Howard, The Mortgage Wars

Just when you thought you knew everything there was to know about the meltdown of the mortgage market, along comes The Mortgage Wars: Inside Fannie Mae, Big-Money Politics, and the Collapse of the American Dream (McGraw-Hill, 2014). Timothy Howard, former CFO of Fannie Mae, was in the trenches until the end of 2004. At that time he left Fannie Mae, “along with Fannie Mae’s chairman and CEO Frank Raines, in the wake of allegations by the company’s regulator that [they] had deliberately falsified its financial reports.” A civil case lasting over eight years ensued, with Raines and the author named as individual defendants. The defendants filed motions for summary judgment in their favor, which was granted in the fall of 2012. Thus vindicated, Howard was finally free to tell his side of the story. And a fascinating story it is. Here’s some background.

Fannie Mae was set up in 1938 as a government-owned national mortgage association. In 1954 it became a mixed-ownership corporation, with the U.S. Treasury holding nonvoting preferred stock that was meant to be gradually retired so that Fannie Mae would become a wholly privately owned company. In 1968, as the national debt was approaching $100 billion, “a threshold President Lyndon Johnson desperately did not wish to exceed,” and as “pressures were growing to include Fannie Mae’s then $2.5 billion in borrowings in the debt totals,” it was rechartered. Fannie Mae was split in two—a stockholder-owned company and a new agency, Ginnie Mae. Two years later Congress created the Federal Home Loan Mortgage Corporation (FHLMC), owned and regulated by the Federal Home Loan Banks. “The act did have one noticeable shortcoming: it did not produce a pronounceable acronym for its new offspring. The closest phonetic equivalent to FHLMC, ‘Flummox,’ was out of the question as a nickname. It became known as ‘Freddie Mac’ instead.” (pp. 21-22)

Fannie Mae may have become a shareholder-owned company, but it enjoyed benefits that both created the perception of a special relationship with the U.S. government and lowered the cost or increased the marketability of the company’s securities. As such, it “faced criticism and pressures from three main sources: free-market advocates, actual and potential competitors, and the two principal bank regulators, the Federal Reserve and the Treasury.” (p. 32) But, despite calls for Fannie Mae to sever all ties with the government and become a stand-alone entity, internal studies concluded that such a step would be suicidal. Fannie Mae remained a GSE.

Fannie Mae’s real challenge was interest rate risk. In 1985, when its credit losses were $170 million, it tightened its underwriting standards; by 1993 management “could credibly claim in Congress and elsewhere that [its] management of mortgage credit risk was second to none.” (p. 46)

Criticism, however, was unrelenting—and from a host of powerful adversaries. For instance, “Greenspan and Summers both viewed the GSEs’ federal charters as the antithesis of the free-market principles they cherished. Their shared ideology led them to advocate tighter restrictions on the government-sponsored enterprises while simultaneously seeking to relax regulations on banks—which they considered to be free market entities in spite of the fact that they benefited from federal deposit insurance and a regulator, the Fed, willing to lower their cost of funds by dropping market interest rates whenever they got into difficulty (as banks periodically did).” (p. 105)

The attacks on Fannie Mae only intensified. Howard describes in vivid detail the campaign against the GSEs, as “seemingly credible sources, including the Wall Street Journal,” argued “with … frequency and fervor that the risky GSE’s must be replaced by far safer private-market alternatives.” (p. 148) The private-label mortgage-backed securities market began to flourish. We know where that took us.

Here I’ve merely offered a glimpse into some of the early events and players (there were many) that prompted the mortgage wars and eventually the housing market meltdown and the nationalization of a Fannie Mae that had lost its way. Howard takes the story through to its end, detailing the chain of events with the passion of an aggrieved insider and the precision of a number cruncher. He adds considerably to our understanding of what went wrong and offers suggestions about how we can prevent a reoccurrence. The Mortgage Wars should be required reading for politicians, regulators, and bankers—and all of us who are tasked with keeping them in check.

Durenard, Professional Automated Trading

I’m in over my head with Eugene A. Durenard’s Professional Automated Trading: Theory and Practice (Wiley, 2013), so consider this post more of a notice than a review.

