Opinion

Felix Salmon

Why we should ban reverse converts

By Felix Salmon
June 18, 2009

I had no idea what a can of libertarian worms I was opening when I suggested that the sale of reverse convertible bonds should be banned. I dealt with one line of objections last night — the silly idea that since reverse convertibles are basically a put-writing strategy, and since Warren Buffett writes puts, then reverse convertibles must be kosher.

But now a more invidious objection has cropped up, as hilariously encapsulated by Daniel Indiviglio:

Its usefulness must be clear to someone — otherwise there would be no market demand for the product, and one never would have been sold.

I must admit I laughed out loud on reading that. Reverse convertibles are sold by banks as a way of generating cheap capital and hefty fee income. No one in the history of the world has ever approached their stockbroker with a bright idea that what they really want to do is lend a bank a few thousand dollars at a high interest rate, but would be happy to receive depreciated Apple stock instead of their money back if AAPL does badly over the next few months.

Indiviglio and his fellow-travellers like Vincent Fernando have been defending reverse converts on the grounds that (a) you can view them as sophisticated options-writing strategies and that (b) sometimes sophisticated investors actually want to enter into such strategies.

But people, these things are called reverse convertible bonds. The options-writing part of the deal — which is the beating heart of these instruments — is generally downplayed to the point of invisibility, while all of the emphasis is on the juicy “coupon” being paid by the bank. (Which is really the bank buying a cheap option from the investor.)

Here’s Fernando:

I don’t think we should be banning products just because we ourselves believe that others are fools for buying them. Rather, I think it’s healthier if we encourage a culture of skepticism towards any investment opportunity rather than banning cherry-picked products completely and implying that the approved products are “safe”. We trust almost anyone to have the brains to drive a car at deadly (upon impact) speeds, yet not to do a little homework towards a financial product?

You need to think hard when you invest substantial sums of money and you shouldn’t give much weight to the words of the guy selling you the product. For any product. Too big of a financial decision for the average person? I doubt it. We let people choose their career types, their schools, their houses, etc. We don’t say the average Joe isn’t sophisticated enough to buy a house. And we shouldn’t.

I think we’re seeing right now what happens when the average Joe buys a complex financial instrument (a subprime mortgage) which he doesn’t understand. The whole point of the Consumer Financial Protection Agency is to prevent predatory lenders from talking naive individuals into products which are egregiously unsuited to them. Similarly in this case, stockbrokers should be prevented from persuading naive individuals to start writing underpriced put options while kidding themselves that they’re just buying a high-interest short-dated bond.

Mike at Rortybomb has a great post on all this, with a couple of very sensible principles:

People are Poor with Estimating Tail Risk; They Underestimate it

People should be discouraged, though not prevented, from profiting by taking on excessive tail risk. If they do want it, they should be made very aware of what they are doing.

People are Poor at Understanding Embedded Options

When embedded options are hidden inside financial products, they should be made very clear, and if reasonable, broken out into another product.

In general, we shouldn’t assume that most Americans can, will, and should “do a little homework” before buying something from their friendly stockbroker. This is why it’s so good and so important that stockbrokers are soon going to have a fiduciary duty: they won’t just be able to blithely sell nuclear waste to their clients any more. But more to the point, most Americans aren’t remotely financially literate enough to understand this stuff. They’re not good at math, they barely understand the difference between a stock and a bond, and they certainly should have no business playing in the options market. (Similarly, an enormous number of investors in the USO exchange-traded oil fund should never have bought it because they think they’re just buying a proxy for the spot oil price, and they don’t have a clue what contango is. If you don’t understand the dynamics of contango, you have no business buying USO.)

People who live and breathe the financial markets are more than welcome to do all manner of sophisticated things in those markets if they’re so inclined. As Mike says, if you want to short a straddle on AT&T stock, go right ahead. But retail-facing financial instruments should never embed such bets, because retail investors, as a rule, lack the sophistication necessary to be making such bets in the first place.

Fernando looks at those investors and says it’s “their responsibility to be skeptical buyers”. No. It’s the stockbroker’s responsibility to act in the investor’s best interest, and it’s the government’s responsibility to prevent the sale of products which can end up being extremely damaging to those who buy them. As Elizabeth Warren famously says, no one has a problem with the government banning the sale of dangerous toasters, and dangerous financial products cause much more damage than dangerous toasters ever do.

The fact is that reverse converts, in particular, are the kind of product which can cause a great deal of harm; what’s more, they exist entirely so that banks can use their stockbroking arms to rip off their clientele. Banning them would do much less harm than selling them. So let’s ban them, and their ilk.

Comments
9 comments so far | RSS Comments RSS

Ponzi schemes occur so there is a market demand for lying promises and thus we shouldn’t regulate them. And why penalize them? Every investment entails risk and the market demonstrates there’s a need for lying investments. If you pick a lying investment and get taken, that’s your bad luck.

Posted by jonathan | Report as abusive
 

Fraud is a continuum, not a black and white thing. There’s a big gray area in between what should clearly be illegal and what should clearly be legal. The financial industry thrives on rip offs.

Take closed end funds as an example. They arguably serve a purpose, but sophisticated investors know they should never be purchased (at offering).

Posted by Max | Report as abusive
 

Felix you have almost prompted me into blogging again with this series but I will make do with a comment on here.

