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.

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