Durenard describes how to set up a framework to research and select trading models and to implement them in a real-time low-latency environment. The book “requires readers to have some knowledge of certain mathematical techniques (calculus, statistics, optimization, transition graphs, and basic operations research), certain functional and object-oriented programming techniques (mostly LISP and Java), and certain programming design patterns (mostly dealing with concurrency and multithreading).”

Durenard focuses on the design of trading strategies as trading agents, the goal being to build “robust trading systems that can gracefully withstand changes of regime.” He introduces swarm systems, which are “aggregate agents that embed various types of switching mechanisms.”

The assumption underlying Durenard’s framework is that markets are complex adaptive systems best understood, and exploited, by an aggregate adaptive agent. This agent has a collection of nonadaptive strategies at his disposal. The agent “is endowed with criteria to choose a subset of behaviors that is expected to produce a positive performance over the next foreseeable future. This is the behavior that the agent implements in real trading. As time unfolds, the agent learns from experience to choose its behavior more effectively. Effectiveness means that as the market goes through various cycles of regime changes, the performance during those change periods does not degrade.”

Durenard draws on concepts from evolutionary theory and learning to endow trading systems with opportunism, robustness, and flexibility. Learning is important because a swarm system needs not only behaviors that have proved effective in the past but also a degree of innovation. The innovation problem is “an active area” of Durenard’s current research.

This book is divided into four parts: strategy design and testing, evolving strategies, optimizing execution, and practical implementation. It offers its fair share of code to help the reader along—unfortunately, not this grossly under-qualified reader.

Birinyi, The Master Trader

Even though he is sometimes derided for being a perma-bull (or in his words, “a redundant bull” [p. 62]), Laszlo Birinyi has a long, proven track record which has earned him the title “a legend.” So the publication of The Master Trader: Birinyi’s Secrets to Understanding the Market (Wiley, 2013) is something of an event.

Birinyi’s investing style is difficult to categorize. He is no fan of technical analysis: “it is not predictive, it is not consistent, and it is not analysis.” (p. 1) And yet his money flows indicator is often included in technical analysis packages. No, no, he argues, money flows are not a technical indicator. “They are the ultimate fundamental input.”(p. 72)

In addition to money flows analysis, which looks at every trade (and, most importantly, the size of every trade) in every stock, Birinyi also uses anecdotal data to inform his trading. Magazines and newspapers, he contends, are “databases in disguise.” (p. 80) He also keeps track of the attitudes of commentators and economists.

And this is just the beginning. It quickly becomes clear that what he’s advocating involves a lot of work. Birinyi concedes the point but counters: “consider a portfolio of $100,000 which hopes to make 10 percent or $10,000. Working as a teacher or administrator or chef, how long would it take to accumulate $10,000? Three months, half a year? Why should you make it on Wall Street in only three days or six weeks?” (p. 196)

Birinyi’s firm crunches numbers relentlessly to analyze, among other things, market cycles, sector rotation, small vs. large stocks, growth vs. value, market sentiment, and the impact of the Fed. As he writes (though in connection with a suggested reading list), “you can never know too much about too many things on Wall Street.” (p. 281) Of course, what you know is more important than how much you know. Birinyi quotes Roland Grimm, former manager of the Yale Endowment, who said, “You have to be careful regarding the railroad analyst who knows how many ties there are between New York and Washington and not when to sell Penn Central.” (p. 244) Moreover, “sometimes too much data is actually a handicap as it incorporates different circumstances. Risk measures, as one example, before the advent of options were a totally different environment.” (p. 248)

In recent years Birinyi’s firm has “found portfolio enhancing opportunities in short-term trading by ignoring or omitting historical data.” And yet, “despite our efforts, we have not been able to develop metrics for shorter periods and have no confidence in others’ efforts to do so either. There is one exception—the next day—and even then only in certain circumstances.” (p. 250)

As for gaps, remember the old rule that large gaps have to be closed? Well, the new rule says that these gaps close only about 25% of the time. Within this number, however, there are tendencies even if no definite answers. “[I]n a world of computerized trading, models, and other mechanized inputs, gaps may provide a significant opportunity for human judgment.” (p. 275)

Times change, markets change, traders and market analysts come and go. But some things remain constant. Over the long haul careful, extensive analytic research combined with keen human judgment will triumph. Laszlo Birinyi’s career illustrates this constancy. The Master Trader details the principles, the studies, and the grunt work that contributed to his investing success over the decades.

