Common Sense from Ben Stein (NY Times)

March 30, 2008
Everybody's Business
Time to Go on a Liquid Diet
By BEN STEIN
AS the market keeps torturing us, many people say the problem is fallout from the losses in subprime mortgages. Others say it is fear of a recession because of the credit crisis, rising oil prices and the collapsing dollar and its flip side, inflation.
We could be in for much more pain as profits fall this year, and maybe even into 2009. Financial companies account for a huge hunk of total corporate profits — or they did.
And we could be in for more suffering if the currents of fear whipped up by the short-sellers grow into tidal waves.
Markets can certainly fall: from 1926 through 2007, the Standard & Poor’s 500-stock index fell 3 out of every 10 years. Some declines can be substantial. And there can be times like the 1970s when the market is sluggish for cruelly long periods.
As we are now seeing, real estate is far from a consistent shelter. And, for many of us, there isn’t much time before we’ll want to hang up our spurs. (Actually, I don’t ever plan to hang up my spurs. I plan to die going through an airport security line en route to a speech.)
So what do we do? I am going to be honest here: I don’t know. Or at least I don’t know for sure. (Hey, honesty may not be the best policy, but it’s worth trying every once in a while, as my old chief, Richard Nixon, once said. He had a much better sense of humor than is usually believed.) But I do have some general considerations that should guide you.
No one ever went broke from too much liquidity. In volatile times like these, cash is your best friend, aside from your dogs and cats. True, you earn very little interest on cash these days. True, if the stock market has a huge move up and you are largely in cash, you will be sad.
But it is also true that cash does not crash — although it does slowly but surely lose its value. You can pay your bills with it without having to sell it at a loss. So, as my pal Ray Lucia, the San Diego money manager, has taught me over the years, your first bucket of money should be in cash.
Having a plan is vital. It does not have to be a perfect or precise plan. Indeed, it cannot be, because you cannot forecast your rate of return or cost of living. But a rough plan to get you to and through retirement (to the Rainbow Bridge, where you meet all your departed dogs and cats) is a must.
Nowadays, alas, such a plan must consider the likelihood of much higher inflation than we had expected, as imports and food costs skyrocket. And we have to plan for the possibility of prolonged low returns from stocks. That means more saving.
Third, we have to be diversified: large- and small-capitalization stocks, foreign and domestic, emerging and developed markets. My own preference is for index funds, but there may be some fine managed funds out there, too.
Diversification should also include real estate investment trusts, with their fabulous yields, and commodities, which can easily be bought through index funds. Commodities may well have hit an air pocket, as commodities do, but they will be back someday.
My preference for a plan would also include guaranteed income that you cannot outlive — and that means annuities. There are now fixed annuities and variable annuities that give you inflation protection as well as protection from a collapse of the stock market. Of course, you have to pay for this, as you would for any hedge, but it can allow you to sleep better. Investigate the fees carefully and buy only the features that you want and need.
Fourth, plan for living more frugally. This is not easy for some of us. “What were once vices are now habits,” as the Doobie Brothers once said. This is true for millions of us, but we simply cannot escape the logic and power of arithmetic.
We cannot live forever on more than we have in principal and interest (or earnings ) and pensions. If that means no more second homes, or no more third cars, so be it.
No comfort is worth putting yourself in genuine fear of poverty. For me, your humble scribe, this is a vicious problem, but at some point, it must be solved.
But look on the bright side. My pal and investment guru Phil DeMuth and I have shown repeatedly that the best returns for stocks come after periods of extreme pessimism. It is just when the horizon seems darkest and cloudiest that we find above-par returns. And it is just when hopes seem dimmest for the United States that the economy starts to rally. If you have enough liquidity, if you are well diversified, now would be a good time to start back into the buying pool, in the most diversified way imaginable.
