Following is a book review I wrote for the newsletter of Chartered Financial Analysts of Los Angeles. It’s not a really technical book, but if you’re interested, a few basics in economics will help. Dr Chincarini is a professor of finance at the University of San Francisco.
The Crisis of Crowding by Ludwig Chincarini, reviewed by Don Steinmann president of the Applied Behavioral Finance Group COI of CFALA
Ludwig Chincarini’s book The Crisis of Crowding examines the forces behind powerful fiscal events over the last 15 years, including the failure of Long Term Capital in 1998, the fiscal crisis of 2008, and the ‘flash crash’ of 2010. Dr. Chincarini proposes an interesting behavioral theory as the root cause to these major financial episodes.
This highly readable book is in three main parts. The first part of the book provides a detailed examination of the failure of Long Term Capital Management in 1998. It includes a blow by blow description of exactly what happened, including interviews with some of the key players at the firm. The second part describes the 2008 financial collapse, starting with the demise of Bear Stearns. In great detail Chincarini describes the collapse of Fannie Mae and Freddy Mac, AIG, and the last straw, the failed rescue of Lehman Brothers. He shares what happened to the hedge funds that were formed from the ashes of LTCM. The third part looks at very recent market calamities including the failure of the Greek economy and the 2010 ‘flash crash’.
According to Chincarini, all of these powerful events have something in common; crowded trades. How would that take place? One company does a number of successful trades. So another firm copies them, then another and another. Soon you have a whole series of nearly identical trades by many players. The players believe they are protected by the diversification of very different positions. But what looks like diversification isn’t actually diversification at all if everyone is doing almost exactly the same trades, especially in illiquid securities. Add significant leverage, and it’s an accident waiting to happen.
The best and most compelling part of the book is the analysis of the downfall of Long Term Capital Management. We are introduced to the major players with biographies and interviews. We find out how the firm came into being, how they had many years of excellent returns. And how that success became their undoing as others copied their methodology for earning above average returns, creating a very crowded market in the same securities.
Particularly intriguing is how different this is from other behavioral phenomena. Humans have been engaged in typical financial behaviors such as anchoring or mental accounting for millennia. However, crowding of the type explored in this book requires computers to make large coordinated trades. So this is a behavior that only goes back possibly 25 years, to the ‘portfolio insurance’ craze that brought about the 1987 stock market crash. The relatively new science of behavioral finance is older than one of the investment fallacies that it describes.
A quote in the book from Han Hufschmid, one of the principals at LTCM, struck me. “In general, one can try and address known problems; it’s the risks that are not known that are dangerous”. It was those unknown risks in crowded markets that have brought us a great deal of financial pain over the last 25 years.