Monday, January 31, 2011

Davidoff, Gods at War

Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion by Steven M. Davidoff (Wiley, 2009; just released in paperback) is a must-read for anyone who wants to learn about M&A. Davidoff, as some of you undoubtedly know, writes as “The Deal Professor” for The New York Times’s DealBook.

Focusing on the years 2007-08, the author explains the ins and outs (the legal intricacies in particular) of deal-making in its many guises. He introduces the major players: private equity funds, sovereign wealth funds, activist hedge funds, and corporations. He describes key concepts such as material adverse change clauses, poison pills, and lockups. And he looks ahead to deal-making post-crisis.

M&A is an extraordinarily complex, constantly evolving field. If you ever wondered why the lawyers who shepherd deals through to successful conclusions get paid such big bucks, just read this book. The law is complicated and of course varies from state to state, barriers to success are high, and sometimes CEOs can’t get out of their own way. Think of the failed Microsoft-Yahoo deal.

Davidoff’s book, though it reads well, is dense and its parts are interconnected. As a result, I found it impossible to pluck out a couple of quick points for purposes of this post. Ah, I thought, I’d write about X, but then that would require explaining the Revlon decision. Yet even as I failed to come up with something substantive for this post I had to admire Davidoff for explaining the complexities so clearly.

Saturday, January 29, 2011

A thought for the weekend

As you might expect, not mine. This comes from Timothy Ferriss, The 4-Hour Workweek.

“It is far more lucrative and fun to leverage your strengths instead of attempting to fix all the chinks in your armor. The choice is between multiplication of results using strengths or incremental improvement fixing weaknesses that will, at best, become mediocre. Focus on better use of your best weapons instead of constant repair.” (p. 34)

Friday, January 28, 2011

Winter miseryland

For those who think I spend my life reading books and sitting at my computer (with the occasional foray into vegetable gardening) dream on! My new, time-consuming hobby is shoveling snow. Here are a couple of photos I took Thursday morning.

The first shows two kennel runs of five (about 15 ft. x 35 ft. each) with fencing 4 ft. high. They date back to my days of breeding and showing basset hounds. Fortunately I now have only one geriatric basset hound, Delta. I keep the path clear for her, as well as for the heating oil and propane delivery men, and ignore shoveling the runs that her ancestors romped in. But since the path is bounded on one side by evergreen hedges (and I have to shovel snow off the tops of them so they don’t croak, though many days I wish they would) and the fence line on the other, shoveling is a real heave-ho project.

The second shows a work in progress—grounded Ford van on the left, Subaru on the right. By this afternoon the Subaru was completely unearthed and ready to go. But, oops, the driveway is not yet plowed and even when it is it will be impassable.

Apparently at Bradley Airport north of Hartford, CT we have already broken the record for the snowiest month ever. We still have about 20 inches to go to smash the winter snow record. I’m not cheering Mother Nature on.

Thursday, January 27, 2011

Benklifa, Profiting with Iron Condor Options

Profiting with Iron Condor Options: Strategies from the Frontline for Trading in Up or Down Markets by Michael Hanania Benklifa (FT Press, 2011) is a book that anyone who trades iron condors or who aspires to trade them should read. It’s not that this is the final word on how to trade iron condors; there will never be such a book. But Benklifa explains what goes into the decision-making process throughout each trade and makes specific suggestions about the best ways to trade iron condors. He also describes in detail a perfect trade, a not-so-pretty trade, and an ugly trade.

The iron condor trader has many decisions to make, including what instrument to trade, how to structure the entry, the best market conditions for entry, trade management as the market moves in sync with the trade or even violently against it, how to mitigate risk, and how to choose the ideal exit. Benklifa makes these daunting decisions a lot easier.

To give a few examples:

The author advocates trading condors on indexes rather than individual stocks and recommends the SPX, RUT, and NDX in particular. These options are liquid and are European-style (hence no risk of early exercise).

In structuring the entry, the trader must consider position, price, and time. Benklifa offers precise rules with respect to these parameters. For instance, “deltas should be 10 or less if possible but never greater than 12” and “expiration day must be no closer than 49 days.” (pp. 89-90)

The exit strategy that Benklifa advocates might seem counterintuitive: “The exit strategy that works best is to give back almost all of the credit.” (p. 106) He recommends that the trader have a profit target before he opens the trade and immediately thereafter place a GTC limit order to buy to close the condor.

As the trade plays out the condor may have to be adjusted, and the author offers some adjustment rules. For instance, “Trade the math: Don’t let Deltas go over 25 to 30.” (p. 148) By the way, “Trade the math” is a mantra that is repeated several times throughout the book and is roughly equivalent to “Trade the Greeks.”

The book ends with a different, somewhat “Wild West” strategy for selling condors—getting in ahead of major news events and essentially day-trading condors.

I have given a very brief, admittedly shallow summary of what is a thoughtful and yet eminently practical book. Quite frankly, I don’t think I need do more. Iron condor traders should definitely read it, option traders in general can profit from it, and the rest of the world can simply move on.

