful consideration in the years ahead. The events covered start with a brief look at the market crash in 1987, and include an in-depth look at the Long-Term Capital Management (LTCM) crisis in 1998, multiple dimensions of the financial crisis of 2007 through 2009 (including the quant meltdown), and recent events such as the flash crash of May 2010 and the Greek debt crisis.

      Many of the events described started with a good idea. A crowded trade or space generally grows up around what seems to be a good idea. Portfolio insurance was a dynamic trading strategy developed in the mid-1980s that seemed to be just such a good idea. The strategy used futures to replicate a put option that would protect a portfolio against a significant equity market decline. It was such a good idea that it was successfully marketed to large pension funds by a number of investment advisors. Putting together a portfolio of convergence trades in fixed income, as was carefully crafted on the proprietary trading desks of Salomon Brothers in the early 1980s and later by the hedge fund LTCM, was another good idea. Carefully identifying characteristics of equities that are likely to predict future returns and then using computer algorithms to incorporate those positions into equity portfolios, as was done inside my group at Goldman Sachs, was another seemingly good idea. And by far the biggest example of all, providing incentives to encourage home ownership, especially to those who might not otherwise be able to qualify for a mortgage, was the seemingly good idea embraced by the U.S. government. As we know from history, each of these good ideas ended in disaster.

      The path that leads from good idea to disaster is eerily similar in each case. A good idea leads to a successful business model. Others, whom Chincarini calls copycats, learn how to enter the space, and the business expands successfully. Capital flows into the strategy, leading to even more success for those already there, until at some point the pendulum swings and the music stops. And thus we have the crisis of crowding, copycats, and crashes.

      If you want to understand the rise and fall of LTCM, perhaps you might start with interviews of the Nobel laureates who were there. The business of LTCM, according to Robert Merton, quoted at length in this book, was as follows: We were not faster, smarter, or had necessarily better models than others. We had good stuff, but that wasn't the secret. It was institutional rigidities. We provided a service. With all the rules, regulations, and complexities, it is inevitable that those rules will have unintended consequences which put intermediaries in a bind. If you can loosen the constraints of that rigidity you can get a premium for that. Just like you get paid for cutting someone's lawn. Similar insights are found throughout.

      There are, however, some unanswered questions raised by the concerns of Chincarini's book. How, for example, can we identify ahead of time when copycats are turning an investment strategy into a crowded trade or a crowded space? This, of course, is a difficult question that does not have an obvious answer. Chincarini suggests that better risk models would help solve this problem. Risk models, he says, should take crowdedness into account as well as valuation. On this point I'm not sure how it could be done. You might criticize an investor for not recognizing the risk as others pile into his space, or for not pulling back having recognized the risk, but I don't know how you can expect the investor's risk model to identify a crowded trade before the investor does. Similarly, you might expect investors to try to identify cheap assets because they have more room to appreciate, but I don't trust an investor whose risk metrics rely on measures of valuation. As Chincarini recognizes, fundamental valuation goes out the window when investors rush for liquidity. Chincarini raises some interesting arguments on crowding and risk models, and practitioners and academics can debate these ideas since risk management is still evolving and the market events of 2008 showed that these models were not fully reliable.

      There are places where Chincarini applies the crowd idea differently. For example, the author puts crowd behavior at the center of the flash crash of May 6, 2010, which is the subject of Chapter 17. The flash crash was, no doubt, a very interesting event. Most accounts blame a large trade in the equity futures market, apparently implemented by a poorly designed algorithm that did not respond appropriately as market impact increased over time. According to this version of events, the trade created a shock that led to a whiplike impact in exchange-traded funds (ETFs) and then even more profound price moves in individual equities as liquidity, today largely provided by high-frequency trading algorithms, dried up. Chincarini suspects that the futures market trade may not have been so central to the event and summarizes the cause as follows: Crowd behavior erased liquidity just when traders needed it the most, and just as the markets saw in the LTCM crisis, the quant crisis, and the subprime crisis. We both agree that an initial order may have triggered confusion in the market space, but Chincarini believes it was the crowded behavior of liquidity providers that ultimately caused liquidity to vanish. It could have been simply that rational actors stepped aside in the midst of uncertainty. Either way, current risk models did not anticipate such flash crashes. Whether it is possible to set risk controls around the many examples of crowdedness may be debatable, but what is not arguable is that the market did and probably will continue to present surprises for which the crowd of investors is not prepared.

      This is an excellent exploration of many of the most interesting events in the financial markets of the past several decades, with insights from many of the former academics turned participants, as well as a very useful compilation of lessons learned.

      Robert Litterman

      Former Partner and Head of Risk Management,

      Goldman Sachs; co-inventor of the Black-Litterman Model

      Preface

      My initial motivation for writing this book was to clarify many of the misunderstandings surrounding financial failures and crises. After a collapse, we are often given incorrect versions of what happened, and this leads us to make mistakes again in the future. Therefore, even if a lot of work is required, it is best to get the story straight.

