Reverse Convertibles vs. Consumer Protection

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.

Really?

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 (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 (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?

Comments

[nobby73]

This product is very stark proof of the fact that the "investment" banks have absolutely no intention of changing their behaviour which is the main reason they are so anxious to pay back the TARP loans.

2009 Jun 18 03:53 PM

[klarsolo]

Wow, you guys are doing overtime in today's "Outrage outrage outrage" section. Individual reverse convertibles are not much riskier on the downside than holding the individual stock. If you want to ban them, just go ahead and ban individual stocks for retail investors as well. (I actually believe that would make sense)

Also, all the hate on these instruments based on 1-2 clients who got burned last year is a little...shall we say...stupid. Last year everything but Treasuries got dragged to hell and lost people money. Maybe you should ban all stock investing then. Before you ban all reverse convertibles, how about looking at a larger sample of clients and a longer time frame? Wouldn't that be fair?

I don't understand the issue with "oh its called bond and that's misleading". Where's the outrage over regular convertible bonds then? These guys lost 40-50 % as a group last year, just as much as equities. Should they be banned as well.

Man, Felix & friends are really something else these days.

2009 Jun 18 04:54 PM

[nobby73]

I think you miss the point - you get the downside of an equity and the upside of a bond. This is not about a few people who got burned, but about a bad product which hides it's lack of purpose behind complexity. Banks make a killing out of selling this sort of crap and it always ends up being sold to people who don't understand it. When it goes wrong (which over a few years is almost always) then the banks say, sorry, we thought you knew what you were doing etc etc, but when banks themselves get in trouble through misunderstanding of risk, the taxpayers have to bail them out.

And no, convertible bond holders did not lose as much as those holding the equity...

On Jun 18 04:54 PM klarsolo wrote:

> Wow, you guys are doing overtime in today's "Outrage outrage outrage"
> section. Individual reverse convertibles are not much riskier on
> the downside than holding the individual stock. If you want to ban
> them, just go ahead and ban individual stocks for retail investors
> as well. (I actually believe that would make sense)
>
> Also, all the hate on these instruments based on 1-2 clients who
> got burned last year is a little...shall we say...stupid. Last year
> everything but Treasuries got dragged to hell and lost people money.
> Maybe you should ban all stock investing then. Before you ban all
> reverse convertibles, how about looking at a larger sample of clients
> and a longer time frame? Wouldn't that be fair?
>
> I don't understand the issue with "oh its called bond and that's
> misleading". Where's the outrage over regular convertible bonds then?
> These guys lost 40-50 % as a group last year, just as much as equities.
> Should they be banned as well.
>
> Man, Felix & friends are really something else these days.

2009 Jun 18 05:39 PM

[klarsolo]

Well, corporate bonds have limited upside and unlimited downside. Are they also bad products?

You have to look at probabilities, not just risk-reward diagrams ex-post. Anybody can say "That was stupid" with perfect hindsight, but that doesn't make them a bad product per se. Unless you have reason to believe that the sold option was mispriced, you can't even say it was an unfairly designed product.

Of course, excessive fees can make this a bad investment, but this is a completely different story. Mortgage refinancings also involve excessive fees and yet nobody wants to ban them.

As I said, I agree that reverse convertibles are not a retail product. But so isn't an option ARM. Nor an individual regular stock. Nor an individual convertible bond. Nor an individual corporate bond.

On Jun 18 05:39 PM nobby73 wrote:

> I think you miss the point - you get the downside of an equity and
> the upside of a bond. This is not about a few people who got burned,
> but about a bad product which hides it's lack of purpose behind complexity.
> Banks make a killing out of selling this sort of crap and it always
> ends up being sold to people who don't understand it. When it goes
> wrong (which over a few years is almost always) then the banks say,
> sorry, we thought you knew what you were doing etc etc, but when
> banks themselves get in trouble through misunderstanding of risk,
> the taxpayers have to bail them out.
>
> And no, convertible bond holders did not lose as much as those holding
> the equity...
>
> On Jun 18 04:54 PM klarsolo wrote:

2009 Jun 18 05:51 PM

[klarsolo]

Oh, and about convertibles vs equities...I'm afraid convertibles as a group did lose as much as equities as a group in 2008.

2008 S&P 500: -36.81 %
2008 Vanguard Convertible Bond Fund: -29.8 %
2008 Fidelitiy Convertible Bond Fund: -51.65 %

As you can see, the Fidelity guys lost even more than the stock market.

