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.

Update: This post has gotten a fair amount of attention, including criticisms by from Nick Schultz and Daniel Indiviglio (who calls this “Simon Johnson’s Baseline Scenario blog,” but whatever). But I think Mike at Rortybomb does the best job discussing this type of security in wonky detail.

By James Kwak

70 thoughts on “More Financial Innovation

  1. The return distribution is not much different from a covered call (cap on the upside, some reward to compensate the downside). The “advantage” of this product is that (unlike covered calls) there is no limit to the number of times you can do this transaction. For the underlying security (and even the call options), there are limits of supply and demand, so if you tried to buy or sell too much you could affect the price by your own action.

    So, if you run a huge small-cap mutual fund, you quickly run out of good small companies that you can invest in without significantly affecting the share price, and you end up buying a lot of crap or sitting on cash, which doesn’t make your investors happy.

    If instead you could go to your banker and buy a bunch of these notes or other derivatives that can exist independently from the underlying shares, you’re golden because you can expose a lot more of your fund to the companies you really like. Golden, that is, until the scheme collapses and your banker goes bust, and you don’t even get the stock because there isn’t enough of it around to satisfy all the note holders.

  2. Felix is 100% RIGHT. I had wholesalers from LaSalle and other structured products shops in explain these to me in depth many times, and not once could I get a straight answer on why I wouldn’t just buy the common stock if I liked it or not be involved if I didn’t.

    The whole concept of attempting to collect a high coupon from a derivative of a stock I don’t even like is absurd.

    These instruments should go the way of the pteradactyl

  3. “What the hell is the point of this product?”
    Ask Warren Buffet, is famous put position is equivalent to a reverse convertible, basically a funded short put.
    Hardly new, have been around for years, institutions don’t need to buy that kind of product since it’s so easy to replicate.

  4. It’s interesting to note that Stifel Nicolaus was also one of the parties involved in the story about the Whitefish Bay School District’s big big problem with synthetic CDOs. Might make you wonder a little if you had your own personal finances with that firm. Again, notice that with these reverse convertibles that the interest rate offered is higher than the average. If it’s such a good deal, why is the bank trying to get YOU to invest in it, instead of investing their own money. Yup, Mr. Banker got up that morning and said to himself “Gee, I wonder how I can make Mr. and Mrs. Joe Q Public richer today?” And hey, it’s your lucky day—the first person he wanted to offer the sweet deal to was YOU!!! Those warm hearted bankers are always trying to make America a better place.

  5. I’m not sympathetic to the investors’ claims, and I’m not persuaded that the rcns are inherently evil. This is much ado about garden-variety fraud. If sold as having no risk, send the brokers to jail. If bought as having none, send the investors to the nursing home. This is what powers of attorney are for.

  6. You quote Ben B. as saying this: “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.”

    When did he say this? 15 yrs ago? What productivity has financial innovation brought us lately?

    Seems to me that innovation in finance left us teetering on the cliff of catastrophe…. Not sure what industry has benefited from the “innovative allocation of capital” we’ve experienced recently.

  7. The type of structured product described is best utilized in a sideways market (or, if the investor does not believe that the underlying security will necessarily appreciate during the term of the note, but also has a belief that the underlying security will not crater either). Engineer27 is correct, it is essentially a packaged covered call program designed to generate above market returns for a relatively limited period of time. The fee associated with the purchase of the structured product is less than what an individual investor would incur engaging in a comparable options strategy. In addition, the interest rate offered on this type of structured product far exceeds that provided by direct investment in a fixed income product for a comparable term, which is an incentive in and of itself. However, they are a sophisticated instrument that can be sold in an inappropriate manner.

    Financial services companies cannot simply develop products that make no economic sense for the investor. There are specific scenarios for which structured products are very appropriate. Educating the consumer as to their features and suitability, however, is the biggest hurdle.

  8. 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.

    In fact, the bank is almost certainly buying underpriced puts from you and then selling them into the market for a profit. The bank is doing literally nothing except parting some fools from their money.

  9. The fee associated with the purchase of the structured product is less than what an individual investor would incur engaging in a comparable options strategy.

    Nonsense. In this case, the “comparable options strategy” is to sell a put. The bank is not charging a fee lower than the bid/ask spread in the highly-liquid options market; if it were, somebody would arbitrage the difference away.

    In addition, the interest rate…

    It’s not interest. It’s a put premium.

    This is a scam, pure and simple.