      This particular story begins with the failure of Long-Term Capital Management in 1998, continues to the financial crisis of 2008 as well as the Flash Crash of 2010 and ends with the ongoing European debt crisis. I hope to show that all these events are connected and might have been avoided. These events all involved crowded trading spaces, where risk models did not take into account either the presence of crowds through valuation or their actions. Prices in many of these instances were determined by the holders of the securities rather than fundamentals.

      When LTCM collapsed many people tried to explain what had happened, but in an effort to make the story easier to grasp, it was distorted, and so were our own perceptions of the financial world. As a result, an opportunity to improve the financial system was lost and bigger crises occurred.

      Still, it is never too late to learn. Thus, in the first part of the book I retell the LTCM story with the help of many conversations with the partners of LTCM and access to a wealth of proprietary data. Also, I decided to tell the story from a financial point of view rather than a personal one, so as to understand the real lessons that we should have learned in the historic LTCM collapse.

      The second part of the book goes through the financial crisis of 2008 in detail. While other books on the crisis have focused on the personalities and the inside stories, this book focuses mainly on explaining what happened in a straightforward way. There is something for everyone. Some technical bits for more specialized readers and simpler bits for more general readers. This part of the book includes the Quant Crisis of 2007, the collapse of Bear Stearns, the implosion of Freddie and Fannie and Lehman Brothers as the housing bubble burst, and finally, the collapse of Liar’s Poker king, John Meriwether’s new fund, JWMP. I also discuss the lessons we should learn from the financial crisis.

      The third part of the book speaks about some of the same elements of crowd behavior snuck into the May 2010 Flash Crash–when Apple stock traded briefly for $100,000 per share–and on to the continuing debt saga in Europe which started with the Greek crisis.

      Throughout the book, I sprinkle in excerpts from my interviews with many of the people who were on the front line of the crises, including five LTCM partners: Eric Rosenfeld, Chi-Fu Huang, Hans Hufschmid, and Nobel prize winners Robert Merton and Myron Scholes. I also spoke with numerous bank authorities, like Sir Deryck Maughan, former Vice Chairman of Citibank, Andrew Crockett, former Head of the BIS, the founders and CEOs of many leading hedge funds, including Goldman Sachs Alpha fund. These are supplemented by numerous other sources–testimonies, court documents, newspaper articles and previous books on the crises–that helped me understand and explain what had happened.

      For completeness, I also provide an online appendix (www.wiley.com/go/crisisofcrowds) that goes through all aspects of the U.S. economy before, during, and after the financial crisis of 2008. There are other online appendices on policy reactions to the crisis, including a detailed analysis of Dodd-Frank, a detailed analysis of unconventional policies offered by the Federal Reserve, a brief analysis of government policies such as Cash for Clunkers, and an overview of the most recent global regulatory standard for bank capital, Basel III.

      I had originally planned to write a small research paper on the financial crisis, but two people inspired me to write a whole book: Eric Rosenfeld and Chi-Fu Huang. Eric has been a friend for many years. He has taken time to come to speak to my students several times about LTCM. Not only did many students learn from his guest lectures, but I, too, learned a lot more about finance. He was patient with me throughout the process of writing this book, sharing his time, his data, his contacts, and his wisdom. Chi-Fu Huang also supplied his time, thoughts, and data. He also provided key insights into parts of the book, especially chapter 12, The Absurity of Imbalance.

      I would also like to thank other people who supplied key insights into various events described in this book, including Hans Hufschmid, Steve Blasnick, Michael Mendelsohn, Cliff Asness, Ray Iwanowski, Mark Carhart, Sandor Strauss, Ken Kroner, Deryck Maughan, Mark Hooker, Eric Scott Hunsader, Pierre-Olivier Gourinchas, and those people who chose to remain anonymous.

      A few people took the time to read my long manuscript and give me their feedback, which helped me improve the book. These people include David Bieri, Mark Schroeder, Daehwan Kim, and Peter Sasaki. I especially wish to thank Neer Asherie for his detailed comments. He has always been there for me and we have helped each other navigate the grand shed show together. I would also like to thank Andrew Crockett for his insights and detailed comments and for reminding me not to be such a hedge hog.

