The Reverse-Convert Scam

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 (C), 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.

Comments

[john s. gordon:]

another scam is born.
> jack

Jun 16 04:56 PM

[Ergo:]

Yeah, I don't buy things I don't understand. Good article.

Jun 16 05:27 PM

[F. Bradeen:]

I know what happened in Oct. 1987 with naked put writing. One loses one's shirt in the operation. Much more than the money on deposit. This obviously should be outlawed.

Jun 16 05:32 PM

[tipalia:]

that s what I , we , call mafia at its best with the blessing of our representatives. In the past it always took a revolution to change the behaviour of people in power positions. So when is the next one ?

Jun 17 08:33 AM

[Zyx007:]

The scam continues - 2-3% upfront for the bank AND unsecured funds from people who do not understand what exactly they are selling. Completely agree that these need to be banned. The only people who can pretend to price these are too smart NOT to buy these.

Jun 17 09:50 AM

[BDHPlayer:]

If I recall, didn't Lehman Brothers issue these securities and the holders of these securities were up a creek without a paddle when Lehman went bankrupt.

Jun 17 12:14 PM

[Robert H. H...:]

It's a shame the WSJ article wasn't better researched and written.

It's too easy to do a drive-by shooting of a financial product by finding a few photogenic "victims" after it's fallen in value by 30%. You could write the same article about an S&P index fund if you could find an investor who will declare no one told him the market could go down 30% in a year.

That said, it's hard to find much good to say about a reverse convert, which was undoubtedly marketed to retail investors who didn't understand it by brokers who probably understood it less (other than the 2-3% upfront fee part).

As you say, the product is essentially a loan to the issuing bank married to a deep (so it seemed) out-of-the-money short put position on a unrelated stock. How any investor benefits by marrying these two unrelated investments is a bit of a mystery.

I suspect the brokers sold it as an "enhanced yield" security whose downside risk was that you'd be buying blue-chip equities at attractive prices... a bit like parking your cash in Treasuries while waiting for the market to trade down to your limit buy order on YHOO. But of course the "enhanced yield" was really just a combination of the risk premium on the unsecured loan to the issuing institution, plus (some portion of) the premium received for writing the puts. If you really wanted a fixed income investment while rolling over out-of-the-money short put positions, why not just buy the Treasuries and sell the puts directly?

So call me cynic on this particular product.

I can, however, imagine a clever and benign financial engineer observing that deep out-of-the-money options are relatively expensive due to the "volatility smile". (Implied volatility of options increases as the strike price moves farther away from the underlying stock price, so if you graph implied volatility as a function of strike price, the graph forms a "smile" with the trough near the current stock price).

So this benign banker has a thesis that rolling over deep out-of-the-money puts can generate consistent cash flow as the seller collects the option premium and lets the puts expire unexercised. Now, he knows that your average doctor or dentist is not going to be talked into an aggressive out-of-the-money option selling program per se, but if it's repackaged as an enhanced yield debt security, he'll snap it up.

A behavioral finance adherent might see this as a framing issue, coaxing an investor into an investment that may have had attractive ex ante risk-return characteristics (even if ex post, they were not). A complete cynic will see it as borderline fraudulent marketing. As is usually the case, the real truth probably lies somewhere in between.

A more interesting article would've explored whether the investors were actually receiving a market return for the lending risk and put-writing program, or whether the sponsoring bank was getting a great deal.

Finally, it would have been interesting if Mr. Light had investigated the benefit to the issuing bank of creating a universe of "natural" sellers of out-of-the-money puts. Selling the other side of that trade as portfolio insurance has probably been pretty good business lately.

Jun 17 12:17 PM

[58robbo:]

the problem is that most people do! when they lose their shirts, they then bemoan the lack of govt control, oversight and regulation. The govt is only happy to oblige!
Whatever happened to Caveat Emptor? Whatever happened to a govt which understood that their regulations encourage investor apathy?


On Jun 16 05:27 PM Ergo wrote:

> Yeah, I don't buy things I don't understand. Good article.

Jun 18 11:58 AM

[CommodityPanda:]

I read your post and the referenced article and there is no face value evidence that this investment is a scan or a fraud. Bad, or better yet horrible investment with practically non-existing risk management, but again I don't see fraud.

To your point of "Reverse converts are a scam, and it’s high time US regulators put an end to them." Now if my assertions are correct and this isn't a scam then why should this investment be done away with? Again, I ardently support your position that this is a poor investment, but is this grounds enough for the omnipotent regulators to end their existence? Has our polity devolved to such a degenerative state that we require regulators, not to shield us from fraud and corruption, but from bad investments? People routinely and continually make bad decisions every day, even though well informed. So in a likewise manner should we cry out to the regulators on high to "put an end to them" i.e bad decisions?

In sum, reverse-converts are a bad investment, but not fraud, and being a bad investment should not be enough "to end them." Heck, I see bad investments and bad investment advice given everyday (not fraudulent just bad), and in a likewise manner to your suggestion should we replace individual responsibility with additional regulation? Regulation can protect us from fraud by making regular (i.e preventing outright fraud), but it should never replace individual responsibility.

Jun 18 12:47 PM