From the October 2011 issue of Research Magazine • Subscribe!

Are Europe’s Bank Notes Safe?

Firmly established in Wall Street’s rich history are financial products which are sold as “safe” that turn out to carry risk reminiscent of a slot machine gamble.

We’ve seen this sinister phenomenon with collateralized debt obligations (CDOs) that were supposedly backed by the collateral of “rock solid assets” behind them. We’ve also witnessed the same sales pitch 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 zapped. Is this about happen to bank sponsored exchange-traded notes (ETNs)?

ETNs, unlike traditional ETFs, are debt obligations that rely on the financial soundness of the banking institutions backing them. And when the financial liquidity or solvency of an ETN’s sponsor comes into question, the note’s performance can track the bank’s corporate debt instead of the note’s intended benchmark. Even worse, the note can become worthless if the financial institution declares bankruptcy. Why is this important?

From the very beginning of Europe’s crisis circa late 2009, the continent’s 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 about the alleged soundness of Europe’s banking system?

Large sponsors of U.S.-listed ETNs include Britain’s Barclays Bank (iPath), Germany’s Deutsche Bank (PowerShares DB) and Switzerland’s UBS (E-TRACS). These particular banks find themselves in the middle of a firestorm and this is no time to be experimenting with client money.

Four of the top five U.S. ETN providers are based in Europe and the simple fact is European banks are probably undercapitalized which means another 2008-styled ETN blowup could be upon us. The only reason the $1 billion or so lost in Lehman Brothers’ ETNs had trouble making news headlines was because the amount at stake was less staggering than the other multi-billion dollar sums that got bombed.

To avoid these acute credit risks, I think advisors should stick with traditional ETFs, which already provide the necessary exposure to major asset classes to build diversified investment portfolios.

At the end of July, there was $16.01 billion invested in 172 U.S. listed ETNs and it could turn out to be $16 billion too much.

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