On Jun 18 05:39 PM nobby73 wrote:

> I think you miss the point - you get the downside of an equity and
> the upside of a bond. This is not about a few people who got burned,
> but about a bad product which hides it's lack of purpose behind complexity.
> Banks make a killing out of selling this sort of crap and it always
> ends up being sold to people who don't understand it. When it goes
> wrong (which over a few years is almost always) then the banks say,
> sorry, we thought you knew what you were doing etc etc, but when
> banks themselves get in trouble through misunderstanding of risk,
> the taxpayers have to bail them out.
>
> And no, convertible bond holders did not lose as much as those holding
> the equity...
>
> On Jun 18 04:54 PM klarsolo wrote:

2009 Jun 18 05:59 PM

[Rollerball]

Bonds have (so-called independent) ratings. Who's rating the underlying in a reverse convertible? Who's the "liquidity provider" of the underlying? What non-retail investor could possibly interested in such a product (except in-house 401k "managers")? I'm with Rortybomb. It's a Corvair Convertible.

Disclosure: own Nadar/Gonzalez '08 ball cap

2009 Jun 18 07:24 PM

[klarsolo]

Oh yes, the ratings agencies and their reliable ratings. You're right, everything should be rated by them. They're so good at evaluating risk.

The lack of liquidity is an issue indeed, and that is why I'm also saying that they're not for the individual retail investor. But that doesn't make them a bad product per se. And this is what all these people are ranting about: them being a bad product that needs to be banned. Just not true.

I'm an institutional investor and work as a fixed income PM for a pension fund. I do find these products interesting and I think they definitely have a place in a professionally managed portfolio. They are a good way of expressing a view like this: "I like Apple at $ 80. Now it's trading at $110. I'd like to make good money off of it with reduced downside risk. I don't mind at all owning it at $ 80 should it fall that low." Try expressing that view with anything but a reverse convertible. Is this view so strange that you believe only a minority would want to express it?

On Jun 18 07:24 PM Rollerball wrote:

> Bonds have (so-called independent) ratings. Who's rating the underlying
> in a reverse convertible? Who's the "liquidity provider" of the
> underlying? What non-retail investor could possibly interested in
> such a product (except in-house 401k "managers")? I'm with Rortybomb.
> It's a Corvair Convertible.
>
> Disclosure: own Nadar/Gonzalez '08 ball cap

2009 Jun 18 08:24 PM

[matt...]

The problem isn't the underlying instrument but how it's packaged. It's not a bond, so you shouldn't be allowed to call it a bond.

2009 Jun 18 08:51 PM

[klarsolo]

What makes a bond a bond? What are the particular characteristics of a bond that could not possibly be replicated with other non-bond instruments such as options and equities? And if you can replicate a very similar risk-reward structure, why does the distinction between bond and non-bond matter? Does the word "bond" automatically imply lower risk? Lower than what? How low does it have to be? After all, the reverse convertible is less risky than the stock position itself.


On Jun 18 08:51 PM matt... wrote:

> The problem isn't the underlying instrument but how it's packaged.
> It's not a bond, so you shouldn't be allowed to call it a bond.

2009 Jun 18 09:02 PM

[Rortybomb]

Klarsolo.

I have absolutely no problem with the probabilities or payouts. If people want to sell put options while holding full cash, or go short straddles, or however else you want to tap this payout/probability structure, god bless em. If retail investors wake up one morning and say "hey, I want to bet that the market is overestimating vol on this one stock" I'll cheer em on. I conclude on this remark.

What upsets me is that this payout is (a) bundled in a way that piles on fees and additional risks that are unnecessary and I'm mostly upset that (b) the put option is embedded in a way that is, imho, designed to be very confusing, and it certainly isn't placed front and center and called what it is. People are terrible with tail risk, and they are terrible with discerning embedded options; why not replace this instrument with a fully-funded put option?

Oh, because nobody would pay huge fees for that.

I have no problem with people buying individual stocks, as long as they understand they are buying an individual stock.

2009 Jun 19 02:30 AM

[Rollerball]

And to clarify: Klarsolo, I would have absolutely no problem with this product should it, subject to your fiduciary duty and confirmed by my CPA, glean any strategic advantage (such as tax treatment) over naked put writing. And please don't take it personally if my first question is: "what part of your (expected) commission is on product sales and what part is attributable to product performance?"

2009 Jun 19 08:23 PM