Nightmares on ETN Street: When Issuers Go Bust

As you probably know, ETNs are debt obligations of someone, usually a bank. Apparently Lehman Brothers (LEH) backed a few of them under the brand name Opta (e.g. RAW, PPE, EOH). Now their fate seems to be in question because Lehman Brothers went under.

For purposes of this post it does not matter what the Opta ETNs tracked or whether Barclays (BCS) makes good or not. If you are interested in that part of it, both Index Universe and Tom Lydon are all over it.

I wrote about several ETNs for theStreet.com about certain funds that I thought were interesting. A typical disclaimer I put in those articles was that it is unlikely that an issuer would go under (despite what has happened, that is still a true statement) but that it would not be a good idea to own a bunch of ETNs from the same issuer.

If you have 2-3% in one ETN provider and it goes under, you will not have sabotaged your financial future. It would be a drag on returns, of course, but would not trigger a "honey we have to talk" conversation.

ETNs have the potential for unintended consequences; for example: There are two products that track the Chinese yuan; one from Market Vectors (CNY), which is an ETN, and one from WisdomTree (CYB), which is an ETF. The issuer for CNY is Morgan Stanley (MS). On September 16, CNY had a bit of a freakout as it may have traded more or less in line with MS debt as opposed to the yuan, and CNY was down 5.8%. It snapped back the next day ,but still someone sold at the lows.

Of course if MS had gone under the next day then the low on the 16th would have looked pretty good and obviously on the 16th the market was worried about something. That this happened once means it can happen again. As past crises have shown us, anyone can fail. The current crisis has supported that notion and then some.

I think where there is a choice you're probably better off with the ETF, and if you are going to use ETNs, keep your issuer risk small. In addition to Barclays having a lot of commodity ETNs, so does UBS. The UBS method is a little different, and of course the back test is superior, but their is overlap such that you could access a couple of different parts of the commodity complex and keep the issuer risk in check.

Comments

[Chris B:]

At a time when currency and commodity diversification are among investors' top concerns, we realize that we are paying fees and getting counterparty risk in return.

2008 Sep 25 03:42 PM

[atlasapple:]

Does this mean that ETF's have less counter-party risk or no counter-party risk?

I own a lot of Proshares and was wondering who backs them up?

2008 Sep 25 05:43 PM

[Reinko:]

To be honest, I never heard in my life from ETNs.

Rather likely they are only Extra Terrestial Nono's.

Just one of those risk pumping around things and after that not expect the whole planet to blow up because 'we have world reserve status'.

Why does the article not explain what a ETN is and why it should be a valuable contribution to world finance?
Has Buffet also ETN stuff and if so, why does he?

2008 Sep 25 05:59 PM

[SA Editor M...:]

Reinko,
ETFs are exchange-traded funds; ETNs are exchange-traded notes.

2008 Sep 25 06:42 PM

[mangy cat:]

"Apparently Lehman Brothers (LEH) backed a few of them under the brand name Opta"
why "apparently"? they did issue them as their indexed debt, not backed them

2008 Sep 25 06:57 PM

[bearfund:]

The really remarkable thing is that there are gold and silver ETNs. The price action there should be fascinating.

2008 Sep 26 03:15 AM

[searcher:]

The only reason (dubious at that) for an ETN is if it gives you desired exposure to a sector not otherwise available solely through the equity risk, or a less desirable synthetic scheme (which involves a more remote counterparty risk).

2008 Sep 26 12:07 PM

[Georgey:]

I use everbank yuan account and hopefully that removes most of the risk with fdic ins.

2008 Sep 29 12:46 PM