Wednesday, January 26, 2011

Sincere, All About Market Indicators

Michael Sincere’s All About Market Indicators (McGraw-Hill, 2010) is written primarily for novices, and much of the material is available in other books. But for those who are familiar with basic market indicators Sincere’s book offers something more: dozens of brief interviews with market forecasters, traders, and indicator developers. For instance, Richard Arms recalls that when he thought of his “stupidly simple indicator” in 1967 he sent it to the technical analyst at E.F. Hutton, who in turn sent it to Alan Abelson at Barron’s. Abelson called Arms and said that he wanted to publish the indicator. “Getting a call from Abelson, Arms recalls, was like getting a call from the president.” Soon after Abelson published it, the Trader’s Index, as it was called in Barron’s, was “on quote machines all over Wall Street.” The Quotron machines needed a four-letter abbreviation—hence TRIN, as it’s still known. Arms admits, “I would love to have it changed.” (p. 46)

In the first part of the book Sincere describes, often with the help of their creators, sentiment indicators, technical indicators, and miscellaneous indicators (e.g., seasonal, Fibonacci, and anecdotal). He then turns to the thorny question of how traders anticipate market direction. Here he relies heavily on interviews with Fred Hickey, Linda Raschke, Brett Steenbarger, Alexander Elder, and later in the book Thomas DeMark. The third part deals with volume, especially as understood by William J. O’Neil and Pascal Willain, and high-frequency trading as studied by Shah Gilani.

I decided to share a couple of points from the interview with Gilani, a hedge fund manager and editor of, that I thought might interest my readers. Gilani argues that high-frequency trading is creating “a false perception of liquidity” and skewing the results of using volume as a principal indicator. (p. 164) HFT, which allegedly accounts for over two-thirds of trading volume, started its rise to volume dominance with the advent of ECNs and the proliferation of private trading networks. “Years ago,” Gilani says, “I thought that if someone could create a computer system that could bring all these disparate quotes from all the different trading venues together to get a ‘master quote,’ that person could game the system. And that’s exactly what has happened. High-frequency traders have programmed their computers to track and trade off of all that information flow. … It might have cost some of them $100 million to do it, but they can make that money back in less than a month.” (pp. 165-66) Gilani says that he is spending “a lot of time and money playing in [the HFT] sandbox.” One of his strategies is tracking the spreads between ETFs and their underlying stocks. He admits that “the cost to program this data runs into the millions of dollars. If I’m doing it, you can bet that teams of rocket scientists for all the big trading shops are also doing it. It’s all wrong. The tail is wagging the dog. And the dog just happens to be the capital markets that make our economy.” (p. 168)

Tuesday, January 25, 2011

A trading image

Images can be powerful. Here is one I particularly liked from Robert Koppel’s Bulls, Bears, and Millionaires (Dearborn Financial Publishing, 1997), p. 55, compliments of Timothy McAuliffe.

“You have to be prepared and disciplined whenever you walk on the trading floor. You also have to remind yourself that you’re just a fly on a rhino’s back, and the best you’re hoping for is a peaceful ride. If you get swell-headed, the tail’s going to get you. The trick is not to end up one dead fly!”

If you look at pictures of rhinos, their tails aren't terribly long. So, however distasteful and ego-deflating it may be to think of yourself as a fly, the good news is that if you're properly positioned you have a decent chance of surviving the ride.

Monday, January 24, 2011

Gleadall, The Metaphysics of Markets

Simon S. Gleadall, a former professional derivatives trader, raises some important questions in The Metaphysics of Markets (2010; available through Lulu). Let’s look at two. Do derivatives exist? What does it mean to place a value on financial instruments?

Initially the first question might appear outright silly because since derivatives are traded, surely they exist. Moreover, we know what they are: they are instruments that derive their value from some underlying asset. Gleadall argues, however, that this definition is inadequate. For one thing, the price of a spot product can become derivative to that of its alleged derivative. Consider the example of a market in a stock or a future that gets pinned around the strike of an option.

Gleadall suggests that “derivatives ought to be considered not so much as a product set but as a concept. Derivativeness might be more apposite than derivative.” It might be viewed as akin to property, which is not an object but “a series of rights and powers over objects.” (p. 61) As the author concludes, considering the extraordinary power of derivatives, the fact that their true nature remains elusive is disquieting.

Second, Gleadall tackles the problem of valuation methods. Invoking Kant, he contends that “true knowledge of valuation could well be not merely practically unattainable but a priori theoretically inaccessible. … [B]ankers all too often forget that their trading in assets because they are ‘mis-valued’ is an act of faith. Their valuation is a subjective impression of what is quite likely an unknowable or even non-existent true objective value. Nothing more.” (p. 70) He shows how the ignorance of value plays out in the real world when competing traders, whose positions are equal and opposite in terms of inventory, can both be awarded bonuses because their profitability is “valued” using their own models.

