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“There’s A Good Awareness Of Risk”: Davos

Bundled Garbage

Oh yeah, this is rich….

Goldman Sachs Group Inc. (GS) President Gary Cohn warned of a potential drop in fixed-income prices as bankers and policy makers in Davos celebrated surging demand for financial assets.

….

“Markets are really giving the sign that progress has been made,” Martin Senn, chief executive officer of Zurich Insurance Group AG, said in an interview after a meeting of bankers and policy makers including Italian Prime Minister Mario Monti and Bank of Canada Governor Mark Carney. Senn said that he and his colleagues have to avoid becoming “complacent.”

“I’m not concerned at this point of that because there’s a good awareness of the respective risks,” he said.

Uh huh.

Let me give you one example of how this “awareness” has played out, and how foolish some people have been.

Back in the late 200x time frame there was a very popular product in the form of “notes” sold by various institutions that were linked to other things.  These typically had above-market coupons and were basically debt of some form, although not all.  One of the more-popular was this bastard Satanic spawn called a “principal-protected note”, which promised to pay the original value (that is, it had no risk of loss) but also had a potential gain associated with it.

The fine print was that the “protection” was only valid if you held the note to maturity; since these traded, there was no guarantee of their value at any time other than when the issuer was obligated to make good on the original terms.

If you’re not seeing how you got your head cut off, you’re not thinking: What happens if the issuer no longer exists?

Why then you might get zero, of course.

That’s exactly what happened with Lehman.

There has been this funny dearth of people willing to buy this crap post-Lehman, and one doesn’t have to wonder much as to why.  But the banksters are never satisfied; oh no, they just target something else.  In one of the more-recent cases what they targeted was Apple.

It worked like this:

You bought a debt instrument that paid an 8% coupon.  In today’s market this ought to have set off massive alarms in your head; with zero-interest rates who the hell borrows at 8% except someone who’s about to go bankrupt? 

Well, in this case what the seller (typically a large bank) did was take your money and use it to hedge Apple stock.  But in the middle of the agreement was a cute little game; if the price declined below a set point the so-called debt instrument became a convertible and guess what — you are long the stock with a basis of $700/share!

This is commonly known as “Heads you get a small piece of the gains, tails you get bent over the table and reamed for the whole loss.

The worst part of it is that you pretty much have to hold the instrument until maturity.  Oh sure, you can try to sell the instrument to someone.  Good luck — many of these things are off more than 25%.

The bank of course has no way to lose in this transaction.  They guaranteed that by how they structured the deal.  Let me explain.

One example outlined by the WSJ is an offering by UBS last September.  The face value of these one-year notes was $700.71, roughly Apple’s closing price at that time.  The notes pay an annual interest rate of 8.03% — radically higher than anything you can get in a short-term bond fund, or, for that matter, in any sort of reasonably-safe short-term bond!

The are supposed to pay the full value in one year, with one exception — if Apple’s stock price is under $595.60.  In that case you get a share of stock instead — even if it’s worth $200.

Oops.

This is pretty much identical to selling PUTs naked.  When you sell a naked PUT you get the money now, but if the price declines below the strike you can be (and will be, at expiration!) “PUT” the stock and forced to own it at the price you negotiated in advance.  I do this from time to time — in the middle of the crash I sold a metric crap-ton of GE $5 PUTs naked.  Had GE gone to zero I would have had my head cut off, being forced to buy the stock for $5/share no matter what it was subsequently worth.  My bet was that the stock would touch $5 (or even go below it) but that the company would not go under; I wanted to get assigned.  Unfortunately it didn’t happen and I made a little money on the premium.  I say “unfortunately” because if it had happened and I got assigned I would have hit a grand-slam out-of-the-park home run, given that GE stock trades today at over $22!

The important point about selling naked options, however, is that you have to be a pretty-sophisticated trader to be allowed to do that because there is a monstrous degree of risk associated with them.  You have to convince your brokerage that you understand the risk associated with this sort of strategy and that you’re willing to accept the loss, if it happens.  In the GE case each option is 100 shares of GE; if you sell 1,000 naked $5 PUTs you can be forcibly long 100,000 shares of stock at a cost of $500,000.

If the stock goes to zero you lose the entire $500,000!

Of course Apple never goes down in price, right?  And all the sell-side analysts were tripping over themselves predicting $1,000+ price targets as recently as last fall.  And these notes were a nice way to make 8% for a year in a zero-yield market.

Right?

So people thought.

Now the question becomes this: How full and fair was the disclosure on these things, and were they sold only to sophisticated traders who were well-aware of the damage that such an investment could result in? 

Second question: If you were aware of this and were sophisticated enough to be trading these things, why didn’t you just sell the PUT? 

In other words: Why would someone buy this vomit from the bank at all?

Here’s the reason I ask — on that date you could have sold naked a $595 Apple PUT for $48.95.  Note that the UBS “investment” carried a 2% fee, had to be held to maturity, and the coupon was good for $56 in interest.

So your total potential “return” on the UBS “note” (their synthetic PUT, natch) was $56 – $14, or $42.

But you could sell the $595 Apple July 2013 PUT directly for $48.95 and take exactly the same risk of winding up long the stock, and in addition you could exit that PUT any time you liked by buying it back if you decided to, or you could take the assignment if it happened and immediately dispose of the stock, stopping the bleeding.

So let’s assume you bought this spawn of Satan.  UBS probably turned around and sold the PUT and they got the use of your money in the interim for free!

They pocketed a guaranteed $6.95 or about 1% no matter what happened and you got screwed no matter what happened.

If the stock went up — or was over $595 in price — you got rooked out of about $7 you should have kept.  But given what actually happened you got assraped because not only are you going to take the loss on the stock you can’t exit early and stop the bleeding.

In short I can’t come up with any financial reason for any savvy investor to actually buy this product.  Therefore, I am forced to conclude that it was sold to people who aren’t savvy, as a literal one minute session looking back at the price of the options on that day disclosed the above to me.

By the way, that PUT is worth $155.39 today, which means that there’s an embedded $106.44 loss in it, assuming you buy it back.  That’s about 15%, which is really bad.  What’s worse is that the WSJ article says if you bought these notes as of today you’d lose at least twice that much.

Then there’s the other risk — if UBS goes out of business I bet your “note” is an unsecured debt and you’re likely to get zero for it.

This sort of crap ought to be against the law.  There is no rational argument for buying this product in the marketplace given that anyone sophisticated enough to understand the risks involved could have, within seconds, purchased something with a similar profile of risk that earned a higher total return for a shorter duration of risk — in this case, the risk ran only until July instead of September. 

That alternative was not hidden, it was not difficult to find, and any sophisticated investor would know where to look for it.

It must thus be assumed that the persons who bought this were (1) unaware of the options market or (2) unqualified to trade in that market in this fashion.

So why is it that there’s a market for this garbage again?

It sure as hell isn’t because sophisticated investors will intentionally take materially less return than they can otherwise obtain — in this case, about 15% less — right?

The Market-Ticker

Discussion (registration required to post)

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Rather than continue to purchase such “creative financial instruments” from the banking sector, which only (as intended) ever benefit the banks, we should have let our insolvent banks fail…

MEP Daniel Hannan, while engaged in the Occupy Wall Street Debate at The Oxford Union Society, would seem to agree…

STOP THE LOOTING AND START PROSECUTING!

FedUpUSA

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