Baseline Scenario

The Baseline Scenario
More Financial Innovation
Posted: 17 Jun 2009 04:30 AM PDT
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:
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.
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.*
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.
By James Kwak

Regulatory Reform For Finance: Three Views
Posted: 17 Jun 2009 02:43 AM PDT
There are three views on who exactly is behind financial regulatory reform package that will be officially presented Wednesday lunchtime (update: NYT.com has the draft). Each view has distinct implications for political dynamics going forward.
The first view is that Tim Geithner and Larry Summers have genuinely become radical reformers. They see the error of the ways they pursued during the 1990s – both in terms of financial deregulation for the United States and in their advice to other countries, particularly through the capital market liberalization policies urged upon the IMF. They now seek to put globalized finance back in its box and will pursue any sensible means possible to this end.
This view is not widely held.
The second view is the consensus: Geithner and Summers want a minimal degree of reform with a great deal of window dressing. This interpretation is supported by the fact that most of the specifics with regard to large financial firms look like moderate technocratic tweaks, i.e., hardly what you’d expect in the aftermath of what the President himself called, “the worst financial crisis since the Great Depression”.
It’s true – and always pleasing to officials – that you can get a nice media bump with background briefings on all the effort that has gone into the proposals. But honestly, what in the administration’s proposals is strong enough to have prevented this crisis, let alone preempt the next crisis which, by all indications, could be even larger – now that big financial players know for sure they are too big to fail?
The administration could have taken over Citigroup – e.g., placing it into negotiated conservatorship – at several points in the last nine months. It did not. Draw your own conclusions and think for a moment about how this will influence future actions in the financial sector.
The third view is more interesting and also controversial: Geithner-Summers have exercised an effective veto over measures that would have constrained large firms directly, but they are not at this time strong enough to prevent sensible consumer protection measures from also going forward.
In this view, someone (Cass Sunstein?) and his/her allies have managed – at least so far – to promote the idea of a consumer protection agency focused on financial products. The details are not yet clear enough to see how what will emerge, and we also don’t yet know how vigorously Treasury will defend this idea against the financial sector lobbies. But at least this is something new and potentially powerful in all the right ways.
Sunstein, of course, is known for the idea of a Nudge – pushing consumers ever so gently towards better decisions. It’s a fine principle to guide thinking, but lobbies, opponents within the administration, and members of congress with their own agenda will not be moved through gentle means.
This is going to be quite a fight.
By Simon Johnson