Morgan Stanley bank-linked auto-callable, UBS real estate note seen risky; Lehman ties to China growth

By Kenneth Lim

Boston, Feb. 29 - Morgan Stanley's auto-callable securities linked to the worst performer of three bank stocks due 2011 is a riskier-than-usual product, said structured products analyst Tim Mortimer of Future Value Consultants.

The Morgan Stanley auto-callables due April 12, 2011, are linked to the common stocks of Goldman Sachs Group Inc., JPMorgan Chase & Co. and Lehman Brothers Holdings Inc.

Every six months beginning Oct. 3, 2008, the notes will be called if all three underlying stocks close above their starting level. The early redemption amount will be 116.75% to 117.75% of par if called on the first determination date, stepping up to 200.5% to 206.5% at maturity if the notes are not called and all three stocks end above their starting level.

If the notes are not called, any of the underlying stocks ends below its initial level and none of the underlying stocks have traded below the trigger level of 50% during the life of the notes, the payout at maturity will be par. If any of the underlying stocks finish below the initial level and the trigger level was breached during the time of the notes, the payout at maturity will be par less the decline of the worst performing stock.

Mortimer said products tied to bank stocks have been popular recently.

"They're topical in light of the recent market volatility, and because of that it's [the Morgan Stanley product] got quite a high coupon," he said.

Despite a stronger-than-usual barrier level of 50%, the product appears riskier than most offerings recently launched, Mortimer said.

"The first point is that if the three stocks are all above their starting level, you get potential early returns," he said. "But if that doesn't happen, then you get the worst of the three stocks, which would be pretty bad news if just one of them falls below their starting level."

"It's quite a risky product compared to what we've looked at recently," he added, pointing out that the current volatility of bank stocks adds to the risk.

And as with most auto-callables, the potential of capturing the high returns from a call trigger event after the first couple of determination dates is not good, Future Value noted in a research report.

"In general the chance of auto-calling occurring much beyond the first or second opportunity is low since it is conditional on not having satisfied the earlier test," Future Value said in its report. "The underlying is likely to be significantly below the next target level and would require a large increase. If none of the six auto-callable tests are satisfied then the investor is exposed to the downside risk of the underlying."

Mortimer said investors in the product must understand the risks attached to the potentially high payouts.

"It depends very much on your view on those three stocks," he said. "There's the kick-out after six months, and if all three stocks are above their starting level you get a good return. But the risk is something you have to be aware of."

UBS real estate notes also risky

Mortimer also advised strong research for UBS' recently launched return optimization securities with partial protection due March 2, 2010 linked to the Dow Jones U.S. Real Estate Total Return index.

If the index, which measures the performance of the real estate sector in the U.S. equity market, finishes higher than its starting level, the 0% notes will return 2.4 times the return of the index, capped at a maximum return of 40%. The payout at maturity will be par if the index declines no more than the protection level of 5%. The principal will be docked 1% for every percentage point that the index declines beyond the protection level.

"It's for investors who think the real estate stocks have fallen so far that they might reach some kind of flattening out," Mortimer said. "As in banking products, you have to be sure about the underlying assets."

Lehman's notes tap China growth

Lehman Brothers' 0% principal-protected China Bull notes due Feb. 28, 2012 tied to a basket of China-related indicators offers exposure to the country's growth, Mortimer said.

The basket consists of the Hang Seng stock index, weighted at 33.34%; the exchange rate of the Chinese renminbi against the U.S. dollar, weighted at 33.34%; the price of copper, weighted at 16.66%; and the price of light sweet crude oil, weighted at 16.66%.

The inclusion of copper and oil give the notes an extra component of exposure to China's growth, Mortimer said.

"It links to the Chinese currency and copper and oil, so if China does well, the stock market should do well, and its currency should rise, and China is definitely one of the world's biggest commodity users, which is why copper and oil are in there," he said.

The Hang Seng, which tracks the performance of the Hong Kong stock exchange, is a small index, but it is better followed and traded than China's other domestic indexes, Mortimer said.

The underlying volatility for the product will likely not come from the currency component, he said.

"The currency actually has got very low volatility," Mortimer said. "But the Hang Seng index and the commodities are more volatile."

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