Atkeson & Houghton, Win By Not Losing

Nicholas Atkeson and Andrew Houghton, founding partners of Delta Investment Management, have written what, in the words of the lengthy subtitle, is a disciplined approach to building and protecting your wealth in the stock market by managing your risk. Win By Not Losing (McGraw-Hill, 2013) is a mix of stories about some not-so-famous investors (in fact, a few are identified simply by their first names) and an introduction to tactical investing.

The authors contend that “stock prices are influenced by oddities in human behavior that often cause security pricing to be predictable.” (p. 120) They support their contention by sharing some of their observations from the trading floor of an investment bank. Earnings momentum, for instance, can be both predictable and profitable: “the cycle of exceeding analysts’ estimates is often predictable in light of the pressures on analysts to be overly conservative.” (p. 121) And one study found that “over the 60 trading days after an earnings announcement, a long position in stocks with unexpected earnings in the highest decile, combined with a short position in stocks in the lowest decile, yields an annualized ‘abnormal’ return of about 25 percent before transaction costs.” (p. 122)

It’s all very well and good to analyze individual stocks, but the overall market environment should be of paramount concern to the investor. The authors suggest that a person should be a tactical equity investor if he believes that “there is a reasonable probability the stock market will experience a period of severe depreciation during your investment horizon” and/or “there is a reasonable probability the stock market will not experience sufficient appreciation during your investment horizon to meet your investment objectives.” (p. 177)

The authors note that the risk-conscious tactical investor has a fairly narrow window in which to make decisions because “evaluations of market risk levels tend to be most accurate over a week to a month.” (p. 180) They recommend entering the stock market when “the perceived market risk is moderate and declining.” (p. 196) Their own favorite indicator is the 75-day simple moving average applied to a group of roughly 3,600 stocks. “When the majority of stocks in the market are trading above their 75-day moving average, the market is bullish. When the majority of stocks are trading under this level, the market is bearish.” (p. 199) (They publish a free weekly Market Sentiment Indicator report on their website; it also appears in Barron’s.)

One of the authors’ recommendations is that an investor should be aggressive when participating in up markets. One way to accomplish this is to boost the beta of the portfolio. If investors “were willing to accept portfolio volatility equal to the market, they could then increase their expected volatility during times they are invested in equities, as the higher in-the-market volatility would be offset by the lower out-of-the equity market volatility. These investors could raise the in-the-market portfolio beta to a level at which the average of in-the-market and out-of-the-market volatility is equal to the market volatility on its own.” (p. 206)

Winning By Not Losing is not for the rank novice, but anyone with some experience in the stock market, especially the person who wants to move beyond a buy and hold strategy, can find useful tidbits in this book.

Li, Tiger Woman on Wall Street

Junheng Li has written a smart, compelling book. Tiger Woman on Wall Street: Winning Business Strategies from Shanghai to New York and Back (McGraw-Hill, 2014) moves seamlessly between autobiography and analysis to create a finely chiseled portrait of the often shadowy Chinese business world. It’s an important read for anyone interested in investing in China—or in companies that have a Chinese presence.

Li grew up in Shanghai under the early tutelage of a harsh (what Westerners would call abusive) tiger dad. He forced her, for instance, to kneel on a washer board for more than an hour while he drilled her on the multiplication tables and slapped her when she gave the wrong answer or was slow to reply. She was three years old at the time. But, as she writes, “His high standards for me were just part of his language of love that got lost in translation.” (p. 10)

Li left Shanghai in 1996 to attend Middlebury College and subsequently to pursue a career as a Wall Street analyst. She now runs the independent equity research firm JL Warren Capital, aimed at plugging the gap between the business reality in China and American investors. If this book is any indication, the firm is doing a first-rate job.

