Here's a good target for financial regulation: leveraged ETNs
So I was going over my currently-meager distribution for my retirement account today and I saw something that scared the hell out of me: UBS is offering leveraged ETNs.
If you're not a geek, that may mean nothing to you, but this seems like a horrible idea and I want to explain why.
The most basic kind of investing would be if I took the money I was setting aside for retirement and used it to buy stuff that I think will become more valuable over time in one way or another. Say, a stock that I think will either go up in price or reliably pay a dividend. Or a bond from a company a trust to remain solvent. (Or art, or real estate, or...)
A mutual fund ("fund", hereafter) makes that a bit more abstract. A fund manager buys a whole bunch of stuff he thinks is going to become more valuable over time in one way or another, and then people buy little pieces of that fund from him. So, I own a little piece of whatever underlying assets the fund manager has bought, I take on the risks of those assets, and I get the profits from those assets, minus the manager's fees. It's true that I could in theory get higher returns by simply buying the underlying assets, but the manager (a) is probably better at picking them than I am and (b) has economies of scale that I don't (he's using tens of millions of dollars rather than thousands).
Funds are subject to what's called "volatility risk". If I invest in a fund that's got a lot of real estate in it, and real estate values fall, the value of my fund falls. But they do not have what's called "credit risk" -- even if my manager goes bankrupt, the underlying assets in my fund are still mine.
Now, originally funds were sold only by brokers (think Charles Schwab, etc.) to their customers, but somebody had the bright idea back in the 1990s of putting funds on an exchange like stocks. These are called exchange traded funds (ETFs). This hasn't particularly caused any problems, and is probably a good thing. Really small fish like me saving for retirement can buy shares in funds which offer me diversity that I could never get on my own. I still own the underlying assets, I still don't lose them if the fund manager goes belly-up -- worst case, they just liquidate all the assets and I get that money. Because they're sold on an exchange and their contents are publicly available, the price pretty much stays really close to the price of the underlying assets (for all of the problems that arbitrage trading causes, that is one nice service it provides). So, more complex, but still not an awful thing.
Now, in the early 2000s somebody had a new idea: the exchange-traded note (ETN). In an ETN, a bank "pretends" to be a mutual fund, and issues a "note" promising to pay what a mutual fund would pay if the bank were one. In practice, these have tended to operate just like mutual funds: the bank buys the underlying assets and essentially passes the dividends through to the investors minus a fee (which tends to be smaller than for mutual funds, both because of tax and administrative reasons -- it costs less for the bank to not have to keep track of who owns what piece of what asset). So ETNs offer a slightly higher return than ETFs, at the cost of an additional risk. The volatility risk remains the same, but now there is the credit risk of the issuing bank, too. If the bank goes bankrupt, I don't own the underlying asset and I'm just in line with all of the other creditors, because the ETN is just a piece of debt. People who owned Lehmen Brothers ETNs were told to go pound sand. (There's a third risk, a "call risk", but that doesn't actually matter very much -- it just means that the bank can decide to liquidate the note at any time, which would mean paying me cash equal to its market value.) (Also -- sorry for all the parentheses -- notes theoretically have a termination date, but in practice they'll presumably just be replaced with an identical note.)
So, higher risk, higher yield; whatever. The problem here is that now some banks are getting tricky. A fund, legally, cannot leverage -- it cannot borrow money to buy the assets. It has to buy them outright and then sell a little piece of them to me. This regulation is both consumer protection (that greatly increases the risk) and just legal principle: the debt would be "mine" at that point, and a manager can't take on debt in my name. (I can borrow money to invest in a mutual fund, though that would be stupid, but the stuff the fund itself buys has to be with cash at the time.) But a note has no such limitation. In fact, since the bank doesn't have to actually say what's "behind" a note, there's no real way of knowing what it's using to get the money. But the bank is legally free to take on as much leverage as it wants to meet the payment schedule of the ETN. And some now are.
This is pretty clearly just a clever attempt to get around the law that prevents leverage in mutual funds. The notes quack and waddle like a fund (we're talking about "too big to fail" issuers here, so the credit risk isn't really something you can put a quantifiable value on, since if DeutscheBank or UBS fail there's probably not much left standing in the world anyways), but they are using leverage that funds cannot use for very good reasons. I'd really like the CFPB to stop this.