The best time to go house-hunting may be when pundits say the housing market is hopeless. That market, too, will eventually turn around. Many homes bought decades ago, when prices seemed insanely high, are now a steal. If you do buy a home, be patient. The days of flipping for easy money are long gone.
Prudence is the order of the day. If we can remember that, we’ll really be well off when, soon enough, the good times start rolling again.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.

Unregistered Securities & Sellers AKA Scams - just one story from NY Times

March 30, 2008
An Oilman Entices, and Investors Cry Foul
By JULIE CRESWELL

LIKE so many of the over-the-top birthday parties that typically appear on “My Super Sweet 16” on MTV, Ariel’s celebration took the fairy-tale-princess theme to new heights.
Horse-drawn carriages delivered teenage guests to a faux-castle tent where they were met with dancing jesters and disco lights. The birthday girl, wearing a white dress and tiara, flew in via helicopter. And the evening ended with fireworks and the arrival of Ariel’s gift from her father: a brand new BMW 325i.
As viewers learned, Ariel’s dad was a successful oilman. “I love oil. Oil means shoes and cars and purses,” Ariel exclaimed to the camera as she and her father stomped around oil drilling sites in the muddy hills near her home in Campbellsville, Ky. When her father pointed to one of the sites and told viewers that it produced 120 barrels a day, Ariel asked, “How many Louis Vuittons is that?” Her father’s answer was “a bunch.”
The show typically attracts younger viewers, but this particular episode, shown in February 2007, caught the attention of an entirely different demographic: government regulators.
Ariel’s father was Gary M. Milby, a man regulators now say was bilking hundreds of investors across the country out of millions of dollars by offering fraudulent investments in nearly 30 oil and gas limited partnerships with names like “Black Gold Oil No. 6” and “Fort Knox Oil No. 8.”
Last fall, the Securities and Exchange Commission filed a complaint accusing Mr. Milby of raising more than $19 million from 375 investors over about a year and a half, starting in February 2005. At least $12 million was diverted into offshore accounts and family trusts and millions of dollars was spent on Mr. Milby’s lavish lifestyle, the S.E.C. said in its complaint. Mr. Milby denied all of the accusations against him.
“That MTV show really put Milby on the road map,” said Frank Panepinto, a fraud investigator with the Louisiana Office of Financial Institutions. “That really got people aggravated with him.”
These days, with oil prices topping $100 a barrel, investors are scrambling for a piece of the latest gusher, and schemers and con artists seem to be eager to help them out. An association of state securities regulators said there were 260 open investigations into oil and gas scams across the country in early 2007. Updated figures are not available, but regulators say complaints continue to pour in.
“I bet you right now that I have over 20 oil and gas cases that I’m looking at involving unregistered securities and unlicensed people selling this stuff,” said the Colorado securities commissioner, Fred J. Joseph. “A year or two ago, I doubt that I had five cases.”
As suspect energy investments go, Mr. Milby’s offerings are pretty standard. Through private placement offerings, he sold units in limited liability partnerships managed by two companies he owned, Mid-America Energy and Mid-America Oil and Gas, that would use the money for shallow drilling mostly in Kentucky. Investors were told that they would receive monthly checks for as much as $4,800 for 30 to 50 years, according to the S.E.C., which said Mr. Milby bragged to some investors that “no one who has invested with me has ever lost money.”
What Mr. Milby didn’t tell investors also spoke volumes. He had filed for bankruptcy in 2003, and in 2005 and 2006 several states had banned him from selling securities, the S.E.C. said. The agency also said that Mr. Milby was barred from drilling in Texas and that the Kentucky counties where he was drilling had never produced enough oil to support his lofty claims. And, while some individuals received modest dividends from partnerships managed by Mr. Milby and the Mid-America companies, no investors ever recouped their entire investments, the S.E.C. said.
Mr. Milby’s story illustrates the limits of state securities regulators, who cannot keep a suspect operation from seeking investors in other states — and struggle to enforce bans even in their own states. For months, Mr. Milby continued to seek out investors across the country, even though several states had filed cease-and-desist orders against him.
