JPMorgan’s $6.55 million autocall on Morgan Stanley seen as hedge ahead of merger announcement

By Emma Trincal

New York, Feb. 20 – JPMorgan Chase Financial Co. LLC’s $6.55 million of 0% trigger absolute return autocallable notes due Feb. 17, 2022 linked to the common stock of Morgan Stanley, which priced less than a week before the firm said it will buy online brokerage E*Trade Financial Corp., may be used to hedge a big position in the underlying bank stock, according to a financial adviser.

The structure pays a call premium upon the automatic call and if not, an absolute return payout if the underlying finishes above a downside trigger, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus an annual call premium of 11.3% if the shares close at or above the initial share price on any quarterly observation date.

If the notes are not called and the stock finishes at or above the 75% downside threshold, the payout at maturity will be par of $10 plus the absolute value of the return.

Otherwise, investors will be fully exposed to any losses.

The notes priced on Feb. 13 with the initial price of the stock at $56.18 a share.

Morgan Stanley announced the $13 billion all-stock takeover on Feb. 20 before the bell.

The stock opened at $54.00, down 4.1% from the previous day close. It finished at $53.75, down 4.6% on the day.

Hedging instrument

“This is a very interesting structure,” said Lance Roberts, chief investment strategist at Clarity Financial.

“My guess is that there is a large holder of Morgan Stanley shares out there that’s using this structure to hedge off their position in the stock,” he said.

“This is a reasonably priced product. If you think Morgan Stanley will go up within the next two years, it’s a reasonable way to do it.

“You have the downside protection and the absolute return to mitigate the risk.”

But the risk should not be overlooked.

“If you run into a bear market, it’s possible, it’s even quite easy to breach that 25% barrier,” he said.

The stock has a support level at around $38 to $40, he added.

He offered an example of a significant drawdown back in 2018.

On March 9 of that year, the stock closed at $54.80. By Dec. 23, it dropped to $38.00, a 30.6% decline in just over nine months.

“If we have a pullback, the share price could easily retrace back to that support,” he said.

The bullish case

The transaction provides upside potential for shareholders, according to a press release Morgan Stanley issued on Thursday.

Shareholders from both companies will benefit from potential cost savings estimated at approximately $400 million as well as potential funding of approximately $150 million from “optimizing” E*Trade’s approximate $56 billion of deposits, according to the press release.

Morgan Stanley will also gain access to an estimated $7.3 trillion of combined current customer assets held away, which could boost revenues, according to the release.

Patience required

Roberts identified two distinct risks – one associated with the merger with E*Trade, the other with the market cycle in general.

“The problem with the merger for Morgan Stanley is that it’s not going to be earnings accretive immediately,” he said.

“The acquisition process takes time and you’re only going to see the benefits long-term.

“E*Trade is driven by trading revenues, and if we have a downturn it will impact the bottom line.

“Two years is probably how long it will take for the acquisition and consolidation to take hold. Whoever bought this note needed to hedge that risk. That’s what the structure is designed to do for the next 24 months.

“It’s interesting from that standpoint. The deal struck at the time the merger was announced.”

A second risk associated with the notes was simply the current market environment.

“The problem I have for a two-year investment is that we’re so late in the cycle... 11 years into a bull market, it’s likely that we’ll have a pullback in the next two years,” he said.

Shifting business model

Another financial adviser said he liked the structure of the notes but usually avoids products tied to a single stock.

“It’s interesting. They just announced the deal today. At first, I wasn’t really sure why they’re buying E*Trade,” said Steve Doucette, financial adviser at Proctor Financial.

“But E*Trade has a decent RIA platform,” he added referring to registered investment advisers.

“It’s probably a good thing for their wealth management franchise.

“Here is a brokerage firm moving to the fee-based type of account. It’s a step in the right direction.

“There’s an awful lot of people leaving the wirehouses to go independent.

“The fee-based model is the one that’s growing right now.”

Even if the stock is slightly down right now, the takeover may yield positive results over time, he said.

Morgan Stanley stressed the expected benefits in its release. The bank expects to be a leader in wealth management across all channels as a result of the acquisition. Both platforms combined will have $3.1 trillion client assets, 8.2 million retail client relationships and accounts, and 4.6 million stock plan participants, according to the bank’s news release.

Terms, company risk

“The terms of the notes are pretty impressive,” said Doucette.

“You’re collecting an 11.3% return.

“There’s a pretty significant range of absolute return to capture if the stock doesn’t go down more than 25%.

“The 25% barrier is quite good in and of itself.

“But I’m not sure how much I would want to play on a single stock.”

Morgan Stanley’s performance over the past year has outpaced its peers at the exception of JPMorgan.

But in general, Doucette prefers to avoid risks associated with one company.

“If I’m going to bet on the sector, I’d rather be in an ETF. If you’re exposed to a single stock, you never know what can happen especially with mergers and stuff like that,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

UBS Financial Services Inc. and JPMorgan Financial and JPMorgan Chase & Co. are the agents.

The notes settled on Wednesday.

The Cusip is 48132J280.

The fee is 1.5%.

© 2015 Prospect News.
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