Reverse converts and Vincent Fernando’s straw man

By Felix Salmon
June 19, 2009

How long can this debate over reverse converts go on? I’m not sure, but I’m willing to put up one more blog entry on the subject, since Vincent Fernando is both misrepresenting my views and giving me the opportunity to make an important broader point.

Fernando seems to think, on zero evidence, that I’m saying reverse converts are simply too risky for retail investors. But I never said that, and I never would. Pretending that I said that allows Fernando to make a cheap and obvious shot: pointing to all manner of other investments (like simply buying individual stocks) which are even riskier, and which I don’t want to ban. He then can accuse me of being inconsistent, or illogical, or hypocritical, or worse.

I have no problem with people taking on risk — especially upside risk. Never mind individual stocks, they’re more than welcome to disappear off to Vegas, if they’re so inclined, and put thousands of dollars on a single number in roulette. (That said, no stockbroker has any business putting his client into a roulette gamble, no matter how much commission he’s getting from the house.)

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

I’m not saying that no investor should ever buy or sell options. But any investor who does play in the options market needs to know exactly what she’s doing, and why. In stark contrast, the way that reverse converts are sold makes every possible effort to hide the fact that they’re a put-selling strategy — even unto calling them “bonds” and disguising the proceeds you get from selling the put as being a “coupon”.

There are two big reasons why a high-risk stock is a much better investment than a reverse convert. For one thing, stocks generally go up over time: they’re a positive-sum game. And for another thing, stocks have a lot of upside: while it’s certainly possible that you can lose all your money when they go to zero, it’s also possible that you can double your money, or more, if they spike upwards. Reverse converts, by contrast, have massive downside (all the downside of the stock) but no upside beyond the “coupon” which you expect to receive all along.

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game. Bond investors, as a rule, are always better off in bond funds than they are picking and choosing their own bond portfolio, not least because the trading costs for bonds, if you take account of the enormous bid-offer spreads shown to retail investors, are a good order of magnitude bigger than they are for stocks.

At least with bonds, however, there is a bid-offer spread: a market actually exists in them. Next time you’re offered a reverse convert from your broker, ask him to find you one on the secondary market and see what he says. There’s zero liquidity in these things, which means zero price transparency: there’s no indication whatsoever what their market price is, just because there isn’t a market price for them. That’s always a bad sign — and it’s a very strong indication that they shouldn’t be sold by stockbrokers. A broker should always be willing to buy and sell any instrument he’s dealing in: when he’s selling but not buying, at any price, then something very fishy is going on indeed, and you’re almost certainly getting needlessly ripped off.


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I’m very sympathetic to the view that certain investors should not be allowed to enter certain types of deals or contracts. I think, however, that reverse converts are not the most egregious example. The worst – by far – are the interest-rate swaps that local goverments (state and city) enter into, under the guise of better managing their financing, when almost certainly what they are doing is forking over a huge commission to a Wall Street salesman. The real pigeons in this financial game are the taxpayers, not the retail investors; and it should be priority one to protect their interests. Once that happens, maybe we can begin to worry about retail investors.

Posted by a | Report as abusive

correct, Salmon

Posted by otto | Report as abusive

I thought your point was clear: a client makes some extra money but isn’t adequately compensated for the capital risk of the potential loss of collateral value. If the client knew the trade’s design and took all the money with the broker taking a small fee, that makes sense. But the case where a client is paid a pittance to take on capital risk is nonsensical.

There is a solution: no capital risk like this should be incurred by a company on behalf of its clients if that risk is not insured. In other words, if your client is giving you the use of a capital asset – a stock or bond – in exchange for a small additional return that isn’t directly compensated as a capital risk, then the brokerage should insure the capital value.

Posted by jonathan | Report as abusive


Consider this – it’s something I’ve been fighting for years:

The people who are arguing with you over reverse converts are not out to get you. Perhaps they just don’t get ‘it.’

Too few people understand options. Don’t know why that is, but mistakes are printed everywhere by reporters and others who don’t understand and apparently don’t want to understand how options work.

So, don’t take it personally. Not only are they trying to protect the sell side brokers, they may truly have no way to evaluate these reverse converts – due to a lack of knowledge.