Regulators in Tennessee, where Mid-America Energy was registered, did not issue any public warnings against the company despite numerous complaints from investors. Leslie A. Newman, the state’s commissioner of commerce and insurance, said that issuing a cease-and-desist order would have prevented the state from aiding in other investigations, such as the S.E.C.’s.
“There is still federal activity ongoing in this case,” Ms. Newman said. “Other agencies with criminal authority are still actively pursuing this case.” She declined to say which agencies were involved.
To date, Mr. Milby faces just one criminal charge, a count of felony fraud in a Louisiana parish.
Some federal prosecutors say they lack the resources to chase after every allegation of an oil and gas scheme.
“These are complex cases that take a lot of investigative time, and there’s just not a lot of investigative resources in this area right now,” said David L. Huber, the United States attorney for the Western District of Kentucky.
“The No. 1 federal priority right now, criminally speaking, is terrorism,” said Wynne James, a lawyer at Waller Lansden Dortch & Davis in Nashville, which is representing about 75 investors in multiple lawsuits filed against Mr. Milby. “You ought to feel somewhat comforted that the feds will drop everything to go after terrorism, but other things suffer for that.”
The group has so far won more than $5.1 million in its cases against Mr. Milby, who did not respond or defend himself in them. The investors, however, have not collected any money.
Mr. Milby and one of his lawyers, Hunter Durham, said that all material information was disclosed to investors, that several wells that were drilled did hit oil and that participants received some returns on their investments. Both declined to make any individuals who had made money with Mr. Milby available for interviews.
As for the lavish MTV party, Mr. Milby says that one of his former wives (he has been married five times, twice to the same woman) picked up the bill and that he paid for only the fireworks. As for the BMW, he said he traded in another car and paid the price difference, $4,500, out of his own pocket. Efforts to contact the former wife were unsuccessful.
“If investors think I’m stealing their money, they’re wrong. I’m broker than a church mouse right now,” Mr. Milby said. “We spent and spent and spent, and borrowed and borrowed and borrowed, just to keep these wells going.” Nonetheless, he added, the wells have been shut down and are not currently operating.
WHEN oil is hot, Mr. Milby is an oilman. He said he became involved in the oil business in the late 1970s, drilling for himself or local Kentucky investors.
“When oil went on its tail in the 1980s, I sold cars, sold insurance, sold anything I could to make a living,” he said with a thick drawl.
While the S.E.C.’s complaint involves activities beginning in early 2005, Mr. Milby had returned to the oil patch a year earlier as oil prices started to rise.
In January 2004, he and Terry Goff, whom Mr. Milby describes as a former business partner and friend but whom several former investors and business associates said Mr. Milby often presented as a cousin, were drilling for oil in a remote spot about 25 miles south of Abilene, Tex.
Ronda Hyatt, a local geoscientist hired to monitor the drilling, said: “They had gotten a farmer to lease them a piece of land. But it was really strange. They picked the most difficult location you could on this place. You had to scrape off 20 feet of dirt before you could start drilling.”
Mr. Milby was eager to drill more sites. Eventually, Ms. Hyatt directed him toward a site called Crockett-Owens in Texas, which Ms. Hyatt said had high potential but would require a lot of capital and take years to develop.
Mr. Milby was hooked. He bought the option for the lease in April for $25,000 and immediately began raising money to drill the wells.
In August 2004, Pamela and David Hallin met with Mr. Milby for lunch at a hotel near their home in Memphis. Ms. Hallin had been impressed with a presentation Mr. Milby had made at an asset allocation seminar a month earlier, and the couple were interested in investing. Mr. Milby was hoping to raise $1.4 million for drilling, private placement documents stated.
Mr. Hallin, then a pilot for FedEx, said the couple thought that they had done their homework. “We called all of the references he listed, including his banker, and she said there were no problems with him. That he was in good standing,” Mr. Hallin said. By the time lunch was over, the couple had handed over a check for $84,000.
