Reverse Convertibles vs. Consumer Protection

| About: Morgan Stanley (MS)

Since we’ve already run new stress tests out of this webpage, I’m going to go ahead and run the Consumer Protection Agency out of the Rortybomb Blog while President Obama and team continue to get the legislation worked out. (If I keep doing Elizabeth Warren’s homework for her, she’ll no doubt go to the Prom with me.) So welcome to the RCFPA – Rortybomb’s Consumer Financial Protection Agency. Today we also have the responsibility of the Financial Product Safety Commission. Let’s see what the thought process of such a government agency might look like. Our principles for consumers interacting with financial innovation:

1 – Markets Work; No Free Lunch
We trust that prices that reflect more market information than less. If you are earning extra money on your investments, barring very clear reasons why markets have failed, it is because you are taking on more risk.

2 – Reduce Transaction Costs
Transaction Costs are wasteful and destructive to capital, and should always be avoided whenever possible.

3 – 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.

4 – 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.

That’s a good start. Following these guidelines for consumer interaction with financial innovation will make the financial system stronger, more equitable and more stable. And I don’t find any of those four controversial.

So our first case at the RCFPA comes from Felix Salmon – Reverse Convertible Bonds, which the WSJ just called a nest-egg slasher. This bounced around the blogosphere yesterday. Here’s James Kwak on the instrument:

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 Wall Street Journal article follows the story of a radiologist who buys the instrument expecting to get a safe bond plus a free stock if things go bad and is surprised that he was written out of the money put options on stocks.

Our verdict at the RCFPA: FAIL. This instrument should not be allowed to retail investors, or perhaps not at all.

Hey! I’m a radiologist who wants to buy this instrument. What makes you want to nanny-state over me?

First off this is really selling people an embedded put option but calling it a bond. FAIL Rule #4. I’m mad he beat me to it, and so well, but here’s Nemo nailing this out of the park in comments:

As jck points out below, this is actually a naked put. (Same risk/return as a covered call, but a simpler and more accurate description when you do not already own the stock.) Since markets are efficient — at least in this sense! — there is no possible advantage whatsoever to anybody, except the bank, who is ripping people off. If you tried to use these things in volume, you absolutely would move the stock, just as if you sold lots of puts. And if these gadgets were more cost-effective than simply selling puts, somebody would arbitrage the difference away.

Therefore, this is simply a way to convince naïve investor to sell puts, but with the extra risk of the bank as a counterparty and with the extra friction of having the bank as an intermediary.

So it also involves taking on extra transaction costs when they could be avoided by just buying a put option. Rule #2 FAIL. Indeed this strikes me as more destructive of capital than breaking it down into components.

It also is FAIL on the crucial Rule #1 – It believes that the market price of a put is somehow inefficient. This is all I can read where its defenders, such as Nick Schulz say: “They are cash-secured put options.” Asking Nick if he doesn’t believe in markets is almost akin to asking him if he doesn’t believe in America and Apple Pie, but I need to ask – does he not believe in markets? Does he, and people like Daniel Indiviglio, believe there is a Free Lunch to be had by structuring cash and a put option this way?

I think I was confusing a few months ago when I said that believing in efficient markets should cause us to doubt most financial innovation. This is exactly what I mean. I believe the best price of a put option on a stock is going to the market and getting the price of a put option. I believe that the implied price of a put option, married with odd extra risks and transaction costs, in this reverse convertible bond instrument is a worse price for the put option than the market one, because I believe the more markets vet prices the better they are. Nemo’s point is absolutely correct – if they were much different, the market would be arbitraging them away.

And if you got a better deal taking this reverse convertible bond instead of just a market put, which I highly doubt but let’s assume, is it because there was a market failure that had been innovated away, thus increasing value? Or have you simply just piled into a new risk factor that you are being compensated for? Again, if you believe in markets the only sensible thing to do is assume the later until it a very clear argument has been made for the former.

Hey! Maybe I want to take on those extra risk factors so I can be compensated for them.


Yes. What are they?

Well, as Nemo said, you’ve taken on counterparty risk. If you bought, say, a Morgan Stanley Reverse Convertible Bond on AT&T (SEC – html), if Morgan Stanley isn’t around you aren’t getting anything. If you bought a put option and secured cash, you wouldn’t have that to the same degree. In so much as that is hidden tail risk, it violates #3. If you want to bet that Morgan Stanley is going to be around in a year, and be compensated for that, there are other options available that directly do this that are traded with more information.

If you dig into that SEC document, there’s a bunch of risks with stock-splits and extra dividends and accelerations if AT&T (NYSE:T) goes bankrupt. Fine print risk.

There’s also that knock-in portion, of which Felix says “pricing these things is pretty much impossible.” Here’s a screen shot from Wilmott’s intro guide of just part of the equations you’d have to solve to estimate its value:


The answer to the value doesn’t have a closed-form solution, so you’ll need to set up computers to iterate simulations to solve it. At Morgan Stanley (NYSE:MS) there’s a room full of Math PhDs who instead of developing solar energy are spending their hours trying to rip off radiologists using math. Buying this instrument is a bet that you can solve those equations better than them. Good luck. In practice, it means more hidden tail risk in the form of another embedded option, so FAIL #3 and #4.

Ha! I fooled you all. I’m actually a very sophisticated investor, and Felix, James, Nemo and you were wrong to be looking at this by charting the stock price. I’m actually betting that the volatility of this instrument has been overrated, and am betting it will come down.

That’s very sophisticated for a radiologist who just wanted to buy a bond.

I know. Thank you. Now take your laws off my bong, man.

Hey, I’m not at all against you make esoteric bets with options. If you, Mr. Radiologist, wake up in a cold sweat after having dreams that the market is overestimating the term structure of the second moment of AT&T stock, go ahead and place a bet (I have those same dreams myself). Go short a straddle. Just sell the put option. There are baskets of derivatives that can handle this. The RCFPA should help you achieve your dreams.

What I do want, though, as Chief of an imaginary government agency, is for you to make that statement in the positive. I want you to say clearly “I am selling a put option on AT&T” or “I am betting that the vol numbers will decrease.” I don’t want you buying what you believe is a magic bond only to realize later you’ve taken a large position in tail risk.

What should be our next case?