When is the last time you took out a loan? Chances are the application process required tons of paperwork and financial disclosures on your part. If the loan was for the purpose of buying something, such as a car or home, then you also had to hand over that purchase as collateral to "secure" the loan.
Banks make you jump through many hoops before they lend you any money, and then they want something in return-guaranteed monthly payments plus interest, and the ability to repossess the object of the loan as a way to enforce that guarantee.
What happens when the roles are reversed? If a bank wants to borrow money from you, do you put the bank through a similar wringer? If you are one of the thousands of people that have lent money to a bank by purchasing one of its ETNs, then the answer is probably no. Let me explain.
Exchange-traded funds ("ETFs") and exchange-traded notes ("ETNs") are similar in many ways, but they have major differences as well. When you buy an ETF, you receive an ownership stake in a pooled investment, structured as an independent entity. However, when you buy an ETN, you are lending your money to the issuer. All you own is an IOU, and the identity of "I" and "U" may not be entirely clear.
Although often glossed over, the offering prospectus for ETNs typically state that it is an unsecured debt obligation of the issuing bank. The issuer will often include the word "senior" in that disclosure to make you feel better, but it is not something that will help you much in the case of default. In other words, ETNs are a "promise" to repay the money borrowed, but ETNs do not own anything, are not collateralized, and are not segregated from other debts and obligations of the borrowing bank.
If this sounds different from ETFs and mutual funds, you are correct. ETFs and mutual funds are fully collateralized stand-alone entities, independent of the sponsor, issuer, and manager. If one of the previously mentioned parties goes out of business, through bankruptcy or more graceful terms, then another company can step in and take its place. The fund itself is not affected.
Therefore, when you buy an ETN, you are lending money to the issuing bank without any collateral. Another important but often overlooked point is that the issuer may be different from the ETN's sponsor and may not be identified in the product's name. Therefore, it may not be obvious who or what you are lending your money to.
Occasionally, identifying the issuer is a straightforward process: Morgan Stanley (NYSE:MS) issues the Morgan Stanley brand of ETNs, and Deutsche Bank (NYSE:DB) issues the DB ETNs. Some firms use brand names. iPath ETNs are from Barclays (NYSE:BCS) and ETRACS are issued by UBS (NYSE:UBS). Some banks issue ETNs under multiple brands. For example, Credit Suisse (NYSE:CS) issues ETNs under the Credit Suisse name, its own CS X-Links brand, the ELEMENTS brand, and as VelocityShares.
If that is not confusing enough, some brands are used by multiple issuing banks. For example, ETNs issued by Credit Suisse, Deutsche Bank, Swedish Export Credit, and HSBC have all come to market under the ELEMENTS brand. Credit Suisse issues most of the ETNs under the VelocityShares brand, but some are issued by Citigroup, and these are separate from Citigroups's own C-Tracks brand of ETNs.
Once upon a time, all these banks were considered too big to fail. All that changed in 2008 when Lehman Brothers declared bankruptcy and the owners of the Opta brand of ETNs it had issued were left holding the bag. Last year, the financial viability of Deutsche Bank came into question, putting a dark cloud over its ETNs. In November, Credit Suisse started taking successful products off the market in an apparent attempt to shore up its balance sheet. If you are lending money to Credit Suisse, then that should make you nervous.
Before you buy an ETN, you need to do a few things: Know who the issuing bank is. Have a plan to monitor the credit worthiness of the bank. Have an exit plan if the bank's debts are under scrutiny. Have an exit plan if the ETN does not perform as expected. Execute your plan.
Disclosure: At the time of this writing, author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned