Reverse Combustible

FINRA has recently launched a probe into what they are calling yield chasing instruments, among which are derivative-linked CDs. 

http://www.bloomberg.com/news/2012-02-07/finra-examines-cds-tied-to-derivatives-as-banks-increase-sales-to-a-record.html

Banks have been selling a lot of these products, which tend to be quite profitable for them. Here’s a short explanation of a popular product called “reverse-convertible”, “barrier” or “knockout bond”, so you can understand why these are popular with the banks.

The standard Reverse Convertible  product works something like this:

Joe, a 65 year old retiree. is looking to invest $1 million, but is unhappy with the yields offered on short term CDs and other similar products. So his banker or broker offers him a "reverse convertible", sporting a 10% yield over six monhs with stock XYZ as underlying and subject to certain conditions.  Joe is enticed by the yield and buys in. 

In six months, Joe expects to get his $1 million back plus $50.000 in interest. Those $50.000 are normally to be paid regardless of what happens to XYZ. 

The principal, however, is only guaranteed if certain conditions are met. In this hypothetical case, the condition is that XYZ, which is currently trading at $20, doesn’t trade 20% lower at any point in time during the 6 month period. That is, if XYZ trades at $16 or lower, even briefly  intraday, the “knockout” feature is activated and the instrument is no longer principal-protected.

Once the knockout feature is activated, it means that instead of Joe getting his $1 million back, he might get 50.000 shares of XYZ instead (its the banks option). 

Since XYZ is a nice company and Joe doesn’t think it will go down that much, he invests, thinking that the bank is dumb to give him such a great deal. Ten percent interest in these days of low yields is great, right? And in the worst case, he gets some shares in a great company like XYZ. 

Ah, but the bankers smile, because they have this covered. Here’s what they do:

They sell puts 6 months in the future at that $16 strike. Five hundred contracts, which should net them at least $1 each, possibly more. That’s $50.000 for those who are doing the math. That covers the interest that needs to be paid to Joe when his product matures in 6 months. So in case XYZ stock behaves nicely and Joe’s bet pays off, the bank doesn’t lose a cent. They also have $1 million to play around with for 6 months, so you can assume they make some interest on that, too. 

Of course, if XYZ tanks, Joe stands to lose some serious cash . Let’s say it goes down to $14.The bank will get its puts assigned buying 50.000 shares at $16 per share which they will give to Joe in exchange for his million dollars. Net profit for the bank: $200.000.

Net loss for Joe is $250.000: the $300.000 in lost market value for his shares of XYZ minus the $50.000 in interest he collects. 

If XYZ closes somewhere between $16 and $20, the bank can still make a tidy profit, if somewhere along the line XYZ traded under $16 triggering the knockout provision and allowing the bank to assign the shares to Joe at $20/sh. In this case, since the stock has settled above $16, the bank would buy the shares in the market and then “sell” them to good old Joe at the agreed upon $20, earning the difference.

Of course, if the stock trades higher, or never breaches the $16 limit, Joe simply collects his interest and the bank might make a small profit. But Joe now feels like a winner, and armed with his new "knowledge", you can be pretty sure he's going to try his luck again on one of these products. He'll probably lose one of these bets eventually, and even if he doesn't the bank is still making small profits on each sale. 

Naturally, there are numerous variations of the product, including with multiple strikes and underlying instruments. The underlying doesn’t have to be a stock, it could be an index, or a commodity. If the bank doesn’t have the product you want, if you have enough cash, they will build it for you. That’s how much they like these things, and after this explanation it should be clear why.

Of course, times are hard for yield-seeking investors and many opt for these products, given the dearth of interest-producing alternatives. And to make a little, you have to risk a little, right?

Perhaps, but the problem is that the investor is bearing all the risk here and reaping only a fraction of the potential reward. If he were to sell those puts himself, he could pocket the $50,000 premium and tell the bank to take a hike. Heck, he doesn't even need to put up the whole $1 million in collateral.

What’s more, his risk in XYZ stock would be lower since the puts are assigned at  $16 (as opposed to $20 in the RC) .

Ah, but selling naked puts is complicated and brokers and regulators (including entities like FINRA) feel that Joe, who isn’t all that sophisticated, shouldn’t be allowed to take on that risk. So its not something that fits with Joe's profile and if a broker puts him in that trade (the naked put) and it goes wrong, he (the broker) could be looking for trouble. 

They have little problem, however, with Joe buying a reverse convertible. “Go ahead Joe. Knock your self out with a knockout bond”.