Thursday, July 21, 2011

In the News: UBS & Morgan Stanley Subpoenaed over Reverse Convertibles

UBS, Morgan Stanley Subpoenaed Over Reverse Convertibles

Bloomberg news reported today that the state of Georgia had sent subpoenas requesting for data and other information from UBS AG, Morgan Stanley and Ameriprise Financial Inc.. The state is investigating whether these brokerage firms violated the securities laws of Georgia in their sale of reverse convertibles to investors of Georgia.

Sales of reverse convertibles have grown, and investors who are being sold these structured products include the elderly and those with little money. The brokers are required recommend products suitable to their clients, must not omit material facts about the products, and firms are required to establish and maintain adequate supervision and training of their brokers. These are just some of the obligations recommended under Financial Industry Regulatory Authority’s (FINRA) guidance notes on the sale of structured products.

Suitability is hugely important when the product is complex but the target investors – such as the elderly and those with little net-wealth – are unsophisticated.

What, then, is a reverse convertible?

A reverse convertible note is a type of structured product that is linked to an equity security or an index. It is a short-term note that pays a relatively high coupon rate compared to traditional notes. The returns of the note at maturity depends on whether the equity, called ‘reference asset’, falls below a pre-specified trigger price during the term of the note. If it does, then the note returns the market value of the number of shares of the reference asset which could have been purchased on the note’s pricing date with the note’s face value. If it does not, then the note returns its face value.

SLCG has written a paper on the topic including a paper that values and analyzes a large sample of reverse convertible notes. We find that these notes are largely and consistently overpriced, yet reverse convertibles continue to be sold which, combined with the complexity of and the lack of a secondary market for these notes, implies that investors do not fully understand the returns and risks of these notes.

In short, a reverse convertible is a complex product and unsophisticated investors must make every effort to understand the hidden costs, risks and terms and conditions of such a product before being persuaded by brokers to purchase a structured product such as the reverse convertible.

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