  10. As with many “exotic” structures, the main purpose of this vehicle is to rip the eyeballs out of unsophisticated investors who cannot adequately price volatility, counterparty, or liquidity risk.

    It is also to exploit regulatory arbitrage: by selling this “deposit” the banks can boost their capital, which is extremely valuable. To them, that is.

    The legitimate purpose might be that part of the embedded risk is in demand by another client or residual to the bank in transactions, etc.

    Caveat Emptor. I sincerely hope the new CPFA [Consumer Financial Protection Agency] can ban this sort of thing.

  11. I hope that the new CPFA will come up with a list of products that can be sold, and ban everything else. If the people at the FDA ran CPFA, it would be years before we anything new. And that would be a good thing.

  12. Come on people, if there are investors stupid enough to buy such financial products, let them!

    Just make sure they don’t do it with your money.

  13. The basic problem with these products is not just that the public doesn’t understand them, the brokers selling them don’t understand them either. They’re given bullet points and a commission. I guess there is probably a scenario where this type of investment actually makes sense for an investor, just like there was a scenario where reverse amortization loans made sense. (high income sales people with lots of equity but big disparity in income month to month) Unfortunately none of the mortgage products, or these structured products make sense to “innovate” unless you can sell them to far more people then they are designed for.

    I’m in the investment business and I’m all for complete fiduciary responsibility for all products. No more hiding behind multi layers of corporate and regulatory buearocracy and designing products that are called “insurance” but aren’t so they don’t have to be regulated by the SEC or called, “fixed” so they don’t need a series 7. Just make the sale of all financial products subject to the same fiduciary requirement as fee accounts and everything is regulated, hedge funds, private partnerships etc. In my experience equating amount of money with “sophistication” to determine who can invest in unregulated products is a poor metric. Some of my “least sophisticated” clients are my wealthiest.

    It really pisses me off that I can’t use the words mutual funds in my newsletter without filing with FINRA, paying a fee and waiting two months for a response, but jackels can be out there selling equity index annuities to 80 year olds with 20 year surrender charges of more than 10%, return calculation structures that insure the client never actually earns more than 2-3% per year, and 15% commissions to guys who had to study for five hours to pass an insurance exam. The whole regulatory world is backward based on over reactions to individual cases rather than any common sense.

  14. This is a big issue with ETNs also. They are selling a lot of ETNs in which they promise to track gold or silver etc. But the prospect doesn’t say how the bank plans to make money to pay off this “loan”.

    Most regular investors don’t realize that ETFs and ETNs are different in that respect. And before Lehman, I guess no one cared about it also.

    But, it’s really crazy that this is being allowed and most people who realize that this is how ETNs work, must just hope that the banks know what they are doing.

  15. “Financial services companies cannot simply develop products that make no economic sense for the investor.”

    What planet are you from?

  16. In the same spirit, let’s have the Government ban casino gambling, lotteries, fatty food, cigarettes, and ALL investments/speculations that can lose money.

  17. There is nothing innovative about this. It is just a scam, plain and simple. The “enormous economic benefits that flow from” such scams flow in one direction – to highly paid bank executives. It is time someone in charge paid attention and shut down such nefarious activities.

  18. Are you suggesting that we should treat our banking and financial systems like casino gambling and lotteries?

  19. Nana-
    I am suggesting that the purchasers — if they have full and honest disclosure of the terms and conditions — are willingly entering into a transaction with the sellers. The government can reasonably insist on honest disclosure — but it is a slippery slope for the government to go beyond that. For example, in your own words, a Las Vegas casino “provides no innovation”, they are “scamming” the casino players — do you think the government shut down casinos too?

    Furthermore, to the extent that the sellers are FDIC insured banks, the sellers are getting access to a low cost of funding — that benefits the FDIC, which benefits all US taxpayers.

    Lastly, it is both incorrect economics and plainly wrong to suggest that these securities have no value at any price. If the embedded implied volatility is extremely high, it is not inconceivable that they buyer (and not the seller) will be on the winning side of the transaction.

  20. Like I said, new financial instruments are like designer drugs, and should be regulated when they are created, for pretty much the same reasons.

  21. Rocky Humbert: “The government can reasonably insist on honest disclosure — but it is a slippery slope for the government to go beyond that. For example, in your own words, a Las Vegas casino “provides no innovation”, they are “scamming” the casino players — do you think the government shut down casinos too?”

    This is not a slippery slope. Banks are not casinos. And they are really not brokerage firms, either. If anything, not allowing banks to do these deals is an anti-slippery slope mechanism, to keep banks from sliding down the slope into casinoland.

