James Kwak, Felix Salmon, and other smart folks are jumping on the anti-financial-innovation bandwagon. This time their target is reverse convertibles, unflatteringly profiled in a recent WSJ article.
Salmon calls reverse converts a “scam” and suggests they should be outlawed by a Financial Product Safety Commission. “What the hell is the point of this product?” asks Kwak. And if they are as pointless as he alleges—or indeed a scam—then maybe there’s a case for prohibiting them.
The reality is the products are, contrary to Kwak’s assertions, not that difficult to understand. They are cash-secured put options, basically a form of insurance whereby someone can pay a premium to unload the downside risk of owning a stock (such as Apple). They are so much like insurance that it explains why Mr. Geico himself, Warren Buffett, has been selling put options. So if insurance is pointless then Kwak has a point.
This is no brief for the brokerage houses. It is entirely possible some people have been “scammed,” as Salmon puts it. But it’s also possible that, as Donald Davret says in the WSJ piece that started the backlash, “Clients like to pretend they’re stupid when an investment loses money.” Our existing regulators should look into credible allegations of fraud. And maybe there is room to rethink how these products are regulated, under whose jurisdiction the regulation falls, and so forth. But there’s no need for a Consumer Product Safety Commission for the financial services sector to start banning products that are of value to many but distasteful to some.