Pointless Financial Innovation?

Over at Simon Johnson's Baseline Scenario blog, James Kwak wades into a discussion with a few other journalists about reverse convertibles. He asks:

What the hell is the point of this product?

He concludes, along with Felix Salmon, that it has none and that financial products that don't raise any capital should be outlawed by a possibly soon-to-be-created Financial Product Safety Commission. I'd like to disagree on both accounts, but instead suggest that if such a commission must be created, it should not outlaw any products. At most it should require licensing (to prove the risks are understood) before investors can purchase very complex financial products.

I hate to include such a long block quote, but Kwak does a good job explaining reverse convertibles:

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that's the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

1. The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the$10 in interest, which is probably more than the dividends you gave up.

2. The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it's a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.* (see note in Kwak's post).

3. The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

So what's the point? Well, from an investor perspective, you buy a reverse convertible if you believe the stock price will be above a certain threshold, but not substantially. I'm sure there are also ways a reverse convertible can be used as a hedge. Its usefulness must be clear to someone -- otherwise there would be no market demand for the product, and one never would have been sold.

Moreover, a reverse convertible actually seems like a pretty good alternative to buying the stock. The only scenario in which you're better off having purchased the stock is one in which the stock goes up pretty dramatically. So unless you were buying reverse convertibles of tech stocks in the late 1990s, chances are you have done pretty well with them.

I think this also shows that it's pretty unlikely that consumer safety is a concern. As long as the consumer understands the potential downside, which in this case results in owning the stock and receiving some interest, then I'm not sure what harm it could pose. After all, the consumer could have just purchased the stock instead, and not even have gotten the interest. Surely we don't want to make that illegal. As a result, this seems like kind of an odd product to choose to argue the point that the commission should outlaw some securities. Instead, why not just make sure investors understand what they're getting into, if you fear complexity.

But what about Kwak's point that such products don't serve as an example of Bernanke's criterion of financial innovation -- that they don't help to allocate capital where it can be most productive? He says:

This product isn't allocating capital anywhere - at least not to the company you are betting on. It's allocating your capital to the bank, which has one year to figure out how to make more money than it has to pay you back, but this serves the same allocation function as an old-fashioned bond (plus some additional risk). Or the bank might be an intermediary with another investor on the other side of the transaction, in which case you are simply betting each other and the bank is taking a fee.

A point about each scenario he envisions:

In the first, the bank must figure out how to "make more money," which presumably will require investing in some venture that likely has more risk, so to outdo the return the investor will receive. That means capital which the investor did not want in a very risk asset, might make its way there anyway, due to this financial innovation. Chances are this will also require a higher return than regular debt. Sounds like Bernanke would be okay with this.

In his second scenario, there might be two investors betting on opposite sides. This might not make Bernanke happy, but unless you are planning on outlawing virtually all swaps, options and derivatives, I'm not sure how this criticism matters.

It seems to me that truly useless financial innovation will be eliminated by the market already: if it's not useful, no one will buy it. If you want to regulate to make sure that investors are savvy enough to know what they're buying, that's fine. But to eliminate financial products just because bureaucrats don't understand their purpose seems like a bad idea to me.