Lehman Meltdown Raises ETN Questions

September 12, 2008

What is the risk to the Opta ETNs if Lehman goes bankrupt? And what is the credit default swap market saying about Lehman's prospects?

With Lehman Brothers fighting to stave off bankruptcy, shareholders of the once-mighty investment bank aren't the only ones facing possible big losses.

Those owning exchange-traded notes issued by the firm could face a tough time getting out of their investments at fair market value if things take a dramatic turn for the worse. The chance may be very small, but it points toward the types of risks ETN shareholders accept as debt holders.

Debt Notes

Lehman has a trio of ETNs operating under the "Opta" brand name. ETNs, of course, are debt instruments. Unlike exchange-traded funds, which represent actual share holdings, ETNs are backed only by the credit of the issuing bank. So if Lehman were to go bankrupt and no "white knight" swooped in to pick up the pieces, ETN shareholders would join the list of creditors making a claim on the company.

Proponents of ETNs note that shareholders have two important "outs" that limit their credit risk in holding ETNs:

1) They can sell notes on the open market at any time.

2) Institutional investors can redeem notes for full market value directly from the issuing bank on a daily basis. 

The two "outs" are intertwined, of course, because it is precisely the fact that institutional investors can get full market value that keeps the notes trading close to their fair market value in the stock market.

There's talk today that Lehman won't make it through the weekend as an independent company. Many expect it will be either sold or go bankrupt, and the question of whether the Fed would bail out another firm is up for debate. If it is sold, the backing of the notes would be protected; if it goes bankrupt with no bailout, the pain could be very real.

Such a scenario leads to a wrinkle in the critical ETN redemption policy. According to the notes' prospectus, investors can redeem shares of Opta ETNs at fair market value, but a one-day lag is built into the process. And according to the offering, for institutions to redeem at fair market value, a request must be sent by the broker/agent no later than the business day prior to the desired valuation date for redemption. Specifically, Lehman says that the notice must be received via email no later than 11:00 a.m. Eastern time on or prior to the notice deadline date.

That would seem to indicate that if an Opta investor wanted fair market value at the close of trading today, they had to put in their notices for redemption at 11:00 a.m. on Thursday. If you put in a notice by 11:00 a.m. today, you're not redeeming until Monday night.

Lehman Brothers didn't return calls asking to verify this arrangement.

So how real is the Lehman risk? The price for five-year credit default swaps on Lehman debt jumped to a record 6.1% on Thursday, meaning it costs $610,000 annually to insure a $10 million investment in the company's debt against default, according to a Bloomberg report. (It credited the data to broker Phoenix Partners Group.)

Lehman shares were down 13% as of 11:00 a.m., trading at $3.74/share, and have fallen 94% over the past six months. The company reported a third-quarter loss of $3.9 billion on Thursday. It's planning to turn around the company's fortunes, in part, by selling off most of its lucrative asset management arm and other noncore holdings. But whether or not it will achieve that remains to be seen.

"This is the problem with ETNs—you're taking on the duel risk of both the investment as well as the creditworthiness of the issuer," said William Koehler, chief investment officer at ETF Portfolio Solutions. "That's why if there's an exchange-traded fund in the same area, we prefer to go that route."

As yet, managers at the investment house haven't invested in ETNs for their clients. "This ongoing Lehman Brothers situation is a classic example of the risk in ETNs," Koehler said.

The banker's ETNs currently on the market include:

  • The Opta Lehman Brothers Commodity Pure Beta Total Return ETN (AMEX: RAW). It's designed to track the performance of the LBCI Pure Beta Total Return Index, a diversified commodities index. The ETN provides exposure to energy, metals, agriculture and livestock. Those are considered the four main segments of the raw materials market. It has a market-cap size of about $4.8 million, according to Lehman Bros.
  • The Opta Lehman Brothers Commodity Pure Beta Agriculture Total Return ETN (AMEX: EOH). It tracks the LBCI Agriculture Pure Beta Total Return Index, which covers grains (corn, soybean meal, soybean oil, soybeans and wheat) and softs (coffee, cotton and sugar). It has a market cap of about $4.4 million.
  • The Opta S&P Listed Private Equity Net Return ETN (NYSE Arca: PPE). Its 30-component index follows listed private equity companies. It has a market cap of around $4.3 million.

By Friday afternoon, there had been little actively in the lightly held Opta ETNs, indicating no rush to the exits. The shares continue to trade quite close to the underlying value of their indexes, as well. That has some veteran market trackers expressing the hope that concern about Lehman's dire financial condition has somewhat exaggerated.

"The likelihood that they'll collapse still remains pretty thin," said Kevin McPartland, a senior analyst at the TABB Group. "At least a portion of the Wall Street trading community is holding to the belief that Lehman's is just too big to fail."

Whether such a fiasco happens or not, Koehler maintains that it's worth continuing to monitor the CDS market as a means to track the underlying creditworthiness of ETNs. He believes that CDS pricing can act like a "real-time rating by the market" on the credit quality of an ETN's issuer. That's due to the fact that as risk perceptions by institutional investors most intimately tracking the financial stability of their holdings rise, so do the costs of taking out such private insurance contracts.

So does McPartland, who observes that while CDS prices have jumped to historic levels lately, sellers of such protection are still making a nice profit. "It's definitely a more risky situation, but they're still finding buyers willing to take on that risk at this point," McPartland said.





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