    James Kwak: “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.”

    Oh, there’s a big clue. Why have that term? Because the bank bought a put and exercised it when the stock closed below $70. The bank is doing arbitrage on you. ;)

  22. I misspoke: “Because the bank bought a put and exercised it when the stock closed below $70.” That would have done the opposite to what I meant. :(

    Anyway, the bank acquired the stock below $70, and you are stuck with it. ;)

  23. Min:

    Casinos are exactly like banks in your example. They both sell a product to “willing” buyers, and both products are priced at a negative expected value to the purchaser.

    But in both cases, the purchaser is choosing to enter into a transaction. There is no coercion. You seem to think the Government should limit choice. That’s the slippery slope.

    Freedom = personal choice.

    I like my freedom to choose. You want to delegate your freedom to choose to faceless bureacrats and regulators — the same folks who couldn’t detect Bernie Madoff even though he was handed to them on a platter.

  24. As many have noted here, this is simply a way for banks to offer unsophisticated customers a product that looks a lot like a covered call (or naked put, it’s the same thing) and to pocket some fees in the process. I’m 100% certain that the banks won’t take the risk to their balance sheet, but will arbitrage it away in the options market. So any reasoning that this would somehow be useful for thinly traded options doesn’t stand: the bank still needs to dabble in the options market to offset the trade.

    In short, you end up hiring a very expensive broker or market maker to write a naked short.

  25. My understanding is that the FDA looks at three things about a proposed drug, does it do any good (ie is it snake oil?), does it do any bad (what are the side effects?) and I forget the third thing. Something like that would be good for financial products.

  26. engineer27: what happens if everyone runs out of companies to invest in? The number of publicly traded companies reporting to the SEC is dropping again.

    I guess the larger question is if there’s enough of a market for investment today or if these snake oil products are filling a gap?

  27. Banks are just trying to be like Las Vegas. Maybe if we treated them more that way we could at least get a free meal & a drink while they steal our money. I doubt there is a single invention by the finance industry that is REALLY benefical to society since the early credit cards. I guess I shouldn’t care as I don’t invest in companies anyway. People are a much better investment in general

  28. Actaully I do need to care because it’s my brothers & sisters savings & retirement that always get stolen and as usual only the brokers and institutions win. George Carlin said they won’t be happy till they have all your money. He wasn’t making that up. These guys care nothing about the general public. They are for themselves and their families only. period…. the end.. nothing more.

  29. Rocky Humbert: “Casinos are exactly like banks in your example.”

    Oh, Rocky, you have already slid down the slope. ;)

    The financial system rests upon trust. Everybody knows that casinos take your money, otherwise they would go out of business. In return you get to have some fun, and you might even win some money; you might even win a lot. Banks are different. They grease the wheels of commerce, which is a win-win proposition. They are not supposed to just take your money.

    Some people regard life as a gamble. But most people do not. They trust banks in ways that they would not dream of trusting a casino, or even a retailer. This is how our society is built. Rightly or wrongly, we have put banks and bankers in a position of trust, and they should be worthy of it.

  30. cafecb, You don’t work for Stifel Nicolaus by any chance do you??? If not you should apply for a job there. I think you have special BS skills which are very suitable for working at that firm.

  31. Isn’t this the same security that taxpayers would buy from banks in the Capital Assistance Program (CAP)? I’m not sure that there is any bank actually willing to participate in CAP.

  32. Hmmm. Have the feds bailed out any of the casinos lately? If a casino fails, does it drag down the economy? If the casino doesn’t have enough money in the kitty to cover the bets, do the feds have to step in with a very rich handout?

    Banks are nothing like casinos, Rocky. They get to pocket the profit and socialize the losses. That’s a very very big difference between Wall Street and Vegas…

    And with some of the “innovation” going on with banks, people are better off these days “investing” at the craps table.

  33. This might help.

    According to a UBC media release: In a study published today in the journal Neuropsychopharmacology …

    University of British Columbia researchers have shown that rats know how to gamble (play the odds) and demonstrate lower risk-taking behaviour when given the right incentives.

    If the animals (the rats) won the gamble, they received the associated reward (sugar pellets). However, if they lost, they experienced a time-out period during which reward could not be earned.

    High-risk options offered more potential sugar pellets but also the possibility of more frequent and longer timeouts.

    Rats learned how to be successful gamblers, selecting the option with the optimum level of risk and reward to maximize their sugar pellet profits.

    The advance will help scientists develop and test new treatments for gambling addictions, a devastating condition that affects millions worldwide.


