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ETN Market Primed for Disaster

From London's Canary Wharf to Paris' La Defense and back to Wall Street is a colorful history of financial products which are marketed as 'safe' that turn out to have the same level of risk as a slot machine gamble.

We've seen the ugly results with collateralized debt obligations (CDOs) that were supposedly backed by the collateral of 'rock solid assets' behind them. We've also witnessed the same blowup with auction rate securities (ARS), which offered a better yield than money market funds, but with the same level of risk, allegedly. In both cases, the money invested in CDOs and ARS got nuclear bombed.

Now more than ever the $16 billion market in U.S. listed exchange-traded notes (ETNs) bears striking resemblance to these historical disasters. Is the ETN market primed for catastrophe?

ETNs are not ETFs

While ETNs and exchange-traded funds (ETFs) are sometimes grouped together, or worse, confused as the same thing, they are not.

Unlike traditional ETFs, exchange-traded notes are debt obligations backed by the financial or banking institution that issues them. ETNs pay a return linked to the performance of a single security or index. Who pays the return? The financial issuer backing the note.

ETNs can track a variety of assets from commodities (NYSEArca: DJP), to the VIX Index (NYSEArca: VXX) and Indian stocks (NYSEArca: INP). ETNs are also used as day trading instruments for those that want leveraged long exposure (NYSEArca: DGP) or leveraged short (NYSEArca: DZZ) to gold or other assets.

Investors that choose to keep their ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. The annual fees deducted reduce the value of the payment. Maturity periods can vary and may be as long as 30 years. ETN investors that don't want to hold their note to maturity can sell it prior to maturity on the exchange where they trade.

Domestic Implications

Europe's financial crisis (NYSEArca: VGK) has major domestic implications because the U.S. ETN marketplace is heavily composed of products issued by European banks. Here's what ETFguide told its newsletter subscribers:

'From the very beginning of Europe's crisis, its leading voices (from Europe's Central Bank to its heads of state) have been consistent in one regard: They've continually underestimated the severity of the crisis each step of the way. They were wrong about Greece, Ireland and Portugal not needing bailouts - and they were badly wrong on the actual size of the bailout required. Is there any reason to believe they'll be wrong (again) about the alleged soundness of Europe's banking system?'

Which of Europe's banks are illiquid, overleveraged or on the verge of bankruptcy? Is it Britain's Barclays ( BCS )? Is it Germany's Deutsche Bank ( DB )? Is it Switzerland's UBS ( UBS )? Or is it someone else?

Indecent Exposure

The specter of Greece reneging on its debt obligations is public knowledge, the looming ramifications are largely unknown. How large are the liabilities and what would a Greece default mean for Europe's banking system?

The top three banks in France (BNP, Societe Generale and Credit Agricole) hold almost $57 billion in Greek sovereign and private debt. The largest German banks hold roughly $34 billion while British banks hold around $15 billion. While banks from these countries could probably absorb losses tied to a Greek default, would they be able to survive any other major losses?

Beyond Greek debt, French banks hold another $549 billion in Italian debt and $192 billion in Spanish debt, according to data from the Bank for International Settlements. It's doubtful Europe's banking system could absorb losses of that magnitude without outside help.

Other Threats to Europe's Banking System

Exposure to rotten sovereign debt isn't the only problem for European financial institutions. The entire banking sector faces a wave of bureaucratic oversight along with the possibility of nationalization.

For U.K.-based banks, higher capital requirements and invasive regulation are serious threat.

The Independent Commission on Banking (ICB), a nongovernmental panel, just recommended that U.K. banks hold at least 10% core equity against their assets as a financial buffer. Not only would the new requirements be more restrictive compared to non-U.K. based banks, but the estimated cost is a steep $11 billion annually for the U.K. banking industry. According to some estimates, higher capital requirements might cut bank earnings between 15% and 25%. Will Britain's banking regulators implement the ICB's recommendations? If so, it would be more bad news for Royal Bank of Scotland Group ( RBS ), Barclays, and HSBC Holdings ( HBC ).

Don't be a Victim, History is Repeating Itself

WhichETNs are at the greatest risk of loss because of Europe's financial crisis? The September ETF Profit Strategy Newsletter outlined who the top ETN providers are, which ones to avoid and a protection strategy for navigating the storm.

During the 2008-09 Financial Crisis, the ETNs issued by Lehman Brothers got clobbered and eventually became worthless. Today, the $16 billion market for ETNs in the U.S. is much larger than it was three years ago, which means one thing: This time around, the same ETN blowup that's on the verge of occurring will much larger in scale and much uglier .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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