Three Banks’ Too-Big-to-Fall Plans Hamper ETN Sales

At least three major U.S. banks trying to show they’re not too big to fail said they stopped issuing very short-term debt, halting growth in their exchange-traded note programs in a way that may put investors at risk of losses.

Morgan Stanley, Citigroup Inc. and Goldman Sachs Group Inc. aren’t issuing new shares of their ETNs, which count as short-term debt because holders can typically redeem them on about a week’s notice, according to “living wills” submitted to the Federal Deposit Insurance Corp. and the Federal Reserve last month, details of which were released Monday. Existing shares will continue to trade.

When issuers stop creating new shares of their ETNs, their market prices can deviate significantly from their calculated value as buyers emerge. Investors who buy the ETN at a premium can lose their money once the price drops back into line with its indicative value.

“It’s almost instantaneous,” said Dave Nadig, director of exchange-traded funds for FactSet Research Systems Inc. “Once a fund closes creations, any amount of buying pressure will send it to a significant premium. We have seen this over and over again.”

A note issued by Credit Suisse Group AG that’s used to bet on volatility, called TVIX, surged to a premium of as much as 89 percent in 2012 after the bank stopped creating new shares. It then dropped 50 percent over two days. The Financial Industry Regulatory Authority warned investors later that year to be on the lookout for significant deviations.

Capital Clean-Up

The largest lenders are trying to clean up the capital structures of their parent companies in response to prodding by regulators. They’re being asked to provide convincing plans that they can be dismantled in the event of a bankruptcy without disrupting the broader financial markets.

“Short-term debt may be prone to runs in a stress situation which can then actually worsen the situation and precipitate the failure of the institution,” said John Simonson, a partner in PricewaterhouseCoopers LLP’s financial services regulatory practice and former deputy director for systemic resolution planning at the FDIC.

Any debt would be considered short-term for the purposes of living wills if a holder can make a immediate demand for redemption, according to Simonson. Exchange-traded notes -- structured products issued by banks that mimic the performance of assets such as natural gas or carbon credits -- generally have such a feature.

Loss Absorbing

Banks with more than $50 billion in assets must periodically file living wills. Last August, regulators questioned the credibility of earlier filings and told banks to improve their plans.

Restricting the ability to issue short-term debt could put a damper on the growth of the ETN market, where investors often use the products to access illiquid assets that are otherwise out of reach, said FactSet’s Nadig.

The appeal of ETNs may also be waning for issuers because of rules that the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, is writing to ensure lenders have enough capital to withstand a default. The required buffers, known as “total loss-absorbing capacity,” currently don’t count debt with maturities of less than a year as eligible to absorb losses.

ETNs have grown to a $26.3 billion market in the U.S. Citigroup’s notes have amassed $266.6 million in assets, while Morgan Stanley’s securities have $166.7 million. The products still make up a sliver of a bank’s funding: Goldman Sachs’s $163.9 million of U.S. ETNs are less than a 0.1 percent of its $182 billion in total bond debt, Bloomberg data show.

Akhilesh Raina, a spokesman for Morgan Stanley; Scott Helfman, a spokesman for Citigroup; and Tiffany Galvin, a spokeswoman for Goldman Sachs, declined to comment.

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