Reverse Convertibles: More Financial 'Innovation'

By James Kwak

Felix Salmon discusses reverse convertibles, inspired by a Larry Light article in the Wall Street Journal.

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that’s the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

1. The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the $10 in interest, which is probably more than the dividends you gave up.
2. The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it’s a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.*
3. The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

The expected value for $100 of stock after one year is about $108 (6% real return on equities plus 2% inflation), so the chances of a gain and a loss (relative to buying the stock) are roughly equal; however, the distribution of returns is asymmetric, because if the stock does poorly your gains are capped, while if the stock does well your losses are not capped. Whether a given reverse convertible is a good deal or not depends on the specific terms – the interest, the term, the threshold, the volatility of the stock, and the transaction fee. But the question I want to ask is . . .

What the hell is the point of this product?

Here’s Ben Bernanke on financial innovation:

“We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive.”

This product isn’t allocating capital anywhere – at least not to the company you are betting on. It’s allocating your capital to the bank, which has one year to figure out how to make more money than it has to pay you back, but this serves the same allocation function as an old-fashioned bond (plus some additional risk). Or the bank might be an intermediary with another investor on the other side of the transaction, in which case you are simply betting each other and the bank is taking a fee.

A reverse convertible is just a made-up security that creates a different return distribution than conventional securities. It doesn’t help Apple raise capital. And there is no investor who woke up one day thinking he needed the wacky return distribution it provides: basically, a stock with a 10% cap on gains and a small sweetener in case of losses, with some weird behavior in the middle (the $80-110 range). The complexity only serves two real purposes. First, it creates transaction fees for the bank that it can’t charge you for buying a stock; and second, it makes it harder for investors to understand what they are buying, which means that at least some of them will buy it, even if it’s bad for them. In other words, this is an innovation that creates no value, but just redistributes it between investors and banks, with the banks taking a transaction fee just like 0 and 00 on a roulette wheel.

Or, as Salmon said:

“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.”

* Note however that in the standard terms according to Wikipedia, in many of these situations you would end up with the stock rather than cash, if the stock had ever closed below the $70 threshold. So instead of doing a lot better – getting $110 in cash instead of stock worth $81 – you would only do a little better, because of the $10 interest.

Comments

[daniel3582:]

My first thought: This strategy isn't that exotic. It seems to function like a neutral call strategy... one where you believe the underlying market is going to be (roughly) flat, like a short strangle, short straddle, or short calendar spread.

My second thought: I'm sure the birth of credit default swaps began in a similar fashion as this new strategy.

Jun 18 02:00 AM

[Sovestor:]

What we need is not more 'financial innovation'. Investors need to go back to simpler types of securities. Keep it simple.

Jun 18 03:06 AM

[User 305589:]

whoever buys such illiquid crap from a bank after all what has happened so far, deserves any losses he might incur. You could easily replicate that strategy on your own via the options and the money market with the distinct advantage that you can exit easily whenever you like and that you don't have to bother about counterparty risk.
Just another worse than useless ''innovation'' by bankers who are desperately searching for new avenues to milk the retail customers.
Btw, if any institutional investor (fund, pension fund etc.) would buy this nonsense, it ought to get its license revoked and shut down asap.

Jun 18 03:41 AM

[one eye:]

They opened Pandora's Box. What came out doesn't want to go back in.

Variations of what got us into this mess are going to resurface as different applications and Probably, Repackaged.

Welcome Back, "Same Old".

Jun 18 09:51 AM

[maximummarket:]

all they are doing is buying the underlying, selling a year out call, keeping the spread between the "interest rate" they give the client and the premium they collect, plus their transaction fee of course. Plus they get to put it as an "asset" on their balance sheet. It's a covered call strategy. What a rip off. I wonder how many clueless financial advisors will fall in line on this one.

Jun 18 10:47 AM

[harbar:]

These actually have been around for awhile, however, they are being sold more and more to the individual investor. The scary thing is that no one really understands the tax treatment of them. It is my belief that because they are a "bond" attached to a "stock" they believe they it is a dividend which is a fallacy. Buyer beware. Volatile markets are what drive the pricing of these. Stable markets make it incredibly hard for institutions to price them, and thus low profit/high risk with little volatility for institutions. It is like betting against the house in Vegas during volatile markets.

Jun 18 12:42 PM

[Trent Hauck:]

Everything should be as simple as possible if not simpler.


On Jun 18 03:06 AM Sovestor wrote:

> What we need is not more 'financial innovation'. Investors need to
> go back to simpler types of securities. Keep it simple.

Jun 18 02:33 PM

[john12345:]

The idea of financial innovation is to separate a fool from his money. That's what the reverse convertible was created for. No other reason. Do banks still have passbook savings accounts?

Jun 18 03:06 PM

[NLF:]

Reverse converts are a hedging tool for banks' derivative portfolio, that's why banks like them(Gamma hedging). However, and this is important, they should never, ever be sold to retail clients. This is the big boys league of structured products.