      I thank Anthony Gonzalez and Matt Walkup for giving their excellent research assistance. They never gave up no matter how difficult things got. Other research assistance was given by John Wick, Jason Blauvelt, Andrew Oetting, Bridgette Adams, Jing Wen, James Lambert, Coady Smith, Evelyn Khalili, and Saw Jae Won. For data help, I thank Alexey Polishcuk, Wayne Passmore, Terry Lobes, David Blitzer, Michael Rappaport, Kristof Starzynski, Lisa Finstrom, Sabya Sinha, Salvatore Bruno, Robert McCauley, Sabya Sinha and Andrew Dialynas, For useful discussions, I thank Jim Barth, Pierangelo De Pace, Wayne Ferson, Carl Hopman, Viral Acharya, Bob McCauley, Mark Schroeder, Wolfgang Chincarini, Chris Kawasaki, James Angel, Chris Lalli, James Hamilton, John Taylor, Steve Ross, Robert Whitelaw, Ross Waldrop, Kevin Brown, Bryan Bashaw, Dennis To, Jacob Gyntelberg, Stefan Avdjiev, Silvio Contessi, Gregg Berman, Claudio Borio, Mathias Drehmann, and Frank Fabozzi. Thank you Morgan Ertel for trying.

      I thank Pam Van Giessen for putting up with me over the years and taking a leap of faith with me on this book, Evan Burton for helping to make this book a reality, and Judy Howarth and everyone else at Wiley for their support.

      I wrote this book all over the country, but the place that most inspired me was Berkeley, where I had studied as an undergraduate. I thank the Royal Ground Coffee of Albany, CA for letting me live in their cafe. At times they must have thought I was a homeless person. The Aroma Cafe in Studio City, CA, and the Coffee Bean in Claremont, CA also allowed me to work for long periods of time and for that I am grateful.

      If you would like to send me suggestions or comments on the book, please send them to my email address below with the subject line: Book Comments. If you were involved in any of the events I describe, please let me know as well, and perhaps I can include your story in the future.

      Ludwig Chincarini,CFA, Ph.D.

      [email protected]

      Cast of Characters

      Herbert Allison: President and COO of Merrill Lynch during the LTCM crisis. Appointed President and CEO of Fannie Mae in September 2008 and is currently the Assistant Secretary of the Treasury for Financial Stability of the United States.

      Madelyn Antoncic: Managing Director and Chief Risk Officer at Lehman Brothers during the financial crisis.

      Cliff Asness: Co-founder and CEO of the quantitative hedge fund AQR Capital Management. Previously was Managing Director of Quantitative Research at Goldman Sachs.

      Ben Bernanke: Chairman of the Federal Reserve during the crisis of 2008.

      Lloyd Blankfein: CEO and Chairman of Goldman Sachs.

      Steve Blasnik: President and CEO of Parkcentral Capital Management, a relative value hedge fund that managed Ross Perot and other investors' private wealth.

      Warren Buffett: Billionaire investor and CEO of Berkshire Hathaway.

      Erin Callan: Managing Director and Head of Hedge Fund Investment Banking; Chief Financial Officer, 2007–2008.

      Mark Carhart: Former co-head of Quantitative Strategies and Global Alpha hedge fund at Goldman Sachs.

      Jimmy Cayne: Chairman of the Board of Bear Stearns during the financial crisis. Former CEO of Bear Stearns.

      Ralph Cioffi: Managing Director of Bear Stearns Asset Management and head of two Bear Stearn hedge funds that collapsed in 2007.

      Jon Corzine: Former CEO of Goldman Sachs and Meriwether's classmate at the University of Chicago. Also served as Governor of New Jersey from 2006 to 2010 and former CEO of MF Global.

      Christopher Cox: Chairman of the SEC during the financial crisis.

      Jim Cramer: Host of Mad Money television show, author, and founder of Street.com.

      Andrew Crockett: Former CEO of the Bank for International Settlements from 1994 to 2003. Currently President of J.P. Morgan International. Knighted by Queen Elizabeth in 2003.

      Jamie Dimon: Former President and co-CEO of Smith Barney Salomon. Currently CEO of J.P. Morgan. At Salomon when arbitrage group was shut down, which may have helped trigger LTCM crisis.

      Chris Dodd: United States Senator from Connecticut during financial crisis. Co-author of Dodd-Frank bill.

      Rudi Dornbusch: The late MIT professor of international economics. The mentor of almost every well-known international economist, including Paul Krugman, Ken Rogoff, Jeffrey Sachs, and many more.

      Stanley Druckenmiller: Former lead portfolio manager of the Quantum Group from 1988 to 2000, the George Soros hedge fund.

      David Einhorn: President of Greenlight Capital, a long-short value-oriented hedge fund.

      Antonio Fazio: Governor of the Bank of Italy at the time that the Bank of Italy invested with LTCM.

      Eric Felder: Managing Director and head of Global credit products at Lehman Brothers during the financial crisis.

      Barney Frank: Democratic member of the House of Representatives from Massachusetts. Co-author of the Dodd-Frank bill.

      Paul Friedman: Chief operating officer of Bear's fixed-income division.

      Richard Fuld: CEO and Chairman of the Board of Lehman Brothers during the financial crisis.

      Timothy Geithner: President of the Federal Reserve Bank of New York during the financial crisis. Currently, Treasury Secretary of the USA.