Soon after, though, investors like the Hallins had cause for concern. Mr. Milby and Mid-America hired Ms. Hyatt and her business partner to oversee the drilling and repair work on the wells at the Texas site. As she became concerned about vendors’ bills that were going unpaid, Ms. Hyatt also began to hear from investors complaining that they had not received their promised checks.
In October, Ms. Hyatt gathered the Crockett-Owens investors, including Mr. Hallin, in Memphis. There, she told them she thought the money was gone. Shocked and in disbelief, the investors decided to wait and see whether Mr. Milby would make good on his promises.
Instead, over the next few weeks, the situation soured further. By mid-November, all of the wells ceased operating. If production did not resume within 60 days, the lease would expire. Faced with losing the drill site itself, which Ms. Hyatt maintained could still be successful, she and the investors decided to try to buy out Mr. Milby and run the site themselves.
On an early December morning, the group, including Ms. Hyatt and Mr. Hallin, met Mr. Milby at the business center at Nashville International Airport. Although Mr. Milby had indicated that it would take $250,000 to buy him out, the group had a check for $50,000.
“We were betting on the fact that we believed he was totally desperate for money,” Ms. Hyatt said.
Mr. Milby reacted angrily to the size of the check and shouted that he had been misled, Ms. Hyatt and Mr. Hallin said, but after two hours of heated debate he signed the necessary documents, pocketed the check and walked out the door.
Now in control of the partnership, the investors had access to the bank records and could see where the money had gone.
What they discovered shocked them. The Crockett-Owens account not only was empty but also appeared to have been pillaged: Mr. Milby had written checks on the account for $68,339.74 to Mercedes-Benz of Memphis and for $800 to the Campbellsville Middle School cheerleading squad, of which his daughter was a member. There also had been wire transfers totaling $49,000 to unknown accounts over two days in September. Copies of the checks were provided by Mr. Hallin.
In a complaint to Nashville securities regulators, Mr. Hallin said Mr. Milby had raised about $868,000 from investors, of which about $408,000 appears to have been used for personal expenses.
Mr. Milby disputes the accusations. He says he was forced out of the venture by Ms. Hyatt and her partner, and he accuses them of running a shoddy operation. (A records search on Ms. Hyatt, her partner and their company, HighGround, turned up some small-claims lawsuits against them, which they say have been settled.)
Mr. Milby also said he had deposited money back into the account for the Mercedes, the cheerleading contribution and any other personal expenses. He said the wire transfers to unknown accounts paid for drilling equipment and expenses. Mr. Hallin said money was deposited into the account for the Mercedes but disputes Mr. Milby’s other contentions.
Lastly, Mr. Milby says investors were paid. “They’re lying. They got the checks, everything we promised to them. But nobody ever gets enough money. Do you? I sent one guy a check for $18,000, and he called up to complain it wasn’t $22,000. That’s just the way people are,” Mr. Milby said.
MR. MILBY may have been out of the Texas partnership, but he was busy selling deals all over the country throughout 2005.
A group of eight wealthy Ohio investors — largely family trusts — invested $504,000 into a number of the private investments in late summer and early fall that year.
Instead of sending the checks that the investors expected, Mr. Milby diverted the money for his personal uses, including child-support payments, the group alleged in an arbitration case it later won.
The investors say Mr. Milby’s lawyer, Bryan S. Coffman, in Lexington, Ky., created an irrevocable trust called Arimor Trust and named himself the trustee, according to a lawsuit the investors later filed against Mr. Coffman and Mr. Milby’s brother Paul. Their investments and other money totaling nearly $6 million were put into this and other trusts, and some of that money was diverted to Paul Milby to buy 17 cars and trucks, five boats, and real estate, the lawsuit said.
