Shareholders in exchange-traded notes or ETNs have put
themselves in the middle of an uncontrollable hurricane and many of
them don't even know it.
Do you own ETNs?
Let's analyze reasons why the ETN market is brewing for a
meltdown.
Miscalculating Risk
ETNs are unsecured debt obligations issued by banks and the ability
of an ETN to successfully execute its prospectus stated investment
strategy hinges on the ability of its sponsor to stay out of
trouble. And as history shows, banks aren't very good at staying
out of trouble.
Are global banks over-leveraged? Are they any good at managing
risk? The press releases tell us that everything is OK, but don't
believe them.
JPMorgan Chase & Co. (
JPM
) just announced a cap on new share issuance for its Alerian MLP
Index ETN (NYSEArca: AMJ). Why?
Clearly, JPM's ETN announcement is the bank's preemptive
reaction to lowering its swap exposure. Even so, JPM's exposure is
off the charts. The U.S. Office of the Comptroller of the Currency
(
OCC
) estimated late last year that JPMorgan had $70 trillion in global
OTC derivatives exposure.
Lack of Transparency
Accurately measuring an ETN's true credit risk is nearly impossible
because of the banking industry's opaqueness.
Just one example is the repo market, which involves the
exchanging of cash and securities between banks, financial
institutions, hedge funds, etc.
Sometimes these transactions are "triparty" and go through a
custody bank. At other times, the parties deal directly with each
other via "bilateral" agreements.
What's the size of the total repo market? Estimates have ranged
from $2-10 trillion, but nobody can be certain. Even financial
regulators and the Federal Reserve Bank have no clear picture about
the repo market's size. Putting money into an ETN puts the
shareholder at risk to these unknowns.
Credit Risk
ETNs, unlike
ETFs
, carry the added dimension of credit risk. If the ETN issuer
becomes insolvent or goes bankrupt, the investor can lose their
entire investment. Likewise, the money invested in ETNs gives
issuers a cheap source of capital since they don't have to pay note
holders for assuming credit risk. It's a bad deal for ETN
shareholders.
Deutsche Bank (
DB
) is among the largest ETN issuers and the bank has a funding gap
of almost $18 billion at its Italian and Spanish units alone,
according to estimates.
This is significant from two angles. First, it shows Europe's
distressed and diseased banking system has spread directly to its
savior - Germany. Second, it highlights the acute danger of
investing in credit backed products like ETNs issued by DB and
others.
Five of the six largest ETN providers are European institutions
and the only one that's not (JP Morgan Chase) doesn't know the
difference between gambling and hedging.
Conclusion
Just months before the VelocityShares Daily 2X VIX Short-Term ETN
(NYSEArca: TVIX) and the iPath DJ-UBS Natural Gas ETN (NYSEArca:
GAZ) imploded because of operational snags, the December 2011 issue
of the
ETF
Profit Strategy Newsletter
warned against these products in a feature story titled "Which ETNs
Will Blow up First?" The just released July 2012 edition
provides an updated status on the ETN market.
Today, there's roughly $16 billion parked in U.S. listed ETNs,
which is almost double the amount that was invested in ETNs in
2010. People have piled into ETNs linked to volatility (NYSEArca:
XIV), Indian stocks (NYSEArca: INP), and gold (NYSEArca: DGP).
The ETF Profit Strategy Newsletter outlines pitfalls in the
overcrowded ETP market along with profit opportunities for
investors. It gives clear-cut analysis and propaganda-free facts.
