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”. 

In Jefferies we Trust.

With the Euro crisis as a backdrop, as opposed to the housing/mortgage crisis of 2008, this year's Lehman Brothers has been MF Global, a medium sized commodities broker-dealer, spun off from Man Group a few years ago and which had actually purchased the business from REFCO back in 2005.

REFCO, as many may remember was the subject of a famous meltdown of its own. 

MF Global's demise came reportedly due to large leveraged bets on European sovereign debt which didn't pan out.  That's tough for MF's stockholders and bondholders, who are probably looking at steep losses.

Here's the graph for MF's 6.25% 2016 bond, issued in August 2011, which basically fell off a cliff in two months.

Like Lehman, MF Global's debt was "investment grade" (Fitch, S&P and Moody's), right up until the nasty stuff hit the fan in late October. Of course, MF was just a triple B, as opposed to a Lehman's AA at the time of its collapse, so I guess we're getting better in the ratings biz. Off topic, this is why I really don't invest a whole lot in debt of financial companies. Very difficult to analyze and foresee these meltdowns. 

Still, if it were just the stock and bondholders losing, no biggie. The problem is that the issue is affecting customers also. When brokers go down, customers don't normally lose their money or securities, because these assets are (or should be) segregated and separated from the broker's own. It can be a hassle to get everything set up again at new broker/dealer, but competing firms are normally more than happy to bring those customers on board. Sure beats wining and dining them.

The problem with MF is that apparently those customer funds were not well segregated. There is a reported $600 million "missing" from customer accounts. Big problem. 

First off, this isn't supposed to happen. You'd figure that this was a lesson learned from the Madoff scandal (BLMIS was first and foremost, a broker-dealer). Second, this didn't happen with Lehman, where customers were taken over by Barclays and their assets were there. It didn't even happen with Stanford Financial's brokerage arm (other stuff happened there).

So, big black eye for regulators once again. Hopefully the money shows up, but this is kind of like with missing persons. After three weeks, the chances aren't good.

This leads us up to the old crisis equals opportunity adage and the title of this post: Jefferies (JEF). Jefferies is a mid-sized broker-dealer. Not a household name, but well known and regarded in the industry. While checking the company's Sec filings, an analyst at Egan-Jones noticed that the company was long European sovereign debt in an amount equal to close to 80% of JEF's equity and proceeded to downgrade. 

The company said "Whoa, wait a minute. We make markets in those bonds and we're short (as in we have to deliver to clients) pretty much the same amount." (they didn't actually say THAT, but that was the message). JEF even went as far detailing positions and showing how they could change their inventory levels if the wish too. In short, JEF pretty much did everything right to control the damage. (Frankly, if  you used this same yardstick, where does that leave every European bank?)

However, stock and bond traders have not been understanding and much less forgiving lately and JEF's securities have sold off sharply, opening up what appears to be an opportunity. On the very short end,

JEF's 7.75% 2012 bonds (due March 1) are trading below par, for what would look to be nice pickup for less than four months. On the other end, some of the longer dated maturities are yielding at or close to double digits. JEF is still "investment grade" (FWIW, I know).

While the selling could still get worse, I like the odds on this one and am willing (and have) put down some coins on JEF bonds. Drawing on the 2008 parallels, buying Morgan Stanley or Goldman Sachs bonds while Lehman went down in flames, proved to be an excellent investment. We'll see how this one goes. With 2012s, we'll know soon enough. For the long run, the broker-dealer business model is obviously "under review". Bear, Merrill, Lehman and now MF can't all be aberrations. For now, however, "In Jefferies we Trust".