      Michael Gelband: Managing Director and global head of fixed income who was asked to leave in 2007.

      Alberto Giovannini: Senior strategist at LTCM. Currently CEO and founder of Unifortune SGR.

      Ace Greenberg: Chairman of the Executive Committee of Bear Stearns during the financial crisis of 2008. CEO of Bear Stearns from 1978 to 1993.

      Alan Greenspan: Chairman of the Federal Reserve from 1987 to 2006.

      Joseph Gregory: President and Chief Operating Officer of Lehman Brothers up to the collapse.

      John Gutfreund: CEO of Salomon Brothers until 1991.

      Victor Haghani: Principal at LTCM and JWMP. Headed LTCM's London office and also very influential trader.

      Gregory Hawkins: Principal at LTCM and JWMP. Nicknamed the Hawk.

      Larry Hilibrand: Principal at LTCM and JWMP. One of the most influential traders at the firm.

      Chi-Fu Huang: Principal and head of Toyko office for LTCM. CEO and CIO of PGAM from 1999 to 2009. Head of Fixed Income Derivatives at Goldman Sachs with Fischer Black from 1993 to 1994.

      Hans Hufschmid: Principal at LTCM. Responsible for foreign exchange trading, among other things. Currently CEO of GlobalOp.

      Ray Iwanowski: Former co-head of Quantitative Strategies and Global Alpha hedge fund at Goldman Sachs.

      Bob Jones: Former head of the Quantitative Equity group and Global Equity Opportunities hedge fund at Goldman Sachs.

      Mitch Kapor: Founder of first commercially available spreadsheet program, Lotus 1-2-3 (the precursor to Excel). Business partner of Eric Rosenfeld.

      John Maynard Keynes: British economist who first mentioned ideas of quantitative easing.

      Alex Kirk: Managing Director and global head of high-yield and leveraged loans at Lehman Brothers during financial crisis.

      William Krasker: Principal at LTCM. Modeler at LTCM.

      Arjun Krishnamacher: Principal at LTCM and JWMP.

      Ken Kroner: Head of Blackrock's global market strategies overseeing the quantitative hedge fund group.

      Jim Leach: Republican member of the U.S. House of Representatives for Iowa during LTCM crisis.

      Dick Leahy: Principal at LTCM and JWMP. Handled mortgage trading and co-managed with Meriwether the Macro fund at JWMP.

      Ken Lewis: CEO and Chairman of Bank of America during the financial crisis.

      John Mack: CEO and Chairman of Morgan Stanley during the financial crisis.

      Deryck Maughan: Chairman and CEO of Salomon Brothers from 1992 to 1997, Vice Chairman of Citigroup from 1998 to 2004, Vice Chairman of the NYSE from 1996 to 2000, and currently partner at KKR.

      William McDonough: President of the New York Federal Reserve during the LTCM crisis.

      James McEntee: Principal at LTCM and former Chairman of the Board and co-CEO of the government bond trading firm Carroll McEntee & McGinley. Meriwether and McEntee shared a love for horses.

      John Meriwether: CEO and founder of Long-Term Capital Management and JWMP. Vice-Chairman of Salomon Brothers from 1988 to 1991.

      Robert Merton: Principal at LTCM and Professor of Finance at MIT. Winner of the 1997 Nobel prize in economics.

      Euoo Sung Min: Chairman of the Board and Chief Executive Officer, Korea Development Bank.

      David Modest: Principal at LTCM. Managing Director at Morgan Stanley and J.P. Morgan and currently at the Soros Fund.

      Samuel Molinaro: CFO of Bear Stearns during Bear Stearns collapse.

      Paul Mozer: Salomon Brothers trader who made illegal bids in the Treasury auction causing Meriwether and Gutfreund to resign from Salomon.

      Peter Muller: Former head of Morgan Stanley's Process Driven Trading group.

      David Mullins: Principal at LTCM and former Secretary of the Treasury. Principal role to raise capital and raise credibility of LTCM.

      Roger Nagioff: Managing Director and appointed Global head of fixed income in 2007.

      Hank Paulson: Treasury Secretary of the United States during 2008 and former CEO of Goldman Sachs.

      Chuck Prince: CEO and Chairman of Citigroup from 2003 to 2007. Resigned in 2007 due to the poor performance of mortgage-related products.

      Franklin Raines: CEO of Fannie Mae from 1999 to 2004 and Vice Chairman of Fannie Mae from 1991 to 1996.

      Julian Robertson: Founder of the very successful hedge fund Tiger Management.

      Eric Rosenfeld: Principal at LTCM and JWMP. Meriwether's right-hand man.

      Myron Scholes: Principal at LTCM and PGAM. Winner of the 1997 Nobel prize in economics.

      Alan Schwartz: CEO and President of Bear Stearns during 2008.

