The Lehman Bros. ETN Fallout

September 13, 2018

Ten years ago this Saturday, Lehman Brothers collapsed in what was, and still is, the biggest bankruptcy in history.

Among many other things, the bankruptcy left in limbo Lehman's three exchange-traded notes (ETNs): the Opta Lehman Brothers Commodity Index (LBCI) Agriculture Pure Beta Total Return Index ETN (EOH); the Opta S&P Private Equity Index Net Return ETN (PPE); and the Opta LBCI Pure Beta Total Return Index ETN (RAW).

EOH, PPE and RAW were never investor darlings. Between the three of them, they only had $13.5 million in assets under management when Lehman filed for bankruptcy.

But investors who didn't get out when they could have spent more than a decade recovering just a fraction of their money, in a process that is still ongoing. As such, Lehman's ETNs—and their investors—have ended up a cautionary tale, one that has forever changed the once-promising growth prospects of the exchange-traded note.

What Is An ETN?

Though often lumped together, ETFs and ETNs are not the same instruments. Whereas an exchange-traded fund holds a basket of securities—stocks, bonds, futures, you name it—an exchange-traded note holds nothing.

Technically, an ETN is an unsecured debt obligation—an uncollateralized loan on your part to the issuing bank. In exchange, the bank promises to track the performance of a given index, less management fees. If the bank suddenly becomes unable to meet that promise, however, investors have little recourse to get their money back.

That's exactly what happened in the case of Lehman Brothers.

Few Warning Signs Before Collapse

In February 2008, seven months before Lehman declared bankruptcy, the investment bank launched its three Opta brand ETNs.

Even from the start, the notes struggled to accrue assets: As of Sept. 12, the Friday before the bankruptcy filing, the ETNs had gathered just $13.5 million in assets. Most of that was likely seed capital.

Though rumblings of trouble had plagued Lehman for months prior to its bankruptcy filings, few of those warning signs had emerged in the trading of RAW, EOH and PPE, which had actually proceeded fairly smoothly. The three notes carried a relatively low average trading premium to net asset value (NAV) of 0.28%; the largest, RAW, had just a 0.09% trading premium over the seven months prior to its closure (source).

Not only that, Lehman Brothers boasted stellar credit ratings with all three major ratings agencies right up to its Sept. 16 bankruptcy. Though widening spreads in credit default swaps had hinted at the trouble Lehman had found itself in, many investors either ignored or were unaware of those red flags, given Lehman's continued good standing with credit agencies.

Getting Out While You Could

Prior to Lehman's demise, investors in the Opta ETNs had the usual ways of unloading their shares: All investors could sell their notes on the open market, while particularly large institutional investors could redeem their notes for indicative value, directly with Lehman brothers.

But there was a catch. Like many ETPs, a lag was built into the Opta ETN redemption process. To file a redemption request, investors had to send a notice to Lehman no later than 11 a.m. ET on the business day before the day shares would be valued. They wouldn't have received their redemption money until the third business day after that.

This meant that, if an Opta ETN investor had wanted to redeem their shares and receive their cash before Lehman declared bankruptcy on Monday, Sept. 15, they ought to have done it no later than 11 a.m. on Monday, Sept. 8, a full week earlier.

But because the bankruptcy took many by surprise, few investors had done so. In fact, even up to the Friday before the bankruptcy, trading in the Opta ETNs remained light, with no perceivable rush to the exits (read: "Lehman Meltdown Raises ETN Questions").

After Lehman filed Chapter 11, trading in its ETNs was suspended two days later on the NYSE and three days later on the AMEX. Investors had lost their chance to get out.

Barclays No Savior For Opta ETNs

After the bust, EOH’s, PPE’s and RAW's remaining investors joined the long list of creditors making a claim on Lehman's assets—and they joined that line at the back, along with all the other holders of unsecured debt.

When Barclays PLC (BCS) purchased some of Lehman's business, including its investment banking and capital markets divisions, there was some optimism that the firm might shoulder Lehman's ETNs, too. After all, that was what happened when JPMorgan Chase & Co (JPM) purchased Bear Stearns in March; the bank had also taken on Bear's two exchange-traded products, the BearLinx Alerian MLP Select Index ETN (BSR) and the Bear Stearns Current Yield Fund (YYY) (more on those in a minute).

But in the terms of the buy-ut, Barclays—which had its own line of iPath ETNs—stated it wanted no part of Lehman's structured products, including its ETNs.