The Metaphysics of Markets is a significant first stab at dealing with a wide range of philosophical problems that beset the understanding of financial markets—ontological, epistemological, and ethical. It’s not a polished book: it could definitely have benefited from a good editor. But it introduces themes that are all too often ignored in the analysis of markets. Moreover, it sounds a clarion call to “formally establish the Philosophy of Finance as a stand-alone academic subject.” (p. 202) It’s a book I’m glad to have.

Saturday, January 22, 2011

An update from the frozen tundra

I am thrilled to announce that I am now the proud owner of 100 gallons of heating oil, delivered this morning by a four-wheel-drive pickup truck after the driveway was plowed and sanded yet again. With normal heating it’s expected to last two weeks—I fear not long enough to get a break in the weather and clear the driveway completely. What ever happened to the January thaw? Oh well, I’m getting used to 60 degrees at my computer and 55 degrees everywhere else. It’s the new normal.

I’m trying to take my mind off this frigid weather by browsing through seed catalogs and making some tentative plans for my 2011 vegetable garden.

And, yes, I’m starting to read again and will offer a mix of old and new titles next week.

Friday, January 21, 2011

Valentine, Best Practices for Equity Research Analysts

James J. Valentine’s Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts (McGraw-Hill, 2011) is a how-to manual. If, that is, you have what it takes or can develop what it takes to be a successful analyst—and that includes a rather antisocial (a bit more than contrarian) personality.

The book is divided into six parts that range over such topics as organization, generating qualitative and quantitative insights, mastering stock-picking skills, communication, and making ethical decisions. It is eminently practical in tone. For instance, Valentine offers time management suggestions, tips for leaving voicemails, and instructions for creating the best Excel spreadsheets for financial analysis.

I have no doubt that beginning analysts could avoid innumerable stumbles and that more experienced analysts could hone their craft by reading this book. But since I don’t inhabit that world I have opted instead to share two of Valentine’s insights that all investors can profit from. First, modeling inputs unique to value and growth companies; second, one aid in forecasting changes in market sentiment.

In developing company financial models, the analyst of a value (or cyclical) company will be interested in the following kinds of items: factors that have helped forecast cycle inflection points of the past, capacity additions relative to demand, post-retirement benefits, and off-balance-sheet liabilities. By contrast, the analyst of a growth company will want to identify the ultimate size of the market, sources of funding necessary for the company to grow, and dilution from stock options. (p. 239)

Valentine claims that “The key to generating alpha is having a more accurate view about a future stock price than the market. This can only be done on a consistent basis if the analyst has an edge over the market in one of the three areas that compose our FaVeS framework,” financial forecast, valuation, or sentiment. “Sentiment, void of any fundamental changes, is often the only thing that moves a stock or market in the short-term.” (p. 274)

Unfortunately, correctly forecasting a shift in market sentiment is the most difficult of the three. Valentine makes clear that “the skill to be mastered here isn’t understanding how investor sentiment changes after consensus earnings or cash flow forecasts change, but beforehand.” (p. 281) There are some factors that analysts typically monitor for potential sentiment shifts, such as short interest, insider buying and selling, and the market’s relative appetite for risk (reflected in treasury yields, the VIX, the size of the deal calendar, and the recent stock performance of weak vs. stable companies, emerging markets vs. domestic markets, and small cap vs. large cap).

Valentine claims that “one of the most basic elements for understanding investor sentiment is to know which types of investors” own the stock in question. “For example, if a value fund is buying a stock because it believes the company will be recognized for successfully moving into attractive growth markets, growth investors will need to bid the stock up to a point where the value manager has an attractive exit point. While not every stock fits cleanly into an investment style box, it’s often important to know the investment philosophy of the current owner in an effort to: (1) identify the potential owner who will eventually bid the stock higher, or (2) consider which style is the buyer of last resort should the company stumble. Companies that successfully move from value to momentum can see their stocks easily rise 30 to 100 percent, but should that momentum slow, there’s often nobody to catch the falling knife until it becomes attractive to value investors again.” (p. 282)

Savvy investors and traders who are long a stock should always ask themselves who else owns it, who is likely to buy more, when the appetite for buying is likely to wane, and how difficult it will be to bail as the longs head for the exit.

Wednesday, January 19, 2011

Kurzban, Why everyone (else) is a hypocrite

Robert Kurzban’s Why everyone (else) is a hypocrite: Evolution and the Modular Mind (Princeton University Press, 2011) is one of the most thought-provoking books I’ve read in quite some time. Kurzban is an evolutionary psychologist who tries to understand why we can contentedly embrace inconsistent beliefs. His thesis is that the mind is modular; like a computer program, it has subroutines that can operate relatively independently and that “are often ‘opaque’ or ‘invisible’ to other subroutines.” (p. 24)

As Kurzban develops his thesis he takes the reader on a journey to far-flung corners of our experience, starting with a very funny account of crossing a street in Philadelphia (where you do not want to make eye contact with an oncoming driver) and concluding with a range of moral issues—for instance, the value of monogamy, the illegality of drugs in a society that embraces free markets, and the arguments for and against abortion. He maintains that people on both sides of these debates are inconsistent in their reasoning.