Mr. Coffman, who has not been accused by regulators or authorities of any wrongdoing, said in an interview that he did some tax and estate planning for Mr. Milby and Mid-America. As part of the estate planning, Mr. Coffman said, he did set up some trusts, but he declined to speak about any specific trusts, citing client confidentiality.
Mr. Milby said Mr. Coffman did much more. “He’s the one who set up everything with us and the S.E.C.” Mr. Milby said. “He put together the books and did all of the filings that we needed to do to keep us legal. He made sure whenever people invested with us that they were worth so much money and could invest in us. That they were sophisticated investors.”
Mr. Coffman denied writing any of the private-placement offerings. “That is an area of securities law that I don’t have any expertise in,” Mr. Coffman said. “I don’t know who did that service for them, but some attorney was paid for it.”
Mr. Coffman later reached a confidential settlement with the Ohio investors. In court filings, Paul Milby denied all of the accusations against him. A call to his lawyer, Daniel Butler, was not returned.
Undaunted by angry investors, Gary Milby continued to raise money. After hearing ads for Mid-America on XM Satellite Radio in the fall of 2005, Eric Taylor called the company.
“They sounded too good to be true, but you never know,” said Mr. Taylor, who lives in Haymarket, Va., about 45 miles west of Washington. “Oil was trading at $75 a barrel, and I had read about people making decent money from legitimate oil and gas companies, so I called.” At the time, he was a branch manager for a national mortgage company.
After speaking with a Mid-America sales manager and looking at a prospectus he received in the mail, Mr. Taylor spoke with an individual Mr. Milby said was a “satisfied investor.”
And on a rainy day in December 2005, Mr. Taylor visited the Kentucky drilling sites where Mr. Milby told him he had just “uncorked” a well that would be producing in January.
“First there was this noxious smell, like a very, very strong sulfur,” Mr. Taylor recalled. “That smell came out for about 10 minutes and then you hear the sound and oil shot right out of the ground a good 25 to 30 feet in the air.” Excited, he gave Mr. Milby a check for $111,000.
Like the others, instead of getting checks, Mr. Taylor said he was soon getting only excuses. Worse, in the few months since he had looked into Mr. Milby’s background, new information had become available. Mr. Milby’s personal bankruptcy popped onto the radar, and several states, including Pennsylvania, Arizona and California, had filed cease-and-desist orders against Mr. Milby and Mid-America.
Mr. Taylor demanded his money back. He said Mr. Milby refused, maintaining that other investors were making money — lots of it. Mr. Taylor said he doubted that this was true, but he had no way of contacting other investors.
ALL that changed in April 2006 with an e-mail message accidentally sent out by Mid-America to about 20 investors, including Mr. Taylor; it revealed all the recipients’ e-mail addresses.
“Everyone started contacting everyone else,” Mr. Taylor said. “I started to cross-reference the partnerships these people said they were in against the partnerships Milby and his staff were telling me were paying out good money.” It turned out that no one said they were making money, Mr. Taylor said. In addition, he said, he found out that the “satisfied investor” was actually a Mid-America employee.
Now it is Mr. Milby who says he has been swindled; he says Mr. Goff, who was his friend, had “fictitious” liens on the well sites and took them over. Mr. Milby says he has sued Mr. Goff, although no suit could be found on record. Calls to Mr. Goff, Mr. Goff’s lawyer and Mr. Milby’s lawyer were not returned.
“If I could get control of them again, investors could get their money back in six months to a year,” Mr. Milby said, adding that Mr. Goff “robbed me of this whole thing.”
“I would have never thought this could have happened,” Mr. Milby added. “ You know, have you ever gotten to where you just trusted people too much?”

On Health Insurance for the Self Employed - from NYTimes

March 27, 2008
Shifting Careers
Finding Health Insurance if You Are Self-Employed
By MARCI ALBOHER
If there is one thing that separates the self-employed from those employed by others, it is their preoccupation with health insurance.
