The origin of LYONs: A case study in financial innovation

Viewed at a distance and with scholarly detachment, financial innovation is simple process. Some kind of “shock”—say, sudden increase in interest rates volatility or significant regulatory change – introduced into the economic system. The shock alters preferences either investors issuers such way that there then exists no instrument capable satisfying newly-created demand. Observing unsatisfied demand, an entrepreneur moves quickly to seize opportunity by creating new instrument. In process, reaps reward for his efforts, are better served, entire system improved. On closer inspection, however, actual process turns out, like most other human endeavors, be lot less tidy than economists’ models would have it. this article, we provide “up-close” view origin evolution one instrument—the Liquid Yield Option Note (LYON). LYON highly successful product Merrill Lynch 1985. Between April 1985 December 1991, served as underwriter 43 separate issues, which together raised total $11.7 billion corporate clients. include well-known firms American Airlines, Eastman Kodak, Marriott Corporation, Motorola. 1989, underwriters entered market since brought additional 13 LYON-like issues market. words recent Wall Street Journal “one Street's hottest lucrative finance products.”1 As academics examining security, begin posing questions: What does was not available previously? Does really welfare issuers, it simply “neutral mutation”—that is, now accepted practice serves enduring purpose, but sufficiently harmless avoid being extinguished competitive forces.2 spirit full disclosure, must admit entirely disinterested observers. Our association longstanding. When early were 1985, questions arose about pricing. We hired develop model analyzing pricing A by-product assignment learn train events led creation LYON, followed interest. pages follow, relate what observed, thought, contributed during development security. complex It zero coupon, convertible, callable, puttable bond. None these four features new, only their combination makes innovation. These general perhaps best illustrated considering specific issue. Because first one, consider issued Waste Management, Inc. on 12, According indenture agreement, each Management has face value $1000 matures January 21, 2001. There are, definition, coupon payments. If security called, converted, redeemed (i.e., put issuer) prior date, if issuer default, investor will receive per out case, moreover, based initial offering price $250 bond, effective yield-to-maturity 9%. At any time maturity (or date), may convert bond 4.36 shares common stock. Given stock $52 issue, conversion ratio appear indicate “premium” 10% ($250/4.36 = $57.34). But, because convertible thus large discount from par value, fixed. That discuss more detail later, minimum share holders willingly exchange bonds effectively increases throughout life Although unfamiliar feature right gives beginning June 30, 1988, subsequent anniversary pre-determined exercise prices through time, shown below: Based issue $250.00 schedule provides 6% rate return date exercise, rising three 1% increments level 9% over next 3 years. Finally, call fixed also time. immediately after issuance, some protection 1987 unless rises above $86.01. below:3 case convertibles generally, respond choosing accept redemption payment mentioned earlier, although new. Callable certainly existed did bonds. And so options wide array stocks. then, fulfill adequately met already existing instrument? To address question, useful trace history LYON. This begins Mr. Lee Cole. During mid-1980s, largest broker equity retail noninstitutional) investors. period, owing success its Cash Accounts (CMAs), manager individual money accounts. Individuals had $200 invested CMAs. CMAs funds essentially short-term government securities and, reason, subject little risk virtually default risk. 1983, Cole Options Marketing Manager Lynch. discerned (or, aptly, divined) pattern transactions customers. Manager, observed individuals’ primary activity buy calls active maximum term 90 days often expired unexercised. isolation, strategy appeared very risky. reviewing customers consolidated accounts, many maintained balances CMA accounts while making few direct investments. From observations, deduced portfolio strategy: least individuals) willing fraction volatile long bulk largely safe They avoided investment. He leaped further inference used came earned short, individuals all income principal remained intact account. With observations deductions hand, drafted memorandum describing terms appeal segment customer drafting memo, Cole's intent design allow corporations tap sector whose currently options. described therein eventually turned issuer, incorporates option component perceived option, assured can recovered putting back pre-specified prices. approximates trading theory correct, desirable give corporation access untapped theories, rested upon number unproven assumptions. ultimate course, whether pass test. takes two sides make identified he demand investors, could satisfied every issuer. ideal satisfy two, three, criteria: First, downside desired investment-grade rating—and higher rating better. same issuer's exhibit substantial volatility, otherwise “play” critical. target individuals, third characteristic broad name recognition. Beginning mid-1984, investment banking department began search task one. population candidates obviously limited those needed raise funds. Second, even issuing tried true securities, anxious possibility might “fail.” anxiety compounded when proposed—especially Third, credit ratings tend assigned earnings (and thus, presumably, prices), subset companies fairly small After repeated presentations variety potential rejections, expressed authorized Chuck Lewis Thomas Patrick, representatives, move forward proposal. Furthermore, exhibited (perhaps all) requisite characteristics Its debt rated Aa. annual variance 30% placed top half NYSE question sufficient recognition attract Lynch's traded operated communities country. specialized disposal industrial household waste; necessarily consumer product. familiar extensive brokerage network. Over period 1972 managed secondary nine revenue All awareness company. 