Naturally, for Kurzban there is no ghost in the machine, as Gilbert Ryle described Descartes’ mind-body dualism. By extension, there is also no self but rather a concatenation of modules. Who “we” are changes, depending on which module is doing the quarterbacking. And “we” are not always seekers of the truth. The quarterback can sometimes opt for ignorance, sometimes even opt for falsity. And, in the right context (though definitely not when confronting a bear), can act on these flawed beliefs in an effective way.

The driving force behind Kurzban’s argument is evolutionary selection, which takes me to the first of two examples of his thinking: the quest for self-esteem. He writes: “Mechanisms whose function it is to make someone feel good per se have no real function at all as far as evolution is concerned, since the feeling itself is invisible to selection.” He cites the work of Leary and Downs who “liken self-esteem to a measurement tool, like a fuel gauge. When your gas tank is empty, … you don’t want to solve that problem by taking your finger, sticking it in the gas gauge, and moving the meter from empty to full. … Rather, you want to … fill the tank.” (p. 144) Filling the tank, however, is not a particularly rich metaphor because there is not a single gauge but many, “monitoring how one is doing”—becoming more valuable to others—“in various domains of social life.” (p. 145)

The second example, the illusion of control, is not one of the most interesting, but I include it because it comes from the trading world. A study gave 107 traders from London investment banks the task of moving a fictional market’s chart as high as possible during the course of a game; they could press three keys that “might” affect the price chart. As you have probably already surmised, the keys were irrelevant to the randomly generated price movement. How did the traders’ view of their performance on the game correlate with their real-world performance? “Traders who showed a higher illusion of control earned less money and were rated as less effective at their jobs.” (p. 115)

In Kurzban’s style it is easy to see the influence of such writers as Malcolm Gladwell, Daniel Ariely, Scott Page, and James Surowiecki. He peppers his book with allusions to popular culture (films, Homer Simpson, and—importantly—C. J. Cregg in The West Wing) and makes analogies to toasters and vehicles.

After reading this book I can more easily make sense of the findings of behavioral finance where people so often make decisions that are irrational and not in their best interest. By the way, Kurzban critiques the very notion of self-interest.

I’m sure that Why everyone (else) is a hypocrite will provoke a lot of controversy, and I’m equally certain that Kurzban’s theses will require further refinement. But what a fascinating read!

And kudos to the designer of the dust jacket. It doesn't show up well in the Amazon image, but it's terrific.

On a personal note

I’m about ready to cry uncle and move to warmer climes. Here I sit at the bottom of a notorious driveway that has defeated a host of cars and trucks. After having paid a tidy sum to have my driveway plowed after the last storm, I wanted to get out on Saturday in a Subaru. Score: driveway 1, Subaru 0. Each day I kept agonizing over the oil tank gauge that was getting perilously close to empty and kept turning the thermostats down. So on Sunday and Monday I went to work on improving the driveway, using an ice breaker and a snow shovel. I thought I had done a pretty decent job; my body certainly felt it. I figured that if the driveway was also sanded, the oil truck could navigate the driveway. Wrong. The oil truck driver turned thumbs down.

It seems that there is an emergency procedure available as long as some four-wheel-drive truck can get down the driveway. I assume it will be deemed an emergency only when I am completely out of oil. Right now it’s a sheet of glistening ice outside and a toasty 55 degrees in the house. I have a space heater next to my computer to keep me warm, and there are of course blankets and sleeping bags scattered throughout the house to stave off the cold.

As I was writing this tale of woe, we lost power. Fortunately it came back after about five hours and the furnace miraculously started running again. I know, it’s not exactly the siege of Leningrad, but this New England winter is taking its toll on my body and spirit.

The upshot as far as you are concerned: I didn’t get as much reading done this past weekend as usual, so postings may be a little spotty. But there’s a good one coming along within the hour.

Thanks, by the way, to those of you who are clicking through on the Amazon links to buy goodies there—books, electronics, clothing, etc. I really appreciate it.

Tuesday, January 18, 2011

Monks and Lajoux, Corporate Valuation for Portfolio Investment

Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations by Robert A. G. Monks and Alexandra Reed Lajoux (Wiley, 2011) is a surprisingly engaging book. And, let me confess up front, I have spent mighty few waking hours worrying about how to value corporations. Early on in my investing career I admitted defeat: I had no idea how to make sense of the conflicting valuational models.

The authors bring years of academic training and involvement in the corporate and investment worlds to the task of explaining corporate valuation. Monks, the founder of Institutional Shareholder Services and Lens, is the product of Harvard College, Cambridge University, and Harvard Law School. Lajoux, chief knowledge officer at the National Association of Corporate Directors, has a Ph.D. in comparative literature from Princeton. I assume that she’s largely responsible for making the book read so well.

