More reverse convertibles: cutting the nose to spite the face?

June 18, 2009 in Finance

Felix is back at the forefront of the "ban reverse convertibles" charge. He makes some salient points, but continues to encourage a slippery slope form of regulation that would ultimately handicap an industry to protect the naive daytrader.

Referring to embedded short options in general, he notes:

But retail-facing financial instruments should never embed such bets, because retail investors, as a rule, lack the sophistication necessary to be making such bets in the first place.

I suppose then that we should ban nearly every corporate bond (which contain embedded short calls at par), as well as the practice of "covered calls" (broker-jargon for a collateralized short put)? In fact, why not ban levered ETFs as well, since they are mathematically destined to wind up worthless? You can't ban products just because someone isn't capable of understanding it. Imagine if all industries bent to the will of the most naive user!

He continues:

Fernando looks at those investors and says it’s “their responsibility to be skeptical buyers”. No. It’s the stockbroker’s responsibility to act in the investor’s best interest, and it’s the government’s responsibility to prevent the sale of products which can end up being extremely damaging to those who buy them. As Elizabeth Warren famously says, no one has a problem with the government banning the sale of dangerous toasters, and dangerous financial products cause much more damage than dangerous toasters ever do.

Who is still foolish enough to think that their broker's interest is in "looking out for them" as opposed to "selling stuff to make a commission"? And as for toaster ovens, well, it's very easy to describe a bad toaster oven - it spontaneously combusts, or in some way fails to do something other than its stated purpose of charring bread. How can we tell if a financial instrument is deviating from its stated purpose? What is its stated purpose in the first place?

Imagine getting a call from your broker, saying that, "The stock you bought has dropped too much, so we're going to refund you everything you invested because this isn't how stocks are supposed to work." That would be great - unless you were on the other end: "You sold stock to us, but it's gone down a lot and we're going to need you to reimburse us, since we didn't buy it with the intention of losing money."

Felix concludes:

The fact is that reverse converts, in particular, are the kind of product which can cause a great deal of harm; what’s more, they exist entirely so that banks can use their stockbroking arms to rip off their clientele. Banning them would do much less harm than selling them. So let’s ban them, and their ilk.

I can't think of any product that doesn't have the potential to cause "a great deal of harm." Stocks, bonds - just about anything except a Treasury note (and even there...) can hurt investors. And as for the "exist solely" part, what exactly does Felix think stockbrokers do? Transaction costs are famously egregious! Oh, that's right, he thinks they look out for the interests of their clients and try to protect them.

Basically, Felix's plan is to ban anything that could hurt a naive investor. I have a better idea: ban naive investors from products they don't understand. This has worked rather well with CDS: only qualified institutional investors may trade the product. In fact, there are many examples of products which require institutional status to trade. There is no need to cut off the nose to spite the face by banning certain products rather than simply restricting access.

Besides, let's be honest, if you ban one bad product another will just pop up to take its place. The world is full of double-knock-in snowball ratchet options, and there's always another salesman waiting to pitch them.

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