The Opta ETNs delisted Oct. 1, just over two weeks after Lehman declared bankruptcy. They were the first ETNs ever to close.

Did Investors Ever Get Their Money Back?

As holders of unsecured debt, investors in the Opta ETNs had few options to recover their money save the bankruptcy courts. And for a long time, nobody really knew when—or if—that would ever work.

It took more than four years of bankruptcy proceedings for Lehman to begin paying out claims to its "Class 3" creditors, or the holders of senior debt (which included the Opta ETNs). Those payments began in April 2012, and continue to this day.

According to the bankruptcy filings, over the course of the past six years, creditors for the Opta ETNs received a total of 44.5% of their total allowable claim. That comes to $2.14 million for RAW, $2 million for EOH and $1.85 million for PPE.

It's still a 55.5% loss on investment.

Different Ending For Bear Stearns's ETPs

Intriguingly, it didn't have to end this way. And in fact, in another high-profile insolvency, it didn't.

Bear Stearns, which nearly went bankrupt in March 2008, also had offered exchange-traded products, the aforementioned BSR and YYY. When J. P. Morgan bought Bear Stearns, they honored Bear's debt obligations, including that of BSR, and maintained trading in YYY for several months to come.

But eventually, J.P. Morgan closed these products, too. YYY, which was the industry's first actively managed ETF, folded in October 2008 after failing to attract much in the way of assets. (The ticker was later resurrected as the YieldShares High Income ETF, a fund still trading today.) Too much of Bear Stearns' thunder over the innovative product had been stolen by its bankruptcy troubles and by Invesco PowerShares, which had launched its own actively managed ETFs weeks later.

J.P. Morgan kept BSR trading for several more months, but it liked the concept of a master limited partnership ETN so much that it opened its own version, the J.P. Morgan Alerian MLP Index ETN (AMJ). AMJ was even based on the same index as BSR, and it remains popular with investors to this day, with $3.3 billion in assets under management, the second-largest of any MLP ETP.

As for BSR, it was delisted, but not liquidated, in June 2009.

Other Would-Be ETN Providers Pull Out

Until Lehman's collapse, ETNs had appeared to be a promising new growth area of the exchange-traded product market. 2008 saw a record pace for ETN launches; according to ETF Database, 59 ETNs had been issued that year—all before Sept. 15.

In the wake of Lehman's collapse, other would-be providers couldn't run from the ETN structure fast enough. Invesco PowerShares, for example, stepped away from plans to launch its own ETN suite the very same week it became obvious Barclays wouldn't bail out the Opta ETNs (read: "ETN Providers, Investors React With Prudence, Not Panic").

In the 15 months following Lehman's bust, only nine ETNs launched—one of which was AMJ, J.P. Morgan's BSR clone.

Investors, too, had become disillusioned with the exchange-traded note as an investment vehicle. Redemptions surged in the Market Vectors Chinese Renminbi/USD ETN (CNY) and the Market Vectors Indian Rupee/USD ETN (INR) in the weeks post-Lehman. Flows into the biggest notes, like the iPath Bloomberg Commodity Index Total Return ETN (DJP) lagged for months.

While eventually new issuers would tiptoe back to the ETN vehicle—Royal Bank of Scotland, VelocityShares, and even Invesco PowerShares launched their own notes—no new issuer would again launch the same breadth and diversity of products as Barclays or Deutsche Bank, the issuers who got in before Lehman's collapse.

Many of those who did launch ETNs post-Lehman eventually had to shut them down. For example, of the 64 ETNs launched in 2011, only 12 have survived to date.

ETNs: Not Dead Yet

That said, the exchange-traded note has found its uses. Whereas in Lehman's day ETNs were the preferred vehicle for commodity exposure, today they've found popularity among traders looking to make volatility and leveraged bets.

Yet the failure of the Opta ETNs continues to cast a pall over the ETN space. To date, the total assets invested in ETNs are only $22.4 billion—or just 0.61% of the $3.68 trillion invested in all ETFs.

Could we ever see a repeat of what occurred with the Opta ETNs? Maybe. Banks are more tightly regulated these days, but the same risks remain in ETNs as existed back in 2008. What was an unsecured debt obligation remains just that today. So it's possible, perhaps, but not likely.

Then again, Lehman's collapse was considered possible, but not likely as well.

Contact Lara Crigger at [email protected]

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