More on the reverse-convert scam

By Felix Salmon
June 17, 2009

Nick Schulz and Philip Guziec are both pushing back against my assertion that reverse convertible bonds are a scam, and they’re both wrong.

The argument is similar in both cases: by buying a reverse convert, you’re essentially selling a put option. Selling a put option can make sense, sometimes. So what’s the problem?

There’s a bunch of problems. For one thing, as Guziec concedes, these instruments aren’t sold as an option-writing strategy. He was offered one once:

I declined the offer as I would any inbound call from a broker, but I did say, “So, you’re asking me to write a put on company XYZ.” I recall that my comment generated a sheepish response.

For another thing, if, pace Guziec, you actually bothered to price out the bond by working out how much it would cost to replicate it in the options market, you would never buy the bond, since it will always be much cheaper to just do the trade yourself.

But in any case, as JH points out, pricing these things is pretty much impossible, especially when they have “knock-in” characteristics which make them path-dependent (don’t ask).

As for the specific arguments, Schulz seems to think that buying a reverse convert is tantamount to investing like Warren Buffett:

They are so much like insurance that it explains why Mr. Geico himself, Warren Buffett, has been selling put options. So if insurance is pointless then Kwak has a point.

Well, yes. But individuals should be buyers of insurance, not sellers of insurance. If you’re Warren Buffett, you can sell insurance. But most of us shouldn’t go near that business — which is essentially the business of pocketing a relatively small premium up-front in exchange for promising to pay out a large amount of money if things go wrong. Nearly all insurers go bust eventually, and writing insurance is not a remotely sensible thing for any individual investor to do.

Guziec takes a similar tack:

We are actually quite fond of this type of transaction, as the market often offers huge insurance premiums to sell the downside on fundamentally sound companies, often with economic moats. This high-volatility environment actually raises the value of the put options while lowering the value of many sound companies, making put-selling strategies particularly attractive. In fact, even superinvestor Warren Buffett has been selling puts recently.

Again, yes but. Buffett hasn’t been selling short-dated puts on individual companies, he’s been selling long-dated puts on stock market indices. There’s a world of difference. (Oh, and he’s lost billions of dollars on those deals.)

If the reverse converts were tied to indices rather than individual stocks, I might hate them a little bit less. But I’d still hate them, if only because neither Schulz nor Guziec mentions the other toxic part of the deal: you’re taking not only stock-market volatility risk, but also the unsecured credit risk of the issuing bank. In all of these cases you’d be better off just buying short-dated debt of the bank in question. And if unsecured bank debt is too risky for you, you certainly don’t want to go anywhere near a reverse convert.

The fact is that if these things made sense, they’d be much more popular, and they’d be bought by relatively sophisticated investors who are comfortable trading options. In reality, they’re quite uncommon, they’re generally sold by banks desperate for capital, and they’re generally sold to investors who have no idea what, really, they’re buying.

But the good news is that stockbrokers, if the regulatory reforms go through in their present form, are going to have a fiduciary duty for the first time. And that alone should put an end to these things.

5 comments

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“(Oh, and he’s lost billions of dollars on those deals.)”

No, he’s had the appearance of a huge loss.

These options he writes are so long dated that mark-to-market is effectively irrelevant because Black/Sholes is meaningless on such timescales, and, even if the option ends up having to be paid out, the odds are stil good that the premium + gains on the premiums will still cause a net profit for Berkshire/Hathaway when all is said and done.

Posted by Nicholas Weaver | Report as abusive

You can’t replicate this trade in the market. The options that trade tend to be very short term options. In order to go long long-dated options most people buy convertible debt. If you want to go short long-term vol this would be a good way to go about doing it. Well, in theory. They’re probably priced too high given that only retail accounts are buying.

Second, when you buy debt from a company you are selling a put option on that company. The problem isn’t that buying these products involved selling puts, the problem is just that investors weren’t getting properly compensated for the risk they were short . That’s a level problem, not a bond problem (and yeah, if there’s knock-in puts that’s an extra layer of complexity).

What’s the good reason for this product to exist? In bankruptcy they generally wipe out equity holders and convert the debt holders into equity holders. But bankruptcy is costly, partly from court costs but mostly from the ways it messes with the business. If the debt holders had previously agreed to the debt-equity swap terms we could have avoided bankruptcy but ended up with a very similar result (highly diluted equity and debt holders in control of a company). Now all we have to do is price this stuff fairly and a lot of costly bankruptcies can be avoided.

Posted by Kyle | Report as abusive

in fact, these reverse convertibles have been sold to retail investors in Hong Kong for years (They call them ELN – Equity Linked Notes here).

There are many flavours of them. Many of them link to not just one, but a number of underlyings, the so called worst-of put options. There are also many other funky features like autocall, etc.

I have no ideas why anyone would believe a normal layperson would understand the structure.

For example:
http://www.newswit.com/enews/2005-04-20/ 0812-ing-launches-second-series-of-hong- kong-equity/
http://www.sfc.hk/sfc/doc/EN/cfd/ordinan ce/unlisted/pyxis_s.11/c_ip_eng_10jan05. pdf

There are also many credit-linked products which created a great fuss last year when Lehman Brothers went broke.

http://www.reuters.com/article/topNews/i dUSPEK7193220080921

The regulators in HK clearly had failed to their jobs properly..

Completely agree, Felix. The Reverse Converts are a combination between a Money market investment and an option. Special Features: (1) asymmetric risk profile, (2) unlimited risk to the bottom and (3) limited opportunities for upward.

Kyle, I agree with most everything in this and your previous comment, with one exception. It is my understanding that reverse convertible securities, unlike most converts, are almost always written on a different underlier than the issuer. For example, say Company X (e.g. Citi) issues a reverse convert where the stock into which the instrument is convertible is that of Company Y (e.g. Microsoft). In the parlance of converts, this is sometimes called an “exchangeable” feature.

The upshot is that your suggested “good reason for this product to exist” (that it bakes-in an expectation that these subordinated debtholders will get converted to equityholders should the company get in hot water) doesn’t much apply but to a small subset of the population of reverse converts. But should we hope this subset grows for the reasons you espouse? Maybe. Though I’m not sure there’s much of a difference between a issuer-indexed reverse convert and a mandatorily redeemable preferred stock. There is one nuance: the preferred stock at least has a liquidation preference, whereas an issuer-indexed reverse convert would effectively have no claim in liquidation but to the residual (as it would have then converted to common equity).