Here’s a Wall Street Journal article about a Securities and Exchange Commission investigation into “whether Bank of America Corp. (BAC) broke rules designed to safeguard client accounts” by doing “an array of complex trades and loans” with clients.
Generically, I delight in this sort of thing, but specifically, I don’t know what those complex trades were or how they worked. But here we are on the Internet, so let’s not let that slow us down. Instead, let’s just reason the trades out from first principles.
We do have one important clue, which is that “one variety of the strategy, launched around 2009, was called ‘leveraged conversion.’”
Let’s just start with the name: “leveraged conversion.” Sheldon Natenberg, who wrote a good book on options, defines a conversion as a trade “where the underlying contract is offset by the sale of a synthetic position”: buy stock, sell a call, buy a put with the same strike price. Schematically:
“Leverage” also has a well-known meaning. It means borrowing money. The Journal says that, “A small team from Bank of America’s equities desk recruited a handful of clients, including wealthy individuals, to put up token amounts of their own money — a few million dollars in some cases — and in exchange receive loans of nearly 100 times those amounts.” So a leveraged conversion would be: take a loan, use it to buy stock, then sell a call and buy a put. Schematically:
So Bank of America Merrill Lynch lends the client money. The client uses the money to buy some stock. The client also buys a put option, protecting the downside of the stock, and sells a call option, giving up the upside.
Now that we’ve built a leveraged conversion in our imaginations, let’s collapse it. First of all, let’s deal with this put and call. The point of a conversion is, as Natenberg says, to offset the underlying thing (the stock) with “the sale of a synthetic position.” The put and call have the same strike price and expiration, and combine to create a “synthetic” forward sale of the stock.
In a conversion on Apple, you might buy Apple stock for $129 a share, sell your bank a call with a strike price of $130 and buy a put from your bank with a strike price of $130. The put might cost you about $5.25 a share, and the call might bring in about $4.30 a share. 1 You’ve spent $129 on the stock and about $1 net on the options, for a total price of $130. Then you wait a few months or whatever, and the put and call expire. If the stock price is above $130, the bank will exercise the call you sold it: The bank pays you $130, and you give the bank the stock (which is worth more than $130). If the stock price is below $130, you will exercise the put you bought from the bank: The bank pays you $130, and you give the bank the stock (which is worth less than $130). 2 Whatever happens, you end up with (1) no stock and (2) $130, which happens to be the amount you spent up front. 3 You just have to wait for the options to expire.
The put and the call together are commonly referred to as a “put-call combo,” and look just like a forward sale. Graphically:
(Remember to flip the call graph upside-down because you’re subtracting it!) So now our leveraged conversion is simplified a bit. Substituting:
We can keep going. The client has bought some stock from the bank now and has agreed to sell it back to the bank later. What is that? Well, there is a commonly used name for what happens when you buy a thing and immediately agree to sell it back in a little while. The name is “repo,” short for “repurchase agreement,” because that’s what it is: buying a thing with an agreement that the seller will repurchase it.4 One well-known fact about a repo is that it is a loan: The initial buyer is lending money to the initial seller, secured by the stock that the seller delivers to the buyer. This is such a well-known fact about repo that repos are normally accounted for as loans, not sales and repurchases.5
This trade is not exactly a repo, but it has the same structure (buy stock and simultaneously agree to sell it forward). So now we have: