Morgan Stanley's S&P 500 deal unusual, adviser says; industry group welcomes tighter OTC rules

By Kenneth Lim

Boston, May 14 - Morgan Stanley's planned buffered digital notes linked to the S&P 500 index have an unusual payout structure that works best in a weakly bullish market, an investment adviser said.

Meanwhile, proposed new regulation to increase transparency in over-the-counter derivatives trading can be an important tool to improve the stability of banks, said Structured Products Association chairman Keith Styrcula.

Morgan Stanley plans to price zero-coupon buffered digital securities due May 2011 linked to the S&P 500.

At maturity, investors will receive 116% to 121% of their principal amount if the index finishes above its initial level. The exact upside payment will be set at pricing. If the index ends flat, investors will receive par.

If the index ends below its initial level but its decline is no more than 10%, investors will receive par plus the absolute index return. If the index declines by more than 10%, investors will receive par plus the sum of the index return and 20%.

Unusual payouts

The payout structure if the underlying index falls between 80% and 100% of its initial level is unusual because the investor's returns do not vary consistently as the index moves one way or the other, the adviser said.

"It's a very odd position to take," the adviser said. "It's like I'm saying I think the index will either go up or it will fall by 10%, which is a very specific kind of target, and I don't think it will fall by 20% or 0%. I mean, why do you think the downside is most likely to be 10% and not 5% or 15%? Most of the time it's more like I think the index will go up by a certain amount or it won't fall by more than this much. We mostly think in terms of ranges instead of specific points."

Investors are ultimately betting that the index will end up between 80% of its initial level and the upside payment, the adviser said. Investors do not take part in any increases in the index if it moves beyond the upside payment, and they will lose capital if the S&P 500 falls by more than 20%.

"The buffer only matters in protecting from that first 20%," the adviser said. "After that it still cushions your fall a little, but you're still losing capital.

"If you're a small retail investor who's just buying this as a standalone product, which I don't advise my clients to do, you don't care that you're losing less capital than you would be losing if you were holding the S&P 500 directly, you just care that you're losing capital. Some investors will use this as a hedge against another position, then the buffer has more value."

SPA welcomes new rules

The Structured Products Association welcomes a new proposal by the White House to tighten regulations on OTC derivatives trading, chairman Keith Styrcula told Prospect News.

The proposal includes centralizing the clearing of trades, improving the reporting of trades and prices, and tightening capital and margin requirements.

Styrcula said better control of the OTC derivatives market is an important step toward improving the stability of banks, even though certain costs, such as hedging structured products, could go up.

"I agree that anytime there are reporting requirements, regulatory oversight, and exchange fees, the OTC derivatives market will have additional transaction costs that will directly impact the cost of hedging structured products," Styrcula said.

"That said, the lack of oversight in the ironically-named credit default market was a primary contributor to the ill-health of the financial services industry, and regulation of it is not only desirable, but necessary."

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