All methods of valuing functioning corporations, the authors suggest, are attempts to quantify hope—or, in the emotionless language of value investing, attempts to determine the present value of future worth. Done properly, valuation steers a middle course between “tire-kicking,” the appraisal of business assets, and “gambling,” ungrounded speculation. Described somewhat differently, “value lies somewhere between these two extremes of absolute and relative value—or, if you will, between economic value and market value.” (p. 31)

The authors steer the reader, seemingly effortlessly, through the basic valuation models based on assets, earnings, and cash flow. They then move on to valuation based on price where technical analysis, though important, is not the only game in town.

Drawing on the theoretical work of the senior author, Monks and Lajoux offer a different approach to “valuation guidance based on six factors: genius, liberty, law, markets, governance, and values.” (p. 292) This clearly is where their hearts lie; it provides a “big-picture” approach to valuation.

The authors conclude that there is no absolute definition of valuation. “The need for valuation exists in many contexts that have irreconcilable frames of reference…. As a result, valuations of the same security can vary widely. Although each may be appropriate to its intended purpose, the resulting disparities create confusion and no small degree of skepticism regarding the whole language of valuation.” (p. 397)

This book goes a long way toward reducing (or, some might argue, refining) that skepticism. It is lucid, comprehensive, sometimes even passionate. It is a book that every value investor should read. Because, in the end, there’s no substitute for investor knowledge and talent.

Friday, January 14, 2011

A comment on reverse mortgages

My review of the book on reverse mortgages was syndicated on Seeking Alpha (as are most of my reviews). In response, I got the following comment which I thought I should share.


Some valid points but some issues have been or are being addressed. In today's market probably all reverse mortgages are government loans--the private market has dried up.

Many lenders have eliminated the origination fee and a new product, the HECM Saver, has almost no mortgage insurance charge at closing. The combined effect is to reduce closing costs by about 60% from what they were when the book was researched.

Reverse mortgages are not comparable to "risky" zero coupon bonds because today all of them are FHA insured. The mortgage buyer knows they will receive their principal and accrued interest, although they admittedly don't know when. Also, the borrower continues to own their home--the lender doesn't buy the home from the borrower any more than a traditional lender does.

This product can be a very good one for persons of low, medium or high incomes depending on their circumstances. High net worth borrowers can sometimes be far better off drawing money tax free from home equity via a reverse mortgage than selling financial assets in a down market and incurring capital gains taxes.

Best regards,
Dick Poole

Thursday, January 13, 2011

Anson, Fabozzi, & Jones, The Handbook of Traditional and Alternative Investment Vehicles

This is not a book that you’d want to curl up with on a snowy afternoon. The Handbook of Traditional and Alternative Investment Vehicles: Investment Characteristics and Strategies by Mark J. Anson, Frank J. Fabozzi, and Frank J. Jones (Wiley, 2011) is a reference book. It’s a book you dip into to get up to speed on asset classes that you may have ignored in the past or about which you have less than expert knowledge.

I don’t normally list chapter titles in a book review, especially not when there are 22 of them, but in this case I think it’s necessary to convey the breadth of this volume. So here goes: Introduction, Investing in Common Stock, More on Common Stock, Bond Basics, U.S. Treasury and Federal Agency Securities, Municipal Securities, Corporate Fixed Income Securities, Agency Mortgage Passthrough Securities, Agency Collateralized Mortgage Obligations, Structured Credit Products, Investment-Oriented Life Insurance, Investment Companies, Exchange-Traded Funds, Investing in Real Estate, Investing in Real Estate Investment Trusts, Introduction to Hedge Funds, Considerations in Investing in Hedge Funds, Investing in Capture Venture Funds, Investing in Leveraged Buyouts, Investing in Mezzanine Debt, Investing in Distressed Debt, and Investing in Commodities.

To give a sense of the book, I’m going to confine myself to the last chapter. Since commodities are a hot topic right now, I assume most investors have some notion about what commodities are and how they trade. What more can we learn from this handbook?

First, there is a critical distinction between how stocks and bonds are valued and how commodities are valued. In the case of stocks and bonds, one important valuation metric is the present value of the expected cash flows. But, with the exception of precious metals which can be lent out at a market lease rate, commodities “do not provide a claim on an ongoing stream of revenues” and “interest rates have only a small impact on their value.” (p. 455)

We learn that there are six ways to obtain exposure to commodity assets: “through the commodity itself, shares in a commodity-related firm, futures contracts, commodity swaps/forward contracts, commodity-linked notes, or exchange-traded funds.” Each avenue is described briefly but not analyzed critically.

There are three reasons why commodity prices should be negatively correlated with the prices of stocks and bonds. (1) Inflation has a positive impact on commodity futures prices, a negative impact on the values of stocks and bonds. (2) Commodity futures are affected by short-term expectations, stocks and bonds by long-term expectations. (3) The three key inputs to economic production are capital, labor, and raw materials. “In the short to intermediate term, the cost of labor should remain stable. Therefore, for any given price level of production, an increase in the return to capital must mean a reduction in the return to raw materials, and vice versa. The result is a negative correlation between commodity prices and the prices of capital assets.” (p. 467) Actually, there’s a fourth reason, dealing with price shocks. Supply disruptions produce positive returns for commodities, negative returns for financial assets.

The chapter ends with a discussion of the various commodity indexes.