      William Sharpe: Professor at Stanford University and co-inventor of the CAPM. Won the 1990 Nobel in economics for his work on asset pricing theory.

      Robert Shustak: CFO of LTCM. Currently CFO and COO of the hedge fund founded by Sanford Grossman, QFS.

      James Simons: Founder and CEO of Renaissance Technologies, one of the most successful quantitative hedge funds. This hedge fund also suffered during the Quant crisis. Simons was a mathematician prior to his entry into finance.

      George Soros: Founder of Soros Fund Management. Famous for his hedge fund bet that the British pound would devalue.

      Warren Spector: Co-President of Bear Stearns and Head of Mortgages and Fixed Income.

      John Thain: Chairman and CEO of Merrill Lynch during the financial crisis. Former CEO of the NYSE and President and co-CEO of Goldman Sachs.

      Bob Upton: Former Treasurer of Bear Stearns.

      Cliff Viner: CIO of the hedge fund named III.

      Paul Volker: Former Chairman of the Federal Reserve from 1979 to 1987. Chairman of the Economic Recovery Advisory Board. Promoter of the so-called Volker rule under Dodd-Frank.

      Sandy Weill: Former co-CEO of Smith Barney Salomon. CEO of Citigroup from 1998 to 2003. Was instrumental in creating Citigroup and eliminating Glass-Steagall.

      CHAPTER 1

      Introduction

      Since the beginning, it was just the same. The only difference, the crowds are bigger now.

      —Elvis Presley

      Humans are a social species, grouping together to do everything from waging war to attending cocktail parties. This desire to be with others also occurs in the financial markets. Some portfolio managers follow whatever investments are in vogue, mostly because bucking the trend doesn’t pay. If the trend continues and they haven’t followed it, they could look like idiots. If they follow it and it doesn’t continue, they simply join the herd of other wrong-headed investors.

      At other times, portfolio managers create an innovation. This innovation usually makes abnormally large returns, so others desperately want to copy the strategy. These copycats eventually learn the ropes and begin trading money in the same fashion. At first this leads to even more profits for the early innovators, because others buy more and more of their trades.

      The copycats create a side effect, however: They crowd the space. The strategy’s future returns depend increasingly on the copycat’s behavior.

      Oftentimes copycat investors make their trades on borrowed money, which amplifies both their positions and their risks. Modern risk-measurement models generally ignore the presence of copycats and the resulting crowded spaces, which often leads to underestimations of risk. 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.

      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, with nearly every crisis labeled a 100-year event.

      The stock market crash of 1987 was likely the first crisis caused by modern-day crowding. The financial industry had popularized dynamic portfolio insurance, which involved protecting investors from losing money on their portfolios. Many institutions offered this protection by selling the market when it went down and buying the market when it went up. This practice can work quite well if only a small portion of the market pursues these strategies.

      But if that proportion grows too large, crowding the space, the market may destabilize. As the market falls, the large group sells its positions, pushing prices further and further down and sometimes leading to a crash. In 1987 there were too many copycats, too much crowding, and too many models that didn’t adequately account for this crowding.

      The next big crisis came in 1998, eleven years later. It involved Russian markets and the failure of Long-Term Capital Management (LTCM), a well-known hedge fund. In 1994, Long-Term Capital was one of the largest hedge funds. Managers used technological and quantitative techniques learned at Salomon Brothers to sublime perfection. 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 very crowded. Quantitative copycats saturated the space. Risk models were no longer accurate, because they didn’t capture this crowding and its potential effects. 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, just as with Lehman Brothers in 2008. The Federal Reserve stepped in and coordinated a private solution to prevent chaos.

      In 2000, Internet stocks traded at ridiculous multiples. The crowd rushed in and the bubble formed. By April 2000, the bubble began to crash. The NASDAQ dropped by 70%. Yet despite investors’ dramatic losses, the aftereffects were comparatively mild, mostly because of the limited amount of leverage in Internet stocks. This put some brakes on the crash.

      From 2000 to 2008, every aspect of the U.S. economy got more and more involved in a massively leveraged trade: real estate investing. Instead of involving just traders, as most crowding does, the subprime lending bubble featured politicians, greedy home buyers, mortgage brokers, real estate agents, banks, 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 AAA ratings as fast as they could write the three letters and cash the checks. Even the media pushed us forward with talk of rising home ownership, rising stock markets, and good times.

      Like the Internet bubble of 2000, this bubble kept growing. Almost everyone was crowding this trade and using unprecedented leverage. Some home owners 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 worst 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 created 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.

      Three years and a depression later, the markets had slightly recovered. On May 6, 2010, between 2:42 p.m. and 2:47 p.m., the Dow Jones dropped by 600 points, then rose 600 points by 3:07 p.m., events known as the Flash Crash. Procter & Gamble stock dropped by 37% in that short period. What happened? Was a leveraged crowded space wreaking havoc again?