  34. Our banksters have figured it out also. They let the general public take all the risk!

  35. what the heck, didn’t financial innovation just almost destroy the world’s financial system. Now they are coming up with another one. When would congress start investigating this people.

  36. What has financial innovation brought us except utter ruin. Please let’s leave the innovation to the scientists and not the bankers.

  37. I am just a housecat, but this sounds to me something like an off-exchange stock future.

    Wonder why the CFTC is not sniffing around? Probably been neutered.

  38. David:

    It is important to remember that Money Market Funds, Index Funds, Stock Options, Adjustable Rate Mortgages and Treasury Bond Futures are all examples of financial innovation.

    I dare say that we have all benefited from these innovations. Regulation is different from innovation.

  39. Designer drugs!

    The UBC study on rats makes sense. Suppression of seratonin leads to increased impulsive behaviour and higher risk taking. Suppression of dopamine leads to decreased pleasure and lower risk taking. The researchers are looking for possible drug treatments for human gambling addiction.


    Let’s apply this to the casinos of Wall Street. In theory, the pharmaceutical industry could develop a designer drug for financial engineers. The drug indications would be an optimal level of risk-taking (seratonin) and reward (dopamine) to maximize profit on a longterm basis.

    Brave New World revisited ? Certainly a violation of civil liberties if financial engineers had no choice but take this theoretical designer drug. Reforming compensation might create a similar outcome. In other words, financial incentives that create the optimal level of risk and reward to maximize profit on a longterm basis.

  40. Edit required, meant to say:

    … financial engineers and their product sales team

  41. Rocky,

    No one is arguing that all financial innovation is bad, much of it is good. But the last decade has seen the rise of new products that are not in any way innovative, except as a method to part customers with their money.

    To your gambling example, if banks (and insurance companies) actually ran like casinos we wouldn’t be in this mess. Casinos are regulated, the odds have to be within certain perameters, games have to be true “games of chance” so some people have to be allowed to win, and most importantly all casinos have to have enough money to cover the bets on the casino floor. If AIG had enough money to cover the losses in it’s credit default swaps or Lehman had enough money to cover losses in it’s CDO portfolio there would be no problems – and a change in the regs allowing leverage to go from 12-1 to 40-1 was a big player in the collapse. We tried a complete Lazzie Faire market in from the end of the civil war until about 1908, and we got bubbles like the one we just had about once every five years. I’m warry of the coming regulations, and they could do more harm then good, but they are necessary – the public is just not that smart.

  42. These are legitimate investment instruments that are easy for an investor with reasonable experience to put money in to. While they are not for everyone, I would commend to you that the widows and orphans Fidelity Growth and Income Fund was down by 50.9% for 2008. NOTHING did well last year except perhaps for Treasuries. So if all of you kibbitzing “experts” who posted on this board think these structures are toxic, my advice is invest in 6 month CDs for the rest of your life. You will therefore avoid all risk. Of course, you’ll be poor, but you won’t have any risk. The author and his parrots, know less than nothing about these.

  43. Barry,

    You’re missing the point. These products are not “bad” or “toxic”, they simply mimic classic options strategies that can be done at any brokerage firm with far lower costs. Covered calls are as old as I can remember, and these reverse convertibles ARE covered calls. Really.

    The only issue is cost. To take your example: an index mutual fund with a 0.5% fee can lose a lot of money in a market crash, of course. That does not make it a a toxic product, though. But how about an index fund with a 5% fee? I would argue that this IS a toxic product in the long run. Whether such a product should be legal or not I don’t know. I can see arguments on both sides: “protect the consumer” vs. “people should be free to choose their investment as long as adequate disclosure is given”.

    My question to you: do you think the target customers for these reverse convertibles are aware that these products already exist in the options market at a lower cost? Me thinks not. Should we tell them (full disclosure)? Probably. Should we ban the product? I’d say “no”, but I’m not quite sure.

  44. To Daniel:

    You are correct in saying that one could mimic an options strategy and execute a similar result. One could also duplicate the holdings of a mutual fund without paying a load.

    Should we ban them as well?

    Secondly, your question is a bit stilted: what do you mean by “target customers?” Your presumption is that anyone who was offered these was already known to be an idiot. Do you think that is the case?

  45. are these a real problem? how big is the market in these? why are they the hot topic all of the sudden? who in their right mind would buy one — they sound like a real ripoff.

    but trying to ban something because it is STUPID — especially something which is so transparently dumb as this — if people are stupid, and don’t do their homework, SOMEONE will find a legal way to rip them off. if you make this product go away, you won’t stop them from getting ripped off. you’ll just shift the problem from one con artist to another.