Reading between the lines it seems that even though you keep banging on about banning the “product”, what you are exorcised about, broadly, is not the product itself, but the physical act of the sale of the product as it relates to suitability. You rightly point out that RCBs and their kaleidoscope of siblings are sold by voracious broker networks to unwitting retail. Without this sale driven push, the RCB would not be issued as nobody who actually understands the product would buy them. These bonds are sold rich to fair value to pay the fees. Usually, par issued notes are probably fair valued at anywhere from 93-97 on issue.

Frankly once they are trading in the secondary market, and have had the pnl bled out of them by the marketmaker so they trade at fair value, they are not a problem instrument for expressing a view either on the credit of the issuer or the greeks of the optionality. But some poor souls have to be stiffed with them on new issue to pay for a lead order to get them out there in the first place.

Banks also issue structured products, directly and for their corporate clients, to professional investors – for example the mandatory converts, PERQs, DECs or whatever. This is done primarily as a funding exercise – but to get these bonds away they are sold cheap to fair value – vol is sold cheaply to convert arbs and real money funds in the case of converts, and is bought expensively in the case of mandos or RCBs/DECs. How many equity commitment committees start with “so where can we get these away compared to theoretical?”

So which would you ban? Just the ones sold to retail, I suppose. But they’re off the same shelf filing and documentation usually. It is just the pricing and manner of sale which differs.

The key is suitability and pricing fairness/disclosure. Imposing a fiduciary onus has to aid this process, but you simply can’t ban the product as you don’t like how it is being sold. Ban or regulate better the sales process itself.

Posted by Andrew Clavell | Report as abusive
 

It’s a short-put strategy. With permit I try to make math. By buying a reverse convert investor actually sells a put option. But when does the investor has the highest profit? In order to answer this question adequately, we face the 4 possible cases below:

The Reverse Convertible pays a high coupon of, say 8%.

(1) If the price of underlying stock goes up by more than 8%:
It means a loss for the investor, because the investor (buyer) renounces on a part of the price increase.

(2) If the share price increases less than 8%:
The investor had be better off with the the bond.

(3) If the price of the shares decreases less than 8%:
The investor receives the stock cheaper than when it would buy it directly on the market.

(4) If the share price decreases more than 8%:
The investor makes effectively lost.

Conclusion: The potential loss is theoretically unlimited, while the maximum yield remains (in this case) at 8%, i.e. it’s a asymmetric risk profile.

 

In the antepenultimate paragraph, you get to the nub of it; the problem is not the existence of the product, but its (fraudulent?) sale to unsophisticated retail investors. I know that broker-dealer representatives can lose their licenses for trying to “sell dividends”, as well as for more general (but less clear) cases of disregard for their clients’ interests; tightening up these rules (if they need tightening up) is a better idea than going about banning specific structures.

 

With normal use, a house will not fall down, an auto will not roll over, and a toaster will not start a fire. That’s enough for most of us. My last toaster came packed inside a protective bag with this warning affixed: “Remove bag before operating toaster”.

My favorite line in the delightful Bird-Fortune send-up of the housing crisis relates to the funds that sunk Bear Stearns, one of which was called something like “High grade enhanced leverage fund”. “I rather like the sound of that”, enthuses John Fortune, “I’d buy anything that is ‘enhanced’ !” Hilariously absurd, no? Maybe not, given your awe of the magic word “Bond”.

I had to look up “reverse convertible bond”. Needless to say, I hope, I’ve never owned one. The definition came with an example and a warning of possible steep losses. I readily concluded that I won’t be considering one of these bonds (shaken or stirred). Those who don’t think to remove the protective bag before the first toast probably shouldn’t be allow to buy reverse converts. The rest of us who do our own investing should be safe. For those who trust the advice of a stock broker, well, reverse converts are the least of their problems.

Posted by Tom Burton | Report as abusive
 

sure, we can try to ban stupidity in this form, but prove to me that it will not simply resurface in some other more dangerous form.

Posted by q | Report as abusive
 

“This is why it’s so good and so important that stockbrokers are soon going to have a fiduciary duty:”

I think many, possibly most, of the people who listen to a broker’s recommendations for stocks are under the impression that there is already a fiduciary relationship there. If that’s not the case, perhaps that’s the source of the problem, and might be solved in part by a public service campaign. I can see the PSA now:

“You may think your broker is working for you, but he’s not. He’s working for himself, and his company. He has no duty to give you accurate advice. You must check everything he tells you with at least two other people, to see if it is a lie meant only to increase his profit at your expense. If you do not have the time to do this, you should not invest in the stock market.”

(Curious coincidence: the anti-spam word is “toast”.)

Posted by Ken | Report as abusive
 

Our money manager purchased converts for my wife’s accounts, so some comments from my (narrow) experience:

1) The interest rate usually ranged from 15% to 25%
2) The price drop to trigger the put was usually 15% or so (sometimes more)
3) We did OK until the fall of 07, when we were put a couple positions, and we subsequently pulled everything from that money manager (Long story)
4) The biggest downside that I observed was that gains were taxable as interest income but losses were taken as long term (or short term) losses, and this was an expensive mismatch

Net/Net – I agree with Felix. I was much more educated in these products than the average person (I actually read the prospectus and I have traded options), but I had no way of making an evaluation of these at the time – I just took the MM’s word for it.

Posted by Patrick | Report as abusive
 

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