Reverse Convertibles Expose Fear of Innovation

Includes: ABN, BCS, MS
by: Vincent Fernando, CFA

I've seen two sites attacking "Reverse Convertibles" after a WSJ piece by Larry Light which called them "Nest Egg Slashers", those two sites being The Baseline Scenario and Felix Salmon at Reuters. First a brief description of these products... while investors should be extremely skeptical of any products like this foisted on them by their brokers, the negative reaction towards them has strayed from the path of logic.

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.

Larry Light's WSJ piece is right to point out that these products make juicy fees for banks that sell them. And one can imagine that a lot of people lost money in 2008 on them given the collapse in markets. But Felix Salmon and The Baseline Scenario take it a step further and air the idea that such products should be banned and make no sense. Felix Salmon:

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.

Frequently, a lot of professionals can't even price stocks, so 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?

Also, you need to know the terms of each one before you call them a scam. Actually, if priced right they could make sense. If priced right. Which I bet a lot of them aren't. But the key point is that you can't ban the entire concept, at the right price such a product might be a good buy. I'll explain further below.

The Baseline Scenario:

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

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.

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.*

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?

Again, I know these products are likely juicy commission generators, for something that investors could probably do on their own with stocks and options, and probably for less cost. I'm not saying I would necessarily want to buy them and I have never bought any of the special products pitched by private banking types. I think the products are likely not worth it in most occasions, for I'm sure the pricing is likely set in the bank's favor.

Yet this still doesn't mean we should impose a ban on everyone else's freedom to invest their money. We also should not let others think that they can be docile sheep when buying products. 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.

Now having said all that, these products actually don't sound all that wacky. I think they are just attracting uproar due to the recent market collapse, the general fear against any kind of derivative-based financial instrument, and finance-hatred. This is because the return profile for these reverse convertibles actually seems quite similar to what is usually billed as, and I think is, a pretty prudent and lower risk investment strategy. It's called Covered Call Writing.

In covered call writing, you write calls on stocks you own. This allows you to collect a premium, as a % of your stock position value. If the stocks move up beyond a certain level, you collect the premium plus your stock gain, but then are capped out for any further upside. If stocks fall, well then you are exposed all the way down, but get to keep your premium income (from the written call), which will reduce your loss moderately. Sounds pretty similar to how reverse convertibles work, though the degree of similarity will depend on the terms of the reverse convertible we compare, and the option one chooses to use for the covered call trade.

I would say writing near the money calls on a stock you own is probably pretty close in terms of return profile of "Nest Egg Slashers", though with the reversed convertible you are probably better hedged for small to medium amounts of downside. For example, if you still get your money back even if the underlying stock falls 20%, then you are doing very well vs. a naked stock owner (he lost 20%) or even most covered call writers (those whose option premiums for their written calls are less than 20% of the original stock position's value).

Ha, so some of these reverse convertibles might even be more hedged than your average covered call trade. They might be lower risk. Baseline Scenario asks "What the hell is the point of this product?" Don't they understand covered calls? Probably one of the least risky styles of options trades out there. And then to go back to Mr. Salmon... should we then be banning all covered call trades? And if covered call trades are one of the less risky options trades out there, then should we be banning almost all options trades?

There are a lot of dumb options trades one can make as well (and I know from personal experience!), with far more risk than a reverse convertible. Heck, there are a lot of stocks that can be extremely risky too, much more so that reverse convertibles. Should we start banning all of these stocks? And then let me really step back for a moment and get some even broader perspective... What about works of art? Expensive watches? Sports cars? These can cost quite a bit and are frequently worth far less than the buyer initially pays; a lot of normal products can be pretty big, dumb buys. Yet we allow people to make their own decisions.

So to close, of course I would need to see the terms of each product to really give a view on each one. My main gripe and point of agreement with the detractors above is that the fees are likely too high and investors can probably do something similar on their own for less in fees. The marketers were likely just doing anything they could to make their fees. But we give people the responsibility to make a lot of much larger decisions in their life, it's thus their responsibility to be skeptical buyers. Let's not let current sensationalism towards financial products, or finance in general, blur our sense of logic and perspective, without which almost all sources of risk become extremely dangerous.

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