1972–1985 arranged private placement $50 million represented company hostile takeovers. working relationship been key factor necessary overcome “first-issuer anxiety.” event, finally roughly 2 years outline memorandum. sold partly right. traditional 90% typically purchased institutional tiny taken approximately 40% Apparently designed appealed persisted. For example, Euro Disney $965 1990. Of 60% institutions. accounted 45,000 orders. LYONs varied averaged 50% total. puttable, apparently staying power. proceeds convertibles. Lynch, entrepreneurial source innovation, profited handsomely typical underwriter's spread 1.7% dollar amount raised. earliest LYONs, 3% present continues 2.5% Additionally, able “corner” almost 5 before bankers article cited $248 sale LYONs. But brings us obvious question: gains earn rewards? variant let's revisiting “case convertibles” made Michael Brennan Eduardo Schwartz published 1981.4 popular argument they “cheap debt” carry below straight debt) sell “at premium” relative current price. demonstrate, reasoning conceals logical sleight hand: compares under set circumstances (when firm's rise conversion) another (the converts). fails point off second. do average financing “bargain.” exposing fallacy, go argue real convertibles’ effectiveness relatively insensitive Increases reduce portion built-in (by increasing price). risk-neutralizing effect, resolving disagreements (arising refer “information asymmetries”) between management would-be company's operations. reason use tends concentrated among smaller, high-growth earnings—the companies, ordinary fixed-income shy away from. Convertibles well-suited lower payments distress, likely especially disruptive track. cases where activities. risk-shifting possibility, firm required pay high premium debt, far believes warranted given intentions Convertible exchanged stock, bondholder insurance against behavior. LYON—which, all, intended companies? extent values presumably benefit effect comes combining succeeded manner has, benefits well beyond conventional suggested much ability correct assessment latent convertible-like payoff structure—one combining, option. By amounts continuous position, added potentially costs savings. Recall that, call-option-cum-CMA Cole, purchasing series expire 90-day shorter) intervals, thereby incurring commission times year.5 buying holding newly maintain ownership position without paying fees. take advantage long-dated, low-transaction-cost options, realized investors’ normal resistance accomplished, part, grade “name-recognition.” levels acceptable stronger, contractual assurance. Hence giving notes 1-year intervals thereafter), greatly reduced exposure sharp drop standing. doing, dramatically increased (As show 20% issue.) granting turn costly jump fall operating cash flows force retire worst possible “self-select” following sense: Among “play,” greatest confidence operations weather increase, need capital conditions. gaining following) outweighs expected cost having deliver alleged appealing clientele. Generally speaking, “modern theory” offered encouragement explanations kinds notable exceptions. Robert Merton, Presidential Address Finance Association, developed asset size base important determinant securities.6 Starting assumption invest information, Merton's proposed suggests markets “segmented”—that lacking selling discount” retail-owned counterparts. segmentation exists—and still matter contention—management actions expand value. Moreover, study Greg Kadlec John McConnell empirical support predictions model.7 Their reports stocks listed 1980s 5%–6% listing. Also suggestive, significantly correlated year sum, extend supporting evidence plausible LYON's extension previously providing issuers. investors? Why “pay up” identical one? our answer again tentative follows form payoffs flourish tool managers. objective upside limiting presented underlying increases, accordingly. falls holder protected floor provided “pay” insurance, slight “insurance” market, produce competing products, commanded should decline. meantime, “reward.” successfully asked build model? marketing traders analyze reassuring who modern powerful, practical, scientific discipline implications managers investors.8 Following issuance intensified effort bring both liquidity demonstrate just passing curiosity.9 showed interest, questions. Three up: “fair” question?10 how react different conditions? conditions elect stock? last concerned dilutive EPS. Brennan-Schwartz (1977) bonds—which classic Black-Scholes (1973) model.11 Interestingly, minor modifications, today. similarity strategy, great temptation developing sum components: add (callable) firm. problem approach, ignores interactions values. investor's rights reducing put). similarly probability eventual conversion. interactions, depends strategies by-now standard assumptions literature maximize adheres minimizes security's value.12 assumptions, coupled priced eliminate arbitrage profits, yield complicated differential equation valuing Despite appearance, solved numerically personal computer minutes. “intuition” this: rates, LYON; price, greater sooner exercised, dividend (since dividends imply appreciation chance conversion); prices, purposes illustration, earlier. table presents basic characteristics, firm, date. predicted $262.70. fact, close day trading, bond's $258.75. tracked 30 determined model's closely closing slightly Apparently, upward bias table, effects changes conditions, company, Management's interesting insights “sensitivity analysis.” (a 200 basis yields cause 4% decline LYON). insensitivity caused analysis indicates $260 $215 reduces $20 8% value). so, mentioned, exercising length allowed remain outstanding. noted, frequent concern choose deciding convert, weighs forgone put. Thus, low, (to obtain dividend) low. low-dividend stocks, enough, becomes negligible. assumes critical indifferent converting life, steadily years, declining sharply thereafter. opposite driving changes—one unique conventional, optimal shrinking along remaining maturity. unlike convertibles, fact remains constant (4.36 bond)—which, latter dominates former. difficult generalize single observation—and innovations 1980s. illustrate, requires ingenuity, perseverance, perhaps, measure good fortune. illustrates practical power assisting products strategies. practitioners science finance, fortunate enough appears