The Contrarian

“In the investment markets, what everyone knows is usually not worth knowing.”

Financial Engineering 201

Matt Levine was a derivative trader at Goldman Sachs. He writes the following item on derivatives and how they can be used by companies as alternative way to borrow money.  It shows you that today’s market is about everything except true fundamentals. The tail is wagging the dog. Here is his article, originally posted on Bloomberg.

There is a solution that is very lovely, and GoPro, Inc., used it in the $150 million convertible deal that it announced yesterday, and I am going to tell you about it, but first I should give you a disclaimer. This is a thing that I used to do, or at least pitch, in my old life as a convertibles-and-derivatives banker at Goldman Sachs Group Inc., and I am very biased. These people are my people. (Maybe literally? The bankers on the GoPro deal are not yet public.) These are my derivatives. So when I tell you that all of this is lovely, you are entitled to have your doubts, and to think that I like it because I grew up with it and not because it is objectively beautiful.

Anyway, the solution is: You let the convertible arbitrageurs sell their stock short to the company through derivatives contracts. Mechanically, one of the banks underwriting the convertible sells GoPro some stock in a prepaid forward contract: GoPro gives the bank the money now, and the bank gives GoPro the stock in five years. Meanwhile, it is effectively short stock to the company. Then it does offsetting swaps with the convertible buyers, letting them get short the stock (without borrowing it). So they get cheap short exposure, which lets them hedge the convertible, which lets them buy the convertible.

One obvious downside is that the company needs to spend a chunk of the money from the convertible buying back stock, which means that it doesn’t get the full $150 million from the convertible. (So this particular strategy is most popular for companies that really want to buy back stock and don’t really need cash; Herbalife used it a few years ago, and we talked about it then. Incidentally this and related strategies are sometimes called “Happy Meal” convertibles, because they come with a bunch of toys I guess.) But even if GoPro is spending $80 million to buy back stock — a number that I just made up — then it’s still getting $70 million from the convertible, $70 million that it might have more trouble raising in other markets. GoPro is effectively selling a convertible and buying back the stock-price risk, leaving investors with the volatility risk. But it’s getting paid tens of millions of dollars for the volatility, which it couldn’t sell otherwise.

Another downside is that GoPro is helping people short its stock, which is an awkward look. (There have been lawsuits over similar sorts of trades, on the theory that the banks who do them really want to help out shorts, not convertible arbitrageurs.) But this shouldn’t trouble you too much, not only because the short sellers are convertible arbitrageurs (who are really long the company, over all), but also because they are shorting the stock to the company.

So there won’t be net selling pressure into the market; in fact, depending on the exact mechanics, this trade may cause the underwriters or convertible investors to buy stock in the market while the convertible is being priced, pushing the stock up.

You might take a look at the press release, which is not really written for human consumption. This stuff looks bad and hard and complicated and tricky. It’s definitely financial engineering. Derivatives sure are involved.

And yet it’s a clear case of financial engineering solving a real problem: A real company, with a real business, that might have a hard time raising money in traditional stock or bond markets, can raise money by diligent application of financial magic. GoPro has volatility to sell, and its bankers came to it with a way to isolate that volatility, package it neatly, and sell it for millions of dollars that it can use to make waterproof cameras or whatever.

GoPro has found a way to transform volatility into cameras. How can you deny that that’s beautiful?

Our comments: If you fully understand the technique described above, you should get a high-paying job on Wall Street. Several years ago in Dubai I met one of the top derivative people of the former Lehman Brothers when it went bankrupt. I asked him, if the top executives at the Wall Street firms truly understood the exposure of all the fancy derivatives their firms created that eventually triggered the global crisis. He said he didn’t think so.

And that is the problem now, except it’s probably 10 times bigger because the derivatives are much more complicated than at the last top.

You can read more of our current analysis and forecasts on the global stock markets, bond markets, and global economies in our award-winning WELLINGTON LETTER, now in its 40th year.

Visit DohmenCapital.com to learn about our other services exclusively for serious traders and investors.