Bailout

Reverse converts and Vincent Fernando?s straw man

By Felix Salmon

How long can this debate over reverse converts go on? I’m not sure, but I’m willing to put up one more blog entry on the subject, since Vincent Fernando is both misrepresenting my views and giving me the opportunity to make an important broader point.

Fernando seems to think, on zero evidence, that I’m saying reverse converts are simply too risky for retail investors. But I never said that, and I never would. Pretending that I said that allows Fernando to make a cheap and obvious shot: pointing to all manner of other investments (like simply buying individual stocks) which are even riskier, and which I don’t want to ban. He then can accuse me of being inconsistent, or illogical, or hypocritical, or worse.

I have no problem with people taking on risk — especially upside risk. Never mind individual stocks, they’re more than welcome to disappear off to Vegas, if they’re so inclined, and put thousands of dollars on a single number in roulette. (That said, no stockbroker has any business putting his client into a roulette gamble, no matter how much commission he’s getting from the house.)

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

I’m not saying that no investor should ever buy or sell options. But any investor who does play in the options market needs to know exactly what she’s doing, and why. In stark contrast, the way that reverse converts are sold makes every possible effort to hide the fact that they’re a put-selling strategy — even unto calling them “bonds” and disguising the proceeds you get from selling the put as being a “coupon”.

There are two big reasons why a high-risk stock is a much better investment than a reverse convert. For one thing, stocks generally go up over time: they’re a positive-sum game. And for another thing, stocks have a lot of upside: while it’s certainly possible that you can lose all your money when they go to zero, it’s also possible that you can double your money, or more, if they spike upwards. Reverse converts, by contrast, have massive downside (all the downside of the stock) but no upside beyond the “coupon” which you expect to receive all along.

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game. Bond investors, as a rule, are always better off in bond funds than they are picking and choosing their own bond portfolio, not least because the trading costs for bonds, if you take account of the enormous bid-offer spreads shown to retail investors, are a good order of magnitude bigger than they are for stocks.

At least with bonds, however, there is a bid-offer spread: a market actually exists in them. Next time you’re offered a reverse convert from your broker, ask him to find you one on the secondary market and see what he says. There’s zero liquidity in these things, which means zero price transparency: there’s no indication whatsoever what their market price is, just because there isn’t a market price for them. That’s always a bad sign — and it’s a very strong indication that they shouldn’t be sold by stockbrokers. A broker should always be willing to buy and sell any instrument he’s dealing in: when he’s selling but not buying, at any price, then something very fishy is going on indeed, and you’re almost certainly getting needlessly ripped off.

Full post as published by Macroprudential on June 19, 2009 (boomark / email).