I was reminded of this on Feb. 14, when I wrote a post on the Shifting Careers blog asking small-business owners and would-be entrepreneurs what they were doing about health insurance. Within hours, scores of people posted comments about their own experiences and, if they had managed to find good resources, shared those. I have been reading e-mail messages and trying to make sense of the subject ever since. In short, it is not pretty out there.
A 43-year-old woman wrote about going without insurance in the first year of her business. “I lived in terror of needing a doctor visit or worse yet, lab tests or something more,” she said. She then moved to an H.M.O. for sole proprietors through a local chamber of commerce. The cost of that plan, which she said was $171 a month in 2001, has now risen to $500 a month. At the same time, she wrote, co-payments have increased and services have been cut.
That woman’s experience reflected the exasperated tone of several of the other writers. Many entrepreneurs seem to find health insurance after doing a lot of research, though they generally pay more than they think they should. Some who are in good health bet on remaining that way and forgo health insurance or get policies with low premiums and high deductibles, choosing to insure themselves for mostly catastrophic illness. Some are lucky enough to have a well-insured partner.
The unluckiest are those with chronic illnesses or the dreaded pre-existing condition that results in a denial of coverage. Many of these people abandon dreams of entrepreneurship altogether because they need jobs that come with a health plan and they cannot find a way to self-insure.
The comments also revealed that the health care system is a state-by-state patchwork, with options varying based on where you live. A 60-year-old owner of a mail order business from Illinois wrote that she was unable to get insurance until about 10 years ago when Illinois started a high-risk pool with Blue Cross Blue Shield.
A woman in business with her 57-year-old husband wrote to say that her husband is presently uninsured because, as a diabetic with high blood pressure, she cannot find an insurance company in Florida that will cover him. The stories go on. There were reports from Americans happily insured while living in Europe and Canada. And, of course, there were numerous pleas to Washington.
Jennifer Jaff, a reader who happens to be an expert on health insurance issues, shared a valuable tool, healthinsuranceinfo.net. The site, maintained by the Georgetown Health Policy Institute, shows a map of the country and after clicking on a state, a document is downloaded that covers everything from what kinds of programs are available to small-business owners to whether there is a high-risk pool available for those who have been rejected by insurance providers. These primers are comprehensive and frequently updated, and they are a great place to start, especially if you have been wondering about the meaning of jargon that peppers insurance providers’ descriptions of their offerings.
Many readers shared recommendations based on where they buy their insurance. Popular sources were local chambers of commerce, the Small Business Service Bureau (sbsb.com), AARP (aarp.org) (for those over 50), industry-specific trade associations like a bar association or the Institute of Electrical and Electronics Engineers. In states that permit it, small-business owners can also start a group with as little as one member. In that case, a good insurance agent comes in handy.
For the reasonably healthy who know what they are looking for, ehealthinsurance.com got fairly good reviews. The site, which has the feel of an Expedia or Orbitz for purchasing health insurance, allows you to compare a variety of policies offered through about 70 insurance providers. One caveat, pointed out by several readers, is that ehealthinsurance.com does not serve consumers in all states. Rhode Island, Vermont, Massachusetts, Maine and North Dakota are excluded. The company also covers only individuals. So if your company has employees, you will need to explore other options, like starting a group if your state permits that.
Another possibility for consultants and independent workers is the Freelancers Union, which won consistently good reviews in the reader comments. But the union also has some limitations. It operates in only 30 states, and you have to work in one of the industries or occupations it serves.
While healthy business owners have to incur high costs and navigate a maze of choices, the truly unhealthy face the biggest challenges.
To learn more about options for those whose health is getting in the way of their self-employment, I spoke with Ms. Jaff, the woman who directed me to healthinsuranceinfo.net. Ms. Jaff, a lawyer who has worked on legal issues surrounding health care in both the public and private sector, now runs Advocacy for Patients With Chronic Illness (advocacyforpatients.org), a nonprofit organization in Farmington, Conn., that advises and advocates on behalf of the chronically ill. She says she works with about 1,000 patients a year, handling everything from battles to get insurance companies to pay for treatments prescribed by patients’ doctors to helping people figure out the best coverage.