      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.

      This is the story of the crisis of crowding. The story begins in 1998 with Long-Term Capital Management’s fascinating collapse and tries to explain the ways in which crowds and leverage demolished one of the most successful hedge funds in history. The failure of LTCM had many lessons for the financial community and for society at large, but no one paid much attention—perhaps because disaster was ultimately averted. Ignored lessons formed a large part of the basis for 2008’s financial disasters, only this time with more leverage, more participants, and a series of policy mishaps.

      PART I

      The 1998 LTCM Crisis

      All human beings are interconnected, one with all other elements in creation.

      —Henry Read

      The 2008 financial crisis really began 10 years earlier, with the collapse of the famous hedge fund Long-Term Capital Management (LTCM). LTCM was not an ordinary hedge fund. It was a large financial intermediary with a vast amount of technology and a lot of very experienced, intelligent managers.

      LTCM’s enormous, consistent success seemed evidence that it was possible to tame the financial markets with sophisticated experience and quantitative tools. Some people were jealous of LTCM’s success. Others were inspired, as it showed them that traders could understand and manage the financial markets.

      Suddenly, in just two months in 1998, LTCM stood on the brink of bankruptcy. The firm would have failed without an emergency cash infusion and rescue from a consortium of investment banks. The rescue brought cheers from those who envied LTCM and cries from those who wanted to become LTCM, plus a lot of stories that weren’t even true.

      Many of LTCM’s trades were clever. LTCM’s experience in the financial markets was second to none. Its risk-management framework was on a par with state-of-the-art systems, but the firm underestimated the danger posed by crowds. Lured by LTCM’s success, other investors had entered the firm’s investment space. LTCM’s risk management failed to measure the ways that these crowds changed investments’ return and risk. With leverage and quant copycats running for the exits, LTCM found itself trapped in the fire.

      CHAPTER 2

      Meriwether’s Magic Money Tree

      We’re sucking up nickels from all over the world.

      —Myron Scholes

      The Birth of Bond Arbitrage

      In 1974, John Meriwether, having just received his MBA from the University of Chicago, went to work as a government bond trader at Salomon Brothers. In those days, bond trading was not a quantitative endeavor. Traders bought or sold bonds they thought looked good or bad. John Meriwether realized that bond pricing was highly quantitative and saw that, if he could tap into this quantitative pricing, he could not only outperform his industry peers but make lots of money as well.

      He slowly began recruiting top talent, hiring both highly trained quantitative and old-fashioned traders. He went to MIT, Harvard, and other places to find experts in economics, finance, and other sciences. He planned to teach them the basics of bond trading and then tap their intelligence to find ways to mathematically model various fixed-income products, find inherent mispricings, and make money on them. Some of his hires included Larry Hilibrand, who had just finished a master's degree in mathematics from MIT and was hired in 1980. Dick Leahy, with a BS from Boston State College, worked at Merrill Lynch and then joined Meriwether in 1986.

      Eric Rosenfeld, a PhD in economics from MIT, was working at the time as a professor at Harvard Business School. Meriwether called to ask if Rosenfeld had a bright student who would like to come to Salomon. Rosenfeld was sick of teaching case studies and grading exams and asked Meriwether if he could try the job. He left Harvard 10 days later and never went back.

      Rosenfeld’s interest in using quantitative techniques to exploit profitable opportunities started when he was an MIT undergraduate in the early 1970s. He enrolled in a statistics class with the famous econometrician Jerry Hausman. Hausman needed a summer research assistant to help build predictive models for NFL football games. For the previous 12 years Rosenfeld had collected NFL football game data, including the game’s day of the week, which team was home or away, the Las Vegas betting spread, whether the game was played on turf or grass, and each team’s winning percentage at the time of any given match. The pair used this data to build an econometric model to predict the winning margin on NFL games, then bet on games. The model worked during the two-year project; then both researchers moved on to other things.

      Many recruits had interesting backgrounds independent of their financial experience. Eric Rosenfeld and fellow MIT student Mitch Kapor created a regression program at MIT to help Eric with his PhD dissertation. They eventually called the program VisiPlot and sold it alongside the first spreadsheet program, VisiCalc. They sold the rights to a software company for about $1.2 million.

      Rosenfeld went on to teach at Harvard Business School, while Kapor went on to work for that software company. Realizing that one product could combine all their concepts and find a huge market, Kapor launched Lotus 1-2-3, the first commercially available spreadsheet program. His company became Lotus Development and eventually made Kapor a billionaire.¹

      Victor Haghani, who had just received a BS from the London School of Economics, joined the firm in 1984. Gregory Hawkins, a 1982 PhD in economics from MIT and a professor at UC Berkeley, was hired in 1985. Known as Hawk to his trading partners, Hawk was in Rosenfeld’s fraternity at MIT.²

      William Krasker, a 1978 PhD in economics from MIT and a Harvard professor with an interest in arbitrage possibilities, was hired in 1987. One of the quirky strategies he examined was whether buying wine in the current year and storing it for later consumption was an economical way to drink quality wine. He found that, on average, buying and storing wine has a return on investment that’s very similar to that of Treasury bills.