  46. Daniel:
    You articulately cover the relevant points without verbal hyperbole. Well done.

    The only points that I would add:
    1) The reverse convert has a convenience factor of not having to roll a covered call at each expiry. For non-market-professionals, this may be material.
    2) The costs associated with rolling covered calls at each expiry can add up over time. Also, some types of accounts may not be permitted to trade outright options but these structured products are permissible.
    3) The tax treatment of covered calls may be different than for reverse converts. (Not sure.)
    4) The reverse convert allows you to lock in the implied volatility for the term of the note. If you roll covered calls, the volatility may be lower (or higher).
    And perhaps other things that I haven’t thought of…

    But thanks again to Barry and Daniel for showing that this is a two-sided discussion…

  47. q: “but trying to ban something because it is STUPID — especially something which is so transparently dumb as this — if people are stupid, and don’t do their homework, SOMEONE will find a legal way to rip them off.”

    It is obviously not transparently dumb, or so many intelligent but fiscally ignorant people would not have bought it. Also, if people invest their money with you and you do not rip them off, then that’s all the less money that is available for someone else to rip them off.

  48. Rocky Humbert: “Also, some types of accounts may not be permitted to trade outright options but these structured products are permissible.”

    That is an argument for regulating these products. If they are not allowed to sell naked puts, then they should not be allowed to do these deals, either. If the regulation prohibiting the sale of naked puts is wrong, the get rid of it, don’t get around it.

  49. Min:

    Naked puts can only be sold in a margin account. These instruments are equivalent to a series of covered calls — where you can only lose the money that you have spent to buy the security. Covered calls are eligible for ERISA accounts — but many brokers do not provide that functionality, and its those accounts to which I refer. (But I agree with you that these securities should not be eligible for any account that cannot trade covered calls.)

    Additionally, if these products are sold to retail investors, they are ALREADY regulated. An S-1 or Form 424b5 (prospectus) will be filed with the SEC, and the SEC will review the document before the securities are issued. The SEC is usually quite thorough (and slow) at reviewing the Prospectus and required disclosures. What the broker tells the client is a different matter, of course.

  50. There is only one statistic you need to know about these products. Less than 1% of structurers buy these products in their own personal investment portfolios.

    That and the fact that all the banks selling these made tonnes of money from them…and they WEREN’T selling them to compete with equity ie s a covered call strategy.

    They are sold to compete with CDs and bonds – hence the marketing mentions the ‘interest rate’ or ‘coupon’ first. If the stock price goes down, you get to own the stock! Yippee!

  51. Kacky write:
    “There is only one statistic you need to know about these products. Less than 1% of structurers buy these products in their own personal investment portfolios.”

    Kacky: Lehman and Bear and Merrill bought the complex mortgage-backed securities for their own portfolios and it didn’t work out so well. Did it? So this is conclusive proof that your statistic (if true) is entirely irrelevant.

    Next you write: “They are sold to compete with CDs and bonds – hence the marketing mentions the ‘interest rate’ or ‘coupon’ first. If the stock price goes down, you get to own the stock! Yippee!”

    EVERY product is sold to compete with CD’s and bonds. Hence the Econ 101 concept that ALL securities are priced to compete with so-called riskless ones. If CD’s and bonds were yielding 10% today, other investments would be priced massively lower. That’s how capital markets are supposed to work.

    As to your last comment, some people (myself included) often prefer to buy stocks when they are lower in price — (and to sell them when they are higher in price.) It’s called “buying low and selling high,” and it works for some people.

    None of this addresses the issue of whether the securities are systematically expensive (they are); whether the regulators are enforcing the current laws (they aren’t); and whether long-biased investors will make money during a severe bear market (most don’t).

  52. Schultz’s and Indiviglio’s lame and on the verge of PR articles contain only one sentence which pretends to be an argument:
    ‘Clients like to pretend they’re stupid when an investment loses money’.
    Schultz also says that reverse convertibles are used as an insurance. But what the hell are options for?? I am no expert in this but if you want the weird return distribution for some reason you should be able to create it using ordinary simple derivates. Otherwise it really is just a scam. And calling this an innovation is only a way to make no-argument defending of the product look as if critics were backward looking guys halting progress.

