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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“The number of people buying these notes who are qualified to price them is exactly zero.”

Which is certainly true, since anyone who can price them would know better than to buy them.

A friend of mine named Eric Stein has recently accepted an appointment as Deputy Assistant Secretary for Consumer Protection at the Treasury in DC. He joined Treasury after a distinguished career as a watchdog at the Center for Responsible Lending in Durham, NC, which focused on predatory lending practices, both subprime and payday.

The problem with things like this Reverse Convertible stuff is twofold:
a. the volume is low (something like $7 bln total issuance in 2008, if memory serves correctly)
b. most of the target buyers probably fall into the Accredited Investor if not Qualified Purchaser category, which is to say, they have enough money to look our for themselves. The guy in the article was a radiologist, which is to say a fairly educated guy.

So Reverse Convertibles are really analogous to seat warmers in a luxury car: they don’t really add value, they’re another thing that can break, but the government can’t get out in front of every product feature that might defraud some rich person. Limited government resources need to be focused on products harming lots of people who are less able to protect themselves (variable annuities packed with tech stocks or synthetic CDOs marketed to less affluent elderly, for example).

Clark, I think you would also agree that if an Accredited Investor’s car is stolen, the police should not investigate, since the guy should have known not to park where it could be stolen.

Posted by maynardGkeynes | Report as abusive

Doesn’t the phrase “ought to know better” assume that the bank places the customer’s interest ahead of its own pursuit of fees? Like the snake-oil salesmen of old, maybe they do know that the product is no good, but as long as they make money selling it, why should they care? Of course that’s why we have the FDA, the CPSC, and so forth, to shut these crooks down; so I wish to echo your call for a FPSC.

Posted by Ken | Report as abusive

Yet another Wall Street SCAM. — Citi and Goldman are the worst offenders and should be closed down by the FBI as racketeers preying on the public.

Posted by Bill | Report as abusive

Whatever happened to buyer beware? or People taking personal responsibility for their actions?
Why do people spend more time researching a 32″ television than researching an investment?
It’s because they believe either that their broker is the smartest guy on earth (highly dubious), that these stocks will not go down (the most likely), or their broker is illegally trading their account (possible, but not probable).

The prevention of doing something stupid is not the job of the government. You should be able to figure that out on your own. If not, tough. That is life.

Posted by Aiden | Report as abusive

Funny, you wrote approvingly of creating debt-instruments that convert to equity last month. What’s with the change of heart? 09/05/05/how-can-we-de-risk-the-economy/

Look, I find the selling of pretty much any financial instrument to retail investors pretty distasteful and I’m sure that these guys are not accurately pricing the option they’re short. But, personally, I would feel more comfortable trying to value reverse-converts than trying to value stocks. Stock values are dependent on a bajillion different factors, most of which I can’t observe. The model for reverse-converts wouldn’t be that difficult to construct and would mostly depend on trying to figure out the long-term vol. Hard, but doable (if they have a low enough convert price or structured in a smart way, they’ll trade pretty closely to preferred stock).

I don’t want this to be a product that exists only to jam retail customers either, but this is one of the few financial products that I have high hopes for. Setting up debt contracts so they convert to equity before they default is fantastic. It dramatically reduces the chance of bankruptcy, which is costly both for the firm as a whole (debt+equity) and for society. If Bear Stearns had used this product they either wouldn’t have gone bankrupt or would have been far cheaper to bail out because the debt load would have fallen.

Posted by Kyle | Report as abusive

How dare you stand against financial innovation?

Posted by jonathan | Report as abusive

Cheap headline, reverse convertible = fully funded short put.

“Cheap headline, reverse convertible = fully funded short put.”

From my reading of the article, I think they are talking about a different kind of product – not just a deposit + short put combination, but a deposit + knock-in short put.

Typically there is a zero-coupon bond or deposit component and the embedded option. For an example, maybe the strike would be set at 100% of the price of the index / stock at inception. That would be relatively easy for a numerate layperson to price if vanilla: discount the deposit and use a Black-Scholes calculator to price the option using the sort of yield/vol data you can find in the FT. Not nearly as accurate as a pro would do it, but close enough to avoid being ripped off too badly.