Ms. Jaff speaks from experience. She suffers from Crohn’s disease, a condition so severe that she does not leave her house during flare-ups except to get to a doctor’s appointment or to the hospital. She wanted to find something she could do out of her home and as she went through the challenge of finding her own health insurance, she discovered what she calls “a community of patients in desperate need of help.”
Ms. Jaff qualified for the Municipal Employees Health Insurance Program, offered by Connecticut to cover small-business owners as part of a plan for state employees. She knew about the plan, which she recommends to all small- business owners in Connecticut, from her days as a lawyer in the attorney general’s office. Even with her extensive experience, Ms. Jaff has not been able to find the holy grail — good coverage at a great price. When she started on this insurance, her premium was $400 a month. Last year, the monthly payment went up to $800.
“I don’t know if people who don’t have chronic illnesses can really understand this,” she said. “But I have worked full time my entire adult life — generally 15 to 18 hours a day. I have paid into the system for all those years. And there is only one thing that could bankrupt me, and it is my health. I could lose every penny I own from one serious hospitalization without insurance. So I chose the plan that would give me the most possible coverage because the year I don’t is going to be the year I get really sick.”

reverse convertibles article in WSJ

March 26, 2008
DOW JONES REPRINTS

Risky Strategy Lures Investors Seeking Yield
Popular 'Reverse Convertibles' Offer Lucrative Payouts But Could Cause Steep Losses
By ELEANOR LAISEMarch 26, 2008; Page D1

Wall Street is luring income-hungry investors with complex securities that come with big risks as well as extravagant yields.
The products -- called "reverse convertibles" -- are typically linked to the performance of a single stock like Apple Inc. or AT&T Inc. and often offer yields ranging from 7% to as high as 25% or more. Sales on these notes have been soaring as yields on many fixed-income investments have been sinking. Small U.S. investors snapped up $8.5 billion worth of reverse convertibles in 2007, up 81% from 2006, according to Arete Consulting LLC, which tracks the products.
At Incapital LLC, a distributor of reverse convertibles, sales doubled in 2007 from a year earlier, says Chief Executive Tom Ricketts. The notes are issued by firms such as Morgan Stanley, Barclays PLC and ABN Amro Holding NV. The companies whose share prices are linked to reverse convertibles have no involvement in the products.
For small investors, reverse convertibles offer a high level of income for a low minimum investment. But investors typically don't participate in any gains in the underlying stock, and if the stock falls sharply, they can lose much of their investment. Regulators have grown increasingly concerned about how complex "structured products" such as reverse convertibles are marketed to small investors, and they're pushing issuers to closely monitor their sales practices.
The products can be lucrative for issuers. They usually come with hefty fees, often in the range of 2% to 3% or more, which are typically priced into the yield investors get. The issuer's ultimate profit varies depending on how it hedges against the risk of issuing the note.
Here's how a typical reverse convertible works: The notes are sold in $1,000 increments and offer regular interest payments during the term of the investment, typically three months to one year. Investors get their full original investment back in cash when the note matures -- except under certain circumstances tied to a set "barrier" level.
If the price of the underlying stock falls below that level -- typically a drop of 20% or more -- during the note's term and then finishes below the initial stock price, investors get beaten-down shares of stock instead of cash. If the stock is down 50%, for example, they get shares worth half of their original investment.
Because of this, reverse convertibles are particularly dangerous when linked to volatile stocks. But higher volatility makes it easier for Wall Street firms to create reverse convertibles with enticing yields. Buyers of reverse convertibles are essentially selling a "put" option on the underlying stock, which obligates them to buy the shares if they sink by a certain amount. The riskier the stock, the more the put option is worth -- and the higher the yield that reverse convertibles can pay investors.