Reverse converts have a limited upside only if the stock is NOT put to the investor, otherwise the investor is long the stock for as long as he wants and has then unlimited upside just as any other stock buyer. So buying reverse convert on stocks you want to own for the long term is fine. There is no basis to ban reverse converts, as they have exactly the same risk profile as covered calls strategies.

jck, once the stock is put to the investor, the investor has a stock, not a reverse convert. So there’s definitely limited upside to the reverse convert.

Posted by Felix Salmon | Report as abusive

yes, of course, but investors don’t sell their stock on the reverse convert redemption date, that’s what I meant, they will have upside after the stock has been put.

jck, perhaps I’m being stupid (again!) but how would that work?

What (non-specialist) investor would want to accept the downside risk but not the upside on a stock for (say) two years, and then own the stock so they can experience subsequent upside risk? Why not just buy a treasury note and then buy the stock when it matures? Or just buy the stock, if they really think it is a good long-term investment?

How would I (as a stereotypical retail investor) ever arrive at such a carefully nuanced view on the relative risk/reward of a stock both now, and also in a few years time? How many purchasers have some sort of complex analysis to support this, and how many purchasers just don’t really understand what they are doing?

Perhaps I am a cynic, but when you look at the product pages of the big and medium-sized investment banks/brokers, they have a lot of products pushed to retail that are “capital guarantee + participation in xyz index/stock/basket”. This leaves the issuers structurally short gamma and short vega.

I’ve always kind-of-assumed that they push the reverse converts to the semi-sophisticated investor market in order to reduce their gamma/vega hedging requirements… That doesn’t mean that the products are necessarily mis-priced /at all/, just that there is another incentive for them to make the sale that may not be obvious to the buyer.

Posted by Jh | Report as abusive

in a range bound market, or a bear market you are better off with the reverse convert, you are worse off if the stock rises by more than the reverse convert coupon. take an example, lehman: buying outright was a 100% write off, but buying the reverse convert gave you the coupon 13 or 14% and you lost the principal, so better off.

Mr. Salmon is clueless- there is a large and robust secondary market for Reverse Convertibles and pricing is at least as transparent as it is for bonds, which sometimes carry huge interdealer spreads. I have been following this debate among several so-called “financial journalists” and each one is a bigger liar or ignoramus than the next. And to flatly state a bond fund is better than buying individual bonds? Is he kidding?

Good thing these people aren’t licensed to sell securities. God forbid what would happen to the retail investor if they actually acted on their beliefs.

Posted by Jack | Report as abusive

I would have said that predicting a stock or index would be within a particular narrow range after a few years was a fairly nuanced bet for retail investor to make compared with “I think this company will do generally well/badly”. It’s not necessarily a bet that is too risky per se, but it is a more complex bet to make, and the payoff is asymmetric, unless you consider lost opportunity costs to the upside to be equal to lost ‘real’ costs to the downside. In practice, ‘real’ losses are far easier to litigate than opportunity costs, which is bad news for the issuers in the current market.

I’m not against giving retail investors the right to take risks, but they already have a wide range of alternatives from ultra-safe treasuries to very risky small-cap start-ups. Giving retail investors the benefit of being able to use new types of medium risk security by using structured notes is probably a good thing from a ‘freedom of contract’ point of view, but it comes with the side-effect of almost inevitable actual or pretended mis-selling frauds. Whether the benefit outweighs the side-effects is up to society, and I think there is room for a range of views. I’m not sure that there is an obvious “sweet-spot”.

Posted by JH | Report as abusive

Citibank is providing a wonderful service in bringing these products to the marketplace, but more people should know about them. How about a televised demonstration to Congress broadcast on CSPAN and rebroadcast on YOUTUBE.

Posted by Sechel | Report as abusive

Look, I don’t like selling these things to retail guys either, but I’ve seen nothing to change my mind that products like this are absolutely fantastic for systemic stability.

Posted by Kyle | Report as abusive

I was late to see this post Felix. I have one question in response. So you don’t think they are too risky for investors? If you don’t think they are too risky then your argument against them falls apart. While you may not have explicitly stated “I think they are too risky” I think it is fair to say that you implied this in your arguments against them… especially since your arguments will have trouble standing if indeed you don’t think they are too risky for retail investors.