In a series of posts Mike at Rortybomb, James Kwak at Baseline Scenario and the usual suspects around the finance blogosphere excoriate financial innovators for producing products like reverse convertibles: an opaque financial instrument that serves to trick unwitting life science folks into selling puts.

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.

To the extent these instruments are being pushed on retail investors there is almost certainly some shadiness going on. However, who exactly are these retail investors that are wary of the dangers of puts but fooled by reverse convertibles?

Indeed, I thought the market had taken care of this problem a long time ago via an innovation known as ringtones. Ringtones allow me to know instantly that my mother is calling and indeed calling from her cell rather than home phone. This is the signal of a quasi-emergency. You see just a few months ago market irrationality tried to rear its ugly head and was duly swatted down by the ringtone.

I had instructed my mother that she was never, under any condition, no not even then, to buy a financial product that didn’t end in the words “index fund” or “Treasury Bond.” This time, however, she called with a sure deal. GM as I might already know was trading near $2. “It’s GM honey”, she exclaimed “I know it’s going to come back.”

“Well mother” I explained, “some of these people on Wall Street are almost as smart as I am.” This is the highest praise that she can internalize for in my mother’s world, no one is as smart as her son.

“If they think it’s not worth more than $2, it’s unlikely that you know something that they do not”, I said.

“I just can’t believe it”, she said.

“Well, ma stranger things have happened”, I went on

“Well, if you say so. Now, about your sister . . .”

And, thus another attempt at market irrationality was thwarted.

I say all of this in jest but there is a serious point. Who exactly are these investors that didn’t get the message about diversification and broad asset classes beaten directly into their head? What financial channel do you watch, what publications do you read, heck what friends do you have such that diversification is not gospel.

I find it hard not to believe that a simple retail investors buying these complex products doesn’t think that he is getting one over on Morgan Stanley, if not the world in general. Arguments about the distribution of Math PhDs notwithstanding, this situation is substantially less bothersome than one in which an innocent old lady is taken in by the brain trust at a big Wall Street investment bank.

Maybe I am wrong here and the allure of shinny and new is just too much for well heeled but poorly read retail investors to withstand. However, I’d like to see some real cases before I am convinced that this is more than a rehashed version of the Fable of the Bees.

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