by ETFguide | June 20, 2012 10:00 am
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.
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 (NYSE:JPM) just announced a cap on new share issuance for its Alerian MLP Index ETN (NYSE: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.
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.
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 (NYSE: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 (JPMorgan) doesn’t know the difference between gambling and hedging.
Just months before the VelocityShares Daily 2X VIX Short-Term ETN (NYSE:TVIX) and the iPath DJ-UBS Natural Gas ETN (NYSE: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 (NYSE:XIV), Indian stocks (NYSE:INP), and gold (NYSE: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.
Source URL: http://investorplace.com/2012/06/etn-market-brewing-for-implosion-jpm-amj-db-tvix-gaz-xiv/
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