Lehman's Fannie Mae-linked product highly risky, Goldman's Core 8 notes 'classic access', analyst says

By Kenneth Lim

Boston, May 23 - Lehman Brothers Holdings Inc.'s reverse exchangeables linked to Fannie Mae stock have an unusually unappealing risk-reward profile, structured products analyst Tim Mortimer of Future Value Consultants said.

Meanwhile, The Goldman, Sachs & Co.'s notes linked to the new Core 8 index of emerging stocks is a "classic access product," Mortimer said.

Lehman links to Fannie Mae

Lehman Brothers plans to price a series of 25% reverse exchangeable notes due Aug. 30, 2008 linked to the stock of the Fannie Mae.

If Fannie Mae common stock falls below the barrier level of 70% of its initial price during the life of the notes and ends below the initial level, investors will receive the number of shares of Fannie Mae equal to par of $1,000 divided by the initial stock price. Otherwise investors will receive par at maturity.

Pricing is expected on May 27.

Underlying highly volatile

The Lehman note had an unusually poor overall rating of 2.2 out of 10 in Future Value's assessment.

The overall rating is based on Future Value's assessment of the product's value, simplicity and return, as well as the risk of the product.

"In our assessment, if you look at the probability table, the probability of hitting the barrier and losing more than 5% is about 50%, which is the same as the probability of getting more than a 15% return, which is why it comes out badly" Mortimer said. "It's an extremely risky play."

The great-or-terrible aspect of the outcome is mostly due to the volatility of Fannie Mae stock, Mortimer explained.

"The stock has got a volatility of about 100%, which is pretty high, right?" Mortimer said. "Our rating is a reflection of the volatility."

Reverse convertibles generally give investors a higher coupon if the underlying has a higher volatility. The 25% coupon Lehman is offering on the note "is well above the risk-free rate which is due to the risk to the principal amount which would be caused by sufficient stock underperformance," Future Value wrote in its report.

But the coupon amount may not be high enough to compensate for the highly volatile underlying stock in this case, Mortimer said.

"The question is, 'Is the coupon high enough to make up for the volatility?'" he said.

The Lehman product, however, could still make sense for investors who strongly believe that Fannie Mae stock will not drop much further from its current levels.

"Someone who thinks the worst is over for the stock [might like the product]," Mortimer said. "At the end of the day, if people are really convinced that the stock is really at its worst, then they might like this product."

Goldman links to Core 8 index

Goldman Sachs earlier in the week launched a product linked to the new Core 8 index of emerging-market stocks.

The 22- to 26-month notes will track the index, and the payout at maturity will be par of $1,000 plus the index return. The exact maturity will be set at pricing.

The Core 8 index, which was created in April, reflects the U.S. dollar price changes of a weighted index of 65 stocks of companies in eight emerging countries. The 65 stocks comprise the top 10 from each of Indonesia, Mexico, the Philippines, South Korea and Turkey and the top five from each of Egypt, Pakistan and Vietnam. The weightings of each index stock will be rebalanced quarterly, subject to a 30% weighting cap per country and a 5% weighting cap per index stock.

Access key to Core 8

One of the first things that stuck out for Mortimer was the mix of countries in the Core 8.

"There are some countries in there you don't see very often," he said. "What we call emerging markets is usually quite a standard group of economies, but some of these are quite different. In terms of the economies they choose stocks from, there's diversification across the economies, one from North and Central America, one from Africa, the rest from Asia, so that's pretty interesting, I guess."

The spreading out of the countries could help to reduce the volatility of the index, which would be expected to be more volatile because of its emerging-market exposure, Mortimer said.

"It's a good spread of generally new economies," he said. "The regional diversification will help the volatility a little bit, I guess, so why not?"

The product is the classic structured product that is designed to offer investors exposure to markets that would otherwise be difficult to access, Mortimer said.

"It's the classic access product," he said. "There are not many other ways to invest in a basket of these things."

"Obviously it's a more risky proposition to just track it directly," he added. "Usually the reason is it's hard enough for an investor to get the currency of a region to buy stocks in emerging markets like these, so the first thing the bank can do is to get a tracker, and then to write options on it is the next level."

The plain vanilla tracker structure may not seem very innovative, but it is often a good way for issuers to start off a new class of products, he said.

"I'm sure the volatility of this index is pretty high, and if Goldman wants to sell it at conservative levels at the start of course the [upside] participation will seem pretty bad," he said. "But if it's a success, if it generates some liquidity, then in due course you'd expect Goldman or someone else to come up with a protected version or something else."

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