More Financial Innovation

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.

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

Visit: The Baseline Scenario

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