The reverse-convert scam

By Felix Salmon
June 16, 2009

How would you like to lend money unsecured to a highly-leveraged financial institution while at the same time writing an out-of-the-money put option on an extremely volatile individual stock? Sounds unappetizing, right? Except somehow a bunch of banks, including Citigroup, which really ought to know better, are approaching retail investors and proposing they do just that — by buying something called a “reverse convertible note”.

Larry Light’s article on these beasts is not particularly clear — it took me a bunch of homework before I realized that it was the banks who were borrowing money, not the companies referenced in the notes — but the main takeaway of what he writes — that they’re a “nest-egg slasher” — is exactly right. This is the kind of thing that a Financial Product Safety Commission should exist to regulate — and, frankly, to outlaw entirely. The number of people buying these notes who are qualified to price them is exactly zero. Reverse converts are a scam, and it’s high time US regulators put an end to them.

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