Saturday, January 8, 2011

Pssst psssst Hey kid, wanna buy a bridge?

Whether by fate or the mother of all %%$%#%, the day I decide to start blogging, Bloomberg LP decided to run a story on the same topic. Read my post with the link to the story here . Maybe there's more to the cookie tracking than we are being told huh? (Or maybe there IS something to be said for tracking cookies). - Hey, one can dream, right?

As I sit here poring over SEC filings, I came across a listing by Morgan Stanley, also selling a derivative on Bank of America’s (BAC) future performance.  I chuckled as unbeknownst to the sheeple clients that are being peddled these “instruments”, they are engaging in volatility trading.  Now most people think volatility is bad, but volatility is what makes the party. 

Think of volatility as the arc of a child’s swing, gentle pushes produces mild euphoria, perhaps a giggle or two.  But to get the squeals of joy/terror dependant on age of child, you would have to increase the arc/volatility of the swing.  Now think what catalyst creates the change in volatility or rate of swinging. Usually it’s a bigger, stronger person or in the case of BAC, the bevy of legal issues that awaits it as the year progresses.

That was rather a simplistic explanation, and before I get rapped by the cognoscenti, if normal distribution, Gaussian distribution, bell curve – all three mean the same thing, your swinging should be nice and symmetrical - , if skewness (in the swing analogy, how far you swing from the middle, ask yourself, do you swing back as high as you swing forward?), if kurtosis( the amount of times you swing to the same height/spot) and if fat tails(the one or two or three time you swung your kid to an angle not recommended by the swing manufacturer) leave you glassy eyed or asleep?

Stick to buying mutual funds. They really aren’t any better but we’ll save that for another discussion.   

The security being sold is a three year 10% to 12% Contingent Income Auto-Callable Note due January 25, 2013 based on the Performance of the Common Stock of Bank of America Corporation. The 80% threshold level is the contingent part; the stock must not be under that threshold on “re-spin” days. These dates are April 22, 2011, July 22, 2011, October 22, 2011, January 22, 2012, April 22, 2012, July 22, 2012, October 22, 2012 and January 22, 2013. 

If the stock price is below issue price but above threshold you will receive seven quarterly payments of 2.5% to 3% on the issue price of $10.  There is also an “early escape clause in case we miscalculated” that says if on one of the seven magic days, BAC is above the original offering price you will be repaid your investment plus the quarterly fee due. Game over.  We're taking our ball and going home. Having the temerity to win, is just not good form.

So, as long as BAC does not fall more than 20% over the next 3 years AND does go above the reference price you will be paid $0.30 quarterly for every $10 invested, except it would not be $10 as you paid 2 % in fees. In reality, you would be earning only 1% on the first payment as you have to fill the 2% hole. Should the price be below the threshold on any date, you get no coupon AND you get to keep playing! Joy oh Joy!!  Oh, and because you are only using BAC as a proxy and not really investing IN BAC, you do not “participate” in any appreciation in BACs price. 

But this is the best part – if on the 7th magic day, 7th heaven? Isn’t there a story somewhere about 7 virgins? I digress. If on the 7th magic day, the price is below the threshold, you get to “participate” in the DEPRECIATION of BAC. If the price is down 25% - you will receive 25% less than you put in. So no price appreciation participation, but what you DO get..., is the opportunity to spin the barrel and pull the trigger, SEVEN TIMES. With a SIX shooter!  
How you like them apples?

Still with me? I hope so, as it gets better. Lets recap, to earn a yield for the quarter, BAC has to be under the reference price - 20% max on the specified date. More than 20% and you get bupkis, however you get to spin the wheel again for the next quarter.  If, however on the specified date BAC is higher than the reference price, your investment is returned with that quarter's payment. 

 I read further and was astounded at the disclosures and pondered what would cause someone to discount them and to invest in an asset that, and I quote:
  • ·         We may engage in business with or involving Bank of America Corporation WITHOUT regard to your interests.
  • ·         Hedging and trading activity by our subsidiaries could potentially adversely affect the value of the securities.
  • ·         The U.S. federal income tax consequences of an investment in the securities are uncertain.
So, basically this is three card Monte, Wall Street style. You win, I take my ball and go home. It’s a draw? Fine let’s keep playing until you lose or better yet until I scr** you. But if I don’t, I’ll sic my uncle on you. Pretty gangster huh? La famiglia could learn a thing or two here.

Think about it, would you fly on an airline that has this disclaimer: Come fly with us, but don’t let the fact that our pilots aren’t trained bother you. They’re cheaper than hiring “real” pilots.

It seems that investors are making the same poor investment decisions as before, likely caused by a combination of behavioral mistakes (fear and greed) and a lack of education and sophistication necessary to properly evaluate these complex instruments. Investors underestimate the risks of equity investments, and in particular, the risks of individual stocks. 

The one thing we can be sure of is that financial institutions will continue exploiting investor mistakes innovating. The complexity of financial investments is designed in favor of the issuer, not the buyer.

Caveat Emptor!


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