Newest Strain of Asian Flu
by Richard
Too bad there is no inoculation for this nasty bug emerging in Asia.
I had never heard of it, until November 6, when I read Laura Santini’s article in the Wall Street Journal, “Asian Investors ‘Accumulate’ Big Losses on Risky Contracts” (page C1).
In the grand scheme of things, it’s not the worst idea that ever came down the pike. It just falls into that huge grab bag of ideas that work only in up markets, and come to grief in down markets.
An Analogy: Your Employee Stock Purchase Plan
You may have seen a version of this from your employer, if they offer an employee stock purchase plan. I’m generally in favor of such plans…not necessarily because the stock is such a great pick…but because any systematic savings and investment plan that involves dollar cost averaging is an excellent financial habit to acquire.
Based on the plans I’ve seen, typically the employer allows employees to purchase the parent company stock at a discount ranging from five to fifteen percent, including the purchase of fractional share units, and with no brokerage commission.
This combines the best features of no-load fund investing, with the added bonus of the built-in discount. The only negative is the single stock focus, and you must diversify this risk away by making broadly diversified purchases in your other investment portfolios.
How Accumulator Contracts Work
Now let’s fast forward to the “accumulator contract” plans that became popular in Asia during the pre-credit bubble years.
Like the employee stock purchase plan, these plans allowed buyers to buy a stock (or a currency or commodity) at a fixed, below-market price.
Well, not allow….more like required the purchase for the duration of the contract.
Here are your possible outcomes:
- The underlying investment goes up during an agreed upon time period. This triggers a so-called “knock out” clause, where the issuer essentially calls in the contract, and pays the profit to the investor.Like I said, it works in rising markets. Just like that hole in your roof won’t bother you at all so long as it never rains.
- Oh oh. The underlying investment unit falls in price. Now things get interesting. If you were dollar cost averaging into your 401k or even your employee stock purchase plan, you have the option of pulling the plug and bailing out.Not with these plans. You are contractually obligated to continue your monthly purchase at the original, agreed upon price. It may have started out as an automatic gain with each purchase. Now it is an automatic loss….and there is no panic button you can push to get off the treadmilll.
- What starts out bad gets worse. Buried in the boilerplate on many such plans is the “double down option”. Optional on the part of the issuer, but not the buyer.Essentially, if the investment falls below an agreed upon threshold, the issuer will lower the fixed purchase price obligation to a new set price, and then require that the investor accumulate twice as many units in return for the adjustment.
Averaging Down…Revisited…
We discussed this in an earlier post…this is a variation on the technique known as “averaging down”…which posits that a falling asset price is an inducement to load up on the sharply reduced price.
This brilliant stratagem was field tested by some very smart people who bought Bear Stearns, Lehman Brothers, and WAMU on their rapid descents, losing billions in the process, with leverage to accelerate their road to perdition.
A quick physics lesson about margin and leverage is appropriate. What is a remarkable force multiplier in a rising market is equally devastating on the downslope.
The typical term on the Asian accumulator contracts was 12 months. But this could be reduced to 3 months if the stock went up. Heads you win. Some. Tails you lose. Big time.
Which is fine, if your twelve months ended before October 2007.
Long Story Made Short…
You might make a limited profit for a short time, but you risked losing all or most of your investment due to the much longer lock in period.
No wonder this was such a popular investment vehicle.
It was a one-decision type investment, that the public could buy and file away. It appealed to their virtuous nature, instilling the discipline of monthly investing.
A classic neutron bomb of an investment, that can wipe out the little guys, while leaving the underlying structure fully intact.
Because it transferred ownership risk from the sellers and their brokers and placed most of it on the backs of their trusting clients.
Let’s start paying closer attention out there.
We could start by removing that “kick me” sign pasted on our backsides.