      Arjun Krishnamachar, a 1987 Wharton business school graduate, came to Salomon in 1988. Hans Hufschmid, with a BA from the University of Southern California and an MBA from UCLA, came to Salomon in 1985. Myron Scholes, a PhD from the University of Chicago and a professor at MIT and Chicago, became a managing director of Salomon in 1991, as well as co-head of the fixed-income sales and trading department. Finally Robert Merton, a PhD from MIT and a Harvard professor, arrived in 1988 as a senior advisor to Salomon Brothers.

      The whole quantitative team worked in fixed income, but focused on slightly different areas. Haghani was a bond arbitrage trader, Hawkins worked in bond arbitrage and mortgages, Hilibrand worked in bond arbitrage, Hufschmid worked on the UK fixed-income arbitrage desk and then moved permanently to the FX trading desk, Krasker worked in fixed-income arbitrage, Krisnamacher worked on the derivatives trading desk, Leahy was head of mortgage trading, and Rosenfeld was the co-head of the bond arbitrage group.

      Meriwether cherished the quantitative discipline and frequently invited prominent scholars to give talks at Salomon Brothers. He also mingled with freshly minted PhDs at the American Finance Association conferences, always looking for bright new talent.

      This small group of traders generated more profit for Salomon Brothers than did the firm’s investment banking services, asset management, private wealth management, and all other divisions combined.

      Figure 2.1 shows the profit and losses (P/L) of the Meriwether trading group and the rest of Salomon Brothers.³

      FIGURE 2.1 Profits of Meriwether’s Proprietary Trading Group at Salomon versus the Rest of the Firm

      Note: For 1998, the LTCM P/L is computed as the –92.04% year-to-date performance through October 1998.

      The profits were mind-boggling. From 1990 to 1992, Salomon Brothers’ investment banking, client services, and brokerage activities posted losses every year. The firm as a whole returned a profit only because of Meriwether’s small team and their innovative work. Meriwether group profits from 1990 to 1993 were $485, $1,103, $1,416, and $416 million respectively, versus mainly losses from the rest of the firm of –$69, –$67, –$26, and $1,159 million. Figures from after 1993 compare Salomon with LTCM. Remember that some members of the Meriwether group had remained at Salomon to run that proprietary trading group.

      In 1988, the team’s success propelled Meriwether to a perch as Salomon’s vice chairman. His traders were fiercely loyal to Meriwether, in part because he shielded them from office politics and in part because he handsomely rewarded their hard work. Meriwether negotiated a deal in which his group kept 15% of the profits they generated and awarded bonuses from that reserve. In 1990, Hilibrand was the talk of the industry with his $23 million bonus. At $20 million, Hufschmid’s 1993 pay package was larger than that of Deryck Maughan, Salomon Brothers then-CEO. Team members grew quite rich, and others in the firm were envious.

      Then in 1991, the Salomon fixed-income trading group was involved in a Treasury auction scandal. Acting independently, a trader named Paul Mozer made false bids on behalf of clients in a Treasury auction. In particular, he bid for more Treasury securities than allowed for any primary dealer by pretending that the securities were for clients.⁴

      Paul Mozer was not part of Meriwether’s arbitrage group, and Meriwether had nothing to do with Mozer’s bids. Even so, he would suffer for Mozer’s actions. John Meriwether and company CEO John Gutfreund became the scapegoats, ultimately taking responsibility for Mozer’s stunt.

      An SEC investigation eventually led to Gutfreund and Meriwether’s resignations. The two settled civil charges that they had failed to properly supervise their employees by paying fines of $100,000 and $50,000, respectively. In addition, Gutfreund agreed to never run a securities firm again and Meriwether agreed to a three-month suspension. Salomon Brothers paid $290 million to settle charges arising from the bidding scandal.

      The firm itself made comparatively little from the illegal bids, estimating that its illegitimate profits were between $3.3 million and $4.6 million. Meriwether, the last of the three to resign, complained to friends that he was unfairly made a target of the investigation.

      Warren Buffett, a major shareholder of Salomon though his Berkshire Hathaway fund, became Salomon’s interim CEO for about six months. During this period, Buffett seriously considered having the firm declare bankruptcy. The Treasury had determined that Salomon would no longer be able to participate in bond auctions. Buffett and other senior management believed this would destroy the firm. After Buffett’s personal appeals, the Treasury agreed that Salomon could bid on Treasury auctions, but not for customer accounts.

