Convertibles: Collateral Damage of the Shorting Ban

It seems a long time ago now, but back at the beginning of the credit crisis, when US banks were being bailed out recapitalized by foreign governments rather than their own, one of their favorite methods of raising new capital was to issue convertible bonds.

Here's a measure of how bad things have gotten since then: In pressuring the SEC to ban short-selling, the likes of John Mack have implicitly conceded that there's simply no way they'll be able to issue any kind of convertible bond for the foreseeable future.

How's that? Investors in convertible bonds are perfectly happy to put up new money, but they invariably short the underlying stock at the same time. It's called convertible arbitrage, and it's popular enough that there's almost no room in the convertible-bond market for anybody else. Any bank trying to issue a convertible bond into a market where short-selling is banned would be doomed to fail.

I'd be interested to see how the prices of various banks' public convertible bonds are doing today. I doubt there's a panicked attempt to dump them all immediately, now that hedging them has been banned. But I also suspect that there's a huge overhang of bonds waiting for any buyers to come along.

Not that you can short the converts -- that's been banned, too, at least in the UK, and probably in the US too, before long. The main effect of that, I suspect, will be to simply drive volumes and liquidity in the convertible-bond market down to zero. Which is fine if the only source of capital right now is the US government. But if other people are interested in putting up money too, the ban on short-selling might, ironically, make it that much more difficult for them to do so.

Comments

[Moon Kil Woong]

You might as well also mention the banning shorts prevents options since no one will write a put when they can't arbitrate their way to delta neutral. Why is this bad, because in the long run the people who buy puts are holders of stock trying to hedge volatility (a good idea). Without the put hedge you might as well not own the stock since financial are about as volatile as you can get these days.

Shorts are all part of the formula (see Black Scholes option valuation and you will understand). It's like saying in physics, you can do anything you want but we don't allow entropy. It may sound wonderful for a second, but eventually you will ask yourself why you are freezing to death because you can't start a fire.

The heart of the issue is that you had excessive multiplication of the money multiplier by allowing banks and others to borrow way beyond the pale of normalcy (not 10-15x equity but 40+ times). This was done to satiate their greed for huge short term returns to justify their huge and growing salaries. How exactly banning shorts solves this is a bit of a laugh. I assume they just do it to make you feel warm and fuzzy over the short squeeze as everyone clears their trades and stops trading financials. But don't worry, the government will magically reinflate the money multiplier and bail out the banks. Don't worry, you will only suffer slightly higher taxes, bigger deficits, a lingering recession, and banks and brokers will continue to hide their losses as they write it off over say 15-20 years. Maybe the government should do something about that, like just double the deficit buy all the bad mortgages and then say shorting the dollar is illegal (that means you can't dump the worthless paper in exchange for goods and services). This of course will make all the other mortgages go bad. Which starts the cycle over again.

Wake up someone and stop this madness....

2008 Sep 19 04:27 PM

[otbricki]

There sure is a lot of crying over banning shorts for two weeks on 7% of equities.

2008 Sep 19 05:43 PM

[Big Al45]

Felix, Your articles are usually good for a laugh, but I appreciated learing about "convertible arbitrage."

I'm curious about the "convertible arbitrage" that you believe purchasers are entitlted to. Why won't buyers of convertible bonds buy them unless they can also short the stock? Shouldn't the interest rate on the bond and conversion terms provide enough return to justify purchase of the bond without having to short the stock?

Also, when do the buyers short the stock - before or after the time that issuance of the convertible bonds is disclosed to the public?

2008 Sep 19 08:40 PM

[logicalthought]

Big Al45: It's all built into the pricing. Sure, you can make an interest rate that's attractive enough to price an unhedgeable transaction. Do you know how you do that? You raise the borrower's cost of capital. That's the unintended consequence of this moronic ruling by the SEC. (Yes, enforce the laws against naked shorting, and yes, reinstate the uptick rule, but no, don't ban short-selling altogether.) And even after shorting of the financials is reinstated, I wouldn't be surprised if investors demanded a bit of a "risk premium" to protect themselves against the possibility that the government will once again arbitrarily prevent them from hedging.

To answer your second question: in a 144a transaction (which is what most big converts are), there's a press release put out announcing that a transaction will soon take place; this permits the investors to short the stock concurrent with-- or ahead of-- the transaction. In a privately marketed deal, the investors can't short the stock until after the deal is priced and announced.

2008 Sep 19 10:52 PM

[Big Al45]

Logical, thanks for the info. In the future, I'll factor in an increase in shorts whenever a stock I own announces a convertible preferred offering.

I always thought the issuance of convertible bonds abused the equity position of existing stock holders, but didn't realize how great the abuse actually is.

2008 Sep 20 01:56 AM

[logicalthought]

Big Al45: It's incorrect to say that the issuance of convertible bonds necessarily "abuses the equity position of existing stock holders". Presumably, your company is issuing these bonds because it needs money. in that case, it can either issue stock or debt, and if it issues stock, it's going to have to do it at a price that's probably at some discount to where it's currently trading (or, at least, to where it was trading before the company announced that it was going to sell stock). On the other hand, most convertible bonds convert at a premium to market, and some of them quite significantly so. Thus, a convert can wind up being much less dilutive to the common stock shareholder than selling more common stock. However, if you've got a company that issued a convertible with little or no premium in the conversion price (or, even worse, convertible at a discount), then you've got a company that no one was willing to finance in any other way, and you should be asking yourself what the market is seeing that you're not.

2008 Sep 20 08:59 AM

[upndown1313]

When companies issues convertibles in order to raise capital, it is usually bad for the small investor. I say good riddance. If the deal is not solid enough to stand alone without being able to short, then I say the idea to support the deal is not good enough and should not be done in the first place. Next.

2008 Sep 20 10:02 AM

[Paulo]

What impact will this have on the likes of AGC (global convertibles and preferred convertibles) and similar funds?

2008 Sep 20 12:18 PM

[logicalthought]

upndown1313: What if "the idea" is to stop the company from running out of money and thus wiping out the common shareholders?

2008 Sep 20 04:57 PM

[hrant]

it just buggles my mind how a small investor is suppose to be in stocks, when even YOU push for the return of shorting . I cannot believe the level of criticism from media re this shorting which most believe was illegal, (never prosecuted by COx of course ) from people ,i assume, are on the side of the little guy.

2008 Sep 21 12:23 AM