The depth of analysis that Li offers is something that no individual investor could possibly match. She has both keen analytical skills and a familiarity with the Chinese business environment (as well as many useful contacts in China). So investors should take her caveats to heart. Consider, for example, the fact that most private Chinese companies “spend a far lower portion of their revenue on R&D than American peers in the same sector.” The reason? “In industries where innovation drives growth and market share, such as technology and healthcare, China’s culture of lawlessness hinders innovation. If you create something commercially compelling, it is nearly guaranteed that others will copy it and undercut your pricing.” (p. 148)

Trying to assess the value of a business in China is a major challenge. Sometimes companies fudge their numbers. Even when they are honest in their reports (and most publicly traded companies by now are), normal valuational methods often don’t apply. “Most value investors depend on what’s called a ‘mid-cycle analysis’ to assess the normalized earnings power before ascribing a value to a business. … To get that estimate, analysts look at the successive peaks and troughs in a company’s earnings and adjust them to a moving average. But for both Chinese companies and China’s economy, mid-cycle references do not exist. Since the introduction of the market reform in 1979, the Chinese economy has only gone up, never down. Whenever the economy showed signs of slowing down, the government stepped in with fiscal stimulus and expansionary monetary policy.” (pp. 188-89)

Chinese corruption is a well-known fact. Li believes that “a big portion of government-led infrastructure spending in 2008 trickled out in the form of bribery, embezzlement, and kickbacks, all of which went to the connected and enfranchised. Interestingly, shortly after Beijing released its massive stimulus package, Macau casino stocks began to soar, led by those companies with the most exposure to VIP gamblers from the mainland.” (p. 155)

I’ve just scratched the surface of the material that Li covers in this book. Tiger Woman on Wall Street offers carefully honed analysis even as it tugs at your heartstrings. I would say that it’s one of the best investing books of 2013 (except that it has a 2014 copyright).

Hirsch, Stock Trader’s Almanac 2014

This year’s Stock Trader’s Almanac, its forty-seventh annual edition, has a new look, at least on the outside. Although it is still spiral bound, it now sports a maroon soft cover with gold embossed lettering and golden spirals.

The inside remains pretty much the same, with a calendar section, a directory of trading patterns and databank, and a strategy planning and (somewhat abbreviated) record keeping section. The calendar section has on facing pages historical data on market performance (verso) and a week’s worth of calendar entries (recto). January’s verso pages, for example, give the month’s vital statistics, January’s first five days as an early warning system, the January barometer (which has had only seven significant errors in 63 years), and the January barometer since 1950 in graphic form. Each trading day’s entry on the recto pages includes the probability, based on a 21-year lookback period, that the Dow, S&P, and Nasdaq will rise. Particularly favorable days (based on the performance of the S&P) are flagged with a bull icon; particularly unfavorable trading days get a bear icon. A witch icon appears on options expiration days. At the bottom of each entry is an apt quotation. There’s about a five-square-inch space in which to write.

As we all know, 2014 is a midterm election year, but what does this mean for investors? Jeffrey A. Hirsch, co-editor of the Almanac, writes that “midterm elections have a history of being a bottom picker’s paradise. In the last 13 quadrennial cycles since 1961, 9 of the 16 bear markets bottomed in the midterm year. … [T]his has provided excellent buying opportunities. … From the midterm low to the pre-election year high, the Dow has gained nearly 50% on average since 1914.” Hirsch anticipates “a good hunk of the next major downturn to transpire in 2014” with a low in the DJIA 12,000 range likely.

We are now in the market’s “magical” quarter where gains over the years have been the greatest and the most consistent. If we take the S&P 500 as our benchmark, it has delivered an average return of 4.0% in the fourth quarter (1949-2012). Compare that to 2.3% for the first quarter, 1.6% for the second, and 0.6% for the third. Looking at the fourth quarter in the context of the presidential cycle, post-election results have averaged 3.1%, midterm a whopping 8.0%, pre-election 3.0%, and election a meager 1.9%.

For those traders who are interested in intra-day trends, the Almanac divides the trading day into half-hour segments and tracks the percentage of time the Dow closed higher in a given half hour than it did in the previous half hour. The positive half-hour segments between 1987 and May 2013 began at 10, 11, 11:30, 12:30, 1, 1:30, 3, 3:30, and the close, with the strongest performances coming from the close, 3 p.m., and 10 a.m. On a daily basis, since 1990 Tuesday has produced the strongest gains although, since the March 2009 bottom, Thursday has taken over the honors.