      The Dream Team

      After leaving Salomon, Meriwether spent three years considering his next move. On February 24, 1994, he launched Long-Term Capital Management (LTCM) with $1.125 billion in capital, making it the largest start-up hedge fund to date.

      More than $100 million came from the partners themselves, especially those who came from the proprietary trading operation that Meriwether had headed at Salomon Brothers.

      Meriwether and Rosenfeld originally asked Warren Buffett to invest. After all, Buffett was familiar with Meriwether’s group, and Berkshire Hathaway had owned about 20% of Salomon Brothers stock. (Though Buffett publicly claims that he doesn’t like derivatives, he likes derivatives when others use them to make him money.) Nevertheless, Buffett declined to invest money in LTCM.

      Meriwether and Rosenfeld then asked UBS for investment funds and perhaps the use of their facilities. UBS refused.

      The pair had hoped that Goldman could raise money for them, particularly as Jon Corzine was an old buddy of Meriwether. At the time, however, Goldman did not market third-party funds.⁵ Merrill Lynch eventually led the team to seek LTCM investors.⁶

      The new company was not without its detractors. During the firm’s road show, Andrew Chow, the vice president in charge of derivatives for Conseco Insurance, told Nobel prizewinner and LTCM partner Myron Scholes that You’re not adding any value. I don’t think there are that many pure anomalies that can occur.⁷

      As long as there continue to be people like you, we’ll make money, Scholes reportedly replied.

      LTCM’s founding partners included Victor Haghani, Gregory Hawkins, John W. Meriwether, Robert C. Merton, Eric Rosenfeld, and Myron S. Scholes. Another founding member was James J. McEntee. He had been chairman of the board, co-CEO, and co-founder of the bond-trading firm Caroll McEntee and McGinley from 1969 to 1983, when it was sold to Marine Midland. In 1988, he formed the investment firm McEntee and Associates. An old friend of John Meriwether, McEntee had experience in both starting a firm and bond trading. At LTCM he was a directional bond trader.

      Chi-Fu Huang taught finance at MIT. The Salomon arbitrage team had wanted to approach Huang before starting LTCM, but felt that their close ties to MIT precluded poaching faculty. But when Huang left MIT to work in Goldman Sachs’s fixed-income area with Fischer Black, LTCM hired him soon after to run their Tokyo office.⁸

      The new firm hired David Modest, who has a PhD from MIT, from the Haas School of Business, where he was a professor. At LTCM he built the firm’s relative value equity business and was actively involved in financial technology management and in mentoring strategists.

      Robert Shustak, with a BA in accounting from Queens College and prior experience in Salomon’s financial division, was LTCM’s new chief financial officer.

      David Mullins, a PhD in economics from MIT and the former assistant treasury secretary under President George H.W. Bush was the firm’s salesman. Mullins had already enjoyed an impressive public career. Secretary of the Treasury Nicholas Brady asked him to run the Brady Commission, which investigated the causes of the 1987 U.S. stock market crash. (They found that derivatives and dynamic hedging of portfolio insurance may have been to blame.)⁹ Mullins helped resolve the savings and loan crisis with the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) and the formation of the Resolution Trust Corporation (RTC). In 1990, President Bush nominated Mullins to a four-year term as vice chairman on the Federal Reserve Board of Governors. He left for LTCM in 1994. His presence brought greater credibility to LTCM’s capital raising campaign and also opened many doors, including those of some central banks.

      Later, other partners joined, including Dick Leahy, Larry Hilibrand, Arjun Krishnamachar, Hans Hufschmid, and William Krasker.

      Myron Scholes and Robert Merton, who had been associated with Salomon and who would eventually win the 1997 Nobel Prize in economics, also joined LTCM as limited partners. But though Merton and Scholes had influenced Salomon’s practices, LTCM’s core trading strategies were those of Meriwether and his team. Scholes and Merton helped with the firm’s marketing. Half of the founding partners had previously taught finance at major business schools, which helped the firm develop creative finance ideas.

      Every organization has war generals and ordinance generals. Meriwether, Haghani, and Hilibrand were the war generals. I was not that. I was the ordinance general. I was involved in marketing—this is ordinance. I didn’t know how to trade strategies initially—I learned this over time. But I was not in charge of fighting the war. Neither was Bob Merton. I did a lot of research on equities and strategies. I built a huge credit facility for LTCM. This helped improve after-tax returns with assets in the UK. It had to do with utilizing the OIC structure in the UK. Because of tax discrepancies between dividends in different countries, a legal vehicle was set up that was able to make the company more tax efficient.

      —Interview with Myron Scholes, July 9, 2011

      I was one of the first four people to start LTCM with Meriwether, McEntee, and Rosenfeld. I had no desire to become a partner. I just thought it was interesting to do this. I presumed that to be a partner, it would be a 150% job. The whole period building the company was fun. I wrote the marketing plan for investors.

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