I suspect that some of my readers would take issue with the reasons put forward for a negative correlation between commodities and financial assets. But a survey of investment vehicles is, or at least should be, a place to begin one’s research, not conclude it. And this volume is a laudable jumping-off point.

Wednesday, January 12, 2011

Bhuyan, Reverse Mortgages and Linked Securities

We’ve all seen the ads for reverse mortgages, touted as a way for your house to pay you. Reverse mortgages are not especially tempting products; among other things, they normally have hefty closing costs. For most people they seem to be a last resort, not one choice among many. After reading Reverse Mortgages and Linked Securities: The Complete Guide to Risk, Pricing, and Regulation edited by Vishaal B. Bhuyan (Wiley, 2011) I begin to understand why.

First, a brief summary for those under the age of 62 who have never given a reverse mortgage a second thought (understandably, because they are not eligible). “A reverse mortgage is a longevity-linked loan that allows senior citizens, age 62 and older, to release the equity in their home without meeting any credit or income requirements. As opposed to traditional mortgages, there is no obligation to repay a reverse mortgage loan until the borrower passes away or no longer uses the home as a primary place of residence.” (p. 3) Almost 90% of reverse mortgages are Home Equity Conversion Mortgages (HECM), insured by the Department of Housing and Urban Development.

Reverse mortgages are inelegant structured products in an era of sophisticated financial engineering. First, securitization is problematical “because the nature of the cash flows generated by the asset is comparable to risky zero-coupon bonds with uncertain maturities. This means that the owner of the asset does not know what will be the value of the mortgaged asset at the unknown maturity date.” (p. 143)

Second, reverse mortgages use blunt pricing models. For example, although the most important variable in pricing a reverse mortgage is life expectancy, lenders simply use large-population actuarial tables in which not even sex is taken into consideration. The life expectancy of a 70-year-old woman who is healthy, physically fit, and comes from a demographic known for longevity is deemed to be identical to that of a 70-year-old man who has emphysema, diabetes, and smokes two packs of cigarettes a day.

Third, the lender, even with a contract in place, essentially has to hope that the senior citizen will maintain the house he is living in but no longer owns and that he will keep paying his taxes and homeowners insurance. “[W]here the senior is in direct breach of the loan agreement, the lender may be forced to remove the senior from his or her home. Clearly, the sight of a sheriff evicting a 75-year-old woman from her home does not sit well with anyone.” (p. 6)

The contributors to this volume analyze the current status of reverse mortgages, the main players in the market, and the ever-changing regulatory environment. They also suggest ways to enhance the methods of underwriting reverse mortgage loans so they will become more attractive to potential borrowers as well as to institutional investors.

The market for reverse mortgages should grow, given the demographic landscape. The question is whether the product can be fine-tuned in a way that is advantageous to both the individual and the institutional investor. This book is a first step toward that goal.

Monday, January 10, 2011

Why Chinese mothers are superior

In case you missed this piece in The Wall Street Journal or thought it was irrelevant to your own learning curve, here's the link. A must read.

Bernstein, The Compleat Day Trader, 2d ed.

The dust jacket of Jake Bernstein’s The Compleat Day Trader: Trading Systems, Strategies, Timing Indicators, and Analytical Methods (McGraw-Hill, 2011) states that this second edition of the book that first appeared in 1995 is “revised and fully updated for today’s volatile markets.” Actually, it has been completely rewritten. So, although it’s telling to see what has been omitted from the strategy and indicator sections of this second edition (for instance, stochastics are gone), it’s best to view this book as a brand new contribution to the literature on day trading.

Bernstein is a discretionary trader in the sense that he believes that “the emphasis must be the development of simple but repetitive and reliable market relationships as opposed to systems per se.” (p. 39) Put another way, he stresses the development of trader skills rather than system development.

Bernstein offers a few simple but potentially powerful technical indicators. First, there is the moving average channel, based on the principles of support and resistance combined with market trend. This indicator uses a simple moving average of price highs, a different moving average of price lows, and Williams AD as a trigger or confirmation. (You really didn’t think I’d give you all the formulas in a book review, did you?) It is not, however, a strictly mechanical trading method; it requires the trader to use some judgment.

Second (and admittedly not a technical indicator) are plays for CNBC addicts, the media day trades. Bernstein then considers momentum and MACD divergence trades. His favorite method, to which he devotes yet another chapter, revolves around trading with gaps. And finally he offers the eight open, eight close method based on the eight-bar moving averages of the open and close.

Of particular value for the day trader is the chapter on profit-maximizing strategies in which Bernstein discusses various strategies for placing stop losses (and underscores the importance of sufficiently large stop losses), profit targets, position sizing, and the equity curve filter.

Bernstein was trained in clinical psychology and is the author of the popular The Investor’s Quotient. It is not surprising, therefore, that he considers “the single most important aspect of any trading methodology” to be “the psychology of the trader.” (p. 189) His chapter on the psychology of day trading focuses on behaviors and qualities that either enhance or limit trading success. Examples of the former are discipline and persistence; of the latter, overtrading and beginning with insufficient capital. The former are behaviors and qualities that all successful traders share; the latter are some of the ways that traders fail. Those who want an analysis of and potential remedies for the specific psychological baggage they bring to trading will have to turn elsewhere.