Investors who appreciate the power of seasonals and who believe that past is prologue will, as usual, relish this Almanac.

Runciman, The Confidence Trap

As we seem to lurch from one self-inflicted crisis in Washington to the next some people begin to despair. Is American democracy itself on the brink? Is democracy inherently flawed? In The Confidence Trap: A History of Democracy in Crisis from World War I to the Present (Princeton University Press, 2013) David Runciman highlights the tension between “the onward march of democracy” and the “constant drumbeat of intellectual anxiety.” Today, as the established democracies face four fundamental challenges—war, public finance, environmental threat, and the existence of a plausible competitor—“it is not clear,” Runciman writes, that they “are doing well in meeting any of them.”

Democracies have certain advantages over their rivals. For instance, they are better at surviving crises. At the same time, they seem unable to learn how to avoid crises. “It is some consolation in a democracy to know that nothing bad lasts for long,” but “consolation can produce its own kind of complacency. Knowing that they are safe from the worst effects of hubris can make democracies reckless—what’s the worst that could happen?—as well as sluggish—why not wait for the system to correct itself? That is why the crises keep coming.”

Starting with Tocqueville as “the indispensable guide to the ongoing relationship between democracy and crisis,” Runciman examines seven crises: 1918 (false dawn), 1933 (fear itself), 1947 (trying again), 1962 (on the brink), 1974 (crisis of confidence), 1989 (the end of history), and 2008 (back to the future).

Throughout Runciman illustrates versions of what he calls the confidence trap. For instance, it is too soon to act and it is never too soon to act. This tension was manifest in the opposing views of Sarkozy and Merkel during the Euro crisis: Sarkozy urged immediate action, Merkel believed that it was important not to be rushed.

Politicians can point to history as a rationalization for their bad behavior. “American democracy had survived its near-death experience in 1933. It had survived everything that had been thrown at it since. It had proved its adaptability and its resilience. There is less incentive for politicians to compromise if they believe the system can withstand most forms of confrontation.” (p. 284)

“This,” Runciman writes, “is the confidence trap. Democracies are adaptable. Because they are adaptable, they build up long-term problems, comforted by the knowledge that they will adapt to meet them. Debt accumulates; retrenchment is deferred. Democracies are also competitive, which means that politicians will blame each other for their failure to tackle the long-term problems. However, they do it in a way that gives the lie to the urgency, because if it were truly urgent, then they would compromise to fix it. Instead they squabble. … So democracy becomes a game of chicken. When things get really bad, we will adapt. Until they get really bad, we need not adapt, because democracies are ultimately adaptable. … Games of chicken are harmless, until they go wrong, at which point they become lethal.” (p. 285)

Scaremongers argue that profligate spending is pushing the U.S. to the point of a full-scale default. Not so, Runciman replies. “The institutional constraints on sustained fiscal irresponsibility would kick in before then. The real problem is not that the United States will knowingly walk off a cliff. It is that no one knows where the edge of the cliff is, or which of the intermediate ridges along the way—the lesser ‘fiscal cliffs’—pose real danger.” … The U.S. may “get itself into more trouble than it realizes because it will be unable to tell apart the point when deferring retrenchment keeps its options open from the point when deferring retrenchment closes them down. Credible systems, like credible banks, can find they lose credibility quickly and unexpectedly.” (pp. 312-13)

Runciman uses dialectical tension to strike an appropriate balance between optimism and pessimism. He opts not to assume that we will eventually encounter the crisis that overwhelms us. He refuses to see politics as inherently tragic; democracy “is too inadvertently comical for that.” (p. 324) At the same time, he believes that democracy is a series of mismatches, that it displays a repeated pattern of crisis and recovery. “The long-term strength of democracy comes from its short-term restlessness; it is also at risk of being undermined by its short-term restlessness.” Put in the most general of terms, “democracies succeed because they fail and they fail because they succeed. There is no way around this.” (p. 304)