We only sell these products to sophisticated investors, even for them it is considered a marginal strategy.

I don't know where the idea that these products are illiquid comes from, we produce tradable NAVs on our products on a daily basis. However, when selling these instruments we tell our clients that out of the 90 reverse convert products we issued in 07, and 08, 88 knock-in. This is not a risk free strategy, its a complex volatility trade, and should be treated as such.

Jun 18 03:48 PM

[klarsolo:]

I agree that reverse convertibles are not a retail product. But any professional can see the point of the underlying strategy. Just because some of them actually lost some investor money doesn't mean that all such products should be banned (as advocated by Felix Salmon).

You know people, being outraged over pretty much *everything* doesn't really do anybody any good. Last year pretty much everything lost money, except Treasuries. Now digging up every product even slighly out of the ordinary and kicking the daylights out of it just because it lost money is just stupid. Reverse convertibles have been around for years. Before you shun the entire group, why don't you try to get a bigger picture of how they did for clients over the long run instead of just looking at a sample size of 1-2 clients who got burned?

Jun 18 04:44 PM

[klarsolo:]

If it's a covered call strategy, please explain to me how they lost money in plunging markets. Could it be because it's not a covered call, but really a naked put? Hmmm...


On Jun 18 10:47 AM maximummarket wrote:

> all they are doing is buying the underlying, selling a year out call,
> keeping the spread between the "interest rate" they give the client
> and the premium they collect, plus their transaction fee of course.
> Plus they get to put it as an "asset" on their balance sheet. It's
> a covered call strategy. What a rip off. I wonder how many clueless
> financial advisors will fall in line on this one.

Jun 18 05:00 PM

[klarsolo:]

Okay, my last comment was a little uneducated. Due to put-call parity, a naked put and a covered call does have the same risk-reward profile, so you're technically right.

Jun 18 05:01 PM

[klarsolo:]

Even though the payoff graphs look similar, a reverse convertible is not "buying the stock and selling a covered call", but "buying a bond and selling a naked put". Just FYI.

On Jun 18 10:47 AM maximummarket wrote:

> all they are doing is buying the underlying, selling a year out call,
> keeping the spread between the "interest rate" they give the client
> and the premium they collect, plus their transaction fee of course.
> Plus they get to put it as an "asset" on their balance sheet. It's
> a covered call strategy. What a rip off. I wonder how many clueless
> financial advisors will fall in line on this one.

Jun 18 05:04 PM

[klarsolo:]

Agh, just ignore my drivel. You can structure reverse convertibles any way you want: either buy stock + sell deep in-the-money call option (what you said), or buy Treasury bond and sell deep out-of-the-money put option. I'm just confused today. All this outrage over everything on all financial sites is wearing me down...

Jun 18 05:18 PM

[balois:]

Agree with comments above: A straight forward, transparent bet - even for retail investors, imho. I really cannot see any hidden toxins or explosives here. Unlike in some so called "money market" funds, for example, when scratching the surface, one suddenly discovered to be the proud owner of a stake in illiquid sub-prime mortgages backed collateralized debt obligations.

Have a good day

Jun 18 05:37 PM

[greg weitzner:]

I agree with the comment above, this isn't a crazy, exotic, risky instrument that is hard to value, but is very comparable to bets you can make in the options market. Should be outlaw options? I don't think we need to regulate or ban this to protect people from themselves (and the only real loss is the commission). Comparing this to CMO's and CDO's, and CDS's is comparing apples and oranges. This does not create systemic risk and perhaps someone or some institution out there finds it useful, although I definitely do not.

Jun 18 05:49 PM

[a fat panda:]

The value was dropping because of counter-party risk and liquidity. Citi issues a product called ELKs, and they were falling much faster than the actual stocks because you couldn't find anyone to buy them in the secondary market. Last fall, you could get 5% holding these things for a month.


On Jun 18 05:00 PM klarsolo wrote:

> If it's a covered call strategy, please explain to me how they lost
> money in plunging markets. Could it be because it's not a covered
> call, but really a naked put? Hmmm...

Jun 18 11:47 PM

[TeresaE:]

Another POS that will bite us.

The banks with their faulty accounting rules just gifted and long-standing, have run up the market when the fundamentals do not show green shoots.

Anyone that is trusting that in a year the market will end up is ignoring history and the garbage coming out of DC and Wall Street.

Gifting more of what you have left to the banks seems beyond foolish and borderline insanity.

Jun 19 01:04 AM

[jnrichardson:]

The attorney representing the investor in the Wall Street Journal article posted about the story here: www.zamansky.com/blog/...

Jun 19 04:58 PM

[GGmcr:]

I am with a class action law firm that is investigating whether certain brokerage firms may have misled investors as to the risks associated with investing in reverse convertible notes. Check it out: www.girardgibbs.com/re... or call [phone] for more information on the investigation and to see if you qualify.

Jul 06 04:32 PM