The Compleat Day Trader is a good book for the beginning or the not yet profitable trader. It also serves as something of an annotated checklist of elements that go into making a good trader. And we know the incredible power of checklists. Just read (or re-read) Atul Gawande’s piece in The New Yorker from 2007 or his 2009 book The Checklist Manifesto: How to Get Things Right.

Friday, January 7, 2011

Taibbi, Griftopia

There’s something for everyone to vehemently disagree with in Matt Taibbi’s Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America (Spiegel & Grau, 2010). In case the author’s name doesn’t immediately ring a bell, he’s the journalist who wrote the famous/infamous piece on Goldman Sachs in Rolling Stone.

It’s not just that Taibbi writes about controversial topics in a categorical, over-the-top way. He also leaves manners (and literary restraint) outside the door of his writing studio. For instance, his chapter on Alan Greenspan is entitled “The Biggest Asshole in the Universe.” He describes Greenspan’s rise as “a tale of a gerbilish mirror-gazer who flattered and bullshitted his way up the Matterhorn of American power and then, once he got to the top, feverishly jacked himself off to the attentions of Wall Street for twenty consecutive years—in the process laying the intellectual foundation for a generation of orgiastic greed and overconsumption and turning the Federal Reserve into a permanent bailout mechanism for the super-rich.”

Taibbi takes on the Tea Party, the mortgage scam, the commodities bubble, sovereign wealth funds, health care reform, and (in an update to his Stone piece) Goldman Sachs. To say he is no friend of big business, especially not of Wall Street, would be an understatement. Government doesn’t come off much better: “government is a slavish lapdog that the financial companies … use as a tool for making money.”

Even though there’s much to dislike in this book, it’s definitely worth reading. First, Taibbi did a lot of research; you’ll find material that is not readily available elsewhere. Second, he can occasionally be wickedly funny. I suggest you save it for a day when you’re really annoyed with the markets and are looking for a reason to blame whatever happened to your portfolio on rich and powerful grifters.

Wednesday, January 5, 2011

Ferri, The Power of Passive Investing

The title says it all. In The Power of Passive Investing: More Wealth with Less Work (Wiley 2011) Richard A. Ferri makes the case for building a diversified portfolio of index mutual funds and ETFs.

He cites several studies and some of his own tests that demonstrate the futility of seeking alpha. Among the findings, a single actively managed fund has a 42% chance of beating a comparable index fund over the course of a single year, a success rate that drops to 12% over 25 years. The statistics get much worse as you add more active funds. If you own ten funds, you have a 27% chance of beating an all index fund portfolio over one year and a mere 1% chance over 25 years.

Ferri’s own work analyzed the returns of actively managed funds within a generic asset class over five years. He found that a portfolio of five randomly selected active funds had only a 16% chance of beating an index fund, that only 5% of them won by 0.5% or more, and that 63% of them lost by 0.5% or more. When the portfolio was expanded to ten active funds, the numbers were much worse. Only 8% were winning portfolios, 1% of them won by 0.5% or more, and 70% lost by 0.5% or more. Ferri then massaged his model to see whether the numbers could be significantly improved; they couldn’t. As he summarized the results, “Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!” (p. 92)

Market timing strategies are also unsuccessful. The worst strategy, using survey data from a large sample of online brokerage clients, is trading based on technical analysis or charting (a negative 0.92% per month). Trend following—that is, shifting money into asset classes that have recently gone up and taking money out of those classes that have gone down—costs investors about 1% a year.

Passive investing, as the title indicates, is “power investing”. (p. 157) The process of implementing a passive investment plan is fairly straightforward. Here I’ll mention only the bucket approach to asset allocation where “one bucket holds cash-like investments for short-term needs and the other bucket has long-term investments that refill the short-term bucket when needed.” (p. 163)

Ferri rounds out his book by looking at passive investing for charities and personal trusts, pension plans, and advisors.

The recommendations in this book are not revolutionary; John Bogle has been making the case for index investing for decades. The recent proliferation of asset class index ETFs, however, has made it much easier to customize portfolios to individual investing profiles.

The real problem, the author says, is not to implement a passive investing strategy. It is to convince people to change their ways, to realize that they’re highly unlikely to beat the market, and to accept the wisdom of being satisfied with market returns (however the markets are sliced and diced).

Tuesday, January 4, 2011


Do you consider yourself to be lucky or unlucky? And is part of being lucky “simply the attitude taken towards life’s events, good and bad”? For this brief post I’m drawing on Martin Cohen’s book Mind Games (Wiley, 2010); he in turn is relying on Richard Wiseman’s The Luck Factor.

Wiseman conducted an experiment in which he divided people into two groups, depending on how they viewed themselves (lucky or unlucky). He then asked everyone to look in a newspaper and report how many photographs were in it. “On average, he found, the unlucky people took about two minutes to count the photographs whereas the lucky people took just a matter of seconds.”