Some observers say that things are going to get rougher. As markets get choppier, "you'll increasingly [see] investors get burned on reverse convertibles," says David Krein, president of DTB Capital, a New York investment adviser that specializes in structured products.
Indeed, a growing number of reverse convertibles are leaving investors with beaten-down shares. In September, investors bought reverse convertibles linked to Countrywide Financial Corp. with a yield of 22%. The problem is that Countrywide's share price sank more than 70% by the time the notes matured in mid-March. Bottom line: Investors lost more than half of their money, even after interest payments.
The situation looks far bleaker with reverse convertibles issued by Barclays that were linked to Bear Stearns Cos. and yield 12.3%. Bear's stock traded well over $100 when the notes were issued in late October, but has since dropped roughly 90%. If shares remain at the current price, investors stand to lose much of their money.
Issuers maintain that reverse convertibles, despite the risks, still offer investors attractive terms. "A lot of investors don't believe there is a whole lot of upside in the equity markets these days," so they don't mind giving up gains in the underlying stocks' share price, says Kevin Woodruff, head of North America equity derivatives at Morgan Stanley.
But some investors who had success with reverse convertibles while stocks were rising are now feeling pain. Sue Chiodo, 54 years old, of Bartlett, Ill., plowed about one-third of her portfolio into them when she retired as a sales manager for a software company about five years ago. She was attracted by the high yields and was happy with the way the notes performed -- but lately many of the investments have soured.
Taking a Beating
Last June, she bought a reverse convertible linked to InterOil Corp. with an initial price of $42.50 yielding 31%. But within a few days, the stock had plummeted more than 50%, and Ms. Chiodo ultimately wound up with the devalued shares, which now trade at about $20. Some of her more recent reverse-convertible investments aren't turning out much better. "I'm holding some right now that ... yuck," she says. "I'm going to take a beating."
There are other issues with the products. Investors who try to sell a reverse convertible before maturity may have trouble recouping their original investment. While many issuers maintain a secondary market in reverse convertibles, there may not be much demand for the notes -- especially in a down market.
Late last year, the Financial Industry Regulatory Authority -- formed by the merger of the National Association of Securities Dealers and a New York Stock Exchange regulatory arm -- sent structured-products providers inquiries about their marketing and sales practices. Massachusetts Secretary of State William Galvin charged one firm with failing to properly supervise its brokers selling structured products.
"My guess is most retail people don't walk in off the street and say, 'Do you have any reverse convertibles?' " says Marc Menchel, Finra's executive vice president and general counsel. "My guess is in most cases they're recommended to retail [investors]."
Alternatives to CDs?
Brokerage firms sometimes liken reverse convertibles to far safer investments. FISN Inc. lists reverse convertibles under "CD Alternatives" on its Web site. But an investor in a certificate of deposit gets federal deposit insurance up to $100,000, whereas a reverse-convertible investor takes on far more risk. FISN President Tom Coan says the site isn't misleading. Reverse convertibles "are alternatives to CDs," he says. "They pay fixed income."
In 2005, the NASD suggested that firms consider limiting sales of structured products to investors approved for options trading. But even relatively sophisticated investors can run into trouble with reverse convertibles.
Jeanne Libit, 57, of Great Falls, Va., a former CPA who is comfortable shorting stocks and trading options, started investing in reverse convertibles about two years ago because interest rates were "pathetic," she says. She has bought about 10 reverse convertibles so far, and only about half of them gave her full investment back in cash at maturity.
Ms. Libit lost roughly $7,000 or $8,000 of her $20,000 investment in one note linked to Advanced Micro Devices Inc. -- and that's only because she used other strategies like buying put options and shorting to mitigate her risk in the stock. If she hadn't done that, she figures she would have lost about $12,000 or $13,000.
"When they go south on you, they go south quickly," she says.
Write to Eleanor Laise at eleanor.laise@wsj.com1

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