Wednesday, January 5, 2011

The Beginning........

After years of procrastination, I have taken the plunge and decided to put pen to pad or words to net instead of mouthing off over a few pints to friends, family and colleagues. I guess part of the procrastination was fear of not being able to articulate my ramblings into some kind of coherent thought. For that I shall apologize way in advance, and hope that as time progresses, I can produce semi- literate thoughts and posits worthy of readership. and so in the words of Henry V: “The games' afoot, follow your spirit..etc etc ".

Remember these:

· SUNS: Stock Upside Note Securities (Lehman Brothers)
· MITTs: Market Index Target-Term Securities (Merrill Lynch & Co., Inc.)
· ELKS: Equity-Linked Securities (Salomon Brothers, Inc.)
· SIGN: Stock Index Growth Notes (Goldman, Sachs & Co.)
· Stock Index Return Securities (Paine Webber Group Inc.)

Coming to a Retail Broker soon, mind your eye!:
Today JPM filed to register a new structured investment on BAC. The mouthful: Capped Daily Observation Knock-Out Notes Linked to the Common Stock of Bank America Corporation due January 25, 2012.

Pricing Date : Jan 7 2011
Observation Date: Jan 20 2012
Minimum denomination: $10k
Minimum Contingent Return: 10%(range -31.80% - +10%)
Maximum Return: 25%(on Stock return over +25%)
Minimum Loss: -31.81%
Trigger Event: -31.81%
No Interest or Dividends.
Lack of price transparency.
Lack of Liquidity.

Optimistic Scenario:
You will receive a 110% payout(principal + 10%) return if BAC returns between -31.80% and +10% until January 20th 2012. More than 10%, you earn market return up to 25% cap.

Pessimistic Scenario
BAC falls more than 31.80% (trigger event), you are then essentially long BAC down 30+% and now need a miracle otherwise known as 43% Stock gain in whatever time remains just to break even. Even though you don’t get interest on money or and with BAC dividend of a ha’penny and yield to match you are not losing anything apart from the fee , which normally runs about 250 to 275bps.

So what are the ingredients in this wonderful concoction that will soon be slung from Amityville to Zanesville?
Well the return on a plain vanilla tracking security, where the payoff at maturity is derived from the performance of the underlying asset is similar to the return on a forward – a simple yet deceptive derivative. A forward contract in layman terms is a customizable agreement between two parties to sell or buy an asset at a specified future time at a price agreed today. No money changes hands until the specified time, simple right?

But why would you pay 250 bps for that? And here is where the harbinger of doom for many, great and small comes into play. To entice you into buying this Pandora’s box higher yield, issuers dangle the possibility of the payoff being more than 100% of the underlying asset’s price appreciation, which is equivalent to including an at-the-money call option with the forward contract. Or as is probably the case here a JPM zero-coupon, unsecured subordinated note, an at-the-money call option and out-of-the-money put and call options on BAC.

Unlike in the past when Issuers offered some principle protection, In this note a 0.01% move in BAC could take you from a 10% gain (42% in theory) to a 31.81% loss.
This is what the payoff looks like. As you see there is a cushion where the stock can crumble and you would still profit.

What are the probabilities of BAC dropping 32% over the next 12 months and 2 weeks? In the last calendar year, BAC fell a maximum of 27% only to rebound by years end to end the year down 12%. You would have made 10% on BAC in 2010. At this point the cynic in me would ask, does JPM the counterparty know something about BAC? Last time I checked, JPM was not a non-profit. Then, again it’s not for nothing these products once solely peddled to Local County and Greeting Card Companies Treasurers are now finding their way to Ward and June Cleaver.

In my opinion BAC has more cloudy days and scattered showers than clears skies – Wiki leaks, Countrywide (recent resolution with FNM and FMCC notwithstanding), Robogate, and lack of an international presence - a far better risk/reward ratio might be found in selling puts.
Most investments that offer a significant upside opportunity also involve significantly more risk. As they say on the London underground upon embarking and disembarking – “Mind the Gap, Please mind the gap”.

Update: An article with interesting statistics on structured notes in general appears today on Bloomberg.
JPM Structured Note on BAC

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