Why the huge disparity between the two groups? “It was because the second page of the newspaper contained the prominent announcement: ‘Stop counting – There are 43 photographs in this newspaper.’ Anyone spotting this was saved a lot of bother. But the unlucky ones tended not to spot it as they worked slowly through the pages.”

Wiseman claims that his experiment shows that “unlucky people are less able to spot opportunities than their fortunate companions. It is part of his general theory that discerns certain key characteristics for being lucky, all of which are possible to learn.

1 Create and spot opportunities.

2 Allow chance (or is it really your subconscious?) to work for you by using your ‘intuition’.

3 Create positive outcomes by starting with positive expectations.

4 Turn bad luck into good by being tenacious and persistent.” (p. 96)

Of course, we might add to this something from the spate of similar adages: “The more I practice, the luckier I get”; “The harder I work, the luckier I get.”

A final point: We don’t always agree on when we have been lucky. As Cohen writes, “people judge luck not by outcome but by expectation. For instance, psychologists have found that amongst Olympic champions, the second placed are not necessarily more content than those who came in third… On the contrary, the silver medallists focus on the gold medal so near and yet so far, ruing their lack of that little bit more speed or whatever, whilst the bronze medallist is very pleased with their lot, thinking of how they might easily have come in fourth and got nothing at all.” (p. 97)

So do you feel lucky? (We need not add the Dirty Harry line, “Well, do ya punk?”) Perhaps in light of Wiseman’s research we can rethink the statement by Jim Simons of Renaissance Technology fame: "Luck," he told a gathering of potential investors,"is largely responsible for my reputation for genius. I don’t walk into the office in the morning and say, 'Am I smart today?' I walk in and wonder 'Am I lucky today?'"

Monday, January 3, 2011

Biggs, A Hedge Fund Tale of Reach and Grasp

Over the holidays I read Jane Smiley’s Private Life, the portrait of a rather ordinary, passive woman whose life is defined by the demands of her unstable, delusional husband—a life so private, one reviewer wrote, that it is no life at all. I then moved on to Barton Biggs’s A Hedge Fund Tale of Reach and Grasp … or what’s a Heaven for? (Wiley, 2011). (The title was taken from Robert Browning’s poem “Andrea del Sarto,” the musings of an artist who has had a disappointing career: “Ah, but a man’s reach should exceed his grasp, or what’s a heaven for?”) I capped off this holiday contrarian reading list by revisiting Dostoyevsky’s short novel of a young man’s descent into addiction, The Gambler. And when I decided enough was enough and that I needed a dose of the triumphant, even if it was triumph in the face of so much devastation, I turned to Gregory Zuckerman’s book about John Paulson’s coup, The Greatest Trade Ever.

I write all this to put my reading of Biggs’s book into context. It would undoubtedly have stood up much better had I not sandwiched it in between books by a Pulitzer Prize winning novelist and a literary giant. If, for instance, I had read it after Corporate Valuation for Portfolio Investment and followed it up with Reverse Mortgages and Linked Securities--both books, by the way, in my “to be reviewed” stack.

Barton Biggs, a major presence at Morgan Stanley for thirty years and cofounding and managing partner of a billion-dollar macro hedge fund, studied writing at Yale in the 1950s under Robert Penn Warren. He is a skilled writer. I especially enjoyed his book Hedge Hogging (Wiley, 2006). But he’s not a compelling novelist. This blog is not the appropriate venue for literary criticism, nor am I a literary critic. Suffice it to say that A Hedge Fund Tale of Reach and Grasp reads much better as a historically grounded morality tale than as a novel.

The protagonist, definitely no Everyman, is the offspring of a black mill foreman and a white waitress. He leaves rural Virginia to attend an academic wasteland of a college in Arizona on a football scholarship. After graduation, his dreams of playing in the NFL having long since been dashed, he pursues his new dream—being an analyst on Wall Street. Initially, he ends up in the back office. But he perseveres and soon enough catches a break (with the help of an asset management “godfather” and eventual father-in-law). From that point on, with Wall Street rewarding not only his seeming investing skills but also his prowess on the football field and the golf course, he moves into the heady hedge fund world. As co-manager of a quant portfolio with a value orientation, he puts up big numbers, makes big bucks, spends lavishly, and thinks the party will continue forever.

We know, of course, from its title that the tale won’t end well. We also know from recent history why it doesn’t end well.

Biggs carefully weaves together fact and fiction. Some facts are painfully familiar, but Biggs’s portrait of the inner workings of his fictional hedge fund illuminates a world that was—and to a large extent still is—all too real. For those of us on the outside this is useful information to store away. Here and there, always in passing, he also dispenses pieces of investing wisdom.

I must admit I cared more about the ideas than the people in A Hedge Fund Tale of Reach and Grasp. But then I suspect that even in real life I would care more about the ideas of hedge fund managers than I would about most of them as human beings. Perhaps that’s simply the nature of a world of reach and grasp.