  53. The subtle genius of Larry Light, author of the WSJ article.

    Sneak Peek 2008
    Larry Light On U.S. Business And The Economy
    12.19.07, 3:00 PM ET
    The Big Trend

    The U.S. will skirt a recession in 2008, having shown it has the stuff to hold off an economic downturn in 2007. Call it a momentum play. An economy with the strength to withstand high oil prices, a housing slump and a credit crunch must have something going for it. That something is strong demand from growing nations like China. American exports are surging. Employment has shown surprising growth. And while there is softness is areas like retailing, the trend of a resilient economy will continue.

    The Unconventional Wisdom

    That housing will continue its downward spiral, smashing mortgage-backed securities with it. Bunk. Certainly, housing starts have fallen precipitously. A lot of attention is on the subprime loans with low teaser rates that are about to reset upward, zapping borrowers with much larger interest costs. But none of this means that the apocalypse is at hand. Heavy pressure is on lenders, especially from Washington, to work out these loans. So the problem won’t be as bad as advertised.

    The Misplaced Assumption

    Mergers and acquisitions will slow down. On the surface, this seems to make sense, because borrowed money, which M&A types thrive on, is harder to come by. And it is true that private equity funds will enter a hiatus. But public company M&A will continue and strengthen. Many companies have a lot of cash on their books that can be used for acquisitions. Financial outfits are cheap to buy these days, thanks to all the scare talk in the air. Expect a surge in bank takeovers by stronger banks, for one.

    Glad he doesn’t actually sell securities. Or is he?

  54. Rocky – that statistic is true. The statistic is entirely relevant. This topic is about retail investors, and individual structurers who choose not to buy the products they create for their own PERSONAL portfolio signals that the products are not good investments, and/or the individual knows just how much profit margin both originator and distributor are taking.

    They are sold to compete with bonds and CDs to investors with a low risk tolerance i.e non-equity investors. That is why they were created – to make more profits by selling artificially high yields to greedy/stupid retail investors(actually, I would prefer the term depositors). These ‘mums and dads’ are looking for safe investments but get duped into buying these because of the high headline yield.

    Most structured product innovation revolves around making the headline yield higher and the downside risks less obvious.

    And another problem with reverse converts – if you sell before maturity you have to cross a HUGE bid-ask spread. This secondary market risk is definitely not adequately disclosed.

  55. Kacky:
    Simply repeating the same incorrect observations and misinformation does not make it true. You did not address my points.

    As for your new comment about bid/ask spreads, this criticsm can be true of generic corporate bonds, muni bonds, CD’s and many other unlisted securities. Have you ever tried to sell $1,000 or $5,000 worth of AAA insured muni bonds? You’ll be lucky to find a bid 5 points below the last sale!!

    Perhaps the only point on which we agree is that investors (both retail and institutional) are attracted to headline yield. That’s how complex AAA mortgage backed securities with a 50 basis point extra yield ended up wreaking havoc in the financial system.

  56. MK-

    I am an independent market research analyst who specializes in the indexed annuity and indexed life markets. I have tracked the companies, products, marketing, and sales of these products for over a decade. I used to provide similar services on fixed and variable products too. However, I STRONGLY believe in the value proposition of indexed products, and that belief is what I have based my business on. I do not endorse any company or financial product.

    I wanted to draw your attention to the blatant inaccuracies in your angry post. First, these products are called ‘indexed annuities’ or ‘fixed indexed annuities,’ not ‘equity indexed annuities’ or ‘EIAs.’ We want to draw a clear distinction between these fixed insurance products, and equities products. Second, the longest surrender charge in the indexed annuity industry is 16 years, not 20 years as you allude. Third, indexed annuities are priced to return 1% -2% greater return that traditional fixed money instruments (fixed annuities, CDs, etc). Although many of these annuities have earned upwards of 30% in a single year, they are not priced to return such performance consistentely. Interest accumulation of 6% – 7% is currently realistic on these products. Fourth, the highest commission available on an indexed annuity today is 12%- not the 15% comp. you reference. In addition, the AVERAGE street level commission on these products as of 1Q2009 was a mere 6.73%. And remember- agents are paid a single time on annuities and expected to service it for life, unlike many of the securities products that you may sell. Fifth, agents selling indexed annuities have to not only pass an initial exam, but take regular continuing education including (but not limited to) indexed annuity education and annuity suitability education.

    The regulation in this market is different than what you are accustomed to, that does not make it wrong.

    I extend my services to you humbly, should you require ACCURATE information on these valuable insurance products.

    Thank you.

    Sheryl J. Moore
    President and CEO
    Advantage Group Associates, Inc.
    (515) 262-2623

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