HOWEVER normally the option is not a vanilla put option. It only exists if the stock falls below a barrier (say 70%) at some point in the product’s life. On that day the option springs into being (‘knocks-in’ – see para 5 of the linked article), and doesn’t disappear even if the index subsequently recovers. Therefore the result is path-dependent, unlike B-S. If the index ends up at 75% of its initial level, you could get back either 100% or 75% of your money depending on whether the path to get there touched 70%.

Pricing path-dependent options with quite deep out-of-the-money long-term barriers is not that easy to get right and requires a specialist and access to information about long-term volatility surfaces that is normally proprietary broker / IB data. How many dentists/radiologists/engineers have Totem subscriptions?

The barriers were so far out-of-the-money at inception that they looked in 2006 like selling “repeat of 1929″ insurance of negligible value… As a result the yield enhancement was quite small but the potential (and, as it turns out, actual) loss was quite large, even assuming the bank behind the deposit component didn’t fail (as some have).

Posted by JH | Report as abusive

It is NOT a knock-in put, if it was it would activate an option and here you may get the stock (the issuer decides, not the bondholder).
With a convertible bond, the bondholder has the right to convert the asset to equity at a preset strike price so there is an embedded call and with a reverse convertible bond, the issuer has the right to convert to equity at a preset strike price so there is an embedded put.

I didn’t mean to be confusing – of course from the holder’s perspective they are indeed long a zero and short a physically-settled put. (Perhaps I wasn’t clear enough that I was talking about embedded /short/ puts from the holder’s perspective – it doesn’t make the pricing easier).

I’ve seen some examples of these products that were vanilla puts and some that were knock-in puts. The knock-in puts are obviously much harder to price. The fact that it is a knock-in put rather than vanilla put doesn’t stop it being physically settled, surely? Perhaps you wouldn’t consider the ones with the knock-in style puts to be “true” reverse convertibles, however they are usually sold along-side them.

For example, if you look on UBS’s website (look for structured products and then “optimisation”, you can download a .pdf named “UBS GOAL/Kick-in GOAL: Investing in flat markets” which describes UBS’s version of these things (I think), in vanilla, kick-in, physical-settled and cash-settled versions.

The WSJ article is not clear, however it does use the phrase “knock-in” so I assumed they were talking about knock-in style reverse convertibles, hence my comment.

Having an OOTM barrier also makes the product much more “tail-risk” driven which raises the risk that unsophisticated investors will misjudge things and assume they are getting enhanced yield without risk. My personal (limited) experience is that I’ve seen more with barriers than without – maybe that is unusual.

Posted by JH | Report as abusive

i was talking about the true reverse convertible, obviously there is a scope for a lot of creativity with that stuff and we can agree that the product is biased in favor of the issuer and should come perhaps with a wealth warning.

are these a real problem? how big is the market in these? why are they the hot topic all of the sudden? who in their right mind would buy one — they sound like a real ripoff.

but trying to ban something because it is STUPID — especially something which is so transparently dumb as this — if people are stupid, and don’t do their homework, SOMEONE will find a legal way to rip them off. if you make this product go away, you won’t stop them from getting ripped off. you’ll just shift the problem from one con artist to another.

Posted by q | Report as abusive

I am with a class action law firm that is investigating whether certain brokerage firms may have misled investors as to the risks associated with investing in reverse convertible notes. Check it out: tibles.asp or call (866) 981-4800 for more information on the investigation and to see if you qualify.

Posted by GGmcr | Report as abusive

Take a look at NASD’s Notice to Members 05-59 (Sept. 2005). The regulators have known that this is a problem for some time now. My read is that they view the risk of reverse converts as greater than options, and yet know that reverse converts are marketed to unsophisticated investors as a good alternative to traditional equity and fixed income investments since they pay interest or are usually tied in some way to an underlying blue chip.