Reverse Converts Kill Retail Investors

Published by clickbroker.blogspot.com

The Wall Street Journal’s “Reverse Converts: A Nest-Egg Slasher?” tells another sad story of retail investors being sold products they did not understand. Should we have the same sympathy that we had for buyers of Auction Rate Securities (ARS)? I think not. Reverse converts (or as JP Morgan (JPM) calls them Reverse Exchangeable Notes), promise returns of up to an annualized 17.25% on a 6 to 12 month deposit. Investors, retail or not, should clearly understand this is not simply interest.

At least ARS were bonds at their core. Whether any investor truly understood how ARS operate is another matter. What the Journal is calling interest on reverse converts is actually the combination of a small amount of interest added to a large put premium. This structured product is really just a very inefficient way for a retail investor to sell a put.

The Journal cites Barclays (BCS) and Citigroup (C) as large banks issuing these securities. But I was only able to find the JP Morgan Term Sheet for Reverse Exchangeable Notes due December 31, 2009 through Incapital LLC’s Structured Investments website.

The basic concept is the purchaser or investor of a reverse convert is issued an unsecured note from the issuer in $1,000 increments. The investor is paid a coupon much higher than prevailing interest rates, but can lose some or all of their investment. The return of capital is based on the price performance of a single reference stock. The upside is limited to return of capital at par plus the monthly coupon.

JP Morgan’s term sheet specifies 3 notes linked to the price performance of Deere (DE), Wells Fargo (WFC) and Whole Foods (WFMI). The coupon rates are 13.75%, 17.25% and 12.25% annualized for 6 months. But the allocations between “interest on deposit” and “put premiums” are 9.75% and 90.25%, 7.77% and 92.23%, and 10.94% and 89.06%. The effective interest that investors are being paid is just about 1.34% for all three. When commissions and “hedging fees” of up to 6% are added in, it’s a pretty expensive way to sell a put. The hedging is for the benefit of the issuer.

The sequence of dates is critical to understanding the product: pricing date, settlement date, observation date and maturity date. Notice the pricing date comes before the settlement date and the observation date precedes the maturity date. Each of the notes has a protection amount: 30%, 40% and 40% of the reference stock price on the pricing date. The shares per note are calculated by dividing the par value ($1,000) by the pricing date closing stock price.

The monitoring period extends from the pricing date to the observation date. If the reference stock’s price falls below the protection amount at any time during the monitoring period, the investor loses protection of their principal. Once protection is lost, return of capital at maturity is the lesser of the note par value or the value of the shares per note on the observation day. JP Morgan’s term sheet gives excellent examples of many different scenarios.

Coupons are paid regardless of whether protection is lost. But if protection is lost, the issuer can return capital at maturity as either the actual shares in the reference stock or the cash equivalent. The cash equivalent is the pricing date shares per note multiplied by the observation date stock price.

The reference stock’s company has no obligation to the investor. The investment is only backed by the credit of the reverse convert issuer (JP Morgan in this example). Think what happened to retail investors in Lehman structured products.

Let’s compare reverse converts to directly buying the reference stock or selling (shorting) a put on the reference stock. The reverse convert has no upside if the stock advances, a fixed exercise price if the stock falls, no stock dividends and limited liquidity. Buying the stock provides dividends, liquidity and upside. Selling the put allows the investor to earn interest on his proceeds as well as the cash maintained for exercise, the transaction can be closed before expiration, and is far more liquid than reverse converts. All three investments have equal downside, so the added liquidity of the second two differentiates.

Whether you buy a reverse convert or sell a put, you have to be willing to be exercised at the strike price. Retail investors will have to maintain enough funds in their brokerage accounts for the exercise to sell a cash covered put, so the upfront is the same. Option contracts are for 100 shares, the amount of shares in a reverse convert will vary by share price on the pricing date.

The key lesson for investors is you are really selling a put, not buying a bond when investing in a reverse convert. And your transaction costs are much higher than simply selling a put.

After all this, I asked myself is this the reason we needed to save the thundering herd of Merrill Lynch (BAC) and Morgan Stanley Smith Barney (MS)? Just like the Federal Reserve and Treasury are trying to recreate the shadow banking system, the full-service/high cost brokerages are trying to create the retail high-margin structured products business.

Reforms, what reforms?

Disclosure: Author is long BAC, BCS, C and WFC.

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